Acquisition Strategy for Cooper Industries’ Planned Acquisition of the Nicholson File

...

Current Situation

H.K. Porter Company, a firm that profits from buying many companies in the same sector as Cooper Industries, also has great interest in Nicholson. Taking a more aggressive route than Cooper’s, the company has already purchased 44,000 shares and has made an offer to purchase another 437,000 shares at $42 all in cash, providing it with a majority stake. Nicholson management firmly rejected the Porter offer due to the principal nature of Porter’s diverse business model. The company operated in a variety of broad markets and so there was fear that Nicholson would become a minimal and non-integral operating division, which is ultimately not in the interest of the Nicholson family. However, the $42 per share offer reflected a $12 premium over the current valuation, thereby sparking stockholder interest in pursuing a potential acquisition. It made sense for stockholders to be open-ears, Nicholson was underperforming as a company, and its market value was quite telling when compared with comparable firms. Upon rejecting the Nicholson offer, the company received a tender offer from VLN Corporation – also a broadly diversified company with major interests in areas such as, but not limited to: original and replacement automotive equipment, as well as in publishing. VLN put forth a preferred share-common share offer whereby the cumulative value of one convertible VLN preferred stock would be exchanged for one Nicholson stock. Mr. Nicholson anticipated for its net asset value to be approximately $53.10, albeit this estimate being met with scrutiny from Porter with specific reference to VLN’s poor performing stock. Thus, Porter Company sort of got caught in the winds in that it had accumulated a 177,000 share position in Nicholson, but had a very minimal chance of succeeding in its takeover attempt. As such, Porter valued the potential inclusion of Cooper in the deal, in that the value of Cooper common shares was perceived to be more valuable than VLN common shares. Thus, it was in the interest of Porter to strategically align with Cooper.

With possibility of reducing COGS, lowering administrative, selling and general expenses, and exposure to new markets, Nicholson File was still a very attractive investment for Cooper Industries. Specifically, Porter was firm that he would agree to tender his 177,000 shares to Cooper at a minimum per-share value of $50. As stated in the introductory stages of this report, Cooper Industries needed to own 292,000 shares of Nicholson common stock to constitute a majority ownership. Presently, it had owned 29,000, resulting it needing to tender 263,000 Nicholson shares. 177,000 of the 263,000 would be tendered from Nicholson at a price of $50/share, and the remaining 86,000 would need to either be tendered from Nicholson family, or other undecided stockholders.

In an attempt to a friendly acquisition, Cooper wants to assure the Nicholson family that they will not be cheated. The offer had to entice the majority of shareholders to agree, and obey the friendly acquisition at the same time. Mixed into all of this, Cooper had to make sure the offer made the company more valuable in the 5-year horizon. These three aspects were critical to the offer Cooper Industries was going to put forward. Additionally, Cooper wanted to refine and stabilize its EPS growth outlook over the next five years, and so the post-deal pro-forma projections for the company had to have been implicative of solid EPS growth as well. Let’s get into the financial analysis.

Financial Analysis

The first order of business was carrying out an intrinsic valuation of Cooper Industries’ stock pre-deal. Given Net Income & EPS forecasts for the next five years, we wanted to get a bit more accurate & specific when projecting out the company’s top-line earnings. As stated in the previous stages of the report, Cooper’s earnings have long been subject to market & economic conditions. In fact, over the past year (1970-1971), the company’s sales plummeted a staggering 8%, which was primarily due to the US economy going through the initial stages of a recession at the time amidst the incoming 1973 oil crisis. As such, we were able to find for 1971 inflation to be 4.3%, which we then used to hold constant as the yearly top-line growth rate. As shown in our model, key line items such as COGS, SG&A, and Depreciation were forecasted using % of Revenue, while we built out a schedule for the company’s expected depreciation over the next 5 years. Moving onto the DCF analysis for Cooper pre-deal, we were able to find the company’s beta from market research to be 1.19, with a risk-free rate of 6%, and market risk premium of 7%. This yielded a cost of equity of 14.330%. Cost of debt was computed as 8.82% by simply dividing the company’s 1971 long-term debt of $34mm by its 1971 interest expense of $3mm. As you will also see in our model, we additionally built out a schedule for the company’s debt, given that it expects to mature $19.5mm of its current outstanding debt over the next 4 years leading to 1975. Armed with this, we arrived at a WACC of 11.94%, yielding a present value of $25.85/share. Given that we found the company’s beta and affiliated risk free and MRP from in-depth market research, we also wanted to compute a best estimate for the company’s cost of equity given available information. As such, given the average share price of Cooper stock in 1971 being $28, and given a yearly growth rate of 4.3% & a dividend of ~$2, we were able to back out a cost of equity of 12.514%. This yielded a WACC of 10.58%, and a fair PV of $31.07 per share. In summary, our intrinsic DCF analysis indicates a fair value range of $25.85-$31.07, noticeably higher than the company’s recent closing price of $24.

The next step was to value Nicholson company to determine the maximum per-share value that Cooper Industries should pay for every Nicholson share. In a similar manner to how we projected out Cooper’s pro-forma income statement, we employed the following key assumptions: first, we took management’s estimate of a Cooper-Nicholson relationship allowing for Nicholson to elevate its current YOY sales growth rate to that of the industry’s (6%). Second, management believed for COGS as a % of Revenue to decrease from 69% to 65%. Lastly, management believed for SG&A as a % of Revenue to decrease from 22% to 19%. The apparent synergies make sense – Nicholson currently faced the issue of ballooning inventories, much of which likely accounted for unsold consumer-oriented hand-tool products, which only accounted for 25% of Nicholson’s business model, and understandably why it was likely having trouble selling the goods. As such, with Cooper’s 75%-consumer focused

...