091113 champion road case report v6

The Chinese University of Hong Kong

Department of Finance

FIN6092 Advanced Financial Management

Case Study:

Champion Road Machinery: Dividend Policy – A Question of to be or not to be

Team members

CHAN Pui Ching Angela (09046580)

CHIU Yu Cheuk Tommy (09046640)

LANDOLT Ryan Brooks (09068750)

LIN Tsun Kit Stephen (09028690)

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COPORATE FINANCE DEPARTMENT

To: The Board of Directors

From: Scott Hall, CFO and VP of Finance

Date: 30th July, 1994

Page(s): 20

Re: Recommendation on dividend policy

SECTION 1 Executive Summary

This report analyses options and provides recommendations on Champion Road Machinery (“the Company”)’s dividend policy in the aftermath of the Initial Public Offering (IPO) this year.

We have analyzed the Company’s cash flow forecast, cash position and borrowing capacity in the near term, against our cyclical nature of business and estimated fund requirements for capital expenditures, working capital and possible acquisition activities.

With regards to the Company’s three main types of shareholders: Sequoia’s executives and investors, other institutional and retail investors, we have evaluated their respective preferences and expectations on our dividend policy.

Assessment of the pros and cons has been done on three alternative dividend policies: no distribution, regular dividend and one-off distribution via special dividend or stock repurchase.

The report concludes that, on the back of the Company’ excellent track record in selecting value-creating investment, and in line with the Company’s existing shareholders’ expectation of a capital gain instead of a recurring income stream, the Company does not have to follow its competitors in making regular dividend payments. Moreover, in view of our cyclical business, we could avoid an investors’ expectation for a recurring income stream and thus downside risk being posed by regular dividends’ changes to our stock price.

The Company should fund its growth and acquisition on the strength of improved cash flows as a result of IPO proceeds and higher profitability. Thus we also do not recommend making a one-off distribution at the next board meeting. However, if we cannot ascertain worthwhile investments in the next 9 months, we recommend a one-off distribution to the shareholders in the form of a share repurchase.

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SECTION 2 Introduction

2.1 Background

Since Sequoia Associates (“Sequoia”) acquired the Company in 1988, the performance of the business has significantly improved. In the past few years, we have implemented measures to improve the financial health of the company by doing the right things: focusing on process improvement, being responsive to customer design recommendations, maximising workforce productivity, expanding and improving the quality of its product lines.

Through the years, the Company has introduced new product series and focused on expanding the company’s existing markets by acquiring other companies that fit with the Company’s core business.

Six years after Sequoia’s takeover, there was another milestone for the Company when we completed the IPO in April this year. During the first half of the year, we were performing well above expectations and our latest forecast is pointing us towards a healthy cash flow for the full year. As a result the Corporate Finance Department was asked by the board in July to recommend whether the Board should declare a dividend.

2.2 Structure of the paper

To answer this question, we have analysed the issue from two different perspectives: the firm and shareholders.

First, we looked at endogenous factors within the boundary of the firm and determined the surplus cash position of the Company in 1994 and the near future. We accomplished that by answering the following questions:

What is the movement of cash in 1994?

What is the projected growth of the operating cash flow in the next 2-3 years?

What is the current / future requirement for capital expenditure (capex) and provision for working capital?

Are there any other expansion or M&A activities and what is the cash requirement for such activities?

What is the company’s capacity to raise funds given the current and target level of leverage?

Does the company have residual cash after considering all of the above?

After we have established the cash position of the company, we then analysed the amount and nature of the dividend, if any, that we would recommend the Board of

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Directors to declare. We have considered different options by answering these questions:

Who are the shareholders and what are their motivations and objectives?

Will the majority of the shareholders welcome a dividend declaration / demand a dividend?

What form of dividend will they expect (regular vs. special vs. share repurchase)?

What are the tax implications of different forms of dividends for the shareholders?

To reach our recommendation, we analysed the pros and cons of three different options and ranked them by a nominal scale.

