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UVA-F-1366
TSE International Corporation
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UVA-F-1366
Version 2.8
On May 2, 2000, T.S. Tom Eliot, chairman, chief executive officer (CEO), and founder of
the TSE International Corporation, was preparing to meet with W.B. Bill Yeats, president of Yeats
Valves and Controls Inc. (YVC) the following week. The meeting was to negotiate the terms of TSE
Internationals acquisition of Yeats Valves. Serious negotiations for combining the two companies
had started in March, following casual conversations that dated back to late 1999. Those initial talks
focused on the broad motives for each side to do a deal and on the social issues (such as
management and compensation in the new firm). What still remained was to negotiate the final term
sheet on which the definitive agreement would be drafted and signed.
Eliot had founded TSE International in 1970, grown it, taken it public, and firmly rooted it as
a Fortune 1000 company. In response to what he perceived to be the firms growth challenges for the
next decade, Eliot had persuaded TSEs board that the company should follow a policy of focused
diversification, which would be achieved by an aggressive growth-by-acquisition program designed
to create opportunities and entries into more dynamic markets than the ones TSE presently served.
Although it had done well in the past, Eliot concluded that the company had produced few new
breakthrough products in recent years. If this trend continued, TSE International would be left
behind by its competition.
Yeats Valves was the first among several potential targets identified by Catherine Cat
MacAvity, TSEs vice president of Business Development, and the architect of the acquisition
program. Eliot approved the choice and believed a smooth and successful acquisition of YVC was
critical to TSEs expansion plans. April 2000 had been a cruel month for stocks in general with the
bursting of the dot-com bubble. It might chill the ongoing talks. If the merger fell through after
going this far, Eliot feared his board might become discouraged. On the other hand, if YVC was
acquired at too high a price or failed to produce adequate returns, the TSE board would be unlikely
to give its full support to future mergers. Eliot decided he would carefully review the YVC deal
before deciding on a negotiating strategy regarding the price/exchange rate issue.
This case was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an
administrative situation. Copyright 2001 by the University of Virginia Darden School Foundation, Charlottesville, VA.
All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.edu. No part of this publication may be
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mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. Rev.
1/05.
-2- UVA-F-1366
In 2000, TSE manufactured products ranging from advanced industrial components to chains,
cables, nuts and bolts, castings and forgings, and other similar products. TSE then sold them (mostly
indirectly) to various industrial users. One division produced parts for aerospace propulsion and
control systems with a broad line of intermediate products. A second division produced a wide range
of nautical navigation assemblies and allied products. The third division manufactured a line of
components for missile and fire-control systems. These products were all well regarded by their
customers, and each was a significant factor in its respective market.
The companys raw material supply (sheets, plates, and coils) of various metals came from
various producers. TSE Internationals plants were ample, modern, well-equipped with substantially
newer machinery, and adequately served by railroad sidings. The firm was considered a low-cost
producer being that it possessed unusual production knowledge. They were also known as a tough
competitor.
Eliot and his management team had initiated several changes to help increase TSEs profit
margins. Chief among them, in late 1998, had been the implementation of a six sigma quality
improvement programthis had already identified numerous opportunities for improving profits and
sales. As a result, TSEs latest sales and earnings forecasts projected a steady increase over the next
five years with sales growing to $2.2 billion and profits to $164 million by 2004. Those projections
did not include the benefits of any mergers. Exhibit 1 shows the balance sheets for 1999, while
Exhibit 2 presents the income statements from 1995 to 1999. TSEs debt was currently rated Baa.
Exhibit 3 summarizes earnings for TSE International for the next five years. Despite Eliots
confidence and optimism for the future of the company, he believed that the stock market still
undervalued his firms shares.
