jp morgan valuation training materials

O C T O B E R 2 0 0 4

I N T R O D U C T I O N T O V A L U A T I O N M E T H O D S U S E D I N I N V E S T M E N T B A N K I N G

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M I C H I G A N B U S I N E S S S C H O O L

This presentation was prepared exclusively for the benefit and internal use of the JPMorgan client to whom it is directly addressed and delivered (including such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this presentation nor any of its contents may be used for any other purpose without the prior written consent of JPMorgan.

The information in this presentation may be based upon any management forecasts provided to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction.

Notwithstanding the foregoing (but subject to any applicable federal or state securities laws), JPMorgan and the Company may disclose to any and all persons, without limitation, the tax treatment and tax structure of any transaction contemplated hereby and all materials (including opinions or other tax analyses) relating thereto, so long as such disclosure is not made prior to the earlier of (x) public announcement of discussions relating to the transaction or of the transaction itself and (y) the execution of an agreement to enter into the transaction.

JPMorgan’s policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors.

JPMorgan is a marketing name for investment banking businesses of J.P. Morgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan arranging, financial advisory and other investment banking activities are performed by J.P. Morgan Securities Inc. and its banking affiliates. JPMorgan deal team members may be employees of any of the foregoing entities.

CONFIDENTIAL, FOR TRAINING PURPOSES ONLYI

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Agenda


Additional valuation materials

LBO analysis

Comparable transactions analysis

Publicly traded comparable company analysis

Discounted cash flow

Valuation overview

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Research

Should our clients buy, sell or hold positions in a

given security?

Research

Should our clients buy, sell or hold positions in a

given security?

Acquisitions

How much should we pay to buy the

company?

Acquisitions

How much should we pay to buy the

company?

New business presentations

Various applications

New business presentations

Various applications

Fairness opinions

Is the price offered for company/division fair

(from a financial point of view)?

Fairness opinions

Is the price offered for company/division fair

(from a financial point of view)?

Divestitures

How much should we sell our

company/division for?

Divestitures

How much should we sell our

company/division for?

Hostile defense

Is our company undervalued/

vulnerable to a raider?

Hostile defense

Is our company undervalued/

vulnerable to a raider?

Public equity offerings

For how much should we sell our company/division

in the public market?

Public equity offerings

For how much should we sell our company/division

in the public market?

Debt offerings

What is the underlying value of the business/assets against which debt is being issued?

Debt offerings

What is the underlying value of the business/assets against which debt is being issued?

Valuation

Applications

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Valuation methodologies

“Intrinsic” value of business

Present value of projected free cash flows to all providers of capital

“Public market valuation”

Value based on multiples for comparable companies in sale transactions

Includes control premium

“Public market valuation”

Value based on market trading multiples of comparable companies

How does a firm’s financial performance match to market value?

Value based on debt repayment and return on investment

Value to a financial/LBO buyer

Liquidation analysis

Break-up analysis

Historical trading performance

Private company valuation

Expected IPO valuation

Premiums paid analysis

Valuationmethodologies

Discounted cash flow analysis

Publicly traded comparable companies

analysis

Comparable acquisitions

analysis

Leveraged buyout/recap

analysisOther

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Approach to valuation

In arriving at a preliminary valuation for its clients, JPMorgan utilizes several methodologies that are consistent with industry practices

In arriving at a preliminary valuation for its clients, JPMorgan utilizes several methodologies that are consistent with industry practices

(3) Comparable acquisition transactionsUtilizes data from M&A transactions involving similar companies

(1) Discountedcash flowAnalyzes the present value of a company’s free cash flow

(2) Publicly traded comparable companiesUtilizes market trading multiples from publicly traded companies to derive value

(4) Leveragedbuy outUsed to determine range of potential value for a company based on maximum leverage capacity

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Equity value versus enterprise value

Enterprise value = Market value of all capital invested in a business1 (often referred to as “transaction value”)

The value of the total enterprise: market value of equity + net debt

Equity value = Market value of the shareholders’ equity (often referred to as “offer value”) The market value of a company’s equity (shares outstanding x current stock price)

Equity value = Enterprise value - net debt2

Liabilities and shareholders’ equityAssets

Enterprisevalue

Net debt

Equity value

Enterprisevalue

1 Assume book value of debt approximates market value of debt2 Net debt equals total debt + minority interest + capitalized leases + short-term debt - cash and cash equivalents

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Equity value versus enterprise value (cont’d)

Value for owners of business

Multiples of

Net income

After tax cash flow

Book value

Equity value or offer valueEquity value or offer value

Value available to all providers of capital

Multiples of

Sales

EBITDA

EBIT

Enterprise value or transaction valueEnterprise value or transaction value

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Application example: Valuation summary

$60.00

$45.00

$64.60

$50.50

$34.75

$55.50$54.70

$55.00

$47.10

$37.60

$37.30 $38.00

$50.40

$19.25

10.00

20.00

30.00

40.00

50.00

$60.00

7.0x—9.0x2004E EBITDA

7.0x—9.0x 2008E EBITDA 8.0%—11.0%discount rate

1.6x LTM sales9.8x LTM EBITDA13.3x LTM EBIT

Public market comparables 2

Precedentcomparable transactions

52-weektrading range

1 Share prices are based on 157.6 million diluted shares outstanding2 Forecasts are based on JPMorgan research3 Synergies assumed to be 6.0% of sales, capitalized at 8.0x

DCF analysis

Analyst pricetarget

With synergiesof $1,500mm 3

Current stock price = $34.20

7.0x—9.0x 25% IRR

LTM EBITDA

LBO

Implied share priceImplied share price

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Agenda



LBO analysis




Valuation overview

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DCF analysis: the process

Project the operating results and free cash flows of a business over the forecast period. The typical forecast period is 10 years. However, the range can vary from five to 20 years depending on the profitability horizon.

