DeÂ LaÂ Rue Plc dates its origination way back to 1821 when its founder Thomas de la Rue started it as a stationer and printer on a small scale in the UK. Since then the company has diversified geographically and has spread its footprints across 24 countries today employing approximately 4000 people all over the world. De La Rue is rated as the world’s largest commercial security printer and papermaker, which is involved in producing over one hundred and fifty national currencies along with a wide gamut of security documents like fiscal stamps, passports, authentication labels to name a few.
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Besides this, it is also the leading provider of equipment to sort cash and is also a reputed software solution provider to central banks worldwide that helps to minimize the total cost of handling cash. It has also ventured into new innovations and technologies in passport issuing schemes, driver’s license and national identification schemes. DeÂ LaÂ Rue is a member of the FTSE 250 and its ordinary shares have been listed with the UK Listing Authority and are tradingÂ on the market on the London Stock Exchange under the symbol DLAR. Its current market capitalization stands at $811.57 million.
Recently De La Rue has been witnessing a series of production problems along with the resignation of its chief executive James Hussey which has taken a toll on its profits to the tune of GBP 35 million. This crisis-hit company has been the subject of takeover in recent times because of its leading position in several growth markets that have high barriers to entry. Its lucrative business potential coupled with its well established business globally makes it a good take-over candidate. Oberthur, a French company, has expressed interest to take over the company in an all cash offer which it has valued at GBP 896 million by offering 905 pence per share.
Takeover deals can be broadly categorized under two heads (Jostarndt, 2007): Financial, and Strategic. While the intent of financial deals is to turn around the loss-making businesses in a profitable manner and command premiums on the time of exit, strategic buyers aim to integrate the businesses with its existing operations to reap the benefits of economies of scale and scope. In the absence of the relevant details, it has been assumed that the buyers have a strategic outlook for the deal and accordingly the analysis has been carried out. Strategic buyers are more concerned about the operating strengths of the business rather than focusing on financial measures of profitability like return on equity, dividend payout ratio which are of primary concern to the retail investor. Thus, while analyzing the performance of De La Rue, emphasis has been laid on the sales figures and turnover ratios along with the asset utilization practices prevailing at the target company. Its leverage has also been analyzed to gain an understanding of the financial risks of the company. The ratios available at Reuters (2011) have been used for the purposes of the above analyses and have been comprehensively summarized underneath:
Receivable Turnover ratio (times) 5.72 4.27 5.91 Inventory Turnover Ratio (times) NA 12 15 Asset Turnover Ratio (times) 1.13 0.97 0.57 Average Return on Assets (%) 23.02 1.80 2.89 Operating Margin (%) 24.69 3.12 8.15
Quick Ratio 0.44 1.43 1.27 Current Ratio 0.68 1.70 1.58 Long Term Debt to Equity Ratio 4.85 19.32 54.94 Total Debt to Equity Ratio 197.58 26.59 73.12 The inputs of ratio analysis are the financial statements of the company and it is essential that the input should be reliable to get consistent output. Thus it is a general practice to use audited financial statements to avoid confusions about its integrity. Hence, for the purposes of analysis, the year ended March, 2010 has been considered for computing the asset efficiency ratios. The capital structure at the latest date of takeover should be considered and hence the un-audited interim results have been considered to compute the leverage and solvency ratios.
Asset efficiency ratios throw light on the turnover that can be generated by deploying the assets in an efficient and effective manner. Since the takeover deal in this case aims to acquire control of the target company, it should be primarily interested in how good the assets of the target are because the major purchase consideration paid would be for acquiring these assets. Asset turnover ratios describe the number of times of it; the particular asset(s) can generate sales. Thus while the asset turnover ratio describes the number of times of the total assets that the sales have been generated, debtors turnover ratio reveal the quality of the current asset debtors that the target has on its balance sheet. A large debtor base with a large proportion of bad and doubtful debts is of less relevance than a small debtor base of high and recoverable quality. A high debtor turnover ratio indicates that the debt collection procedure is sound and hence the incidence of bad debts should be low. Ratios, on a stand-alone basis, are of little relevance as the absolute figures do not convey much information. It is essential to compare them with industry and sector benchmarks to gain a complete insight in its relative positioning in the industry and peer group. Hence accordingly, the benchmark ratios have been also considered. A look at the total asset turnover ratio and debtor turnover ratio show that both these ratios were better for De La Rue than the industry or the sector. The asset turnover ratio for the company De La Rue Plc was almost double than the sector which indicates that the productive power of assets or the revenue generating capacity of the assets of De La Rue is quite good and hence they can be considered to be worth taking over. Even if we look at the earning power of the assets as indicated by operating margin and the return on assets, De La Rue scores well above its industry and sector benchmarks. The return on assets of the company is almost 12 times the industry standard and nearly 8 times the sector benchmark. The operating margin for De La Rue is also nearly 8 times and 3 times greater than the industry and sector benchmark respectively. The following graph indicates the earning potential and the revenue-generating capacity of the assets of De La Rue Plc vis-à-vis the benchmarks. It is clear that De La Rue Plc scores above average on all the parameters on a consolidated basis when compared with its peers or the industry and hence it can be deduced that it has a productive asset base which can be effectively managed to reap the benefits of the takeover deal.