SECTION 3 Establishing the Cash Position

3.1 Cash movement in 1994

According to our initial forecast, the Company is expected to realise net profits of $8.1 million. The Company has been successful in working capital management since the current management took over. We expect working capital as a percentage of sales to decrease from 12.4% in 1993 to 11.6% in 1994. This represents a net increase in working capital of $ 2.38 million.

Net capital expenditure or capex over and above depreciation in 1994 is expected to be $ 3.0 million. Thus for the purpose of estimating cash flow, we include the net amount of $ 3.0 million to represent capex net of depreciation of fixed assets.

In April 1994, the Company successfully increased its share capital through an IPO. The net cash proceeds from the IPO were $ 26.6 million. Part of the cash was used to pay down long-term debt, totalling $ 12.3 million.

Therefore, the total net cash flow of the Company in 1994 is $ 17.5 million (See Exhibit 1).

3.2 Forecast of Net Income (1995 – 1997)

In the years since the current management has taken over, the performance of the company has improved significantly. Operating margins have improved steadily from 5.4% in 1991 to 8.8% in 1994. We expect this improvement to continue until reaching 10% in 1997. As a result, we forecast that the net income of the Company will grow by an average of 15% a year in the next three years.

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3.3 Capex requirement and working capital management

Capital expenditure is likely to accelerate in the next three years to cope with the rapid expansion in the soil compactors and small grader divisions. We expect the net capex to exceed the average depreciation in the next few years. The total forecast net capex for 1995, 1996 and 1997 are $ 4.0 million, $ 5.0 million and $ 5.5 million respectively.

Total working capital employed is expected to be maintained at 11.0% to 11.5% in the next three years.

3.4 M&A and other expansion opportunities

We would like to make at least one acquisition to diversify our business in 1995. We have seen a lot of promise in the snow removal equipment sector, which is growing at 20% p.a. and has great synergy with our existing spare parts and dealership divisions. We have identified a couple of targets and will accelerate our search in the following months. Our expectation is to present the deal to the Board for approval before the end of this year.

In line with our previous M&A experience with the acquisition of the soil compactors and small grader business, we would not expect the snow removal equipment business to account for more than 10% of the Company’s total sales. For new acquisition, we normally require a return on capital of 15%. As snow removal equipment is a niche market, we assume that the industry average net margins are between 12% and 15 %. This will put the indicative size of the acquisition at $ 5-12 million. (Exhibit 3)

We are also looking at opportunities for international expansion in the next few years. The emerging markets in Latin America are undergoing an economic boom. There is a big construction boom in the former Soviet nations and Eastern European countries following the fall the Berlin Wall in 1989. Expanding the Company’s foothold in these key growth markets will help spearheading revenue growth while hedging the business’ cyclical risks of our core North America and European markets. We expect sales to markets outside North America to reach 45% of our total sales by 1997, with emerging market sales accounting for one forth of the sales (Exhibit 4).

In order to achieve these targets, we will invest in the development of these new markets by opening sales offices and increasing the marketing expenses in Eastern Europe and Latin America. As emerging markets are inherently more risky, we expect at least a 20% return from our investment. The total investment in new offices, headcounts, marketing and fixed assets required to develop these emerging markets is expected to be $ 35 million over the next three years. (Exhibit 3)

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3.5 Gearing and borrowing capacity

After paying off all the debt this year, the Company’s effective gearing (total liabilities / total assets) is forecast to be 37% (Exhibit 2). As the Company’s target gearing is 50%, the Company has room to raise debt to finance future expansion and M&A activities without exceeding the target gearing ratio.

Considering peer companies’ relatively high gearing (Finning 67%; Caterpillar 82%) and based on the strength of our balance sheet, we anticipate that the Company can raise $ 15 – 20 million of debt without significantly increasing the risks of financial distress.

3.6 Position in residual cash

Considering all the factors above, the total cash required in 1995 is between $26.5 million and $33.5 million.

