CENAK Consulting - News and Views

Valuation - Art and Science

If we needed more evidence that valuation is as much an art as it is a science, we only need to look at the acquisition of Bear Stearns by JP Morgan.  The initial share price was set at USD2 per share.  A few days later, JP had to sweeten the offer to USD10 per share, a fivefold increase!  How can a company be valued five times as much within such a short period of time?  That's where the art factor comes into play.  This particular deal had many underlying forces, including some parties that really should stay out of the M&A business such as the Fed.  Bear Stearns had to agree to the USD2 offer that weekend if it didn't want to file for bankruptcy on Monday morning.  It also would have sent the financial markets into chaos.  So Bear Stearns' management agreed to the low offer because they had no other chance.  When in subsequent days the stock traded well above the USD2 mark, it send a clear signal that investors believed the offer to be too low, forcing JP to increase it significantly.  I am sure that if we had a chance to take a look at the cash flow models, that JP still predicts a very healthy return even at this price.  We do not know where the "make-or-break" value for JP is based on the cash flow models, but what we do know is that in this case, the science part of valuation clearly took a backseat to the art part.

Business Valuation Using Comparable Company Analysis - Part 2

Part 1 of our valuation series was an introduction to the multiple or comparable company analysis.  The first step to a meaningful analysis is to find a basket of publicly listed companies that can serve as comparable companies to the target company.  In this second part of our valuation series we'd like to talk about where the information and data for a comparable company analysis can be found.

In selecting sources for information, it is important to always favor the primary source over the secondary source.  For example, financial statements should always be taken directly from the company's SEC filings and not from secondary sources such as FactSet or Bloomberg.  These secondary sources often try to standardize their reporting system and it may not always be clear how certain financial items are being treated by these information providers.  However, it is always a good idea to double-check data with one or two of these service providers.

The following sources are most commonly used in the investment banking community for a comparable company analysis:

1. 10-K and 10-Q for financial data and footnotes.  These annual and quarterly reports can be found on the Edgar Archives of the SEC.
2. Real-time stock price data from services such as a Bloomberg terminal or FactSet.  These services are expensive, and other free online sources may provide a cheaper alternative.  However, Bloomberg and FactSet are excellent tools to double-check an analysis and should be preferred sources for stock price data.
3. Equity research reports from investment banks for financial forecasts.  These reports can be bought from services such as Thomson Financial's Investext.  They can cost up to USD30 or more per page to download, however they are important as forward-looking multiples are more significant than historic multiples.  Unlimited subscriptions can cost USD12,000 or more annually.  It is important to get recent reports that are not older than 6 months.  Equity research reports  typically get updated shortly after the companies report their quarterly data.

These are the most important sources to find financial information for companies.  International companies that do not report in the US typically publish their financial data on their websites.  Note that not all countries and exchanges require companies to report quarterly.  We will explain at a later time how to deal with inconsistent data and reporting.

Once the above information has been collected for the basket of comparable companies, the analyst can begin the calculation of the multiples.  In our next segment of the valuation series, we will talk about which multiples are typically used.  We will also talk about industry differences and specifics.

If you have any questions regarding the comparable company analysis, please do not hesitate to contact us at any time.

Happy New Year

A Happy New year to all of our readers, friends and clients.  There are a lot of exciting developments currently at our firm and we look forward to a very successful year 2008.  Current projects we are working on are several biofuel facilities in the US, sulphur fertilizer facilities in India and Dubai, a carbon offset project as well as an advisory project where CENAK advises a European company in the introduction of a new product on the North American market.

For all of these projects we have developed detailed financial valuation models and business plans.  As these projects develop further we will keep you informed about any progress here on our blog.

Have a successful new year and remember that the professionals at CENAK Consulting are there for you at any time to help you and your company with analytical, financial and business advisory services.  We look forward to working with you.

