Strategic Rationale for a Combination of Schneider and Square D (1)

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Strategic Rationale for a Combination of Schneider and Square D (1)

Historically, the industry has been segmented by country or by region. Barriers to entry in these different markets have been perpetuated by:

Differences in standards across countries and regions;
Costs of R&D for new products and costs of translating technologies for different regional standards;
Proprietary distribution networks;

Industry trends point towards increased globalization:

Product standards are becoming common across regions;
R&D costs continue to grow increasing the benefits of economies of scale;

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Strategic Rationale for a Combination of Schneider and Square D (2)

Given the above factors, Schneider and Square D appear to be a good match:

Schneider is a leader in Europe whereas Square D is a major player in the US market;

Schneider appears to be especially strong in industrial distribution whereas Square is strongest in residential distribution;

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Synergies between Schneider and Square D

Rationalization of R&D efforts and benefits from sharing existing technologies;

Access to larger distribution channels for both companies;

Rationalization of manufacturing capabilities;

Benefits from cross-selling products;

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Effect of Acquisition on Goodwill

Purchase Price
$60 / $65 / $70
Square D’s SE ($m) / 603.6 / 603.6 / 603.6
Adjustment for inventory revaluation / 138.1 / 138.1 / 138.1
Revalued SE ($m) / 741.7 / 741.7 / 741.7
Nb of shares (m) / 23.2 / 23.2 / 23.2
Price per Share / $60 / $65 / $70
Market Value of Square D’s Equity ($m) / 1390.9 / 1390.9 / 1390.9
Goodwill ($m) / 649.1 / 765.1 / 881.0

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Effect of Acquisition on Schneider’s Earnings

($m) / Purchase Price
(1FFr = $0.184) / $60 / $65 / $70
Schneider’s Earnings / 251.2 / 251.2 / 251.2
Square D Earnings / 120.7 / 120.7 / 120.7
Merger Synergies / 60.0 / 60.0 / 60.0
Goodwill Amortization / (16.2) / (19.1) / (22.0)
Combined Firms’ Earnings / 415.7 / 412.8 / 409.9

The goodwill effect is thus significant;

There is however little reason to believe that investors will not be able to understand the effect of the goodwill calculation;

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Assumptions Made by Lazard

Sales Growth of 3.5% in 1991 and 7% thereafter;

EBIT/Sales of 15 to 16%;

Net Working Capital/Sales at a minimum of 11 to 13%;

Projected Capital Expenditure/Sales of 5%;

Depreciation Expense/Sales at 4% between 1991 and 1997 and 4.3% thereafter;

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Prior Years’ Financial Performance Based On Square D’s Continuing Operations

(%) / 90 / 89 / 88 / 87 / 86 / 85
Sales Growth / 3.4 / 6.7 / 12.5 / 4.4 / 4.2
EBIT/Sales / 12.9 / 12.0 / 13.1 / 15.9 / 16.8 / 17.4
NWC/Sales / 23.6 / 12.1 / 11.9 / 14.5 / 16.0 / 16.5
D&A/Sales / 3.6 / 3.1 / 3.0 / 3.2 / 3.0 / 2.7
CAPEX/Sales / 5.7 / 5.0 / 4.8 / 2.7 / 5.6 / 5.1

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Some General Observations on Prior Years’ Financial Performance

Square D’s performance declined in the mid-80s from 17% to 12%;

In spite of the recession, there is a modest upturn in 1990. Is this an indication that the firm’s restructuring efforts are paying off?

Net Working Capital/Sales steadily declined until 1990, when there is a large increase due to a build-up in cash;

Capital Expenditure/Sales declined dramatically in 1987 as the firm responded to the deterioration in its business by cutting back on new investments;

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Some General Observations on the Assumptions Made by Lazard

1.Sales Forecasts:

-Perhaps somewhat optimistic given the recession in 1990;

-Analysts however envision a recovery by the end of 1991 or in 1992;

-But for how long can a 7% growth rate be sustained?

EBIT/Sales:

-This profitability margin was equal to 12.9% in 1990;

-It never exceeded 13.1% over the last three years;

Net Working Capital Requirements/Sales:

-About right?

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Pro Forma Statements

Exhibit 1

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Square D’s Cost Of Equity Capital

Equity : 0.95;

In early 1991, interest rates were as follows:

-3 month Treasury Bills rates: 6%;

-30 year Government Treasuries: 8.25%;

Based on these rates, the appropriate risk free rate is 8.25%;

Assuming a market risk premium of 7.9%, Square D’s cost of equity capital is: 15.9%;

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Valuation of Square D Using Lazard’s Assumptions

DDM

Assuming cost savings from the merger of $60m after tax per year, Square D’s stock is worth approximately $86.6;

On a stand-alone basis, Square D’s stock is thus worth approximately $69.0;

Assuming cost savings increasing at the rate of growth of sales, Square D’s stock is worth around $100.0;

These estimates are substantially higher than the stock’s market price before any takeover rumors: $40-$45;

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Valuation of Square D Using Lazard’s Assumptions

PE-Based Valuation

EPS from continuing operations were $4.76 in 1990;

Assuming that Square D’s price before the effect of any merger rumor is $45, the firm’s (trailing) PE ratio is about 9.5;

Given Lazard’s assumptions of operating savings of $60m per year, the stock should be worth about $69!

($45+(9.5*$60/23.181))

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Implications of Lazard’s Assumptions for Pro Formas and Valuation (1)

(%) / 1991 / 1995 / 1998
Growth in SE / (13) / 6 / 5
D/(D+E) / 29 / 30 / 31
ROE / 23 / 30 / 31
AT / 1.45 / 1.51 / 1.56

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Implications of Lazard’s Assumptions for Pro Formas and Valuation (2)

ROE increases from 21% in 1990 to 31% by 1998;

Asset Turnover increases from 1.33 to 1.56 in the same period;

Lazard most probably did not intend making that optimistic implications;

These implications arose primarily because fixed assets are growing at only 3 to 4% per year whereas sales are growing at 7%;

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Revised Valuation Assumptions

Sales Growth of 3.5% in 1991, 7% in 1992 and 1993, 5% for 1994, and 3% thereafter;

EBIT/Sales of 14%;

Net Working Capital/Sales at 13%;

Net PPE to grow at the same rate of growth as sales;

Depreciation Expense/Sales at 7.5% of PPE (BY);

Long-term growth of 4%;

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Revised Valuation

Under the set of revised assumptions, as shown in Exhibit 2:

Square D is valued at around $59 per share including the effect of improved operating performance from the merger;

Square D is valued at $41.40, which is comparable to the value assessed by the stock market before any takeover rumors;