The cash position at the end of 1994 is $ 17.5 million. Therefore, there will not be any residual cash in the business at the end of 1994 / beginning of 1995 assuming the acquisition of the snow removal equipment business takes place in Q195.

In 1996 and 1997, we expect strong investment needs in line with the emerging market strategy. Funds for growth are expected to be generated from retained earnings and, if exhausted, by dipping into the debt market.

SECTION 4 The Shareholders

4.1 Shareholder composition of the Company

Sequoia is the majority shareholder of the Company. Prior to the IPO there were 8.75 million shares outstanding, with the majority held by 91 Sequoia executives and investors. After the IPO, there are now a total of 11.17 million common shares outstanding. With some of the Sequoia investors divesting their shares totalling 1.1 million, the shareholding post IPO splits approximately 7:3 between Sequoia and public shareholders.

A successful IPO is an accomplishment for any company and by offering shares to the general public, we have successfully marketed Champion Road to the investor community. Of the shares owned by the public, 70% were sold to institutional investors and 30% were sold to retail investors.

An understanding of the motivation of these different groups of investors will play a significant part in our final analysis about the optimal course of action.

4.2 Motivation and objectives of different groups of investors

Champion has three main categories of investors.

Majority Shareholder (Sequoia executives and investors)

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Our majority shareholder, Sequoia is a private equity firm that acquired underperforming companies that offered the potential for growth in sales, earnings and cash flows, which would then translate into stock appreciation. Sequoia’s investment methodology is one that inherently involved high risk and also the prospect of high return. The acquisition of the Company was no exception to Sequoia.

We believe the objective for the Sequoia investors could be the prospect and timing of an exit strategy. As part of the IPO agreement, the original 91 pre-IPO shareholders could not sell any stock (other than that allowed in the IPO) for a period of one year after the IPO. This raises the question of what the Company can do to maximize shareholder value in that time period, as well as after the one-year lock up period.

Private equity investment is a risky business. Taking over a company, improving efficiency, creating value, and ultimately selling it at a significantly higher price than you paid for it is not any easy job. There is no guarantee that you will make a profit, and private equity investors therefore need to have certain characteristics in order to be successful. One necessary characteristic is patience. Sequoia Associates took over the Company in 1988, almost six years prior to the IPO. Their objective now is to decide where to go from here. Sequoia is unlikely to see itself as managing the Company forever and they would probably rather see cash be retained in the company to support positive NPV projects so that they can exit on a high rather than giving out dividends and just making out with whatever they can now that it is a publicly traded company.

It seems that by growing the business, and hopefully the share price over the long-term (i.e. the next 3-5 years), the Sequoia investors could eventually be poised to profit handsomely. In this regard, making a cash distribution seems to go against this objective, unless it is determined that there are no worthwhile investment opportunities in a reasonable time horizon.

Minority Shareholders (Institutional and other individual (retail) investors)

The positioning of our stock issue was targeted at investors interested mostly in capital gains. Although some institutional investors may be motivated by a certain percentage of dividend payout, they should be well aware that the Company is not expecting to give out any dividend in the near future.

And while 70% of the issued stock had been purchased by institutional investors, there is no reason to believe that these mostly Canadian-based money managers did not see their investment as one aimed at capital appreciation as opposed to a regular income investment. It also seems safe to assume that that retail portion of the shareholders would prefer possible large capital gains rather then regular dividend payments.

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It seems that the investment objectives of institutional and retail investors do not necessarily conflict with each other. Both of these two parties expect capital gains from an appreciation in the stock price.

SECTION 5 Suggested options

After considering the above factors, we have come up with three possible options for a dividend policy: 1) Do not distribute any dividend; 2) Propose a regular dividend and 3) Distribute cash via a special dividend or stock repurchase.

5.1 Option 1 – No dividend

The first Option is to declare no cash dividend.