Business Plans - Part 1

The following quote from an article in the Wall Street Journal on 9 September 2003 pretty much sums up our thoughts on why every business should have a business plan:

"Years ago I was talking with a mentor about a start-up I was running. He asked to see my business plan  and I proudly told him that I didn't have one. Full of youthful arrogance I said, "I'm doing fine just by the seat of my pants." He replied, "If you think you're doing well using your bottom, imagine what you can do using your brain"

There are countless places on the web where business owners can get free advise on how to structure a business plan and what to write.  Where most business plans lack is when it comes to the financial implications of executing the business model that is presented in the business plan.  That is where we at CENAK Consulting come in and develop, together with the company and owner, a multi-year financial forecast based on the presented business plan and model.  These financial models can be used to test the business model under various conditions, which gives the business owner a much better understanding of the what-ifs of certain business decisions.  It frequently also results in changes to the underlying business model.  In this series about business plans we will write about experiences we've had with business plans that illustrate why it is so important to have one.

Rate Freeze

So government decided to step in and announce a program to help homeowners that entered into ARMs with a rate freeze.  This move has to be seen as a purely political maneuver considering the upcoming elections.  In our view, it is the wrong signal and it might prolong the workout process for the housing market.  Further, for all those people that made sure they understood what they signed and that they could actually pay their mortgages, this is a slap in the face.  If anything, the government should take an active role in educating people early on in school so that they understand how this market works.  21 year old college kids who never saved a dime are buying houses these days.  Most of them have no clue about how to manage personal finances.  Start there and tackle the problem at its roots, the lack of financial education. Don't intervene in the market.  That sends the wrong signal to the markets and the people who might get the idea that the government will bail them out again in the future. 

25 or 50 basis points?

After todays ADP employment data and other indicators the jury is still out if te Fed next week is going to lower the Fed rate by 25 or 50 basis points.  As of today, my prediction is 25 bps.  But then again, we are waiting for important employment data on Friday.  If there is a weakness in the data, 50 bps might be more likely.  We shall see, for now my money is on 25 bps. 

Black Friday and Cyber Monday - How to Really Save Money

The marketing departments of the retail industry have to be considered the masters of how to (mis-)use language to put a positive spin on what is really a negative event.  Consider this typical message that you see everywhere these days in some form or fashion:   

"LCD TV for only USD1,999.  Pay USD1,899 and save an additional USD100 if you buy this TV today".

What's wrong with this message, it looks awfully positive, you think?  Let's take a closer look.

Let's assume you buy this item today.  What really happens? 

First and foremost, you spend 1,899 bucks of your hard earned money!  But is that the message they want you to remember?  No.  The message they want you to remember is that you "saved" 100 bucks, not that you spend 1,899.

But, do you really "save"?  Only, if you actually go ahead and put what you "save" into savings!  That can be an interest-bearing savings account, your retirement account (which I hope you have), invest it in mutual funds or stock, etc.  Now, who really does that?  If my unscientific observations are any indication, pretty much no one. 

The next time you hear someone tell you that you save by buying an item, turn around and tell them that first and foremost you are spending a significant amount of money and not technically saving anything, unless you take that discount amount and stash it away somewhere where it earns you interest or capital gains.

It's the retail industry's positive spin that you save money, when in reality you are spending money.  Think a little bit about that before you hand the credit card over or press the "buy" button this Christmas season. 

Business Valuation Using Comparable Company Analysis - Part 1

One method to value a business (target) is the comparable company analysis (Compco) or multiple analysis.  We at CENAK use this method as one data point for company valuations in addition to cash flow models and other valuation approaches.  The Compco is typically not used as a stand alone valuation method.  Due to its relatively easy mechanics it is often used as a starting point or "back-of-the-envelope" method to get a general idea of a valuation range.  In this series we will describe this method over the next few days and weeks.