In planning TSEs expansion, Eliot had considered several companies as possible acquisition
candidates. For his first acquisition, Eliot was seeking a small, well-managed manufacturer that
could offer TSE strong growth opportunities and bring it more specialized, higher-technology
products that would be less susceptible to succumbing to the competition. Although TSE had done
well, Eliot felt the company lacked the ability to be innovative. No new products had been
developed over the past two years, and Eliot personally felt that the research and development
(R&D) group at TSE International had fallen behind its competitors. YVC, with its proven
management and engineering skills, seemed to offer the R&D capabilities and growth prospects that
Eliot sought.
Yeats Valves and Controls Inc., located in Southern California, was engaged in the
manufacture of specialty valves and heat exchangers. YVC maintained many standard items, but
nearly 40% of its volume and 50% of its profits were derived from special applications for the
-3- UVA-F-1366
defense and aerospace industries. Such products required extensive engineering experience of a kind
only a few firms were capable of providing. YVC had a reputation for engineering excellence in the
most complex phases of the business and, as a result, often did prime contract work on highly
technical devices for the government.
The company was an outgrowth of a small company organized in 1980, for engineering and
developmental work on an experimental heat exchanger product. In 1987, as soon as the product was
brought to the commercial stage, YVC was organized to acquire the properties, both owned and
leased, of the engineering corporation. The president of the predecessor company, Bill Yeats,
continued as the president of Yeats Valves and Controls Inc. Eventually, the company acquired the
patents that it had licensed.
The raw materials used by the company were obtainable in ample supply from a number of
competitive suppliers. Marketing arrangements presented no problems. Sales to machinery
manufacturers were made directly by a staff of skilled sales engineers. The Auden Company, a large
firm in a related field, was an important foreign distribution channel under a nonexclusive distributor
arrangement. About 15% of YVCs sales came from Auden. Foreign sales through Auden and
directly through YVCs own staff accounted for 30% of sales. Half of the foreign sales originated in
emerging economies, mainly Brazil, Korea, and Mexico. The other half originated in the United
Kingdom, Italy, and Germany.
Although the foreign-currency crises in the mid-1990s had temporarily interrupted YVCs
sales growth, better economic conditions in the markets of developed countries, together with YVCs
recent introduction of new products for the aerospace and defense industries, offered the company
excellent prospects for improved performance. As such, sales in the first quarter of 2000 grew 20%
to 25% over the corresponding period in 1999, whereas many of YVCs competitors experienced
limited growth prospects. Exhibits 4 and 5 show the most recent balance sheet for YVC and the
income statements for 1995 onward.
YVCs plants, all of modern construction, were organized for efficient handling of small
production orders. The main plant was served by switch tracks in a 15-car dock area of a leading
railroad and also by a truck area for the companys own fleet of trucks. From 1997 to 1999, net
additions to property totaled $7.6 million. Bill Yeats, an outstanding researcher in his own right, had
always stressed the research and development involved in improved products, with patent protection,
although the companys leadership was believed to be based on its head start in the field and its
practical experience.
YVCs success had brought numerous overtures from companies looking for diversification,
plant capacity, management efficiency, financial resources, or an offset to cyclical business. For
instance, when Yeats Valves was taken public in 1986, Auden Company, which later became a holder
of 20% of YVC common stock, advanced a merger proposal. Rumors of possible antitrust action by
the U.S. Department of Justice had circulated after the news of the proposed merger became public,
and Auden withdrew from the discussions. YVC received various proposals from 1988 on, but none
reached the stage of working out an agreement until the advances of TSE International Corporation.
-4- UVA-F-1366
Bill Yeats and Tom Eliot had known each other for four years, having been introduced at an
industry conference where they were both speakers. As founders and significant stockholders in their
respective firms, they liked and respected each other. Yeats Valves and Controls Inc. had come to Cat
MacAvitys attention a year earlier with the firms disclosure of a U.S. government contract. YVC
was to develop an advanced hydraulic controls system, code-named widening gyre, for use in
numerous commercial and military applications. Due-diligence research led MacAvity to believe that
this system could have a broad application in nautical, aerospace, and automotive products.
