Evaluating Restructuring Actions

Restructuring actions are often difficult because, in most cases, external forces impose them on a company. We will use an illustration to evaluate cost and balance sheet restructuring.

GrimCo

GrimCo, an industrial chemical manufacturer, received an unwanted acquisition offer from Jinx, a competitor with a history of aggressive cost-cutting. The news about the offer increased GrimCo’s share price by 10% and valued the company at a 15% premium. GrimCo’s management rejected this offer stating that it was not in the best interest of the shareholders to accept it. Two weeks after rejecting the offer, the company’s management announced that they would be undergoing an eight-week review of their cost structure to capture the company’s true value.

Exhibit 1 shows a summary of financial data relating to GrimCo and competitor companies, including company X, which offered to acquire GrimCo.

$$ \begin{align*} \textbf{Exhibit 1:}& \textbf{ Summary of Financial Data,} \\ & \textbf{Industrial Chemical Manufacturers} \end{align*} \\ \begin{array}{c|c|c|c|c|c} & \textbf{Total} & \textbf{Revenue} & \textbf{EBIT} & \textbf{Revenue} & \textbf{Debt as} \\ & \textbf{Assets} & & & \textbf{Growth} & \textbf{% of} \\ & & & & \textbf{Rate} & \textbf{Assets} \\ \hline \text{Company U} & 68,496 & 29,677 & 17,002 & -1\% & 35\% \\ \hline \text{Company V} & 97,652 & 39,123 & 8,670 & 2\% & 45\% \\ \hline \text{Company W} & 120,678 & 86,689 & 12,670 & 5\% & 40\% \\ \hline \text{Company X} & 210,210 & 50,645 & 10,090 & 2\% & 32\% \\ \hline \text{Company Y} & 106,540 & 29,321 & 6,567 & 3\% & 30\% \\ \hline \text{GrimCo} & 20,120 & 19,190 & 3,150 & 3\% & 15\% \end{array} $$

During the year, GrimCo’s management announced that it would enter into a sale-leaseback agreement for three of its warehouses next to the port. The lease term will run for 10 years with an option to extend. The cash expected from this agreement is $320 million, which will be used to retire a 15-year bond worth 210 million, and the balance will be used to repurchase 10 million ordinary shares.

The company agrees to take responsibility for property taxes, maintenance costs, and building modification related to the leased assets. The annual rent expense for the leased warehouses is $10 million. Following this transaction, the company expects to receive an investment grade rating but acknowledges that it is the rating agency’s responsibility and no assurance can be made. The following information relates to the retirement of the 15-year bond and the share repurchase transactions.

1. $150 million gain on asset sale will be amortized over 10 years.
2. Incremental occupancy expense is $10 million per annum.
3. Coupon savings from the retirement of the bond is $10 million per year.
4. Operating lease right to use asset and lease liability of $205 million.
5. Depreciation savings of $11.3 million per year.

Required

1. What is the motivation for GrimCo to carry out a cost restructuring?

   Solution

   GrimCo has below-average profitability, which makes it an attractive target to acquire. Also, the company is undervalued, making it a suitable target for acquirers. GrimCo should most likely cut costs to increase profitability, increase shareholder value and fend off acquirers.

2. How much annual expenses will GrimCo reduce if its restructuring matches its peer median EBIT margin?

   Solution

   Based on Exhibit 1. The peer median EBIT margin is 22%, GrimCo’s revenue is $19,190 million, and its EBIT is $3,150 million with an EBIT margin of 16%, which means that GrimCo has expenses worth $16,040 million. For GrimCo to reach an EBIT margin of 22%, it will have to reduce expenses by $1,072 million.

3. What is the most likely motivation for the balance sheet restructuring?

   Solution

   GrimCo seeks to improve its balance sheet by retiring the 15-year bond and increasing its credit rating, leading to more access to financing at a lower cost of capital. The company is also looking to unlock the value of its real estate assets.

4. Based on Exhibit 2 shown below, calculate GrimCo’s pro forma interest coverage and debt-to-EBITDA ratios, assuming a 20% tax rate.

   $$ {\textbf{Exhibit 2: GrimCo Summary Financial Data (}\$ \textbf{millions)} } \\ \begin{array}{l|c} & \textbf{Last 12 Months Before} \\ & \textbf{the Transaction} \\ \hline \text{Net sales} & 6,789 \\ \hline \text{Cost of sales} & 3,395 \\ \hline \text{Gross margin} & 3,395 \\ \hline \text{SG&A expenses} & 2,500 \\ \hline \text{D&A expenses} & 124 \\ \hline \text{Operating profit} & 771 \\ \hline \text{Interest expense} & 125 \\ \hline \text{Income taxes} & 129.3 \\ \hline \text{Net income} & 517 \\ \hline \text{Diluted shares outstanding} & 1200 \\ \hline \text{Diluted EPS} & 0.433 \\ \hline \text{Gross debt} & 796 \\ \end{array} $$

   Solution

   $$ \begin{array}{l|c|c|c} & {\textbf{Last 12}} & \textbf{Transaction} & \textbf{Last 12} \\ & \textbf{Months} & & \textbf{Months} \\ & \textbf{Before} & & \textbf{After the} \\ & \textbf{the Transaction} & & \textbf{Transaction} \\ \hline \text{Net sales} & 6,789 & & 6,789 \\ \hline \text{Cost of sales} & 3,395 & & 3,395 \\ \hline \text{Gross margin} & 3,395 & & 3,395 \\ \hline \text{SG&A expenses} & 2,500 & 10 & 2,510 \\ \hline \text{D&A expenses} & 124 & (3.7) & 120.3 \\ \hline \text{Operating profit} & 771 & & 764.7 \\ \hline \text{Interest expense} & 125 & (10) & 115 \\ \hline \text{Income taxes} & 129.3 & & 129.9 \\ \hline \text{Net income} & 517 & & 519.8 \\ \hline \text{Diluted shares} & 1200 & (10) & 1990 \\ \text{outstanding} & & & \\ \hline \text{Diluted EPS} & 0.433 & & 0.261 \\ \hline \text{Gross debt} & 796 & (210) & 586 \\ \hline \text{Debt-to-EBITDA} & 0.89 & & 0.66 \\ \hline \text{EBIT-to-interest} & 6.2 & & 6.65 \end{array} $$

   As a result of the transaction, the debt-to-EBITDA will decrease from 0.89 to 0.66. The amortization expense increased after the transaction, while the depreciation expense decreased after the transaction. The interest coverage increased from 6.2 to 6.65.

Reading 21: Corporate Restructuring

LOS 21 (g) Evaluate cost and balance sheet restructuring.