Another arena worth considering in a takeover deal is the financial risk of the company. Takeover deals can be undertaken to achieve financial synergy benefits in the form of reduced cost of capital. It is essential to consider the debt burden of the target company which would be taken over by the acquirer. De La Rue Plc’s short term liquidity position as indicated by its current ratio and quick ratio are well below the benchmark standards. Its quick ratio is almost a third of the industry standard and current ratio is also a meager 40% of the industry standard. The situation seems to be a bit less bad when compared with the sector benchmark but still it falls very short of what the prevailing benchmarks have been. A look at the solvency ratios narrates a different story however. Its leverage as implied by the long term debt to equity ratio is way below the standards. It is about 25% and 9% of the industry and sector benchmarks respectively which indicate that the threat of insolvency is low when compared with the peers. Thus it appears to be a safe bet. However, the total debt to equity ratio is quite high for De La Rue, almost 8 times and 2.5 times the industry and sector benchmark respectively. This mismatch indicates that it has substantial liabilities which need to be retired in the short term period and hence the acquirer should determine the consideration payable accordingly. Overall, though the long term financial prospects do not appear bleak, the short term financial stability might command a great amount of resources.
The above cross sectional analysis of De La Rue Plc clearly indicates that its asset base is of good quality and hence attracts significant interest from strategic buyers. However the success of any takeover deal lies in the valuation. Paying a low value may cause the deal to be shelved, while offering a higher price can lead to the syndrome popularly known as Winner’s curse, wherein the acquirer fails to reap the benefits of the takeover deal due to excessive premium paid. It is essential to determine a fair value of the target. The valuation process is a highly subjective process and calls for careful planning. The fair value is not computed using a single method but by computing the weighted average of the values obtained from a range of methods. The weights are placed according to the relevance of the method for the purpose with which the valuation is done. The valuation methods have been broadly categorized under two heads: Fundamental Valuation, Relative Valuation. Both the methods have been used here to compute the fair value of the purchase consideration that should be paid to the shareholders of De La Rue Plc.
Fundamental Valuation or Intrinsic Valuation, as it is commonly known, is based on the premise that the fair value of any company can be deduced by discounting the future stream of returns accruing from the company (Pinto et al, 2010). Returns can be either in the form of dividends or cash flows. Since the takeover deal is carried out with the intent to gain control over the operations of the company, the free cash flow approach is being implemented to value the firm’s equity.
Free Cash Flow to the firm refers to the cash flows that accrue to the stockholders and bondholders after all the capital expenditure requirements and working capital needs have been met. Cash flows are lesser subject to manipulation than the earnings and are hence of primary interest to the acquirer. FCFF can be computed as the net cash flow from operations adjusted for after tax interest payments and capital spending. The FCFF of De La Rue Plc as on March 27, 2010 has been computed under: Amount (GBP million) Net CFO 95.1 Interest 5.4 Tax Rate 13.46% Add: After-tax Interest 4.67 Less: Capital Spending 33.1
The consensus estimate for the long term growth rate of both the capital spending and the revenue of the business has been estimated at around 10.5% (Reuters, 2011) and accordingly, this assumption has been used for valuation purposes. But the sustainability of a growth rate greater than the growth of the industry is questionable in the long run. De La Rue Plc is a matured firm and hence it would grow indefinitely in the long run at a rate no more than the growth of the industry. Hence the sustainable long term growth rate has been assumed to be 5%. However, the time value of money needs to be factored in and accordingly, the indefinite cash flows need to be discounted at the cost of capital.