Estimate the value of the business at the end of the forecast period.

Adjust your valuation for all assets and liabilities not accounted for in cash flow projections.

Discount rate

Present value Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present.

Adjustments

Projections

Terminal value

Use the weighted average cost of capital (WACC) to determine the appropriate discount rate range.

Step 1Step 1

Step 2Step 2

Step 3Step 3

Step 4Step 4

Step 5Step 5

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The first step in DCF analysis is projection of unleveredfree cash flows

Calculation of unlevered free cash flow begins with financial projections

Comprehensive projections (i.e., fully-integrated income statement, balance sheet and statement of cash flows) typically provide all the necessary elements

Quality of DCF analysis is a function of the quality of projections

Often required to “fill in the gaps”

Confirm and validate key assumptions underlying projections

Sensitize variables that drive projections

Sources of projections include

Target company’s management

Acquiring company’s management

Research analysts

Bankers

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Free cash flow is cash available to creditors and owners after taxes and reinvestment

Unlevered free cash flows can be forecast from a firm’s financial projections, even if those projections include the effects of debt

Start your calculation with EBIT (earnings before interest and taxes)

EBIT (from the income statement)

Plus: Non-tax-deductible goodwill amortization

Less: Taxes (at the marginal tax rate)

Equals: Tax-effected EBITA

Plus: Deferred taxes1

Plus: Depreciation and any tax-deductible amortization

Less: Capital expenditures

Plus/(less): Decrease/(increase) in net working investment

Equals: Unlevered free cash flow

1 Although beyond the scope of our current discussions, you should only include actual cash taxes paid in the DCF. Depending on the firm and industry, you may want to adjust for the non-cash (or deferred) portion of a firm’s tax provision. The tax footnote in the financial statements will give you a good idea of whether this is a meaningful issue for your analysis

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Projections

Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%Discount rate = 10%

Fiscal year ending December 31,

2001 2002 2003 2004E 2005E 2006E 2007E 2008E

Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5

EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9

Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4

EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5

Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0

Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5

Plus: Depreciation 16.0 17.6 19.3 21.3 23.4

Plus: Deferred taxes — — — — —

Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3

Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0

Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6

Adjustment for deal date (40.3) — — — —

Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6

Memo: Discounting factor 0.0 0.5 1.5 2.5 3.5

Discounted value of unlevered FCF $0.0 $44.6 $46.7 $48.4 $49.9

Discounted value of FCF 2004P—2008P $189.6

Stand-alone projections for Company X ($ millions)Stand-alone projections for Company X ($ millions)

JPMorgan convention is to use the “mid-year” convention—which assumes cash flows happen midway during the year

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Weighted average cost of capital (WACC) formula

Most firms use a combination of debt and equity to fund their operations. The overall cost of capital is the weighted average of the cost of debt and the cost of equity

WACC = rd * (Total debt) + re * (Total equity)(Total cap) (Total cap)

More accurately stated the formula is:

WACC = rd * [D *(1-T)] + re * ED+E D+E

E = market value of equityD = market value of debtT = marginal tax ratere = return on equity (from CAPM)rd = return on debt (assumed to be weighted average cost of debt¹)

Because interest is tax deductible, the true cost of debt is the after tax rate due to the ability of interest expense to shield taxes. The tax rate used should be the marginal tax rate for each specific company

¹ In order to be more accurate, the analyst should try to estimate the current market cost of debt by looking at the market cost of debt of comparable companies (with similar credit ratings)

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A + B = C

Discounted Discounted terminal value Firm value Terminal value as percent

FCF at 2008P EBITDA multiple of at 2008P EBITDA multiple of of total firm value Discount rate 2004–2008 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x

8% $196.8 $687.5 $802.1 $916.7 $884.4 $999.0 $1,113.6 78% 80% 82% 9% 193.1 662.6 773.1 883.5 855.8 966.2 1,076.7 77 80 82

10% 189.6 638.9 745.4 851.8 828.4 934.9 1,041.4 77 80 82 11% 186.1 616.2 718.9 821.6 802.3 904.9 1,007.6 77 79 82 12% 182.7 594.5 693.5 792.6 777.2 876.3 975.3 76 79 81

- D = E

Equity value Equity value per share1 Implied perpetuity growth rate

Net debt at 2008P EBITDA multiple of at 2008P EBITDA multiple of at 2008P EBITDA multiple of Discount rate 12/31/04 6.0x 7.0x 8.0x 6.0X 7.0X 8.0X 6.0x 7.0x 8.0x

8% $100.0 $784.4 $899.0 $1,013.6 $19.17 $21.97 $24.77 0.2% 1.3% 2.1% 9% 100.0 755.8 866.2 976.7 18.47 21.17 23.87 1.1 2.2 3.0

