A good merger or acquisition can be synonymous with a good investment. Therefore we will begin our approach on the proposed merger with ENER1 from a financial review position. We will then transition into a valuation position followed by reasons why this merger is a good fit for Exide. Before we get started it is important to understand the industry in which ENER1 competes and the basic makeup of ENER1 business and organization.
Industry Overview
Oil has been the primary source of energy for over the last 150 years (Petersen, 2010). During this time batteries have been thought of as little more than a grudge purchase, devices that nobody wanted but everybody needed. Now that issues such as climate change, rapid industrialization of Asia and South America along with volatility in oil prices, alternative energy solutions is beginning to take on more prominence (Petersen, 2010). Investors are beginning to realize that energy storage will be the "beating heart of the clentech revolution" (Petersen, 2010). This is the industry in which ENER1 competes. ENER1 sub-industry is Electrical Components & Equipment. Standard and Poors has a neutral outlook for this industry believing that results are likely to improve.
ENER1 Company Background
Ener1, Inc. is engaged in the business of designing, developing and manufacturing rechargeable lithium-ion batteries and battery systems for energy storage. Its end markets include transportation, stationary power (energy storage for utilities and renewable energy, such as wind and solar power in addition to battery backup systems for the home), military applications and small cell markets. In the transportation markets, the Company is developing systems to power the next generation of hybrid electric vehicles (HEVs), plug-in hybrid electric vehicles (PHEVs) and electric vehicles (EVs). This technology is also developed for other transportation markets, including buses and trucks, as well as alternative transportation vehicles. The Company also conducts research on and develops fuel cells and nano coating processes. The Company has three operating segments: battery, fuel cell and nanotechnology. The company's officer and directors are listed in Table 1.
Financial Analysis
Larry Selden (professor emeritus of finance and economics, Columbia Graduate School of Business and Geoffrey Colvin (senior editor at large for FORTUNE magazine and co-anchor of PBS' WALL STREET WEEK) published a paper titled "M&A Needn't Be a Loser's Game," (Harvard Business Review, June 2003). In that paper it was stated that the reason that many acquisitions destroy shareholder wealth is because acquiring managers are ignoring the balance sheet. We will take a credit analysis approach and examine ENER1's balance sheet as well as income statement. This analysis will be broken out into 4 categories. Graphical depictions along with Industry benchmarks are shown in Exhibit A
Profits and Profit Margin
Is ENER1 generating healthy profit levels? Most finance professionals would agree that the profit area is the most important one to review over time. However, we cannot assume that positive profits will always yield positive cash flow from operations. The company's bottom line has not changed very much from last period. However, sales have gone up significantly and the net margin has improved. This is a somewhat positive trend, because it means the company is operating more efficiently than it was previously. It looks like some operating costs have been cut to accomplish this. It is a good result even though the net margin is still poor compared to similar companies. When a company has a weak net margin, it is very crucial that all expenses be monitored carefully. In this case, higher direct costs over last period negatively affected the bottom line. The company brought in significantly more sales this period, but gross profit levels have stayed relatively constant because of some higher direct costs, resulting in a lower gross margin.
Borrowing
Is ENER1 effectively using debt? This situation is rather unfavorable with regard to this specific analysis area. Total debt has increased this period with net profitability falling. ENER1's overall results in this area do not compare well to the industry. It does not seem to be generating enough earnings (before interest and non-cash expenses) relative to interest expenses, even with a low level of debt (compared to equity) on its Balance Sheet. The most likely source of this problem is in earnings.
Assets
How effective is ENER1 in using fixed assets? These results are unfavorable. The company increased its fixed asset base significantly, but once again profitability fell from last period. This results in a decline in return on assets. ENER1 is simply spending more money on assets while net profitability declined. Offsetting these results a little is the fact that both the net profit margin and overall liquidity have improved from last period. The acquisition of assets does not seem to have hurt efficiency.
Liquidity
Is ENER1 liquid enough? This is a question on efficiency and cash flow. Since last period, the company has generated negative cash flow from operations and profitability (although cash flow has increased relative to sales). These are generally not favorable results, although they do not seem critical at this time, as overall and short-term liquidity appear adequate. Still, negative cash flow will need to be addressed, as it is the biggest driver of long-run profitability over time. ENER1's liquidity ratios seem to be in line with other similar companies. ENER1 has some additional areas to focus on for certain components of overall liquidity. Inventory days, accounts receivable days, and accounts payable days are all higher than industry averages. This indicates that the company may be taking longer to sell inventory and may also be slow in collecting receivables and paying vendor bills. All of these factors can affect the cash account significantly, and it might be good to see these metrics reduced over time.