The dividend policy decision should depend on capital budgeting as well as debt policy (as we want to maintain a target 1:1 debt-to-equity ratio). That is, the Company should distribute dividends only if there is residual cash left behind, after investing in all projects with positive net present value (NPV) while maintaining an “optimal” debt-to-equity ratio.

Retaining cash in the business in anticipation of investment opportunities will better position the Company for future growth. In view of requirements for capex and potential acquisition activities, the Company is not expected to have spare cash in the next 12 months. As we are currently actively looking at expanding the business with the purchase of a snow removal equipment manufacturer and also more overseas investment to support international sales growth, the Company should more or less follow the ‘residual dividend policy’.

From the angle of the shareholders, the Company examined the dividend policy issue at the time of the IPO (April 1994). The prospectus clearly stated that: “The Company does not anticipate paying cash dividends on the common shares in the foreseeable future, but intends to retain future earnings for reinvestment in the business.” Therefore the IPO was targeted at investors interested primarily in capital gains and the profile of the public shareholders did not change since then. The management re-visited this issue three months after the IPO and determined that no change was required. Given that the majority shareholder would prefer keeping the cash in the company to invest, not declaring any dividend will be consistent with the shareholders’ expectations.

The Company’s patient approach in looking for good investments and its good reputation for identifying the right targets has been well recognized by the investment community. For instance, our capital allocation program has been described by one analyst as “very successful”. Thus the public shareholders should have less concern about the Company sitting on a pile of cash and destroying value.

Last but not least, this residual dividend policy approach could avoid incurring additional issuance and time costs in financing (debt and/or equity) in case good investment opportunities arise after excess dividend payments.

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5.2 Option 2 – Regular Dividend

Option 2 is to declare a regular cash dividend during the Annual General Meeting.

As most of our competitors are declaring regular dividends – most recent dividend yields of the major ones are: Caterpillar (US: 0.6%), Finning (Canada: 1.12%) and Toromont (Canada: 1.69%) – some would argue that this provides a very good reference point for the Company to follow.

Per Exhibit 5, based on $ 12 share price and 11,170,000 outstanding shares, if the Company pays an annualized dividend yield (1.12%- 1.69%) which is comparable to Canadian-based heavy equipment dealers, the regular dividend would amount to $1.6 million to $ 2.3 million; while at a level similar to Caterpillar (0.6%), it will only cost the company $ 800,000 in the first year.

In making regular cash dividends, some academics and commentators would argue that the Company could convey a message of confidence to the existing and potential investors on its long-term profitability and growth.

Many of the large Canadian-based money managers subscribed for 70% of the newly issued shares at Champion’s IPO. Indeed, under Canadian legislation or/and conventions, Champion’s stock has already been considered to be eligible for most institutional investments. Despite this, it may still be worthwhile considering making regular cash distributions so as to broaden the potential investor base, particularly targeted at those institutional investors outside of Canada, who might expect a regular income stream.

Although this consideration is against the Pecking Order Theory, it could be relevant as the Company seeks to diversify its business internationally, it should have more financing needs for wider range of investment opportunities, a higher profile and broader investors base (as compared with Caterpillar and other Canadian competitors) should help the Company raise funds, even possibly in the international equity markets, for expansion.

However, a regular dividend is an implicit commitment to the shareholders, which if not maintained, may be perceived as a weakness of the Company. It is clear to us that once a regular dividend is declared, there is an expectation from the minority and potential shareholders that such dividends are going to continue. In case of a future cut or elimination of such regular dividends, there will be an adverse impact to the share price of the Company (a possible 8 to 10% drop at the date of announcement according to some studies).

While we agree that the Company could afford to make a regular dividend of a similar level to that of its peers in the first year, sustaining a regular pattern of dividend from year to year will become a major challenge to the Company as we are engaged in a cyclical business.

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We conclude that regular dividend could pose a downside risk to our share price and will place an unnecessary constraint to the ability of the Company to create shareholder value.

5.3 Option 3 – Special Dividend or Share Repurchase

Option 3 is to declare a special dividend or initiate a share repurchase programme.

