This report outlines the proposal of Games Workshop Group PLC integrating together with Hornby PLC. A strategic rationale is produced to sum up the key benefits of them operating jointly, which should assist you as a board to decide whether Hornby is suitable for Games Workshop and if it's strategically and financially attractive.
Based on financial data of Games Workshop and Hornby an excel model has been created to calculate and estimate the value of both organisations on various possible merger and/or acquisition scenarios. In addition to taking into consideration financial and operational gains that can be made from the transaction, this proposal bases its decision on which method of integration provides the greatest long term value creation for its shareholders.
In terms of an acquisition it's quite obvious from the report that Hornby would compliment Games Workshop in many areas, however this report also outlines potential issues and obstacles that may need to be tackled before taking on the proposed venture. The report suggests that the most favourable and practical option in terms of satisfying Games Workshop's shareholders would be to finance the acquisition using 25% debt.
The Strategic Rationale
Games Workshop is the largest tabletop fantasy and futuristic battle games company in the world and regardless of difficult economic conditions have still managed to increase operational profit margins by 7.17% in last financial year. Trading on the London stock exchange, Games Workshop is an organisation which is always looking to grow, especially in its core business. As stated by the company chairman 'We have nothing to hide and no-one to fear' and the company will continue to focus on what it does best. In addition, it is proposed that this is the perfect time to expand into other fields as currently we rely heavily on one single market, ultimately this will diversify risk.
Hornby Group PLC is a UK brand leader as a model manufacturer, which similarly to Games Workshop distributes its sales on a worldwide scale. Hornby also operates under various well known brands such as Scalextric, Lima and most recently Corgi. It is important to point out that the purchase of Corgi increased Hornby's net debt to £11.8million which in relation to Games Workshop is considered high. Although not as large as Games Workshop in terms of turnover, Hornby had a greater growth in its profit margins in its previous financial year. Thus showing despite the economic downturn they have still managed to prove significant financial performance.
The following part of the report will clearly define the strategic operational and financial justification for the proposed acquisition of Hornby.
Operational Justification
Games Workshop and Hornby both operate on a world wide scale. Furthermore, Hornby is a well established organisation which owns many brands which shows its potential to grow in the future which is ideal in terms of our strategy.
It is clear that Games Workshop and Hornby have similar customer bases and they have the skill sets to compliment each other. In addition, both organisations distribute products which are sold in the same market however do not conflict or overlap.
The differences in size of the organisations make this ideal for an acquisition over a merger. In addition to strong supplier links, Hornby also has proven to have a solid supply and distribution links which can be used by Games Workshop to take some of its production overseas at cheaper rates.
Hornby do extremely well in many areas, Games Workshop have the ability to utilize strong supply, distribution and development processes that are in place already. In result, the share of resources would promote cross selling between both parties which would lead to greater economies of scale.
Financial Justification
Most importantly, if the acquisition proposal is accepted, the model estimates the value of Games Workshop after acquisition will be just over £200million. The boost in value is ideal as shareholder value will be increased.
The model estimates that that rate of return will increase after the acquisition and in addition the acquisition of Hornby will lower the risk rate of Games Workshop. Both of these factors will benefit the existing shareholders of the organisation.
Significant synergies can be produced if the acquisition of Hornby takes place such as cost savings, increase in bargaining powers and share of business functions. There is an increased chance of skill specialisation in many functions with the addition of eradicating duplicate jobs, in result would not only reduce business costs but improve quality of services that are provided.
The value of Hornby to Games Workshop
It is important to point out that Hornby is well established brand name which was been around since 1860's and has been floating on the LSE for a reasonable period. It is equally important to state that Hornby has demonstrated continuous progress in terms of financial performance, in particularly in times where its expenses have nearly doubled due to high material costs http://www.hornby.com/investor-relations/.
Although demand for Hornby's products have strengthened, they still have areas which are causing concerning, such as disruption to their supply chains in China, however this is a issue which they are currently trying to overcome by building stronger relationships with their suppliers.