The quality of the results of a Compco depends highly on the quality of the input data.  In fact, the majority of the preparation time goes into making sure that the data used is consistent and applicable. The data needed for a Compco is:

• Target company's historic and projected financials (2 years forward)
• Comparable companies' historic and projected financials (2 years) as well as stock price and capital structure

The first and most important step in preparing a Compco is to identify publicly traded companies whose business model is similar to the company to be valued.  For example, if the target company is a producer of PCs, then companies such as Dell, Acer, Lenovo and HP could serve as comparable companies.  However, it can already be seen that there are differences even in this universe of comparable companies.  For example, Dell markets its products almost exclusively through its website while others market their products through other distribution channels as well such as retail stores.   HP produces other, higher margin products in addition to PCs such as printers.  Lenovo is traded on the Hong Kong stock exchange and Acer in Taiwan.  It is in the discretion of the analyst to adjust the analysis for these differences by taking into account different accounting treatments and general valuation differences between countries (country adjustment).  Further, certain companies may trade at a premium because they are considered "best in class", while others may trade at a discount to the average.  Some companies may have to be taken off the list because their valuation is based mainly on other product lines.  In our example, HP's data would only be of limited use because HP's core business is computer periphery such as printers.  HP's multiples should reflect this and be a blend of multiples of the different business segments.  IF HP were to spin off its PC business tomorrow, it would trade at a different (probably lower) multiple than the combined business today.  All of these factors will ultimately have to be considered in analyzing the final results.

Some industries may not lend themselves to the Compco due to the lack of comparable companies.  The more comparable companies can be identified the better, however as a bare minimum a basket of at least five companies should be evaluated.  If there are less than five or no comparable companies available at all, a close look should be taken at the underlying business model.  For example, if the target company is in the commodity business but there is no other public company in the exact same space, then it might be worth looking at other commodity businesses as a proxy for the target company, even though the underlying commodities between the target company and the comparable companies might be different. 

Compcos are of limited use if the target company is a start-up with no income or even revenues.  Compcos compare certain financial multiples of companies that are applied to revenues and certain earnings measures (more about that in part 2).  If there are no revenues yet it does not make sense to apply any multiples.  The same holds true for companies with negative earnings (losses).  As an example, Internet start-ups in the late 1990s often went public without having ever produced positive margins.  These companies were sometimes valued using revenue multiples only.  In the biotechnology arena, companies went public without having ever sold anything, making the preparation of a Compco meaningless.

Compcos can be prepared for parts of target companies if data is available for the division to be valued.  This is routinely done for companies that consider spinning off a division.  Conversely, divisions of comparable companies cannot be used for the analysis even if broken down financial information is available, because the stock price relates to the entire entity and reflects a blended value over all of the the company's divisions.

Despite these few limitations the Compco can be a very valuable tool for business valuations.  Most  businesses and industries today can be valued using this methodology.    

 

Once a basket of comparable companies has been identified, the next step is to collect financial data about these companies.   In part 2 of our series we will describe in more detail where the data can be found and how it needs to be adjusted for a meaningful analysis.

If you have any questions regarding the multiple analysis please contact us at any time.

The State of the US Air Traffic System

We are approaching the holiday season and with that increased air travel and congestion.  I think we all agree that there is a problem in the air traffic system in the US and it will need to be fixed soon.  Short term patches such as the suggested opening of military airspace can only be temporary and don't really solve the problem.  How can the problem be solved?

Before I try to give some answers let me point out that I used to be an Air Defense Controller in the German Air Force and know a thing or two about what's going on in air traffic.  But I also travel a lot for  business domestically as well as internationally, and I am as frustrated as everybody else out there.  Let me also say at this point that I believe in free capital markets with a minimum of government intervention.

Having said that, I do believe that the US air traffic needs government intervention.  It can clearly been seen that the airline industry is digging itself a hole in this unregulated market that is getting deeper and deeper.   Airlines have to make money and the the American consumer wants the cheapest fares.  The result is cut-throat competition, airlines in chapter 11 and a system that is stretched to the limits as personnel gets reduced while passenger numbers increase.  And don't get me started on service. 

The ultimate reason why the system is near collapsing is the consumer who wants cheap flights.  This has pushed the airlines into the position they are in today and not only has effects on service but also on the other parts of the system, meaning air traffic control and airports, and ultimately safety.  More and more flights get cramped into the rush hours of air traffic, especially in the afternoon, stretching the air traffic control system to the limits.  The last day when JFK does not show some sort of delays because of volume?  There might have been one in early 2006.  Maybe. 