Although we anticipate a big cash requirement due to the proposed acquisition of a snow removal equipment manufacturer early next year, there is an uncertainty in the timing of the investment and the possibility that the acquisition will not be able to meet our return on capital requirement cannot be ruled out. In case we could not identify suitable targets in 1995, there will be residual cash in the Company and a one-off cash distribution to the shareholders should be the best option. This could avoid the possibility that the Company would accumulate more cash than it could invest profitably. With the one-off nature of the distribution in the form of special dividend or share repurchase, the company could avoid an expectation by the investment community for a recurring dividend.

Public Shareholders will be relieved to see the company paying out the excess cash instead of squandering it on unprofitable investments or leaving it sitting in the bank. Having invested in the Company for six years, Sequoia investors may also welcome some accelerated cash return on their investment. This consideration is particularly relevant when the Company has more cash than ever before post-IPO.

Per pro-forma balance sheet as of December 31, 1994 (Exhibit 2), the company is forecast to have a gearing of 37 percent, which is well below its target of 50 per cent. Comparing against companies in the same industry, Finning (67 percent gearing) and Caterpillar (82 percent gearing), it is on the safe end. In case any investment opportunities arise after the one-off distribution, it could raise additional debt of around $15 – 20 million before breaching its target gearing ratio.

This option may not agree well with the Pecking Order Theory and extra issuance and time costs are inevitable if additional financing is required for new investment opportunities, but the management should weigh them against the opportunity costs of holding idle cash sitting in the company for a prolonged period.

The choice of special dividend against share repurchase will be dependent on the marginal tax faced by the investors. Per Exhibit 6, under the Canadian tax regime the effective tax rate on dividends (29.4%) is lower than that on capital gains (32.7%), thus minority shareholders, who are mostly Canadian investors, should prefer a special dividend from a tax perspective. On the other hand, the Sequoia investors are US based and they are more likely subject to US effective tax rates (instead of Canadian rates), that is, higher dividends tax rate (39.6%) versus lower capital gains tax rate (28%). Consequently, the majority shareholders will prefer a share repurchase over a special dividend.

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5.4 Ranking criteria and results

To reach our final recommendation for the Board, we evaluated each option against the following criteria:

Pecking Order Theory: whether the option promotes the best cash management practice in accordance with the Pecking Order Theory

Company growth: whether the option promotes company growth

Majority shareholder’s objectives: whether the option meets the majority shareholder’s objectives

Other shareholders’ objectives: whether the option meets the minority shareholders’ objectives

The result of our analysis is summarised below using a weighted scale of 1 to 3 (1 = least favourable, 3 = most favourable):

Criteria Weight Option 1 (Nothing)

Option 2 (Regular)

Option 3a (Special)

Option 3b (Repurchase)

Pecking Oder Theory

2 3 1 2

Growth 4 3 1 2

Majority Shareholders

3 3 1 1 2

Minority Shareholders

1 3 2 2 1

Weighted Score

3.0 1.1 1.7 1.9

SECTION 6 Conclusion and Recommendation

Based on the above results, we recommend not declaring regular dividends at the forthcoming Board meeting in August 1994 because it is in line with best cash management policy, promotes growth and is generally in line with our shareholders objectives and expectations. A cash buffer will allow us to respond quickly once any worthwhile acquisition targets surface in the next few months.

However, we recognize that it is possible that we will be unable to identify suitable value creating projects within the next 9 months, in which case the Company will

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have residual cash. Therefore we propose a “wait-and-see” approach to a one-off distribution in the form of share repurchase.

We recommend that the Company should continue the patient, prudent capital allocation policy that it is well known for. We therefore propose to the Board that we will continue to evaluate different investment opportunities in the next 9 months. In the event that we cannot ascertain any investment targets with strong positive net present values, we will decide on a one-off distribution by the end of April 1995.