10% 100.0 728.4 834.9 941.4 17.80 20.41 23.01 2.0 3.1 3.9 11% 100.0 702.3 804.9 907.6 17.16 19.67 22.18 2.9 4.0 4.8 12% 100.0 677.2 776.3 875.3 16.55 18.97 21.39 3.8 4.9 5.8

Terminal values: The exit multiple method

Note: DCF value as of 12/31/04 based on mid-year convention1 Based on 40.0 million basic shares outstanding and 2.0 million options with a weighted exercise price of $8.13 calculated using the treasury method

In the EBITDA exit multiple method, a multiple is applied to the final year’s EBITDA to determine a terminal value in the final year. This terminal value is discounted to the present and added to the PV of the cash flows

A review of the terminal value and implied perpetuity is useful to help understand the drivers of the DCF value

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Terminal values: The perpetuity method

A + B = C

Discounted Discounted terminal value Firm value Terminal value as percent

FCF at perpetuity growth rate of at perpetuity growth rate of of total firm value Discount rate 2004–2008 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 2.5% 3.0% 3.5%

8% $196.8 $991.0 $1,095.4 $1,223.0 $1,187.8 $1,292.2 $1,419.8 83% 85% 86%

9% 193.1 811.9 883.8 968.9 1,005.0 1,077.0 1,162.0 81 82 83

10% 189.6 681.5 733.7 794.0 871.1 923.3 983.6 78 79 81

11% 186.1 582.6 622.0 666.7 768.7 808.1 852.8 76 77 78

12% 182.7 505.1 535.8 570.1 687.9 718.5 752.8 73 75 76

- D = E

Equity value Equity value per share1 Implied EBITDA exit multiple

Net debt at perpetuity growth rate of at perpetuity growth rate of at perpetuity growth rate of Discount rate 12/31/04 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 2.5% 3.0% 3.5%

8% $100.0 $1,087.8 $1,192.2 $1,319.8 $26.59 $29.14 $32.26 8.6x 9.6x 10.7x

9% 100.0 905.0 977.0 1,062.0 22.12 23.88 25.96 7.4 8.0 8.8

10% 100.0 771.1 823.3 883.6 18.84 20.12 21.59 6.4 6.9 7.5

11% 100.0 668.7 708.1 752.8 16.34 17.31 18.40 5.7 6.1 6.5

12% 100.0 587.9 618.5 652.8 14.37 15.12 15.95 5.1 5.4 5.8

Note: DCF value as of 12/31/04 based on mid-year convention1 Based on 40.0 million basic shares outstanding and 2.0 million options with a weighted exercise price of $8.13 calculated using the treasury method

In the perpetuity method the final year cash flow is used to determine the terminal value of the cash flows

The PV of a growing perpetuity in year 5 is:FCF * (1+g)

(r - g)Thus, this PV 5 years forward must then be discounted back to the valuation date

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Concluding DCF remarks

DCF analysis is a key valuation methodology

Three key variables

Projections/relevant and incremental cash flows (unlevered free cash flow)

Weighted average cost of capital (discount rate)

Residual value at end of the projection period (terminal value)

Remember

Validate and test projection assumptions

Determine appropriate cash flow stream

Utilize appropriate cost of capital approach

Carefully consider all variables in the calculation of the discount rate

Thoughtfully consider terminal value methodology

Sensitize appropriately (base projection variables, synergies, discount rates, terminal values, etc.)

Footnote assumptions in detail

Think about other value enhancers and detractors— NOLs— Options, warrants, etc.

Check it with a calculator!

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Agenda



LBO analysis




Valuation overview

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Overview

Comparable company analysis values a company by reference to other publicly-traded companies with similar operating and financial characteristics. It compares the public company value with operating statistics to calculate the valuation multiple

Comparable companies values do not incorporate the “control” premiums reflected in comparable acquisitions. Depending on market conditions, the comparable companies' multiples may or may not be higher than comparable acquisitions’ multiples

The trick to comparable company analysis is to find good comparables

The bad news: no two companies are really comparable

The good news: it doesn't matter, because everybody else (equity research analysts, traders, arbs, etc.) has to deal with the same problem

Once you have chosen the comparable companies, calculate the implied value of your company by multiplying the company’s historical and projected sales, EBIT, EBITDA, net income, book value and other key operating statistics by the respective comparable company multiples

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Identifying the right peer group

The key to compiling a trading comparables analysis is to identify companies that are considered comparable and that closely resemble the composition and function of the Company you are evaluating

SIC code search

Research reports

10K

To find comparable companies, look for companies with similar characteristics to those of the business being valued

Industry

Product

Markets

Distribution channels

Customers

Seasonality

Cyclicality

Size

Leverage

Margins

Growth prospects

Shareholder base

Operational Financial

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Choosing the right metric

Even with standard metrics, certain multiples are more relevant for some industries than others

For many industries, FV/EBITDA multiples are the most common trading metric (e.g. Industrials, Transportation, Distribution, etc.)

For other industries, P/E multiples are more widely followed (Pharmaceuticals, Restaurants, Biotech, etc.)