If incorporated, considerable synergies could be produced by the both companies, most commonly through economies of scale. In addition, shared business functions such as marketing, finance, human resources management and distribution and many others could provide further cost savings to Games Workshop. These synergies would allow us to gain a competitive advantage over our competitors as the company would hold a greater market share. It is estimated by using the model (see assumptions) that sales turnover and operation profit margins would increase by 1% after acquiring Hornby. This would give Games Workshop a total synergy benefit of approximately £2.8million on operation profit margin over the next 5 years (appendix). In addition to possible synergies, the comparative size of Games Workshop and Hornby will allow for the elimination of duplicate line of works, consequently saving on wage expenses.
When acquiring Hornby it is important to see that the market value equity of the company prior to take over is at £54million. Along with the benefits increasing value it is imperative to point out that integration of Hornby could also bring a liquidity risk as they carry a high debt value of £11.7million in comparison to debt value of Games Workshop of £1.6million. It is vital in any organisation that gearing is kept to manageable level and therefore the reasoning behind proposals of funding this acquisition using 30% premium will be evaluated next in this report.
Proposition for Merger or Acquisition
Games Workshop's net present values are currently looking very superior and the model shows that acquisition of Hornby at the premium of 30% is affordable. The model suggests that greater benefits could be made by an acquisition rather than a merger between both entities. Benefits from an acquisition are greater than merger not just from a financial viewpoint but also an operational viewpoint.
From a financial perspective, we can estimate using the model that rate of return when acquiring Hornby using 25% debt is the better. For example, Games Workshop merging with Hornby would provide a return rate of 6.93% compared to superior rate of 7.01% if acquiring Hornby. In addition to a higher rate of return, Games Workshop could benefit from many other non financial factors.
Diversification is a key to lowering risk, especially in terms of acquiring Hornby as the organisation holds a lower risk factor. The model calculations show that, Hornby has a lower asset beta than Games Workshop, this in fact will lower the business risk for the new organisation.
From an operational perspective, we need to look at whether both of the firm's strategic plans coordinate with one and each other. Both Games Workshop and Hornby aim to grow by increase sales for their existing strong market brand names. The strength behind Games Workshop's management is that it focuses on the importance of its customer base of hobbyist's, identically Hornby has a strong customer base of product followers and therefore the benefit of having similar customer bases would offer growth benefits.
Over a long period Hornby has built to solid relationships with its suppliers, where it can benefit from cheap production of its products, especially in India and China. Potentially it could mean Games Workshop could benefit from Hornby's supply chain taking some of its production of miniatures and other products to China or India.
Furthermore, by acquiring Hornby, Games Workshop will have the ability to take advantage of areas in which Hornby excel. Both organisations could share common areas of resources such as distribution processes, supply procedures and development methods. Share of resources will ultimately encourage cross-selling between both parties, which would lead to economies of scale. The opportunity for cost savings for both Games Workshop and Hornby is vital as this is outlined as a key strategy for success in the long term.
Limitations of both Games Workshop and Hornby is that they rely heavily on the cost of raw materials, and therefore cost reductions will be vital in terms of strategy for both parties, specifically now more than ever in current uncertain economic times. We can regard the acquisition of Hornby could potentially distract the group from its current core business activity, particularly with in regards to Hornby dealing with its supply chain problems.
On the basis of the model results, financial benefits and operation benefits it is proposed that Games Workshop should acquire Hornby on the basis of a 30% premium. The acquisition should be funded using 25% debt as this will give the greatest benefits and also keep gearing low. Shareholder value after the acquisition would be increased by £29million, even through this is lower than the merger this incorporates the cost premium of £70.2million. (See appendix.)
Raising Financing & Shareholder value
Shares and cash are the most common ways of financing mergers and acquisitions according to Arnold (2005) however there are other ways of raising finance including borrowing. These three forms of raising finance have an affect on the shareholder value and change the risk they present depending on how they are used.
Out of all the above methods it's obvious that the most ideal way of raising finance would be using cash. Cash is the least complex and it also the easiest to account for in the balance sheet. Using cash to fund an acquisition would also avoid paying any agency fees and other payments, in result this would sustaining shareholder value. Alternatively to cash, the company may wish to issue new shares to raise finance however, it is a possibility that this could negatively affect current shareholders.
As stated above, the third common way to raise finance for an acquisition would be increasing debt, however this form of finance does have many concerns, for example. A high amount of debt financing means that paying back large loan payments which can dent profits and the higher the amount of debt will lead to a bigger risk of bankruptcy. To lower the risk for shareholders and to maximise their wealth, the model has indicated the best mix of sources of finance that Games Workshop should use.