Cost of Capital refers to the minimum return the business must provide to its financers. It is calculated as the weighted average of the cost of equity and after tax cost of debt. The cost of equity here has been computed using the Capital Asset Pricing Model, as shown below: Risk-free return (%) 3.70 Beta 0.11 Market Return (FTSE 250)(%) 20.14 Cost of Equity (%) 5.51 The yield on 10 year bond issued by the UK government has been used as a proxy for the risk free rate (Bloomberg, 2011) while the market return is assumed to be the return earned on investment in FTSE 250. To compute the cost of equity, there are several other approaches available. Hence, to determine the intrinsic cost of equity, the Gordon’s Growth Model has been applied and accordingly the required rate or return has been computed as shown: Expected Dividend per share 46.74 p Current Market Price 819.5 p Long-term growth 10.50% Cost of Equity 16.20% Both the methods have yielded significantly different values and hence the weighted average is used with 80% weight being assigned to the latter. Thus the cost of equity is 14.06%. The cost of debt has been computed by dividing the post-tax interest with the amount of long term debt and is equal to 10.27%. The long term debt equity ratio of 4.85 implies that the capital structure is made up of 82.91% debt and 17.09% equity. Thus the weighted average cost of capital has been computed as shown: % of debt 82.91 % of equity 17.09 Cost of debt in % 10.27 Cost of equity in % 14.06 Weighted Average Cost of Capital (%) 10.91
Applying the Free Cash Flow to Firm Valuation approach, we estimate the value of the firm which can be computed by applying the formula: Firm Value = FCFF (1+ Growth rate)/(Cost of capital-Sustainable growth rate) Inputting the above calculated parameters in the equation, the value of the firm is GBP 1245.45 million. In the absence of information regarding the market value of debt, the book value of debt has been deducted to determine the value of equity which stands at GBP 841.95 million and thus the amount to be paid on a per share basis stands at 856 pence.
Alfred Rappaport introduced a new concept of deriving shareholder value. As per Rappaport, shareholder value is driven primarily by the understated seven factors: Sales Revenue Operating Margin Tax Rate Incremental Capital Expenditure Investment in Working Capital Weighted Average Cost of Capital Planning Horizon or the Competitive Advantage Period Rappaport states that the total economic value of any business can be computed as theÂ sum of the values of its debt and equity.Â Thus, shareholder valueÂ can be deduced asÂ the corporation’s value minus the value of the debt, wherein the corporate value is equal to the sum of its future cash flows that are discounted at the weighted-average cost of capital (WACC). The free cash flows equal the present value of all of the operatingÂ cash flows (the net of cash inflows & outflows) during theÂ planning horizon and theÂ terminal value. The terminal value is computed as the present value of the businesses’ estimated value beyond the forecast period. It can be expressed as: Enterprise Value = Present Value of Net Operating Cash Flows during the planning horizon + Terminal Value + Value of marketable securities. The FCFF has been computed above as GBP 66.67 million. While the long term growth rate as per analyst’s consensus is 10.5%, the sustainable growth rate is 5%, the growth rate of the entire industry. The competitive advantage period in the current scenario seems to be no greater than 4 years as per analyst’s consensus and accordingly, that estimate has been used here. The weighted average cost of capital has been computed above to be 10.91%. These estimates have been used to value the firm as shown below:
FCFF 73.67 81.41 89.96 99.40 Present Value of FCFF 66.43 66.18 65.92 65.67 Sum of Operating Cash Flows during Planning Horizon 264.20 Terminal Value 1763.06 Present Value of Terminal Value 1164.74 Value of Marketable Securities 44.5 Firm Value 1473.43 Equity Value 1069.93 Per Share Value (GBP) 10.87 Under this approach, the per share vale comes close to 1087 pence which is quite higher than the one obtained through the other NPV approach. Thus it is advisable to consider other methods also.
The estimates obtained above are subject to several limitations, the primary being the reliability and consistency of the input parameters. Several assumptions have been made regarding the long term growth rate of the company, its cost of equity, etc. Past performance can provide some insight, but cannot be deemed to be sufficiently reliable to predict the future. But this model relies on past performance to estimate future performance, which is a major drawback. Moreover, the achievability and sustainability of the estimates is also questionable. This model also ignores the synergy benefits that accrue form the deal and is overly simplistic. It also assumes that the growth rate would be constant in perpetuity which is rarely the case. Hence, other models need to be applied to determine the fair value of consideration payable.