Reading analyst reports will help you understand the metrics analysts use to value the sector and the industry

Certain sectors have unique metrics

Telecommunications Natural resources Retail/Real estate

Enterprise value to— Run rate revenue (LQA)— 2000 to 2002 revenue— Net PPE (Latest 10-Q)— Route miles (Latest 10-Q)— Fiber miles (Latest 10-Q)— Access lines (Latest 10-Q

and 1-year forward)

Enterprise value to— Pretax Sec10— EBITDAX— Reserves— Production

Equity value— Discretionary cash flow

Enterprise value— Square footage— EBITDAR

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FV/EBITDA4 P/E5

Company Share price1

% of 52-wk. high

Equity value2 Firm value3 2004E 2005E 2004E 2005E LTGR5 2004E PEG

Large capitalization

WellPoint $111.05 94.0% $17,926 $19,164 8.9x 7.8x 15.6x 13.6x 15.0% 1.04x

Aetna 87.40 91.9% 14,598 16,211 8.7x 7.8x 12.9x 11.3x 15.0% 0.86x

Anthem 87.35 92.0% 12,264 13,927 7.4x 6.8x 14.0x 12.2x 15.0% 0.94x

Cigna 65.22 92.5% 9,273 10,773 7.7x 7.4x 11.3x 10.2x 10.0% 1.13x

Mean 92.6% 8.2x 7.5x 13.5x 11.8x 13.8% 0.99x

Median 92.2% 8.2x 7.6x 13.5x 11.7x 15.0% 0.99x Mid capitalization

Oxford $53.62 88.1% $4,561 $4,965 7.8x 7.3x 12.0x 10.9x 12.0% 1.00x

PacifiCare 38.25 89.5% 3,752 4,372 7.4x 6.5x 12.5x 10.5x 13.0% 0.96x

Coventry 42.63 90.2% 3,979 4,149 8.9x 7.7x 13.1x 11.4x 15.0% 0.87x

Humana 18.10 75.4% 2,973 3,616 6.8x 6.1x 11.1x 10.1x 13.5% 0.82x

Health Net 26.05 72.8% 3,028 3,427 5.4x 4.8x 9.3x 8.1x 13.5% 0.69x

WellChoice 36.75 94.5% 3,079 3,128 7.3x 6.4x 13.1x 11.5x 15.0% 0.88x

Mean 85.1% 7.3x 6.5x 11.9x 10.4x 13.7% 0.87x Median 88.8% 7.3x 6.5x 12.3x 10.7x 13.5% 0.87x Small capitalization

Sierra $35.98 92.7% $1,322 $1,324 8.0x 7.7x 13.3x 11.8x 15.0% 0.89x

American Medical Security 25.74 92.3% 397 427 7.1x 6.5x 12.0x 11.0x 15.0% 0.80x

Median 92.5% 7.5x 7.1x 12.6x 11.4x 15.0% 0.84x Blended mean 90.3% 7.6x 6.9x 12.7x 11.2x 14.2% 0.90x Blended median 92.4% 7.6x 7.1x 13.0x 11.4x 15.0% 0.88x UnitedHealth Group $65.41 95.5% $43,979 $46,379 11.2x 9.9x 17.4x 15.0x 17.0% 1.02x

$ millions, except for per share data$ millions, except for per share data

1 As of 4/16/042 Based on diluted shares outstanding using the treasury stock method3 Calculated using equity value plus debt4 Based on equity analyst research reports; includes investment income5 Based on I/B/E/S

Managed care trading comparables

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Concluding remarks on comparable companies

Trading comps are an important valuation metric for a number of reasons

Benchmark of how the equity market is valuing the company stand alone and relative to its peers

Every CEO knows his own multiples and those of his peers

Key steps for comps

Choose the right comparable companies and valuation metrics to focus on

Spread the comps correctly

Use the comps to determine a valuation range

Getting the comps correct

Ensure you have correctly captured the equity and net debt components — Diluted shares (includes options using the treasury method and convertibles if in the money)— Net debt includes preferreds, out of the money converts, capital leases, etc.

Ensure your income statement projections are uniform across your comps— Adjust for extraordinary items and one time charges— Calendarize so that projections reflect the same time periods— Check analyst projections to make sure they are treating all expense components the same

across the comps (e.g., amortization of intangibles)

Determining a value range

Thoughtfully consider the multiple range—using the mean/median is not thoughtful

Calculate the value correctly (Firm value versus Equity value issue)

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Agenda



LBO analysis




Valuation overview

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Overview of comparable transactions analysis

Comparable transactions analysis values a company by reference to other private market sales of similar businesses.

The trick is to find the right comparable transactions and to ferret out the information required to do the math. As in comparable companies analysis, look for acquisitions of companies in similar industry spaces, with comparable operational and financial characteristics

Recent transactions are a more accurate reflection of the values buyers are currently willing to pay than acquisitions completed in the further in the past because market fundamentals are subject to dramatic change over the periods of time

Establish relative values of various component businesses i.e., break-up analysis)

Multiples should be based on the latest public financial information available to the acquiror at the time of the acquisition

Develop understanding of M&A activity in industry

Relative activity

Who is buying?

What are they buying (market share, technology, etc.)?

How much are buyers paying?

Deal technicals (e.g., termination fees, lock-up options, etc.)