To fund the acquisition at a premium of 30%, to receive the greatest benefits the acquisition should be funded using 25% debt. Shareholder value after the acquisition would increase by £29million, even through this is lower than the merger this incorporates the cost premium of £70.2million. (See appendix). The model allows a sensitivity analysis to be carried to show the affect funding has on its shareholders. Contradictory to above, there is a possibility for Games Workshop to fund the acquisition through 50%, 75% and 100% debt. However the model suggests that gearing at these rates would be high and also that maximum shareholder wealth can not be reached at such high debt amounts.
According to the model it is not a viable option that Games Workshop use cash and cash equivalents of £10.3million to finance as these are not sufficient to cover the acquisition premium of £70.2million. This source of finance would be difficult to use as a part payment because cash is required to keep up adequate liquidity in the balance sheet, especially in difficult economic climates.
Raising finance for the premium of £70.2million could potentially be done in either one or many various ways. Firstly, using the proposed method, Games Workshop could fund acquisition through increasing its debt to £31million and increase its equity funding to £170million. This proposal would increase the companies gearing ratio to 15.4% which is seen as an acceptable by many scholars (Reference). Ultimately, these are best combinations of raising finance as these would provide the greatest increase in shareholder value.
Conclusion
Operating in a similar market, it would be an excellent option for Games Workshop to acquire Hornby. This report gives clear operational and financial justifications for proposal of the acquisition of Hornby and outlines that there are huge benefits to be gained. Ultimately, the acquisition of Hornby would create better returns for those who are involved. It should be noted that Hornby has a well established brand portfolio and worldwide product licences which should utilized by Games Workshop to make its own brand name even more powerful and increase its market share globally. This acquisition could potentially give Games Workshop the ability to diversify and exploit new markets and stretch its current abilities to a wider level.
Overall, the acquisition would reduce Games Workshop's investment risk, increase its rate of return on investments and also reduce the cost of capital. Furthermore synergies and economies of scale and other cost savings would increase Games Workshop's competitive edge in the market.
To conclude, although the report discusses various other scenarios such as merging, it is recommended to the board to consider the proposal of acquiring Hornby as it would yield the best long term results for Games Workshop and its shareholders.
Assumptions (UNFINISHED)
NEED TO BACK UP WITH REFERENCES AND JUSTIFY WHY YOU HAVE USED THEM
For the purpose of this report, some assumptions have been made to able us to have a better understanding and the consequences of the integration of Hornby. All information used in the model was collected on the same date to give us an most accurate valuation. It should be noted that the model may not be fully accurate due not having all information available and therefore assumptions need to be made. Ultimately, these assumptions have been made to demonstrate various scenarios which in result would allow with better decision making.
The market premium rate used in for calculations was 6% based on Stern and Stewart Equity Risk Measurement Handbook (Reference). This assumption is based on their general knowledge, analysis and understanding of value. It is made clear that these market premium rate used is subject to change but is correct at the time of the report.
To ensure accurate valuation information available was taken at the same time and from the same sources. Both the beta and market value equity was taken from Bloomberg on the 25th of January 2010 and is assumed correct at the time of data collection. The risk free rate of 2.79% has been collected from FT.com on the same date as shown above. To get the most accurate rate we assume the risk free rate should be taken over a 5 year yield.
The model also assumes that Cost of debt (Kd) will remain at 6.30% if the integration of Hornby takes place, this is due to Games Workshop being the larger corporation (Based on value). In addition, asset beta also remains constant as Games Workshop is the larger corporation.
An acquisition premium of 30% has been used for the purpose of the model. This assumption has been made at 30% on the basis of the industry average over the last 10 years is between 40% and 30%. Although it is agreed that not a guideline and premiums should be based on 'competitive factors, trends, economies of scale and buy and seller motivations'. http://media.wiley.com/product_data/excerpt/19/04714110/0471411019.pdf
Sales growth and profit margins are assumed to remain at the same rates over a 5 year period due to doubt over changing in various costs. To maintain margins, synergy benefits of 1% per year are included to boost the sales and profits.
It is also assumed that synergy benefits from an acquisition would be greater than a merger. It is a possibility that synergies do not materialising at all or not to the full extent.
