Generally Accepted Accounting Principles and International Standards

US public companies prepare their financial statements in accordance with generally accepted accounting principles (GAAP). GAAP financial statements are those prepared in agreement with guidelines established by the Financial Accounting Standards Board (FASB). GAAP is a rules-based system, giving explicit instructions for every situation that the FASB has anticipated. In contrast, international accounting standards (IAS) are a principles-based system, with more generalized standards. GAAP and IAS currently exhibit significant differences. When and the extent to which GAAP and IAS systems converge are open questions. While the way financial data is recorded often differs by country, GAAP-based reporting is used throughout this book.

In 2017, the US Securities and Exchange Commission announced that it was investigating allowing public companies to supplement their GAAP financial statements with information prepared according to international accounting standards. The supplemental information is used by US companies seeking to purchase foreign firms to see what the firms’ consolidated financial statements might look like if they two firms were to merge.

GAAP Financial Statements

A firm’s financial statements typically consist of an income statement, balance sheet, and cash flow statement. The income statement measures a firm’s financial performance over a specific time period: month, quarter, or year. The statement displays revenue and expenses generated from both operating and non-operating activities. Operating revenues and expenses are derived from the firm’s normal operations; non-operating revenues and expenses result from activities such as the sale of assets or employee termination expenses associated with a facility closure. Such events are not a regular part of a firm’s normal operations.

The balance sheet provides data on what a firm owns (i.e., its assets), what it owes (i.e., its liabilities), and its value to its shareholders (i.e., shareholders’ equity) at a moment in time. Assets are resources that generate future cash flows for shareholders. Liabilities are obligations to parties outside of the firm. Shareholders’ equity is the value of the business to its owners after all obligations to external parties have been satisfied.

A cash flow statement summarizes the firm’s cash inflows and outflows from operating, investing, and financing activities. Cash flows from operations arise from the firm’s normal operations such as revenues and actual cash expenses after taxes. Cash from investing activities arises from the acquisition or disposition of current or fixed assets. Finally, cash inflows from financing activities include the issuance of additional shares or new borrowing; cash outflows include share repurchases, principal repayments, and dividend payouts.

Pro Forma Accounting

Pro forma financial statements (also referred to as adjusted financial statements) present financial data in a way that may describe more accurately a firm’s current or projected performance. Because there are no accepted standards, pro forma statements may deviate substantially from GAAP statements. In 2015, 5.7% of US Standard & Poor’s companies reported their financial statements using GAAP accounting standards exclusively.¹ Most public firms supplement their GAAP statements with pro forma statements which are “adjusted” to reflect factors that firms will argue more accurately represent their business. Pro forma statements are used to show what an acquirer’s and target’s combined financial performance would look like if they were merged.

The US Security and Exchange Commission’s Regulation G (introduced in 2003) requires public firms disclosing non-GAAP measures to the public to also present comparable GAAP financial measures and to reconcile the GAAP and non-GAAP metrics. In 2010, the SEC in an effort to clarify the implementation of Regulation G issued new Compliance and Disclosure Interpretations (C&DIs) giving firms more discretion in how they adjust for non-GAAP financial indicators, somewhat offsetting the rigor introduced by Regulation G. However, the net effect of Regulation G and the C&DIs has been to reduce the extent to which firms have manipulated reported earnings to beat analysts’ earnings projections.²

Although pro forma statements serve a useful purpose, such liberal accounting can easily hide a company’s poor performance. Exhibit 9.1 suggests some ways in which an analyst can tell if a firm is engaging in inappropriate accounting practices.

The failure to adequately review a firm’s financial statements can have disastrous results for acquiring firm shareholders. Firms may manipulate earnings upward prior to a bid in an effort to get a higher offer price. Earnings manipulation tends to occur more commonly with respect to overstating net sales rather than mishandling accruals, since the latter may be more easily detected during acquirer due diligence.³ Furthermore, earnings manipulation reflects on the target firm’s managerial competence and integrity, with substantial earnings management indicative of less competent and honest managers. ⁴

Valeant Pharmaceutical International Inc., a Canadian based company, found itself at the center of a firestorm generated by alleged accounting irregularities. In late 2016, the firm was accused of understating its normal operating expenses by burying a portion of such expenses among one-time acquisition related write-offs and inflating sales by “channel stuffing.”⁵ The firm publishes both a GAAP based EPS and proforma (adjusted) cash flow based EPS. The latter made its performance look much better than the standard method of calculating EPS.