We propose to delay the decision on one-off distribution until April 1995 because it is more likely that we will: (1) have enough time for project evaluation and negotiation; (2) see how the actual operating results and balance sheet positions compare to our forecasts.

Compared against a regular dividend, either a special dividend or a stock repurchase can serve the same purpose of distributing cash to the investors. However, the Company will not be perceived as making a long-term commitment on returning cash to investors, as the information implied in the announcement of a share repurchase or special dividend program is considered to be different from that of a regular dividend payment.

We would propose a share repurchase over special dividends as the majority shareholders are subject to lower US capital gains tax and would prefer share repurchase over special dividend.

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($'000)Net Income 8,100 Add: Proceeds from IPO 26,600 Add: Deferred Tax adjustment 523 Less: Capital Expenditure (net of depn) (3,000)Less: Increase in Working Capital (2,382)Less: Repayment of Debt (12,302)Net Cash Flow 17,539

Exhibit 1 – Pro-forma Cash Flow Analysis of the Company in 1994

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1994($'000)

Balance Sheet

Assets:Bank and Cash 17,539 balancing figureAccounts Receivable 18,354 % of salesNotes Receivable 1,886 % of salesInventory 25,057 % of salesPrepaid Expenses 349 % of sales

63,184

Property, Plant and Equipment 13,253 add $3M capital expenditures (net of annual depreciation)

Other Assets 622 % of sales

77,059

Liabilities:Bank Indebtedness 0 assume all clearedAccounts Payable 23,532 % of salesIncome Tax Payable 4,139 ratio based on tax P/LCurrent Portion of Long Term Debt 0 assume all cleared

27,671 Long-Term Debt 0 assume all clearedDeferred Income Taxes 1,178 ratio based on tax P/L

Shareholders' Equity:Share Capital 28,178 add the net IPO proceeds ($26.6M)Retained Earnings 20,032 add current yr forecast P/L $8.1M

77,059

Total debt to total assets 37%

Exhibit 2 – Pro-forma Balance Sheet of the Company as at December 31, 1994

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$ (‘000) Total Sales 155,000@ 5% 7,750@ 10% 15,50010% net margins 77512% net margins 1860ROC 15%Lower Bound Investment Cost 5,167Upper Bound Investment Cost 12,400

Exhibit 3 – Estimate of indicative acquisition costs of a snow removal equipment manufacturer

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1994 1997North America 72% 55%Western Europe 20% 20%Latin America 5% 15%Eastern Europe 2% 9%Other Regions 1% 1%

($'000) ($'000)

Total 155,000

235,736

North America 111,600

129,655

Western Europe 31,000

47,147

Latin America 7,750

35,360

Eastern Europe 3,100

21,216

Other Regions 1,550

2,357

Geograhical Segmentation of Sales

72%

55%

20%

20%

5%

15%

2%9%

1% 1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1994 1997

Year

Perc

eta

ge o

f to

tal

Sale

s

North America Western Europe Latin America Eastern Europe Other Regions

Required ROC 20%

Estimated Investment 1995-1997 34,900

($'000) 1995 1996 1997

Estimated Investment 17,450

10,470

6,980

Exhibit 4 – Geographical Segmentation of Sales

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Market Price of Champion Road: 12 $

Total number of outstanding shares 11,170,000

Dividend yields

If Champion followed the same yield

Caterpillar (US) 0.60% 804,240

Finning (Canada) 1.20% 1,608,480

Toromont (Canada) 1.69% 2,265,276

Exhibit 5 – Estimates of Regular Dividend Based on Industry Dividend Yields

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CANADA

$1,000 Dividend Income$294 Tax paid

29.4% Effective tax rate on dividend

$1,000 Capital Gains$327 Tax paid


UNITED STATES

$1,000 Dividend Income$396 Tax paid


$1,000 Capital Gains$280 Tax paid


Assume that US investors should pay at effective US tax rates (instead of Canadian tax rates)on both types of income.

Exhibit 6 – Effective Dividend and Capital Gains Tax Rates

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091113 champion road case report v6

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