During the early part of 2000, a series of group meetings had taken place between Tom Eliot
and Bill Yeats and their respective advisers. By early May, a broad outline of the merger seemed to
be developing. Yeats Valves was to become a subsidiary of TSE Internationalthe deal would be
structured in such a way as to preserve YVCs identity. In preparing to negotiate the final terms of
the deal, Eliot asked MacAvity to develop recommendations on a range of issues:
Social terms
The two sides had explored some of the governance and compensation issues in the merger.
Bill Yeats would be retained along with his top management team and all other employees. No
layoffs were contemplated. This reflected TSEs intention to invest in and grow with the YVC
operation. YVCs solid management team was one of the factors that had attracted TSE in the first
place, and Eliot wanted to keep the same management in place after the merger. Yeats had asked for
a grant of five-year options to purchase 80,000 shares of TSEs stock at 90% of its market price at
the close of the acquisition. In addition, he requested a generous incentive bonus that would result in
a salary increase of between $50,000 and $200,000 per year.1
Valuation
Eliot sought a range of values for YVC upon which to base his negotiating strategy.
Specifically, he wanted to develop his opening and walk-away offering prices. MacAvity planned to
approach two key aspects:
Stand-alone value of Yeats: MacAvity wanted to estimate the value of YVC from a number of
approaches. She noted the recent, rapid rise in Yeatss share price and wondered whether the
firms shares were already fully priced or whether the market had not yet capitalized the full
expectations of the new widening-gyre technology. YVCs shares traded on the NASDAQ,
while TSEs traded on the American Stock Exchange. YVCs stock had risen sharply in the
last six months as rumors of the merger surfaced. Exhibit 6 gives a forecast of YVCs
earnings, dividends, and cash flow items. Yeats shared this information with Eliot. Exhibit 7
1
Bill Yeats current salary was $300,000 a year.
-5- UVA-F-1366
shows recent share prices for Yeats Valves and TSE.2 Exhibit 8 provides valuation
information on exchange-listed possible peer firms of Yeats Valves and TSE. Exhibit 9
presents information on recent acquisitions within YVCs industry. Exhibit 10 presents
money market and stock return data for 1997 through May 1, 2000. Eliots financial staff
believed that a 40% marginal tax rate was warranted for both TSE and Yeats.
Synergy value: Not included in the stand-alone value estimates for Yeats would be two kinds
of synergy benefits that arose from the deal. First, TSEs greater purchasing power would
lower the cost of materials and components. Second, TSEs six sigma quality control
program could be expected to reduce YVCs in-process costs. Due-diligence research had
identified pretax constant-dollar cost savings of $1.5 million in the first year of operation,
and $3 million thereafter. For conservatism, Eliot and MacAvity planned to ignore other
synergies that arose from TSEs stronger marketing clout, cross-selling with other TSE
products, and its deep financial pockets (allowing for more aggressive investment in
promising new technologies, such as widening gyre).
In the discussion over social terms, Eliot and MacAvity had envisioned that YVC would
continue as an entity under TSEs corporate umbrella. Eliot wondered whether this transaction
would be structured as a merger or as an acquisitionand of what? Also, from the very start of the
negotiations for combining the two companies, the merits of the alternative methods had been
considered by counsel for both parties. Eliot was open to a straight common-for-common stock
exchange, although he would consider other forms of payment as well. He assumed that the
shareholders of YVC would want to defer taxes from this deal. In the event that the deal was
structured as a cash offer, he wondered about TSEs financial capacity to borrow the entire amount
from banks, or whether TSE needed to issue more shares in the equity market.
Exchange ratio
If the deal were to be structured as a share-for-share exchange, Eliot would need to propose
an offer based on a ratio of the number of TSE shares offered per YVC share. MacAvity planned to
assess the relative contribution of YVC to Newco and derive a range of possible offering ratios. Still,
Eliot wanted to be sure that the exchange ratio would not exceed the maximum that TSE could
afford to paysimilarly, he did not want to derail the discussions by offering a ratio less than the
minimum that Yeats could accept.
