Formed in 1869, Eaton was one of the highly respected and recognized brands in the Canadian retailing sector. However, through the early 1990's, Eaton's financial performance suffered due to internal and external factors. It incurred losses (1996, $128 million & 1995, $80 million) and declined in revenues (1996, $1.7 billion, which is down $2.3 billion from 5 years ago). Given its leveraged position and reducing operating profits, Eaton's management had filed for bankruptcy protection in early 1997 and proceeded for a restructuring plan which was proposed later in the year. The new management structure and board of directors comprised of individuals from notable retails organizations. After implementing a full-fledged restructuring plan in November 1997, it covered up some of its losses and posted a profit of $58 million. Since, its capital needs exceeded the operating line of credit extended from its current lender i.e. Bear Sterns & Co, it decided to raise equity through IPO issuance. It chose Scotia Capital Markets, the investment bank as a co-lead manager for facilitating the IPO process. Now, the issue in front of the bank is to decide the appropriateness of the timing of this IPO, value this IPO, and calculate the share price range and no. of post-IPO shares outstanding.
Present State Analysis
Economic Environment: Economic conditions in North America were favorable for growth, even in the retail sector. Strong increase in retail spending and highest consumer confidence in North America, low interest rates and high disposable incomes had been a feature of the market in this decade. Companies in retail industries continuously rallied forward on the stock exchange. However, factors such as 1997 economic crises in Southeast Asia and banking crisis in Japan, federal reserve's inclination towards raising interests to avoid inflationary trends which might be caused by low unemployment and savings rates in US and Canada, had some observers concerned about the sustainability of North American equity markets at their current levels.
Appropriateness of Eaton's IPO: Buoyed by the novel restructuring plans in management and operations and the fact that the economy was in a bullish-state, an IPO launch for Eaton seemed to be a favorable option. Also, Eaton has a competitive advantage of over hundred years of goodwill and reputation in Canadian retail sector which extended to suppliers and creditors which few competitors could boast of. Investors would buy in shares of a hundred year old Canadian retail icon which seemingly is in a turnaround stage and holds promise of growth in a healthy economy. Having said that, the underwriters need to be extremely careful, if equity markets fall soon after the IPO (given the sustainability concern with the North American bull-run), Eaton's ability to raise equity in the future might be adversely effected. Firms whose economic performance has been lackluster but who expect improvements in the future earnings, often prefer a relatively small IPO followed by larger seasoned equity offerings when earnings have improved and seems sustainable. However, urgency of capital need to implement operational restructuring and capital investments is an incentive for Eaton's management to raise the full amount required at the IPO stage.
IPO Valuation Methodology
A company's equity at market value is measured by its prospects to grow and ability to generate future earnings. Various financial techniques can be utilized for Equity valuation of a company. Choosing the most appropriate method depends upon the specific industry and state of the company being evaluated. In Eaton's case, following specifics need to be noted:
Eaton had just emerged out of Bankruptcy Protection act, the CCAA
The organization is re-structuring its management and more importantly its operating strategies
Thus, recent historic revenue growth, sales figures, profit margins or cash flow statements will not yield an accurate picture of future cash flows. The DCF model to value equity and thus enterprise value is as accurate as the accuracy of the future cash flow stream. DCF method works best for firms that are mature and stable but renders inaccurate results for firms recently formed or emerging from insolvency. Thus, for a turnaround company like Eaton's, the DCF model is an inappropriate method to estimate the firm value for an IPO. Then, there is the Asset-based pricing approach. This method is useful in liquidating the firm, but is not recommended when valuing a firm based on future growth prospects.
Another option to value firms is the comparable firms approach, i.e. by using multiples of comparable firms, capitalizing (adjusting) those multiples to Eaton's scenario and estimating the firm value for Eaton. The key in using comparable firm multiples is to select the appropriate comparable firms and then selecting the appropriate multiples. Based on Eaton's market position, cash flow characteristics, risks and growth, the comparable firms selected were: Hudson's Bay Company, Sears Canada and Canadian Tire.
To determine Eaton's Equity value or Firm value through comparable firm's multiples approach, the options available are: P/E ratio, EV/EBITDA ratio, Market Value/EBIT ratio, Market Value/Sales ratio and Market Value/Book Value ratio.
The P/E ratio (Price/EPS) is the most widely used ratio, but it takes into account the capital structure the firms and is not accurate with companies where recent earnings have been negative (Exhibit 1). Using ratios involving Sales will represent an accurate picture of the firm value, only if the cost structures for the comparable firms are similar (Exhibit 2 & 3). On the other hand, EV includes the cost of paying off debt and EBITDA measures profits before interest expense, unusual expenses and D&A. Thus, to determine the true value of the firm, the EV/EBITDA ratio is selected as the most representative multiple.
Eaton's Equity Valuation
Eaton's pre-IPO Enterprise value range using the EV/EBITDA method is calculated as $530.4-634.4 Million (Exhibit 4). By April, 1998 total debt outstanding was $274.4 million. Thus, pre-IPO equity would lie in the $256-$360 million range. Historically, IPOs are underpriced at around 15% of their value, but due to Eaton's situation compared to its competitors, and to attract more investors Eaton's share would be underpriced at 30% of its mathematical value. Since, Eaton is raising $175 million equity, post-IPO equity ranges between $354.2-427 million.
Share Price and No. of Shares to be issued at IPO Launch
Determining share price during IPO procedure is where the Investment Bankers truly add value. The process takes into account the equity value of the firm, the market demand for its shares and investor confidence in the growth of the company. Here we have calculated the post-IPO share price range, which is post-IPO value of equity divided by no. of shares outstanding pre-IPO. According to our analysis, Mary Vitug must report a price range of $15.4-$18.48 per share to Sandra Schumacher. The argument for this would be that usually investment banks tend to under-price the stock to invite as many investors as possible. The investors through competitive bidding process reveal lot of information and eventually reach to the true price of share. Investors are compensated for their costly analysis due to underpriced stock. Assuming the higher end of this share price range is the final offer price i.e. $18.48, no. of shares issued would be 10,371,711. Usually underwriters exercise "Greenshoe" option in which case the total number of shares to be issued is 11,721,143. Since an optimal distribution ratio of 70:30 is chosen for institutional and retail investors, thus no. of shares to be issued to institutional investors are 8,204,800 while shares issued to retail investors are 3,516,343.
Final Recommendations
Given the need for capital to pay the operating line of credit and to finance the restructuring process, Eaton's management decision to issue an IPO to raise equity via the market was appropriate. As underwriters in the IPO process, Mary Vitug should follow a conservative approach in valuing a turnaround company like Eaton. Investors would not be incentivized to invest in Eaton if the share price is not at a discount to comparable companies in the retail sector.
The recommendation is therefore to launch an IPO with the following price on securities:
Price/Share= $15.40 to $18.48 and No. of Shares Issued = 10,371,711 (Greenshoe : 11,721,143).
Exhibits
Exhibit 1: P/E Analysis
Exhibit 2: Market Value to Sales Ratio
Exhibit 3: Market Value to EBIT Analysis
Exhibit 4: EV/EBITDA Analysis