US IPOs are not allowed to provide earnings projections at the time of listing but those in the United Kingdom are permitted to do so. Most large IPOs in the UK generally provide earnings forecasts in their prospectuses. Using data on UK IPOs, earnings manipulation has been found to be lower for large IPOs that provide earnings forecasts than for those that do not. The risk to firms providing earnings forecasts that are too optimistic is that they may lose public trust with investors. Furthermore, those that provide forecasts tend to outperform those that do not in the long-run. This suggests that earnings forecasts for modeling and valuing IPOs may contain useful information for analysts.⁶

Step 1: Analyze Recent Financial Statements

Understanding how a firm made money historically is helpful in determining how it may do so in the future. Once the firm’s historical financial data has been collected,⁸ the analyst should look for relationships or correlation between line items on financial statements and the firm’s free cash flows. Variables exhibiting strong historical correlation with operating cash flows and in turn firm value often are referred to as value drivers. Value drivers are variables which exert the greatest impact on firm value. For nonfinancial firms, they generally include the rate of growth in sales, the cost of sales as a percent of sales, S, G, & A as a percent of sales, the WACC assumed during the annual cash flow growth period, and the WACC and sustainable cash flow growth rate assumed during the terminal period.⁹

Equal to the difference between sales and cost of sales as a percent of sales, gross margin per dollar of sales summarizes a firm’s ability to create value. A simple diagram plot of a firm’s gross margin over at least one full business cycle (usually 5–7 years) provides useful insight into how the firm was able to create value historically. An increase in the ratio over time indicates that the firm has been able to reduce its costs compared to sales, raise prices on items sold, or a combination. A declining ratio reflects deterioration in the firm’s ability to control costs, raise prices, or both. However, gross margin may show considerable variation from 1 year to the next. How we deal with this issue is addressed next.

Understand Determinants of Revenue Growth and Profit Margins

A firm’s revenue growth and profitability are determined by a combination of industry specific and firm specific factors. A suggested approach to understanding the determinants of a firm’s revenue growth and profit margins is to evaluate the industry’s attractiveness in terms of the intensity of competition within the industry (and in turn potential profitability) and the firm’s competitive position within the industry.

A convenient means of evaluating industry attractiveness is to apply the Porter Five Forces Model described in Chapter 4. The Porter Model identifies a series of factors that collectively help determine the potential competitiveness and in turn profitability of an industry. Highly competitive industries tend to offer lower potential profitability than less competitive ones. These factors include: the threat of new entrants, bargaining power of suppliers, bargaining power of customers, threat of substitute products, and the degree of competitive rivalry within the industry. Bargaining power refers to the ability of a firm’s customers to influence the prices of the products and services it sells and suppliers to set the prices the firm pays for materials and services that it buys. This influence can extend well beyond price and include transaction payment and delivery terms. Table 9.1 summarizes the factors that determine the significance of each “force” and its implication for potential profitability. These forces can be augmented to include other considerations such as the role of regulation, unions, and government as needed.

Table 9.1

Porter Five Forces Model Summary

Force	Implication for profit margins
Threat of new entrants into a market: Stronger when • Entry barriers are low such as - Low capital requirements - Absence of strong brands - Access to distribution channels • Competitors use a common technology	New entrants may: • Intensify rivalry/competitive environment • Compete for market share by reducing selling prices • Add to costs by stimulating innovation and boosting advertising and marketing expenses
Bargaining power of suppliers: Stronger when • Resource supplied is scarce • Switching costs high • Customer small relative to supplier • Few substitutes	Suppliers having substantial bargaining power can: • Boost prices paid for inputs used by current customers • Impose less favorable terms such as longer delivery schedules
Bargaining power of customers: Bargaining power stronger when • They are few in number relative to sellers • A customer purchases a large portion of a seller’s output • They possess a credible backward integration threat (i.e., ability to enter the supplier’s business) • Switching costs are low	Customers having substantial bargaining power can: • Force selling prices down and squeeze supplier profit margins • Extract more favorable terms such as longer payment periods
Threat of substitute products: Impact on reducing demand for current competitor products greater when • Substitutes are close to existing products • Switching costs are low • Customers willing to switch	Many substitutes (i.e., those meeting the same customer need) can: • Limit prices that can be charged • Reduce demand for product and service offerings of current industry competitors
Degree of competitive rivalry: Intensity greater when • Competitors are comparable in size and few in number (oligopoly) • Market size and growth prospects are limited (stagnant markets breed more intense competition) • Product differentiation and brand loyalty is low • Exit barriers are high • Capacity utilization is low • Fixed costs as a percent of total costs are high	Intense rivalry may: • Breed competitive price reductions, innovation and investment in new products • Intensify sales promotions and advertising campaigns • Reduce current competitor profit margins

Table 9.2 generalizes the results of the Porter Five Forces Model by summarizing the characteristics of high profit versus low profit industries. In general, highly profitable industries are subject to less competition than lower profit industries. Highly competitive industries tend to experience so called normal profits. That is, a level of profits that compensates firms for the risk they have assumed. Less competitive industries often result in firms earning abnormal profits (i.e., those in excess of the risk assumed). An example of a high profit industry would be soft drinks and a low profit industry would be airlines. The terms weak and strong refer to the bargaining power of suppliers and customers relative to the firm being analyzed.

Table 9.2

Characteristics of High Profit Versus Low Profit Industries

High industry profits are associated with:	Low industry profits are associated with:
Weak suppliers	Strong suppliers
Weak customers	Strong customers
High entry barriers	Low entry barriers
Few substitutes	Many substitutes
Little rivalry/competition	Intense rivalry/competition

Once factors affecting industry profitability are understood, the analyst can turn to analyzing firm-specific factors determining profit margins: sales and cost of sales.