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Overview of comparable transactions analysis (cont’d)

Comparable transaction analysis contains information about selected acquisition transactions in the same industry as the company being evaluated or in similar situations, e.g. LBO, hostile, reverse acquisitions

Purpose is similar to that of public comparables analysis except that by looking at prior acquisitions, insight can be gained as to the premium paid to gain control (i.e., control premium) of the target company, valuation multiples, social issues, and technical transaction elements

In addition, “private market” values sometimes differ from public market values

Measure private market value, including control value, strategicbenefits and synergies

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Date announced

Acquiror/ target

Transaction value

($mm)

10-day premium

paid (offer/

average) Transaction value/

LTM EBITDA Equity value/ net income

Transaction value/

adjusted members2

LTM EBIT /

adjusted members2

Long term growth rate3

4/26/04 UnitedHealth/Oxford

$4,999 7.8%4

10/27/03 Anthem/ WellPoint

17,529 20.4

10/27/03 UnitedHealth /MAMSI

2,695 16.0

6/3/03 WellPoint/ Cobalt

930 13.8

4/29/02 Anthem/ Trigon

4,326 24.7

11/21/01 WellPoint/ CareFirst

1,300 NA

10/18/01 WellPoint/ RightCHOICE

1,358 45.1

LTM/1-year forward

Mean5 11.9% 9.7x 15.3x/14.2x $2,984 $310 13.8%

Offer6 43.8% 9.8x 16.1x/13.8x $1,724 $154 10.0%

Selected precedent managed care transactions

1 Forward estimates based on equity research at the time of the transaction2 Adjusted members calculated using 100% of risk members and 20% of non-risk members, as of most recent filing prior to announcement3 I/B/E/S long term growth rate prior to announcement4 Premium paid to the 10-day average stock price prior to the news of the rumored Wellchoice/Oxford transaction was 18.9%5 Based on highlighted transactions6 LTM EBITDA based on Company financials as of 6/30/04

LTM1-year forward¹

8.7x

10.6x

12.1x

19.8x

11.3x

11.6x

19.0x

17.2x

16.5x

33.7x

26.1x

22.6x

15.9x

15.2x

13.7x

20.8x

23.3x

20.2x

10.6x

13.3x

13.1x

$1,792

$2,254

$1,813

$2,828

$1,506

$698

$51

$3,714

$152

$202

$125

$125

$106

$417

NA

15.0%

16.0%

20.0%

15.0%

NA

11.5%

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Calculating the LTM (latest twelve months)

Fiscal year Most recentperiod

Period endingone year prior to

most recent+ –

Q1 Q2 Q3 Q4 Q1 Q2

Annual

QT-1 QT

Annual (12/03) + Six months

10-Q (6/04) – Six months 10-Q (6/03) = LTM

(6/04) Total revenue $2,292.2 $1,480.4 $1,447.0 $2,325.6

Example: Terra Industries LTM = 6/30/04Example: Terra Industries LTM = 6/30/04

Note: If the third quarter Form 10-Q is being used, revenues for nine months should be used when calculating LTM results, not three months

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Agenda



LBO analysis




Valuation overview

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LBO analysis provides another perspective on M&A transactions

A leveraged buyout is an acquisition transaction in which much of the purchase price is funded with debt; usually done by financial sponsors

This type of capital structure provides the ability to “leverage” returns on a relatively small equity investment, as cash flows generated during the investment period are used to pay down debt

Financial sponsors profit by exiting three to five years after the transactionSell the target to another buyerTake the target publicRecapitalize the target

Assumptions regarding the investment transaction, the exit and the period between the acquisition and the exit are critical to determining an appropriate capital structure and potential returns to equity

M&A clients include both financial sponsors and strategic playersFinancial sponsors typically pursue M&A transactions with different perspectives and objectives (e.g., a shorter investment horizon)Strategic buyers sometimes behave like financial investors (i.e., acquiring with the expectation of selling in several years)

Financial sponsors generally analyze a transaction using LBO methodologies in the first instance (and DCF, comparable companies/transactions analyses thereafter)

LBO valuation may be useful from a competitive point of view, as strategic players vie with financial sponsors for the same assets

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The process of LBO analysis

ProjectionsProjections

AdjustmentsAdjustments

Terminal valueTerminal value

IRRIRR

Pro forma capitalization

Pro forma capitalization

Develop an integrated model of the business that projects EBITDA and cash available for debt repayment over the investment horizon (typically three to five years)

Estimate the multiple at which the sponsor can be expected to exit the investment at the end of the investment period

Determine a transaction structure and a pro forma capital structure that result in realistic financial coverage

Calculate returns (IRR) to the equity sponsor

Tweak the transaction/capital structure as needed to achieve harmony (if possible) between IRR, leverage and valuation

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The initial steps in an LBO analysis are identical to those in a DCF analysis

The same financial projections developed for a DCF analysis can be used to build a basic LBO model

Free cash flows are expected to be used to service debt, with positive flows to equity typically coming at exit

Amount and predictability of free cash flows dictate whether a company is an attractive or viable LBO target

Cash flows are not discounted

Terminal value drives valuation, and is calculated on the basis of multiples

Multiple of exit-year EBITDA is generally used to bound the valuation of the enterprise in any possible exit scenario

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Pro forma capitalization and transaction structure are set forth in “sources and uses”

Sources should show the entire pro forma capitalization of the company, including

New debt

New equity

Rolled-over debt and equity

Uses of funds should address all parts of the target’s existing capital structure, as well as transaction-related leakage

Refinancing existing debt

Transaction expenses

Equity purchase price

Debt and equity to be rolled-over

Sources must equal uses

Any debt or equity that is rolled-over shows up under both sources and uses

Always depict every part of the capitalization, whether it changes pro forma or not

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LBO models are driven by the characteristics of the sources of capital for the transaction

