Dec 18, 2018

M&A: Analysis of Kohler

Recapitalization
SYNDICATE C
Q1. Why does Herbert Kohler want to do the recap? Why does he want to buy out the minority shareholders
when he already controls about 90% of Kohler Co.?

Herbert Kohler is committed to keeping Kohler & Co. private. He believes that as a private company Kohler will
have the following advantages:

1. Take a long-term view of its development as it will be free of pressure to report quarterly numbers;
2. Make investments that may be difficult for a public company to justify or explain to outside
shareholders, such as Kohler’s diversification into real estate and revitalization of its power business;
3. Keep information about its financial and operating performance private, and thereby prevent disclosure
of important proprietary information to competitors;
4. Maintain freedom from the threat of a corporate takeover;
5. Maintain commitment to its mission, long-term performance, and bets on big ideas.

While Herbert Kohler controls 90% of the company, a small secondary market exists for its shares. This secondary
market has allowed family members to cash in some of their shares by selling to outsiders. As of April 1998,
Kohler & Co. has around 140 outside shareholders (including mutual funds owned by SoGen and Franklin),
around 30 direct beneficiary owners who are part of the Kohler family or linked to Kohler & Co. via its employee
plan, as well as some restricted stock held by company executives. This seems to the be a long way from the
limit of 500 shareholders which would trigger SEC mandatory reporting requirements. However, the high prices
commanded by Kohler shares on the secondary market creates an incentive for family members to cash in more
of their shares to outside shareholders.

Over a period of decades, with even a few sales every year, it is possible that eventually Kohler & Co. will have
more than 500 shareholders and trigger mandatory reporting requirements. Such a dilution of ownership would
also make Kohler a target for a hostile takeover or leveraged buyout. The high prices commanded by Kohler
shares on the secondary market may also create an unnecessary temptation for future generations of managers
and executives to push for an IPO.

Additionally, the existence of a small but speculative secondary market raises the risk of creating costly tax and
regulatory liabilities for Kohler. High prices quoted on this market may be used by the IRS to assess the value of
the estate of Frederic Kohler – thereby increasing the family’s tax liability. The secondary market prices may also
create a risk that the Kohler Foundation, which is required by law to spend 5% of assets on charity, would be
forced to increase its spending in line with an inflated asset valuation, which might not be sustainable in the long
run, especially if the secondary market values are far from fair value.

Herbert Kohler’s objective is to create an ownership structure that will end transfers to outside shareholders,
stop secondary market speculation on Kohler’s value, and ensure that the company remains committed to its
vision of private ownership and independence from public equity markets for generations to come. The equity
structure he is putting in place will end most transfers and consolidate ownership in a way that will make Kohler
more secure in the future.

Given Kohler’s culture of long-term thinking – as demonstrated by its “50-year plan” for developing its
hometown – it seems most likely that Herbert Kohler is not only responding to an immediate threat of tax or
regulatory liabilities, but also putting in place safeguards to ensure Kohler’s independence and freedom from
outside interference in the long run.

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Q2. Estimate the total enterprise value of Kohler Company using a variety of valuation approaches/models.
What is the value of a share held by minority shareholder in Kohler Co, implied by your valuation?

We have used the following commonly used and accepted methods for determining the enterprise value of
Kohler Company and subsequently value of equity shares of the company.

1. Discounted Cash Flows Method

2. Comparable Companies quoted Multiples Method

Discounted Cash Flows Method

Under the DCF method, the projected free cash flows to the business are discounted at the weighted average
cost of capital.

Free cash flows are the cash flows expected to be generated by the company that are available to the providers
of the company’s capital and debt. For arriving at free cash flows, we have considered the projected financials
in Exhibit 3 for the years 1998 to 2002. We have computed the free cash flows as follows -

FCF = Net Income + Depreciation - Change Capex - Change in Working capital

For the terminal value we considered a yearly growth rate of 12% on FCF on year 2002. The growth rate was
arrived based on the growth considered in the projected financials given in the Exhibit 6.

For arriving at the weighted average cost of capital, we have computed specific cost to debt providers and to
equity providers. We have computed the cost of debt based on the interest expenditure of the company incurred
from the year 1993 to 1998.

Cost of debt was the average per cent of interest paid by the company for the total debt owed by it. For example,
interest expense as a percentage of total debt including short term for the year 1998 = 14031/244039 = 5.75%.
We have computed percentage of interest expense for all the 5 years from 1993 to 1998, and the cost of debt
considered for WACC is the average of all the 5 years.