The airline industry needs regulation, I am afraid.  What is going to happen without regulation is not pretty. We are going to eventually see accidents happen because of the broken air traffic system.   For starters, if 80 movements in one hour are the limit for an airport in best weather conditions, then don't schedule 100.  Secondly, significant money needs to be spend to modernize the ATC system.  Further, there needs to be oversight over the airline industry to a certain extend.  That includes how many standby planes need to be available, the number of personnel servicing passengers, etc.  I am afraid that in the case of air traffic the government needs to save the American customer from him or herself in the quest for the cheapest flights out there.

The interesting thing is that this problem is somewhat confined to the US carriers.  I don't use this word lightly, but I hate flying domestically in the US.  When I travel internationally, there is a noticeable improvement in service and friendliness, especially when I fly international carriers.  Again, the consumer gets what the consumer wants.  A quite curious thing in a country that otherwise is a case study in service.

Safety concerns in air travel demand that the government gets involved.  Hopefully, that will happen soon.  I am tired of oversold flights, chewing gum chewing gate agents, disgustingly unclean planes and sitting on the tarmac for three hours with no information whatsoever.  But most importantly, I am afraid that we wait until accidents happen before change will take place.

Opportunities in the Sulphur Industry

One of our valued clients is Omni Sulphur, located in Nipomo, California.  Omni Sulphur was formed to take advantage of the exciting opportunities in the global sulphur industry.  We at CENAK Consulting actively assist Omni Sulphur in developing its business plan and realizing its growth potential.  We prepared the company's budget model and are currently working with the company to develop and refine its long term business plan.  It is anticipated that a first round of equity capital will be raised in the first half of 2008.  CENAK Consulting is preparing the financial models and information memorandum as well as actively advising Omni Sulphur in its project development efforts around the globe.

Sulphur is a commodity product produced mostly during the refining of crude oil and natural gas.  It is stripped out of oil and gas as a by-product.  Given that most new oil and gas production is from fields that are of lower quality with a high sulphur content, it is widely expected that there will be a glut of sulphur inventory starting in late 2008, when a number of new refineries are expected to come online.  The price for sulphur is therefore expected to decline and even be negative in certain areas of the globe.

On the demand side, sulphur is used mostly to ultimately produce phosphate fertilizers.  Other applications are in the mining industry and some other industries to a small extend.  One niche product is to use sulphur in conjunction with clay and micronutrients as a fertilizer. 

Omni Sulphur is best positioned to take advantage of the expected overproduction of sulphur by offering solutions to refiners as well as users of sulphur.

Sulphur produced at refineries is typically in a molton form.  Unless there are applications for the sulphur nearby these plants, the molton sulphur needs to be formed into a product that can easily be shipped.  This process is called forming of sulphur.  There are several different technology providers who manufacture machines that can be used for this purpose.  Omni Sulphur has significant experience with building and operating these plants, and continues to develop opportunities globally for the forming of sulphur, as refiners are looking for ways to manage the ever increasing amount of sulphur.   

Another core competency of Omni Sulphur is the production of sulphur fertilizers using beforementioned forming equipment.  Omni Sulphur has developed a proprietary technology that allows the company to  mix elemental sulphur with clay to form a 90% sulphur/10 clay product called GreenSun 90.  This product is widely used and accepted in North America, however the largest growth markets for this product are in Asia and Brazil, where soils are significantly sulphur deficient.  Omni Sulphur is currently constructing its first sulphur fertilizer plant in India and expected to commence development of a second facility in Dubai before the end of this year.  Omni Sulphur is one of few companies that can make the forming technology work for the production of sulphur-based fertilizers and expects significant growth in this arena.  Further, the sulphur fertilizer can be mixed with micronutrients for additional fertilizer applications.

CENAK Consulting is actively involved in the development of several of Omni Sulphur's global forming and fertilizer projects.  Omni Sulphur and ultimately its clients profit from our international experience and our project development experience.  Further, we continuously help Omni Sulphur refine its business plan and financial model.  At present, CENAK Consulting is developing an information memorandum and strategy to raise capital for the company's rapid expansion.  We are very excited to be a part of the company's growth and about the future of the sulphur market.