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# Project "Dial Tone" - Final Exam

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### Project "Dial Tone" - Final Exam

1. 1. Entrepreneurial Finance, Luigi Zingales FINAL EXAM Project “Dial-Tone” Authors: Philip Larson I pledge my honor that I have not violated the Honor Code during this examination.
2. 2. Project “Dial-Tone” 1. Under the assumptions of the proposed deal structure in exhibit 7, what are the economics of the deal for MDC? i.e. what IRR and value can MDC expect to earn? Page 2
3. 3. Project “Dial-Tone” Adjusted Present Value Analysis: To calculate MDC’s expected return, I have performed an APV analysis. Using the long-term Treasury Bond rate of 6.4% as the riskfree rate, I have assumed a risk premium of 6.5% because that is the amount by which the market exceeded T-bonds over the last 50 years according to Kaplan’s article. The appropriate discount rate for valuing the cash flows is rUe = rf + βU*(rm - rf) where rUe is the appropriate discount rate for an all equity firm, βU is the unlevered (or asset) beta for the firm, and rm - rf is the market premium over the riskfree rate of 6.5%. We do not have betas for Cady, Dialplus or Datacom. However, APAC and SITEL are good analogs for these businesses as both exclusively provide telemarketing services similar to MDC’s acquisition targets. I have used an unlevered beta of 1.111, the median of these two analogs, to calculate an overall discount rate of 13.6%. Assuming a terminal growth rate of 3% (in line with inflation) and a tax rate of 41% (blended pro forma rate per exhibit 8 footnote b), the present value of the cash flows together with the present value of the debt tax shield is roughly \$100M.2 The actual APV value will be less than this because the \$100M does not take into account the present value of the cost of financial distress which in this case is non-zero and potentially quite large. Given that these costs are difficult to measure, we can compute MDC’s present equity value assuming the cost of financial distress is \$0. MDC’s equity stake is 21,150/41,900 or a little more than 50%.3 The present value of MDC’s 50% stake amounts to \$24.5M. That is, MDC must invest \$21M to receive an equity stake worth \$24.5M, for an overall return of 16%.4 This is not quite up to the 20% return a private equity firm would generally look for in an LBO. If the debt tax shield is discounted at the riskfree rate, a less realistic assumption, rather than the unlevered cost of capital, the enterprise value only goes up to \$103M5 leading to a slightly better return of 24%.6 IRR Based on Terminal Value: As is to be expected, the IRR based on an exit at the perpetuity value depends heavily on the value used for the terminal value of the free cash flow. For all reasonable levels of terminal value this deal has also has a decent IRR. For example, if we simply use the FCF at the end of year 2000 of \$3.5M, without zeroing out depreciation, changes in NWC and capital expenditures, the IRR based on perpetuity value is negative because MDC must invest \$21M to receive \$9M in year 2000 resulting in a very negative IRR.7 However, there is a very large change in networking capital in Year 2000 that is getting blown out in the terminal value. Therefore, if we zero out capital expenditures, depreciation and changes in NWC and use Page 3
4. 4. Project “Dial-Tone” the resulting free cash flow of \$11M, the IRR is a more impressive 21% based on the \$21M investment leading to \$44M in year 2000.8 Therefore, IRR based on terminal value suggests the deal is not the greatest ever but could be worse. IRR Based on Exit at Multiple: When calculating the IRR based on an exit multiple the investment looks more attractive. The two public comparables, APAC and SITEL, currently have Enterprise Value/EBITDA multiples of a whopping 40x and 14x.9 Using the average EBITDA multiple of these comparables (i.e. 27.4x), the IRR for MDC would amount to 112% based on Year 2000 EBITDA of \$33M.10 This amounts to MDC cash on cash of 20.4x.11 If MDC is able to secure participating preferred common stock, the IRR goes up slightly to 114%.12 Even using a more conservative multiple of 7.2x (i.e. the purchase price multiple in the proposed deal) the IRR is still 45%.13 This amounts to 4.5x cash on cash.14 Both of these would be sufficient to cover the required return on the investment of 13.6%. The pro forma projections for the combined company do not have cash in 2000 so there is no need to calculate an IRR based on exit multiple + cash. Therefore, IRR based on exit at multiple appears very attractive at most levels of multiple and operating performance.15 2. Assuming Hellman can get Cady to agree to sell, would you recommend that Hellman and McCown De Leeuw (MDC) proceed with the negotiations for the deal? i.e. is this an attractive opportunity for MDC? Why or why not? While the quantitative numbers make this deal appear moderately attractive on balance, particularly when looking at IRRs based on exit multiples, I would not recommend that Hellman and MDC continue with the deal. A qualitative analysis (OUTSIDE-CUPID) of the deal weighs heavily in favor of not pursuing the deal. Competition: Competition for the deal is likely to be fierce. An industry observer noted that the SITEL and APAC IPOs would encourage the remaining top ten telemarketing firms to undergo a capital structure transformation by either going public, recapitalizing, or being acquired in a private transaction. Therefore, the wider market is aware of the opportunity in telemarketing. Additionally, the telemarketing market has already been looked at by numerous other private equity firms, including TA Associates, Summit Partners, and Golder Thoma Cressey Rauner some of whom have already made large investments in the space. Even the large telemarketing agencies have made acquisitions in this space and could create more competition for deals like these. Hellman is aware that each of his target companies have “several other options” in addition to closing a deal with MDC. Therefore, competition for the deal is likely to be high driving up the price of the deal overall. Page 4