As the debt has tax advantage, and net cost of debt is after the tax leverage, we have calculated the average tax
rate paid by the company for the last 5 years from 1993 to 1998 which is 43%.

For computing the cost of equity, we have used the CAPM model - Re = Rf + Beta (Rm-Rf)

Rf was the prevailing yield on 10-year US government securities, which was 5.75%. For Rm, we have used the
average annual returns on S&P 500 index for the past 5 years (1993-97), which was 21%.

For computing beta, we have first unlevered beta of each peer group company. [Unlevered beta = levered beta
/ (1+ (1-tax rate) *D/E]. We have considered average unlevered beta of each company, which was 0.86. We then
levered, the average unlevered beta, using the target equity ratio of Kohler based on the projected financials for
the years 1999 to 2002, which was 23%/77%.

Hence, the re-levered beta for Kohler is 1.01.

Cost of equity for Kohler using CAPM based on the above details is 21.2%.
[5.75% + 1.01 (21.06% - 5.75%) = 21.2%]

Weighted average cost of capital considering the target debt equity ratio of 67%/33% is Therefore, the WACC
estimate for Kohler is = 5.75% (1-43%) *0.25 + 21.4%* 0.75 = 16.75%. We have computed the present value of
future FCF by discounting them at WACC. We have then added cash and equivalents of $2.45 million and arrived
at enterprise valuation of $1,209 million.

After excluding the debt of $232 million we have arrived at the equity value as $976 million, which is $131,195
per shares considering 7588 outstanding shares.

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Comparable Company Approach

EV/ EBIT

Using the EV/EBIT Multiples approach, we arrived at a fair value of $144,187 per share.

Business Fittings/Hardware Engines

EBIT (US$ 000) 156,696 34,520
EV/Revenue Multiple 6.6x 6.6x
1,030,607
EV 226,678

Total Enterprise Value 1,257,285

Less: Debt 183,815
Equity Value 1,073,470
# of Shares 7,588
Value of Per Share ($) 144,187

Price/ Earnings

Using the P/E Multiples approach, we arrived at a fair value of $164,653 per share.

Net Income (LTM ‘98) 87,029

Average P/E Ratio 14.36x
Equity Value 1,249,367
# of Shares 7,588
Value of Per Share ($) 164,653

Book Value Per Share

Using the BVPS approach, we arrived at a fair value of $103,685 per share.

Book Value (LTM ‘98) 786,733

# of Shares 7,588
Value of Per Share ($) 103,685

Weighted Average Value Per Share from Multiples Approach

Approach Value Per Share Weight (%) Value

EV/EBIT 144,187 33.3
P/E 164,653 33.3 137,371
BVPS 103,685 33.3

Concluded Value Per Share combining DCF and Comparable Company Approach

Approach Value Per Share Weight (%) Concluded Value

DCF 131,195 50.0
134,283
Comparable Company 137,371 50.0
In performing our analysis, we made some assumptions with respect to market returns, beta for business
divisions of the company. We also emphasise that valuation of business is inherently imprecise and is subject to
certain contingencies.

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Q3. If you were advising Kohler management in a lawsuit, how would you justify the share price of $ 55,400
estimated by Kohler management?

Target D/E Ratio:

Using the projections, we see that D/E ratio the company changes from 1:2.03 in 1998 to 1:6 by 2002.

WACC:

Cost of Equity (Re) 21.3%

Cost of Debt (Rd) 5.75%
Weight of Equity (We) 86.00%
Weight of Debt (Wd) 14.00%
WACC 18.80%
Using the targeted D/E ratio, we arrive at a WACC of 18.80%. Essentially discount rate has increased due to
increased financial risk.

Growth Projections:

As per the projections the growth seems to be slowing down from 44% to 10.1%. We have conservatively
assumed the company will maintain a similar growth rate of 10% going forward.

Using the revised parameters for WACC and growth rate in the Free Cash Flow model, we arrive at a share value
of $52,460.