This method is based on the law of one price. The principle that similar securities should be equally priced is the foundation of this approach. Under this approach, the price multiples of the industry and peer group are deemed to be the best indicator of the worth of the stock and they are correspondingly multiplied with the measure to determine the fair value of the security. It assumes that markets are efficient and prices all securities efficiently. Hence the valuation should be arrived at using the market consensus. There are several price multiples that are applied in this approach but here the focus is limited to the following four multiples (DePamphilis, 2009): Price to Earning Multiple, Price to Sales Multiple, Price to Free Cash Flow Multiple, and Price to Book Value Multiple. The weighted average of the price obtained through the above approaches is calculated to arrive at the fair price. All the multiples are not weighted equally, but a larger weight is applied to P/S multiple and P/FCF multiple because in the process of acquiring control, the acquirer stands to gain by turning sales and free cash flows in an efficient manner. Moreover these two measures are less subject to manipulation than earnings which is normally believed to be window-dressed.
The PE approach is the most commonly used approach in stock valuation because of its simplicity and easily accessible information. The mean ratio for the trailing twelve months in the industry has been 26.12 (Reuters), while the reported earnings per share were 71 pence. Accordingly, the value of share has been computed as 1854.52 pence. But for valuing takeover targets, this method is given less weightage as the earnings can be manipulated and the acquirer is always more interested in the turnover of the target which it can effectively convert into profits. Thus we need to use a combination of methods.
Herein, the book value per share is used to value the equity of De La Rue plc as shown in the adjoining table. The price per share under the different methods of relative valuation have been computed and shown under:
Price Multiple of Sector (Source: Reuters)
Sales 1.71 570.22 975.08 0.4 390.03 Free Cash Flow 17.86 67.75 1210.09 0.4 484.04 Book Value 1.37 9.65 13.23 0.05 0.66 Earnings 26.12 71.00 1854.52 0.15 278.18
Thus the relative valuation approach provides a per share value of 1152.91 pence valuing the company at a price of GBP 1134.46 million.
This approach is also widely subject to criticisms. It is based on the premise that markets are efficient which does not hold good in reality. It is not necessary that the benchmarks are always aptly priced. They may be over priced in boom periods and under priced in the depression periods which affects the valuation of the company as their over/under valuation is reflected in the fair value of the target too. Moreover, it also ignores synergy benefits and is based on the past performance (the trailing multiples) which provides an insight on the future performance but do not serve as a good proxy for it. Besides this, it is essential to cover the entire cycle of a business rather than just a year. Despite of all these shortcomings, both the methods provide a starting point for deal valuation.
While the fundamental valuation assigns a value of 856 pence per share, relative valuation assigns a value of 1152.91 pence. If we average the two, the per share value comes close to 1002 pence. Hence the bid can be made accordingly. Since the bid of 905 pence per share has already been rejected, it can bid more than that to the limit of 1002 pence. If the group can estimate the synergy benefits accruing from the deal, the present value can also be computed and a portion added to the bid offer to share the gains of the takeover with the shareholders of De La Rue Plc.