ENER1 Valuation
Value should not be confused with price. Price is the agreed upon amount between seller and buyer in the sale of company. From our standpoint, value is the maximum amount that should be paid. Valuing a company with negative earnings is extremely difficult. Our opinion is that ENER1's negative earnings can be attributed to where they are in the firm's life cycle. We will need to estimate the cash flows of the firm over its lifecycle and let them turn positive at the right stage of the cycle. We utilized a discounted cash flow method to value the company.
The first step in our valuation was to assess ENER1's current standings and make sure the most current data is being used. We are using the company's latest annual report for year ending 12/31/10. A summary view of market statistics, income statement and balance sheet are shown in Exhibit B.
The second step in our valuation was to estimate revenue growth. ENER1 has grown at a substantial rate since 2008. Their revenues have increased from $6.8 million in 2008 to $34.8 million in 2009 to $77.4 million in 2010. The growth rate last year was 122.4%. The 5 year growth rate for the industry is 14.6%. Due to the current state of the economy and the overall infancy of the market we were conservative about our estimate of revenue growth. Exhibit C summarizes our forecasts of revenue growth and dollar revenues at ENER1 for the next 10 years. The dollar increase in revenues each year is greater than the previous year until year 7
In step 3 we estimated a sustainable operating margin in stable growth. A key assumption in our valuation is that while the operating margins are negative now they will be positive in the future. The median operating margin of businesses in ENER1's business segment was 5.55%. We assumed that ENER1's margins would reach 5.5% by year 10. Marginal improvements will be greater in the first few years but operating profits will not be seen until year 5. Exhibit D summarizes the forecasted operating margins and earnings before interest and taxes for the next ten years and for the terminal year.
The fourth step in our valuation was to estimate the reinvestment needed to generate growth since this is a young firm and reinvestment is crucial to their success. For our analysis we estimated the expected reinvestment by dividing the expected change in revenue by the sales to capital ratio. We utilized a sales to capital ratio of 1.5. The results are shown in Exhibit E. The total capital invested in ENER1 is derived by adding the total reinvestment to the capital invested at the beginning of the period.
The fifth step in our valuation was to estimate the discount rate and value the company. There is enough historical data to arrive at a weighted cost of capital which we used in our discount model. Utilizing a weighted average cost of capital of 9.3%, inputs on earnings, reinvestment rates we were able to calculate the present value of the estimated free cash flows for years 1 through 10.A summary of the estimated free cash flows is shown in Exhibit F. The result is a negative value of $290 million. There is one significant cash flow that is not reported in Exhibit F and that is the terminal value of the firm. The cash flow of the terminal value is $1.2 million and was calculated without attention to growth. Utilizing the terminal value cash flow brings the value of ENER1 to $164 million. To complete our valuation we added cash on hand of $71 million to bring the value of ENER1 to $235 million.
Why the merger makes sense and potential risks
Financing this acquisition with 100% stock will be dilutive for the first 4 years. The initial benefit to shareholders and 5 year earnings per share forecast is shown in Exhibit G. A conservative estimate of synergies is valued at approximately $1.6 million (See Exhibit H). The current lithium-ion battery market is about $13 billion per year. This figure is estimated to increase to $44 billion in 2015 with $13 billion in consumer electronics, $13 billion in vehicle applications and $18 billion in power storage (Wallstreet, 2011). In the vehicle application market the heavy duty segment is expected to grow from $110 million in 2010 to $642 million in 2016 (Peterson). ENER1 weakness due to a lack of knowledge in the automotive heavy duty segment as noted in their annual report is a strength of Exide. ENER1 weakness of high volume manufacturing is a strength of Exide. Exide's weakness in advanced battery technologies is a strength of ENER1. It is anticipated that the current management teams would remain in place after the merger. This would ensure specific industry knowledge is maintained during the time after the merger. Labor savings may be generated a few years after the merger due to economies of scale but these savings were not used in the valuation. There are a few risk associated with this merger. A major risk is the current ownership Ener1 Group and Bzinfin are affiliated entities that as of December 31, 2010, own 49.3% of ENER1 outstanding common stock (and 57.3% if these entities exercised all of the warrants they own). Ener1 Group and Bzinfin have the ability to effectively control all matters submitted to a vote of the shareholders of ENER1, including any decision regarding any potential merger. Other risks include the decrease in the price of oil and decrease in government grants and loans.