1998a 1999 2000 2001 2002

Net Sales 1,511,000 2,240,528 2,393,187 2,509,100 2,608,385

Cost of Sales 1,125,884 1,690,366 1,780,531 1,862,103 1,933,387
Gross Profit 385,116 550,162 612,656 646,997 674,998

Selling & Administrative Exp. 268,748 411,254 428,161 446,143 460,518

Amortization of Intangibles 13,680 12,876 12,876 12,876 12,876
Operating Income after Depreciation 102,688 126,032 171,619 187,978 201,604

Non-operating Income (Expense) -6,299 -10,173 -10,783 -11,430 -12,116

Interest Income 2,307 4,569 5,670 7,500 9,932
Interest Expense 11,521 14,325 12,987 10,286 8,134
Pretax Income 87,175 1,06,103 1,53,519 1,73,762 1,91,286

Income Tax Expense 38,585 46,071 66,659 75,448 83,057

Net Income 48,590 60,032 86,860 98,314 1,08,229
44.7% 13.2% 10.1%

Net inc + Dep 62,270 72,908 99,736 111,190 121,105

Less: delta WC 66,683 81,354 96,606 101,386
Less: delta Capex 44,263 63,294 81,512 79,218
FCF 44,263 63,294 81,512 990,528*
*Including terminal value
Discounted PV 628,052
Cash 2,454
Total Enterprise Value 630,506
Less debt (232,444)
Equity value 398,062
Equity value Per Share $52,460

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Q4. If you were advising the dissenting shareholders, how would you justify the $270,000/- a share value
estimated by them?

WACC

Since Dissenters are not confident about the success of the company’s recapitalization plan, we have kept the
D/E ratio unchanged at 1:2.03 as it was at the Valuation Date.

Using the above D/E ratio, we arrive at a WACC of 15.4% as shown below:

Cost of Equity (Re) 21.3%

Cost of Debt (Rd) 5.75%
Weight of Equity (We) 67.00%
Weight of Debt (Wd) 33.00%
WACC 15.40%

Growth Projections

The Company is expected to have a CAGR of around 21.0% over CY1998 through CY2002. However as per the
projections the growth seems to be slowing down from 44% to 10%. To avoid being overly pessimistic, we have
taken a medium-term growth prospect of 13.00%, assuming company can recover some of its momentum.

Using the above revised parameters in the Free Cash Flow model, we arrive at a share value of $280,804, close
to the dissenter valuation.

Net inc. + Dep 62,270 72,908 99,736 111,190 121,105

Less: delta WC 66,683 81,354 96,606 101,386
Less: delta Capex 44,263 63,294 81,512 79,218
FCF 44,263 63,294 81,512 3,778,648*
*Including terminal value
Discounted PV $2,271,949
Cash 2,454
Total Enterprise Value 2,274,403
Less debt (183,815)
Equity value $2,090,588
Equity value Per Share $280,804

Multiples Approach

We also used the EV/Sales Multiples approach to corroborate our valuation and arrived at a fair value of
$287,926 per share, which is also close to the value demanded by the dissenters.

Business Fittings/Hardware Engines

Revenue (US$ 000) 1,631,245 540,260
EV/Revenue Multiple 1.2x 0.6x
2,031,675
EV (US$ 000) 336,887

Total Enterprise Value (US$ 000) 2,368,562

Less: Debt (US$ 000) 183,815
Equity Value (US$ 000) 2,184,747
# of Shares 7,588
Value Per Share ($) 287,926

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Q5. What will be your advice to Herbert Kohler about the idea of pursuing a settlement with the dissenters?

We would urge the management to immediately pursue a settlement with the dissenters at any value up to and
including their asking price of $273,000. This is because of the extraordinary contingent liabilities that would be
created for Kohler by an unfavourable court judgment entering the public record, and the very high risk that the
court judgment will in fact be unfavourable.

The court’s determination of fair value in case of a trial is hard to predict. We may reasonably assume that it will
converge around our fair value estimate of $134,283. However, there is a chance that due to various factors the
court may judge the value as high as the dissenters’ valuation or as low as Kohler’s own valuation. Due to the
long tail of expert estimates of value (as high as $400k according to one case), there seems to be a good chance
that the court’s valuation will be above fair value. To quantify these uncertainties, we performed a Monte Carlo
simulation of the court’s valuation by generating a random probability distribution with the following
assumptions:

Lower endpoint of court valuation: $55,400

Modal value of court valuation: $134,283

Upper endpoint of court valuation: $273,000

A triangular random distribution specified by T(min: 55,400; mode: 134,283; max: 273,000) is the most
conservative approach to predicting the court’s valuation in the absence of any other information on how the
court is likely to rule. We performed 10,000 random simulations of the court’s judgment using this triangular
distribution, which yields the following distribution of valuations by the court:

Simulated_Court_Valuation
Mean $ 154,347
Median $ 150,375
Standard Deviation $ 44,941
Minimum $ 55,811
Maximum $ 271,403

Based on this simulation, we estimate Kohler’s total contingent liability in each of the 10,000 scenarios:

(a) Additional Payout to Dissenters for 811 Shares

= 811 × (𝐶𝑜𝑢𝑟𝑡 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 − $55,400)

(b) Additional Charity Spending per Year Due to Revaluation of Kohler Foundation’s 960 Shares

= 960 × (𝐶𝑜𝑢𝑟𝑡 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 − $55,400) × 5%

(c) Perpetuity Value of Additional Charity Spending

𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐶ℎ𝑎𝑟𝑖𝑡𝑦 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟 𝑌𝑒𝑎𝑟 (𝑏)

=
𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 𝑜𝑓 6% 𝑓𝑜𝑟 𝐶ℎ𝑎𝑟𝑖𝑡𝑎𝑏𝑙𝑒 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

(d) Additional Tax Liability for Frederic Kohler Estate's 975 Shares (based on top US Estate Tax Rate of 55% in
1998)

= 55% × 975 × (𝐶𝑜𝑢𝑟𝑡 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 − $55,400)

6
 𝑻𝒐𝒕𝒂𝒍 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑪𝒐𝒏𝒕𝒊𝒏𝒈𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒚
= 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒑𝒂𝒚𝒐𝒖𝒕 𝒕𝒐 𝒅𝒊𝒔𝒔𝒆𝒏𝒕𝒆𝒓𝒔
+ 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒊𝒕𝒚 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂𝒅𝒅𝒊𝒕𝒊𝒐𝒏𝒂𝒍 𝒄𝒉𝒂𝒓𝒊𝒕𝒚 𝒔𝒑𝒆𝒏𝒅𝒊𝒏𝒈
+ 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒂𝒅𝒅𝒊𝒕𝒊𝒐𝒏𝒂𝒍 𝒆𝒔𝒕𝒂𝒕𝒆 𝒕𝒂𝒙 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒚

The table below summarizes the mean outcome of the Monte Carlo simulation for each of these potential
liabilities from a court judgment, and estimates the total contingent liabilities that would be faced by Kohler.
We translate these liabilities to an implied per share premium for the dissenters’ 811 shares – this is the
maximum premium Kohler should be willing to pay per dissenter share, over and above the current $55,400
valuation, to prevent these contingent liabilities:

Potential Contingent Liability Expected Value of Contingent Additional Premium

Liability Based on Simulation Implied per Dissenter
Share
Additional Payout to Dissenters $80.2 million $98,947
Annuity Value of Additional Charity Spending $79.2 million $97,605
Additional Estate Tax Liability $53.1 million $65,426
Total $212.5 million $261,979

In the mean simulation outcome, the court values the shares at $154k – slightly above fair value based on our
conservative probability distribution. In the average scenario, Kohler would incur contingent liabilities of $212.5
million due to the court judgment entering the public record, or an additional $262k per dissenter share.

Total expected value of dissenter shares in case of a court judgment:

= $55,400 current value + $261,979 of expected contingent liability per share = $317,379

In essence, due to the contingent liabilities, Kohler should value the dissenter’s shares at a valuation that is
higher than what the dissenters are actually demanding ($317k vs $273k).

The best way to prevent the additional contingent liabilities for the Kohler Foundation and Kohler Estate is to
ensure that no court judgment enters the public record. A public judgment would create a precedent for actions
by the IRS and regulators and trigger these contingent liabilities. On the other hand, a private, sealed settlement
would not provide a precedent to trigger regulatory or IRS activities. Therefore, Kohler must take whatever steps
it can to prevent the case from going to trial. This means a negotiated settlement must be pursued. We compare
some of the likely outcomes below:

Scenario Expected Additional Payout

Settlement - Pay Dissenters Fair Value $64.0 m
Settlement - Pay Dissenters’ Asking Price $176.5 m
Go to Trial, Wait for Judgment $212.5 m

Ethically, Kohler is obliged to offer fair value to their outside shareholders. Strategically, we would recommend
that Kohler can start the negotiation by offering the dissenters the estimated fair value of the shares ($134k),
but should be willing to adjust their offer upwards in order to achieve a successful settlement in a quick and
friendly manner. The dissenters are in a strong negotiating position given the known facts on Kohler’s business.
Success of the negotiation depends on the skill of lawyers employed. Kohler should attempt to drive a rapid and
friendly settlement at reasonable terms. The most important objective by far is to get the dissenters to drop
their claim quickly and complete the recapitalization without establishing a public record of the fair value of
Kohler’s shares. To accomplish Kohler’s long-term objectives, even paying the asking price of the dissenters is
more acceptable than going to trial.