Typically supplied by an investment or commercial bankUsually secured/most restrictive covenantsAmortizing 5- to 8-year tenorFirst in line at liquidationLowest coupon

Typically supplied by an investment or commercial bank or a mezzanine fund Riskier debt/typically unsecuredPrimarily bullet structuresTypical tenor is 10-yearHigh coupon

Typically supplied by an investment or commercial bank or a mezzanine fund (often sponsor-affiliated)Multiple forms: Convertible debt, exchangeable debt, convertible preferred stock, PIK securities and warrantsExpected IRR in the 15—20% range

Typically supplied by a financial sponsorHighest risk/cost of capitalSometimes “stapled” to high-yield paper to attract broader investor groupMinimum annual returns >20%

Mezzanine securitiesMezzanine securities

Subordinated debtSubordinated debt

Common equityCommon equity

Senior debtSenior debt

RevolvingTerm

30%–50% of total capitalLIBOR + 200-400

5–8 years

Senior/sub notesDiscount notes

25%–35% of total capitalT + 350–6507–10 years

Sub. debt (conv.)Preferred stockPIKWarrants

0%–35% total capitalHigh teens/low 20s7–10+ years

20%–40% of total capital20%-30% IRR5–7 year horizon

Sample inputs

Sample inputs

Sample inputs

Sample inputs

Components of capitalComponents of capital

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Exit multiple 6.5x 7.0x 7.5x

2008 projected EBITDA $556 $556 $556

Implied 2008 firm value 3,613 $3,891 $4,169

Plus: 2008 cash 36 $36 $36

Less: 2008 total debt (1,154) (1,154) (1,154)

Implied 2008 total equity value $2,496 $2,774 $3,052

Implied 2008 sponsor equity value1 $2,371 $2,635 $2,899

Required return 25% 30% 35% 25% 30% 35% 25% 30% 35%

Implied max. equity contribution $869 $728 $614 $965 $809 $683 $1,062 $890 $751

Plus: Maximum transaction debt

(@ 5.0x LTM EBITDA) $1,550 $1,550 $1,550 $1,550 $1,550 $1,550 $1,550 $1,550 $1,550

Implied firm value2 $2,419 $2,278 $2,164 $2,515 $2,359 $2,233 $2,612 $2,440 $2,301

Implied LTM EBITDA multiple 8.0x 7.5x 7.1x 8.3x 7.8x 7.4x 8.7x 8.1x 7.6x

Value sensitivity analysis 25% returns 30% returns 35% returns

Exit multiple Exit multiple Exit multiple

6.5x 7.0x 7.5x 6.5x 7.0x 7.5x 6.5x 7.0x 7.5x

Maximum leverage3 4.50x $2,336 $2,433 $2,530 $2,185 $2,266 $2,347 $2,062 $2,131 $2,199

4.75x 2,378 2,475 2,571 2,232 2,313 2,394 2,114 2,182 2,250

5.00x 2,419 2,515 2,612 2,278 2,359 2,440 2,164 2,233 2,301

Sample LBO valuation analysis

1 Assumes management promote of 5% 2 Valuation as at 12/31/013 Leverage based on bank/bond case

$ millions$ millions

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At purchase

No operatingimprovement/

No arbitrage

Operatingimprovement/

No arbitrage

Operatingimprovement and

arbitrage

EBITDA purchase multiple 7.0x

EBITDA on purchase date $100

Firm value at purchase date $700

Debt at purchase (5x EBITDA) 500

Equity value invested 200

EBITDA exit multiple 7.0x 7.0x 8.0x

EBITDA at exit $100 $128 $128

Firm value at exit 700 896 1,024

Debt (after paydown of $75 per yr.) 125 125 125

Equity value at exit 575 771 899

IRR (5-year exit) 23.5% 31.0% 35.1%

IRR drivers

Three important factors drive IRRs:1) De-levering2) Operating improvement, and3) Multiple expansion (arbitrage)

$ millions$ millions

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Agenda



LBO analysis




Valuation overview

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Several other types of analysis are common in M&A transactions

Pro forma analysis—what is the impact on the company of this merger/acquisition?

Earnings impact (accretion/dilution)

Growth impact

Multiple impact

Premiums paid analysis—how does the premium to be paid compare with prior transactions?

Analysis at various prices (AVP)—At different prices what are the implied premiums and multiples?

Contribution analysis (stock for stock deals)

Shareholders of each company receive shares in the merged entity—contribution analysis looks at what each company gives versus what it gets

Shares traded analysis

Attempts to establish cost basis in shares

Interloper analysis

On the buyside, tactically it is important to determine which other companies may be interested in the target

Once other potential bidders have been identified it is important to analyze their capacity to pay and the pro forma impact on their earnings

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Purpose of pro forma analysis

Evaluate the impact of a merger or acquisition on the income statement and balance sheet of a potential buyer

Pro forma analysis is used to determine

Pricing capacity of Acquirer to pay for Target based on certain key measures

Optimal form of consideration (cash, stock, other securities, combination)

Key measures

Dilution in earnings per share

Pretax synergies required to break even

Leverage/capitalization

Interest coverage

Post-transaction ownership

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Accretion/(dilution)

Acquiror standalone EPS xxx Acquiror NI xx Target NI xx

Combined NI XX A

Transaction adjustments: Amortization of identifiable intangibles (xx) Incremental interest expense from transaction debt (xx) Foregone interest income on cash (xx) Amortization of transaction fees (xx) Tax rate differential (xx)