2
TSE Internationals stock had a beta of 0.85; the beta for YVC was 1.50, based on the most recent years trading
prices.
-6- UVA-F-1366
Dilution
Another concern was about the earnings dilution that TSE might incur from the acquisition.
In fact, two directors had cautioned Eliot against impairing the firms forecasted growth in earnings
per share.
Control
Eliot wondered whether the proposed terms would significantly alter the balance of
shareholder control in TSE. The shares were widely held. Roughly 70% of the Yeats Valves stock
was held by its board of directors and their families, including the 20% owned by the Auden
Company and 40% owned by Bill Yeats. The Auden Company did not object to the merger, but it
had given notice that it would sell its holdings of Yeats Valves stock. The Auden Company was
about to undertake a new expansion of its own, and its executives were not disposed to keeping tag
ends of minority interests in a company like TSE. However, they saw no reason for not maintaining
their satisfactory relationships with the Yeats Valves enterprise when it became a TSE International
division.
Conclusion
It seemed clear to Eliot that both YVC and TSE could profit from the merger. Eliot believed
that Yeats Valves would be an excellent acquisition for TSE. With its solid earnings record and good
management team, YVC seemed to offer TSE good prospects for its first venture in diversification.
Eliot realized that time was of the essence, especially since other competitors were also
interested in Yeats Valves. Nonetheless, he wanted to be certain that acquiring it would truly place
TSE in a better competitive position. One concern was how well YVCs employees would handle the
transition from working in a small, entrepreneurial company to a much bigger place like TSE. The
two companies possessed quite different cultures.
As Eliot prepared his analysis, he was confronted with the problem of how much TSE should
be willing to pay for Yeats Valves. At what price did the potential growth produced by the merger
cease to outweigh the risks involved? Eliot had also noticed the following comment from a leading
analytical service:
Modest ValuationsIn light of currently modest share prices, we believe that the
number of acquisitions will increase in the future. Some valuations are so low, in
fact, managers are considering leveraged buyouts of their individual companies.
advise most investors to delay additional commitments until the stock market
settles.
-7- UVA-F-1366
Exhibit 1
TSE INTERNATIONAL CORPORATION
Consolidated Balance Sheet as of December 31, 1999
(in thousands of U.S. dollars)
Assets
Cash $46,480
U.S. government securities, at cost 117,260
Trade accounts receivable 241,761
Inventories, at lower of cost or market 179,601
Prepaid taxes and insurance 2,120
Total current assets 587,222
1
$150,000,000 note, payable semi-annually beginning June 30, 2000; $30,900,000 due within one year, shown in
current liabilities. One covenant required company not to pay cash dividends, except on preferred stock, or to make
other distributions on its shares or acquire any stock after December 31, 1999, in excess of net earnings after that
date.
2
Issued in January 1999; convertible at rate of 1.24 common share to one preferred share; redeemable beginning in
2004; sinking fund beginning in 2004.
3
Resulting principally from the excess of par value of 827,800 shares of preferred stock over the par value of
common share issues in conversion in 1999.