The stock price of De La Rue Plc rose from 647.5 pence to 861 pence, implying a gain of around 33% the very same day. This spurt in prices can be explained by several theories, but two have been discussed here:
Financial market is a broad market that provides for the exchange of both capital and credit. It can be broadly segregated intoÂ money marketsÂ and theÂ capital markets. Money market refers to the market of short-term debt securities. Such securities are typically safe and highly liquid in nature. On the other hand, capital market refers to the market which provides for the transaction of long-term debt and securities. Every transaction involves the exchange of some consideration, and to determine the amount of this consideration, it is essential to correctly value the securities to conduct a fair transaction. Hence it is essential that the markets are efficient. By Market efficiency, we mean that the current price of the security should include all the values of publicly available information about the particular security. The basic idea that underlies market efficiency is that the existence of competition drives all information about a security into its price quickly.Â The maximum price that a prudent investor would be willing to pay for the financial security is determined by the current value of all the future cash flows that are discounted at a slightly higher rate so as to compensate for the riskiness and uncertainty in the future cash flow projections. Thus, investors are actually trading information in the form of commodity in the financial markets for the expected stream of future cash flows along with information about the level of uncertainty. Efficient marketÂ refers to the state of the market when new information is speedily incorporated in the price to make the price become information. Put simply, the current market price of a stock reflects all the available information about it. Thus the current market price in the financial market can be regarded as the best-unbiased estimate that can be assigned to the value of the particular investment. Here in our case, De La Rue Plc shareholders would stand to benefit if the takeover attempt is successful, as they would stand to gain a higher margin on their investment than they could get by simply trading on the market exchange. Thus, as per this theory, the stock price of De La Rue Plc should provide an indication of this possibility and it should not be possible for traders to beat the market by arbitraging on the shares of De La Rue Plc. TheÂ Efficient Market Hypothesis (EMH), as the theory is popularly known, has been ranked as an important cornerstone of modern financial economics. Fama (1970) laid the foundation of the theory and defined the term “efficient market” as a market in which the security prices completely reflect all the available information about it. The market is said to be efficient if the reaction of the market prices to the newly obtained information is instantaneous and more importantly unbiased.Â Thus it undermines the fact that no old information can be used to predict the future price movements, a major blow to the technical analysts. Consequently, there are three versions of EMH which have been distinguished depending on the level of information available.Â TheÂ weak form of the Efficient Market Hypothesis states that the current asset prices have already incorporated historical price and volume information. In other words, the information that is contained in the historical sequence of values of a particular security is completely reflected in its current market price. This form is labeled as the weak form because it is based on security prices that are the most easily accessible and publicly available piece of information. The theory asserts that no one would be in a capacity to outperform the market just by using something which everybody else in the market knows. However there are several financial researchers who have been studying the sequence of historical stock prices along with the data on trading volume so as to generate profit. This methodology, popularly called technical analysis, is asserted by this form of EMH as insignificant for the prediction of the future price changes. TheÂ second form of EMH – the semi strong form, stipulates that the entire gamut of publicly available information about a security is already incorporated in the asset prices in a similar fashion. In another words, all of the publicly available information about a security is comprehensively reflected in its prevailing market price. Here, the public information stated covers both the past prices and the data that is reported in the company’s announcements, its financial statements, prevailing economic factors to name a few. It also implies, like the weak form, that no one can outperform the market simply by using something that is a known fact of everyone else. This also indicates that a particular company’s financial results are of no use in the process of forecasting the future price movements of the stock so as to secure higher investment returns. TheÂ strong form of EMH, the final form,Â states that all the insider information or the private information is also quickly incorporated by the market in the prices of the security and hence cannot be exploited to gain abnormal trading profits. Put simply, it implies that all information, public and private, is fully consolidated in the security’s prevailing market price. Thus, the company’s management or the insiders too cannot make supernormal gains from the inside information which they hold as per this thesis. The insiders cannot take the undue advantage to profit from the private information such as a take over or an acquisition decision that has been taken minutes ago. The underlying rationale behind this is to support the fact that the market predicts future developments and accordingly incorporates that information in the stock price in an objective and more informative manner than the insiders. There have been several extensions to this work, the popular one being the random walk model, which also asserts the notion that the stock market cannot be beaten on a consistent basis, and it also rules out the possibility of arbitrage. Thus, in a nutshell, the efficiency theory states that the price of a particular asset on the exchange includes the value of all publicly available information about that particular underlying asset (Fama, 1970). De La Rue Plc had been grappling under serious production issues which had taken a toll on its share price. But the news of a possible takeover has generated interest in the stock. Yet the deal is not confirmed and there also exists the probability of the deal fading off. Thus accordingly, the price did not rise to match to the bid offer but was a bit low factoring the possibility of failure. This reaction shows that the efficiency theory holds good to some extent in practice.
In takeover deals, the shareholders of the target can be compensated by two means – cash or stock or a combination of both. Since the group is interested in an all cash offer, it implies that the shareholders of the target won’t benefit from the long run synergistic benefits of the deal since after the takeover they would cease to exist as shareholders of the combined entity. Hence the consideration payable on the spot would be higher than the actual value of the target to proportionately share the gains from the deal with the target shareholders. Moreover, all cash offer also implies the confidence of the acquiring firm’s management in the target company and accordingly the target’s shareholders would command a premium price for the same. Thus the stock’s value increased by 33% on a single day, in anticipation of the deal, after factoring the probability of a possible failure.
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