Total transaction adjustments (XX) B

Pro forma net income A — B

Total shares outstanding xxx Pro forma EPS xxx

Proforma calculationProforma calculation

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Premium to Target

0% 20% 25% 30%Implied offer price per share $22.67 $27.20 $28.34 $29.47Implied exchange ratio2 0.39x 0.47x 0.49x 0.51xImplied transaction value3 $373 $446 $465 $483Implied Acquiror ownership 89.7% 87.9% 87.5% 87.1%Target 2004E transaction P/E 10.4x 12.5x 13.0x 13.5xTarget 2005E transaction P/E 9.3x 11.2x 11.7x 12.1x

100% stock2004E $—EPS ($0.08) ($0.24) ($0.27) ($0.31)2004E %—EPS (1.3%) (4.0%) (4.7%) (5.3%)Add’l pre-tax synergies to break even $5.8 $18.4 $21.5 $24.6

2005E $—EPS ($0.13) ($0.30) ($0.35) ($0.39)2005E %—EPS (1.9%) (4.5%) (5.2%) (5.8%)Add’l pre-tax synergies to break even $9.7 $23.8 $27.4 $30.9

Pro forma debt $735.5 $735.6 $735.7 $735.7Pro forma capitalization 2,586.5 2,660.0 2,678.4 2,696.8Pro forma debt/pro forma 2003E EBITDA 1.3x 1.4x 1.4x 1.4xPro forma debt/pro forma total cap 28.4% 27.7% 27.5% 27.3%

75% stock/ 25% cash2004E $—EPS $0.03 ($0.11) ($0.15) ($0.18)2004E %—EPS 0.6% (1.9%) (2.5%) (3.1%)Add’l pre-tax synergies to break even NM $8.3 $11.0 $13.7

2005E $—EPS $0.03 ($0.13) ($0.17) ($0.21)2005E %—EPS 0.4% (2.0%) (2.5%) (3.1%)Add’l pre-tax synergies to break even NM $9.9 $12.9 $15.9

Pro forma debt $820.5 $839.0 $843.6 $848.2Pro forma capitalization 2,586.6 2,660.1 2,678.5 2,696.9Pro forma debt/pro forma 2003E EBITDA 1.5x 1.5x 1.5x 1.6xPro forma debt/pro forma total cap 31.7% 31.5% 31.5% 31.5%

EPS accretion/dilution summary

EPS1 P/E

Current price 9/27/04 % 52-wk high 2004E 2005E 2004E 2005E

Target $22.67 99.3% $2.18 $2.43 10.4x 9.3x

Acquiror $57.99 97.9% $5.87 $6.70 9.9x 8.7x

$ millions, except per share data$ millions, except per share data


Note: Target estimates based on equity research, expect EPS, which is based on I/B/E/S; Acquiror estimates based on JPMorgan equity research; Assumes transaction date of 12/31/03, tax rate of 37.0%, 10.0% of excess purchase price allocated to non-goodwill intangibles and amortized over 10 years, transaction expenses of 0.20% and financing fees of 0.10% for illustrative purposes; Assumes interest expense of 6.5%, existing Target debt is refinanced at this rate 1 Based on I/B/E/S2 Exchange ratio calculated as offer price per share over Acquiror price of $57.993 Includes assumption of $33.3 million in Target debt

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Bootstrapping

Potentially increasing your P/E by acquiring a company with a lower P/E and “bootstrapping” Acquiror’s P/E

FC acquires CC for stock. It takes 1/2 of FC stock to acquire CC

Finance club (FC) Consulting club (CC)

P/E multiple 20x 10x

Stock price $20.00 $10.00

EPS 1.00 1.00

Shares outstanding 1 1

Earnings 2.00

Shares outstanding 1.5

EPS $1.33

Stock Price $26.66Accretive, assuming multiple stays the same

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1 day prior to announcement (median %; 2004YTD)1 day prior to announcement (median %; 2004YTD) 1 month prior to announcement (median %; 2004YTD)1 month prior to announcement (median %; 2004YTD)

22% 22% 24%30%

Premiums paid analysis for US targets

Source: Thomson FinancialNote: Includes all transactions with US targets (friendly and hostile) from 1/1/99 to 7/31/041 Cash transaction if cash is greater than 40%

15%

24%

10%

25%

$0.5-$1bn $1-$5bn $5-$10bn $10bn+

# of transactions27 32 4 5

$0.5-$1bn $1-$5bn $5-$10bn $10bn+

Median: 20% Median: 23%

# of transactions27 32 4 5

1 day prior to announcement: $0.5bn+1 day prior to announcement: $0.5bn+ 1 month prior to announcement: $0.5bn+1 month prior to announcement: $0.5bn+

27%26%32%

29% 27% 25%20%

20% 18% 19% 15%

27%

1999 2000 2001 2002 2003 2004YTD

Stock Cash

40%

13%

30%

44%38%

31%

22%

36% 34%28%

25%

52%

1999 2000 2001 2002 2003 2004YTD

Stock Cash1 1

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Current Offer Price per share $23.39 $30.00 $32.75 $33.00 $34.00 $35.00 $36.00 Implied premium/(discount) to:

Current price (9/10/04) $23.39 - 28.3% 40.0% 41.1% 45.4% 49.6% 53.9%

52-week high $27.76 (15.7%) 8.1% 18.0% 18.9% 22.5% 26.1% 29.7%

One month prior average price $22.60 3.5% 32.8% 44.9% 46.0% 50.5% 54.9% 59.3%

Three month prior average price $24.61 (5.0%) 21.9% 33.1% 34.1% 38.1% 42.2% 46.3%

Six month prior average price $25.20 (7.2%) 19.0% 30.0% 31.0% 34.9% 38.9% 42.9%

One year prior average price $23.83 (1.9%) 25.9% 37.4% 38.5% 42.7% 46.8% 51.0% Implied equity value1 $377 $483 $527 $531 $547 $564 $580

Add: Total debt2 30 30 30 30 30 30 30

Implied firm value $407 $513 $558 $562 $578 $594 $610 Implied firm value multiples

OperatingMetrics3

LTM revenue2 $740 0.55x 0.69x 0.75x 0.76x 0.78x 0.80x 0.82x

2004E revenue $744 0.55x 0.69 0.75 0.75 0.78 0.80 0.82

2005E revenue $799 0.51x 0.64 0.70 0.70 0.72 0.74 0.76

LTM EBITDA2 $57 7.2x 9.0x 9.8x 9.9x 10.2x 10.4x 10.7x

2004E EBITDA $58 7.1x 8.9 9.7 9.7 10.0 10.3 10.6

2005E EBITDA $62 6.6x 8.3 9.0 9.1 9.3 9.6 9.9

Implied P/E multiples

LTM EPS2 $2.04 11.5x 14.7x 16.1x 16.2x 16.7x 17.2x 17.6x

2004E EPS $2.15 10.9x 14.0 15.2 15.4 15.8 16.3 16.8

2005E EPS $2.37 9.9x 12.7 13.8 13.9 14.3 14.8 15.2


1 Based on 16.1mm fully diluted shares outstanding as of 9/5/04 provided by management2 As of 6/30/043 Based on management estimates

Analysis at various prices

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14.1%

13.7%

14.0%

13.7%

14.1%

13.8%

8.9%

10.1%

85.9%

86.3%

86.0%

86.3%

85.9%

86.2%

91.1%

89.9%

Revenue - 2004E

Revenue - 2005E

EBITDA - 2004E

EBITDA - 2005E

Net income - 2004E

Net income - 2005E

Current equity value

Transaction equity value

London Umbrella

Contribution analysis

Contribution Total($mm)

$40,940

$46,126

$4,868

$3,195

$48,695

Note: Estimates for London and Umbrella based on projections prepared by Umbrella management; analysis excludes transaction adjustments

$5,542

$2,850

$49,360

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44%

25%

7%

24%

$22.00—23.50 $23.50—25.00 $25.00—26.50 $26.50—28.00

21%28%

24%27%

$22.00—23.50 $23.50—25.00 $25.00—26.50 $26.50—28.00Cum: 21% 45% 72% 100%

8% 7%18%

42%25%

$19—21 $21—23 $23—25 $25—27 $27—29

One-monthOne-month Three-monthThree-month

Six-monthSix-month 1 year1 year

Shares traded analysis

Avg. daily trading vol (’000s) 56Total shares traded (’000s) 7,132Peak daily volume (’000s) 266VWAP $25.17High price $27.76Low price $22.07



45%

6%14%

6%

29%

$22.00—22.25 $22.25—22.50 $22.50—22.75 $22.75—23.00 $23.25—23.50


Cum: 8% 50% 75% 93% 100%

Note: As of 9/10/04Source: Tradeline

Cum: 44% 51% 75% 100%Cum: 29% 35% 80% 94% 100%

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Interloper analysis

Potential acquirors

Apogent Applied BioSystems Mettler-Toledo Thermo-Electron Waters

2003 cash EPS $1.36 $1.07 $2.53 $1.19 $1.60

Accretion/dilution - $ (0.07) 0.01 (0.11) (0.02) (0.08)

Accretion/dilution - % (5.0)% 1.3% (4.1)% (1.6)% (4.8)%

Incremental pretax synergies to break even 15.0 NA 9.5 6.2 20.4

% of target S,G&A 19% NA 12% 8% 26%

2004 cash EPS $1.66 $1.35 $3.26 $1.41 $2.00

Accretion/dilution - $ 0.04 0.08 0.13 0.06 (0.01)

Accretion/dilution - % 2.4% 6.0% 4.3% 4.2% (0.4)%

Incremental pretax synergies to break even NA NA NA NA 2.0

% of target S,G&A NA NA NA NA 2%

Ownership

PBSC 21% 11% 24% 13% 16%

Acquiror 79% 89% 76% 87% 84%

2003 Break even price $6.45 $9.41 $7.06 $7.48 $5.942004 Break even price $9.44 $12.96 $9.89 $11.08 $8.24

1 Based on Pedro offer of 0.311 shares per Pablo share, implying a price per share of $8.46 based on Pedro closing price of $27.19 on 7/12/032 Assumes synergies of $30 million with 50% realized in 2003

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Valuation references

Valuation—Measuring and Managing the Value of Companies, Copeland, Koller and Murrin

Introduction to Business Analysis and Valuation, Palepu, Bernard, & Healey

Mergers & Acquisitions, Marren

The Quest for Value, Stewart

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jp morgan valuation training materials

Documents