-8- UVA-F-1366
Exhibit 2
TSE INTERNATIONAL CORPORATION
Summary of Consolidated Earnings and Dividends for Years
Ended December 31, 1995, to December 31, 1999
(dollars in thousands, except per-share figures)
Net earnings per common share $2.55 $1.86 $2.01 $1.92 $2.23
Cash dividends declared
Per common share $1.39 $1.25 $0.86 $1.25 $1.49
Per preferred share $0.00 $0.00 $0.00 $0.00 $0.40
Cash payout 51.2% 58.4% 31.8% 51.7% 56.2%
Ratio analysis
Sales 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 78.3 79.9 76.1 82.9 82.0
Gross profit 21.7 20.1 23.9 17.1 18.0
Selling, admin., & general expenses 3.6 4.7 5.0 4.4 5.5
Income before federal income taxes 18.1 15.4 18.9 12.7 12.5
Net income 10.3 8.9 11.2 7.6 7.5
-9- UVA-F-1366
Exhibit 3
TSE INTERNATIONAL CORPORATION
Forecast of Sales, Earnings, and Other Items for the Years Ending December 31, 1999,
through December 31, 2004
(dollar figures in thousands, except per-share figures)
Actual Projected
1999 2000 2001 2002 2003 2004
Sales $2,187,208 $2,329,373 $2,480,785 $2,642,037 $2,813,769 $2,996,658
Cost of goods sold $1,793,511 $1,910,086 $2,034,244 $2,166,470 $2,307,291 $2,457,260
Gross profit $393,697 $419,287 $446,541 $475,567 $506,478 $539,398
Selling, general, & admin. expenses $120,296 $125,786 $131,482 $140,028 $146,316 $155,826
Income before tax $273,401 $293,501 $315,060 $335,539 $360,162 $383,572
Tax expense $109,360 $117,400 $126,024 $134,215 $144,065 $153,429
Net income $164,041 $176,101 $189,036 $201,323 $216,097 $230,143
Ratio analysis
Sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 82.0 82.0 82.0 82.0 82.0 82.0
Gross profit 18.0 18.0 18.0 18.0 18.0 18.0
Sell., gen., & admin. 5.5 5.4 5.3 5.3 5.2 5.2
Income before tax 12.5 12.6 12.7 12.7 12.8 12.8
Net income 7.5 6.6 6.6 6.6 6.7 6.7
1
62,694,361 common shares in 1999. Thereafter, 64,416,919 shares reflecting conversion of the preferred stock.
2
1,389,160 preferred shares in 1999. Conversion into 1,722,558 shares of common stock assumed in 2000.
-10- UVA-F-1366
Exhibit 4
Exhibit 5
TSE INTERNATIONAL CORPORATION
YVC Summary of Earnings and Dividends for Years Ended
December 31, 1995, through December 31, 1999
(dollar figures in thousands)
(Unaudited)
Three months ended 3/30
1995 1996 1997 1998 1999 1999 2000
Sales $36,312 $34,984 $35,252 $45,116 $49,364 $11,728 $14,162
Cost of goods sold $25,924 $24,200 $24,300 $31,580 $37,044 $8,730 $10,190
Gross profit $10,388 $10,784 $10,952 $13,536 $12,320 $2,998 $3,972
Selling, general, & admin. expenses $2,020 $2,100 $2,252 $2,628 $2,936 $668 $896
Other income, net $92 $572 $108 $72 $228 $14 $198
Income before taxes $8,460 $9,256 $8,808 $10,980 $9,612 $2,344 $3,274
Taxes $3,276 $3,981 $3,620 $4,721 $4,037 $1,009 $1,391
Net income $5,184 $5,275 $5,188 $6,259 $5,575 $1,335 $1,883
Earnings per common share $3.74 $3.61 $3.60 $4.35 $3.87 $0.93 $1.31
Cash dividends declared:
Per preferred share $5.00 $1.25
Per common share $1.00 $1.40 $1.40 $1.60 $1.60 $0.40 $0.52
Percentage payout to common stock 27.8% 38.2% 38.9% 36.8% 41.3% 43.1% 40.0%
Ratio analysis
Sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 71.4 69.2 68.9 70.0 75.0 74.4 72.0
Gross profit 28.6 30.8 31.1 30.0 25.0 25.6 28.0
Selling, general, & admin. expenses 5.6 6.0 6.4 5.8 5.9 5.7 6.3
Other income, net 0.3 1.6 0.3 0.2 0.5 0.1 1.4
Income before federal income taxes 23.3 26.5 25.0 24.3 19.5 20.0 23.1