5. 5. Project “Dial-Tone” Additionally, competition in the deal (e.g. within the telemarketing space) is also high. Barriers to entry in the industry are low. Deregulation is likely to increase competition and put downward pressure on margins. Labor is the largest component of product cost which makes emerging markets with lower labor rates a credible and frightening mid- to long-term threat. Even in the US, competition for new campaigns has been “increasing rapidly”. Therefore, telemarketing is a very competitive place making it difficult to maintain high margin rents. Unique: In addition to stiff competition, there is nothing incredibly unique about the acquisition targets. The primary assets of the targets are employees and contracts. These assets are not sticky because there are very few switching costs for workers and customers. Cady has some unique experience with joint ventures in foreign markets (low telemarketing penetration and high market potential) but has not created entry barriers in this area. DialPlus has a unique focus on selling long distance services (over 70% of revenue came from a single long distance reseller). However, this is likely a bad thing given the upheaval in this industry once the impending deregulation takes place combined with the threat of competing technologies like cellular.16 And finally, Datacom has developed a “sophisticated psychological screening test” that has reduced turnover, but this can hardly be considered an insurmountable differentiator. There is also nothing incredibly unique about MDC as the buyer. MDC does not provide unique value add to the deal. MDC has never invested in a telemarketing company before. Its partners do not have domain knowledge in telemarketing. MDC does not have a long rolodex of contacts in the telemarketing space nor can they provide good strategic guidance for corporate decisions. Therefore, it does not appear crucial that these companies get their investment capital from MDC as opposed to other sources. MDC does not provide strategic value. Price: Per the discussion in question 1 above, the price is more attractive based on EBITDA multiple than with an APV analysis. However, the price of the deal will likely get pressured upward as competition for the deal heats up among private equity firms and other telemarketing organizations. This will make it more likely that MDC overpays for the deal. Improvements: MDC plans to improve the company through cost savings, improved margins, and economies of scale. However, these improvements are likely to be fairly limited. MDC is not planning on major cost-cutting reductions which would be the most reliable way of improving the combined company. Moreover, MDC hopes to improve margin by bringing in more sophisticated new management (e.g. CEO). However, this might upset the Page 5
6. 6. Project “Dial-Tone” old management and make them less productive. Additionally, MDC seeks to leverage economies of scale to purchase the latest IT solutions for managing the business that the smaller companies could not afford. However, MDC is not particularly well-positioned to provide guidance in this area as they have no experience in high technology. While economies of scale at the sales and marketing level might also be a possibility, it is unclear how valuable these synergies will be. Distress: While financial distress can be difficult to measure, the probability of the combined company becoming distressed is fairly high. While the market for telemarketing is large and growing, the revenues are not as stable as in other industries. Competition for outbound telemarketing contracts is steadily increasing while switching costs are very low, making revenues more volatile. DialPlus, the most expensive part of the deal for MDC (at \$46M), derives 70% of its business from a single company selling long-distance services. If this company were to fail due to the impending deregulation of telecommunications, due to the reduced need for long- distance in an increasingly cellular world, or for any other reason, MDC’s investment would be devastated. Therefore, the probability the combined company will default or otherwise become distressed is fairly high. In addition to the probability of distress being high, the costs of financial distress are also high. Financial distress would destroy a large percentage of the combined company.17 The primary assets of telemarketing businesses are its employees and its contracts, both of which will be incredibly difficult to retain in financial distress. Workforce retention in the industry is difficult under ordinary circumstances, let alone when a business can’t pay its bills. There are few switching costs for employees and there are plenty of other growing telemarketing companies that would be ready to hire them. Customers will likely flee. Revenue is highly concentrated in a few customers which if lost would be devastating. For inbound telemarketing in particular, no customer will be willing to sign a contract with a firm if there is risk the company will go out of business. There are large upfront costs and difficult switching costs associated with choosing an inbound telemarketer. Even companies looking for outbound telemarketing services will likely flee to other providers if it appears the combined company has entered financial distress. Therefore, if the combined firm becomes distressed, a large portion of the value of the combined firm is likely to be destroyed if the firm becomes distressed. Uncertainty: There is a large amount of uncertainty in this deal. Two of the targets focus on telecommunications which is in the middle of deregulation. The largest portion of the deal is for DialPlus, a Page 6