1. How does Torrington fit with Timken?
Timken Company is one of the biggest companies in bearing industry, and it is considering expanding, and Torrington is a good choice for Timken. Torrington is a company focusing on making sewing-machine needles. So these two companies are operating in the same steel industry and they have same customers. Since Timken is producing bearings and needles are hard for it to manufacture, Torrington is producing complementary products for Timken.
After the merger and acquisition, customers can meet their different needs in one company instead of two, which is a win-win situation for both the companies and customers.Since case mentioned that two companies have only a 5% overlap in their product offerings and the customer lists overlapped by approximately 80%, we believe this merger belongs to vertical merger type, which is a combination of manufacturer and a supplier who operating in the same supply chain of a product. As a result, this merger not only will make production process more efficient, but also will allow Timken to provide better value for its customers by offering nearly twice as many products.
Another reason is that make merger and acquisition with Torrington can achieve cost saving. These two companies can share their equipment which will lower their costs. To be specific, this merger is expected to result in 80 million cost saving each year, by the end of 2007. Due to they are in the same industry, they can share the market budget and use same customer bases so that they can increase their purchasing power.
What is more, after this merger, the combined company will have increased market shares, and then the company will be a leader company in the global market. Timken would be the third largest bearings producer in the world. Timken would increase its global market share in bearing market by 4%, from 7% to 11%, since Torrington are able to sell their products through Timken’s international network.
2. What is Stand-Alone valuation of Torrington?
The stand-alone value of Torrington is $783.94 million. Mainly assumption and data resource are stated below.
Before tax cost of debt: We assume the capital structure of Torrington would like Timken’s. Thus, we use Timken’s cost of debt as Torrington’s. We found Timken’s debt rating is BBB (from exhibit 8) and industrial yield for BBB company is 7.23% (from exhibit 9).
After tax cost of debt: Through model calculation, after tax cost of debt is 4.34%.
Beta: From exhibit 7, we found the change in stock performance are similar between Timken and Ingersoll-Rand. Thus, we assume beta of Torrington is the same as Timken’s beta 1.10 (from exhibit 8)
Risk free rate: We use government long term treasury yield as risk free rate, which is 4.97% (from exhibit 9)
Market risk premium: Normally market risk premium range between 3% to 9%, based on factors such as business risk, liquidity risk, financial risk. We assume market risk premium of Torrington is 6%
Cost of equity: Through model calculation, cost of equity is 12.7%
Tax rate: We assume Torrington’s tax rate is the same as Timken’s 40%, calculating by Timken’s income tax divided by income before tax (exhibit 1).
Market value of debt and equity: We assumed that Torrington had the same capital structure as Timken. Thus, we calculate Timken’s capital structure Timken’s market value of debt is $461.2 million (from exhibit 8) and market value of equity is $609.1 million (from exhibit 2).
Debt and equity weight in capital structure: Through model calculation, debt weight is 43.1% and equity weight is 56.9%.
WACC: Through model calculation, WACC is 9.1%.
Working Capital as % of Revenue: We assume Torrington’s working capital as % of revenue is 13.5%, calculating by dividing Timken’s working capital in 2002 $334.2 million (exhibit 2) by total revenue in 2002 $2550.1 million (exhibit 1).
Terminal growth rate: The case mentioned in page 2 that analyst predict that bearing industry will have a 2-3% growth rate in 2003. Thus, we assume terminal growth rate for Torrington.is 2%.
3. What is “With-Synergies” valuation of Torrington?
Value of Torrington with synergy is $1253.06 million and value of synergy is $469.12 million. Mainly assumption and data resource are stated below.
Cost saving: we use $80 million each year as cost saving. Since the case mentioned in page 7 that $80 million will be saved in cost each year for Timken.
Integration cost: The case said in page 7 that analyst predict there will be total $130 million integration cost over first couple years of merger. Thus, we assume integration cost is $26 each year for 5 years, calculating by $130/5=$26.
4. Should Timken be concerned about losing its investment grade bond rating?
Yes, Timken definitely should concerned its lower investment grade bond rating. As mentioned in the case, it would be very difficult for Timken to raise the needed cash without significantly raising the level of debt based on the cash condition on its balance sheet. If IR accepted the $800 million deal and Timken raised the entire amount by debt, Timken’s leverage ratios would increase from 43.1% to 67.4%.
According to Table 3 and Table 4, EBIT interest coverage, EBITDA interest coverage, and total debt/capital after raising money by debt close to the ratios of high yield bonds, so Timken has large likelihood to lose its current investment-grade rating. This was troubling not only because Timken would be forced to borrow the money at “high-yield” rates, but also because the availability of future funds could become limited for companies carrying non-investment-grade ratings.
The lower bond rating will make Timken difficult to raise money by issuing bonds. Firstly, if Timken would be forced to borrow the money at “high-yield” rates, the borrowing cost of Timken will increase a lot. According to Exhibit 9 in the case, the yield of BB rating is 9.69% and the yield of B rating is 10.84%, which are much higher than the yield of BBB rating (7.23%). The higher yield of bonds indicates that Timken need to pay more interest for the bond buyers. Furthermore, it is risky for bond buyers because they will face huge interest risk as well as default risk.
For example, as the interest rate goes high, the price of these kinds of “high-yield” bonds will decrease. The investors will not buy these kinds of bonds due to the high interest risk. At the same time, as the duration of the bonds goes longer, based on the fluctuation of the interest rate, there will be a big chance that the companies default on the bonds they issued.
Secondly, as mentioned in the case, both Moody’s and S&P 500 had placed Timken ‘s ratings of Baa1/BBB on review. In other words, according to table 2 (Select Financial Ratios by S&P Credit-Rating Categories), the company’s EBIT interest coverage multiplier is 3.9-6.3, and Total debt/capital is 42.6%-47.0%. The data shows that the company has high leverage ratio and low coverage ratio. And once the company becomes the ones carrying non-investment-grade ratings, the difficulty of raising funds from public for Timken will be high.
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