Net income 14.3 15.1 14.7 13.9 11.3 11.4 13.3
-12- UVA-F-1366
Exhibit 6
TSE INTERNATIONAL CORPORATION
YVC Forecast of Sales, Earnings, and Other Items for the Years Ended
December 31, 1999, through December 31, 2004
(dollar figures in thousands, except per-share figures)
Actual Projected
1999 2000 2001 2002 2003 2004
Sales $49,364 $59,600 $66,000 $73,200 $81,200 $90,000
Cost of goods sold $37,044 $42,316 $47,850 $52,704 $58,058 $63,900
Gross profit $12,320 $17,284 $18,150 $20,496 $23,142 $26,100
Selling, general, & admin. expenses $2,936 $3,612 $4,024 $4,464 $4,952 $5,492
Other income, net $228 $240 $264 $288 $320 $352
Income before taxes $9,612 $13,912 $14,390 $16,320 $18,510 $20,960
Taxes $4,037 $5,565 $5,756 $6,528 $7,404 $8,384
Net income $5,575 $8,347 $8,634 $9,792 $11,106 $12,576
Ratio analysis
Sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 75.0 71.0 72.5 72.0 71.5 71.0
Gross profit 25.0 29.0 27.5 28.0 28.5 29.0
Selling, general, and admin. 5.9 6.1 6.1 6.1 6.1 6.1
Other income, net 0.5 0.4 0.4 0.4 0.4 0.4
Income before federal income taxes 19.5 23.3 21.8 22.3 22.8 23.3
Net income 11.3 14.0 13.1 13.4 13.7 14.0
-13- UVA-F-1366
Exhibit 7
TSE INTERNATIONAL CORPORATION
Market Prices for YVC and TSEs Common Stock for 1995 to 1999
Exhibit 8
TSE INTERNATIONAL CORPORATION
Information on Peer Firms in the Industrial Machinery Sector
Expected
Price/ Rate of
Earnings Dividend Growth Debt/
Ratio Beta Yield to 2005 Capital
CASCADE CORPORATION
Designs, manuf., and markets hydraulically
actuated products 8.2 0.85 4.0% 12.5% 49%
CURTISS-WRIGHT CORPORATION
Manufactures precision components in
motion (42%) and flow (36%) control;
metal treatment (36% of sales) 10.3 0.65 1.4 10.0 8
FLOWSERVE CORPORATION
Makes, designs, and markets fluid handling
equipment (pumps, valves, & mech. seals) 11.0 0.80 nil 6.5 39
IDEX CORPORATION
Designs, manuf., and markets industrial pumps,
compressors, and a range of industrial prod. 14.6 1.10 1.9 9.0 42
ROPER INDUSTRIES
Operates in 3 segments: industrial controls,
fluid handling, and analytical instrumentation 16.3 0.75 0.9 15.5 39
TECUMSEH PRODUCTS
Manufactures compressors, condensers, pumps
for commercial, industrial, & agri. applications.
Foreign sales & exports = 43% of 1999 sales 7.0 0.65 3.0 8.5 1
THOMAS INDUSTRIES
Leading manufacturer of compressors and
vacuum pumps. 10.7 0.85 1.6 9.5 16
WATTS INDUSTRIES
Designs, manufactures, and sells extensive
line of valves for the plumbing & heating and
water quality markets 10.4 nmf* 2.9% 14.0% 36%
*
nmf = not meaningful figure.
Exhibit 9
TSE INTERNATIONAL CORPORATION
Information on Selected Recent Merger and Acquisition Transactions in the Industrial Machinery and Aerospace Sectors
na = not available.
Source of data: Thomson Financials SDC Platinum.
-16- UVA-F-1366
Exhibit 10
TSE INTERNATIONAL CORPORATION
Capital Market Information
(average percentage per annum except for May 1, 2000,
which offers closing prices)
Stock Market
S&P 500 Index 873 1,085 1,327 1,481
Price/Earnings ratio 15.9 17.4 19.4 18.8
N.B.: The geometric-average equity market risk premium for the period 1926 to 1999 was about 5.5%. The
arithmetic-average equity market risk premium for that period was about 7.2%.
Sources: Value Line Investment Survey, 5 May 2000, Federal Reserve Bulletin, April 2000, Wall Street Journal, 2
May 2000.