Sales are the product of price per unit times the number of units sold. The growth in the firm’s sales thus reflects the ability of the firm to raise prices (i.e., pricing power), the firm’s ability to gain market share, and the growth in product demand in the industry. The firm’s capacity to raise prices is a measure of its pricing power. Pricing power tends to be less in highly competitive markets than in less competitive ones. The degree of competitiveness in a market and in turn pricing power is affected by the ease with which new firms can enter a market, the availability of close substitutes for products or services currently offered in the market, the degree of industry concentration, and the amount of excess capacity. Fig. 9.4 provides a framework (the Pricing Power Continuum) for assessing a firm’s pricing power within its served market. Firms in an industry have significant pricing power when barriers to entry are high, there are few close substitutes for its product or service offering, there is little excess capacity, the firm’s market share is high relative to current competitors and government regulation and oversight is limited. An analyst can describe subjectively the degree of a firm’s pricing power by its relative position on the continuum. The further to the right the firm is placed the greater its perceived pricing power.

The other major component of revenue growth, unit sales, is driven by the growth in industry product demand and by gains in market share. Industry product demand often is correlated with one or two key variables. The determinants of unit sales will differ by industry. For example, beer, beverage and personal care products (e.g., shampoo) are heavily influenced by demographics such as population growth and changes in the age composition of the population. Sporting goods sales are directly related to advertising and marketing expenditures. Automotive sales are driven by a combination of changes in consumer real income (i.e., purchasing power), consumer confidence, and borrowing costs. Pharmaceutical product sales are impacted by research and development spending and the aging of the population. The demand for smart phone apps is correlated with the growth in handset sales.

Once the analyst feels that they understand what determines pricing power and unit sales growth historically, it is necessary to analyze the determinants of the cost of sales. Depending on the industry, the two largest components of the cost of sales are usually direct labor costs and purchased materials and services. Direct labor costs are those directly attributable to the production of goods and services. Indirect labor costs such as those affecting distribution, marketing and sales are excluded from the calculation of cost of sales. Factors affecting direct labor cost often include the availability of labor having the requisite skills, the degree of unionization, government regulation, and productivity (i.e., output per worker).

Purchased material and service costs correlate with the size of purchase (i.e., purchase discounts are larger for larger quantities purchased), the number of suppliers, product uniqueness, and substitutes. In addition to labor and capital costs, raw material costs are frequently impacted by external factors such geopolitical supply disruptions and the weather.

Since current sales can be satisfied from current production or from inventory, cost of sales is affected by how a firm values its inventory. The current cost of sales is reduced by units produced currently but not sold and placed in inventory and increased by current sales that are satisfied by reducing inventory. The two most common ways to value inventory are first in, first out (FIFO) and last in, last out (LIFO). FIFO uses inventory that is purchased earliest in the production process, resulting in lower priced inventory used to satisfy sales in the current period. Items placed in inventory that are purchased at earlier dates are generally considered to have been purchased at a lower price due to inflation. Thus, FIFO has the effect of reducing the cost of sales. In contrast, LIFO uses the most recently purchased inventory items resulting in higher cost inventory items, which adds to the cost of sales.

Step 2: Project Pro Forma Financial Statements

If the factors affecting sales, profit, and cash flow historically are expected to exert the same influence in the future, a firm’s financial statements may be projected by extrapolating historical growth rates in key variables such as revenue, with other line items on the financial statement projected as a percent of sales. If the factors affecting sales growth are expected to change due to the introduction of new products, total revenue growth may accelerate from its historical trend. In contrast, the emergence of additional competitors in the future may limit revenue growth by eroding the firm’s market share and selling prices.

Financial statements should be projected for at least three-to-five years and possibly more until the firm’s cash flows turn positive or the growth rate slows to what is believed to be a sustainable pace. Some firms may show profit growth in excess of the industry average. Since above average profit growth is not sustainable, cash flows for such firms should be projected until they are expected to slow to the industry average. This usually happens when new competitors are expected to enter the industry. Projections should reflect the best information about product demand growth, future pricing, technological changes, new competitors, new product and service offerings from current competitors, potential supply disruptions, raw material and labor cost increases, and possible new product or service substitutes.

Because accuracy diminishes rapidly the further the analyst projects detailed financial statements into the future, projections are typically made over two forecast periods: the planning period and the terminal period. The planning period represents the period of annual projections, while the terminal period approximates the present value of all cash flows beyond the last year of the planning period. The planning period forecast begins with an estimate of the firm’s revenue using either the top-down or bottom up approaches. The top down approach projects the size of the firm’s target market using macro (e.g., personal income, interest rates) or market level data (e.g., the number of customers) and then applies an estimated market share for the firm. That is, if the market is projected to grow to $800 million next year and the firm’s market share is expected to be 10% then the firm’s revenue next year is expected to be $80 million.¹³ The bottom up approach involves summing up forecasts made by the firm’s sales force by product line and by customer. Alternatively, the analyst could extend present trends using historical growth rates or multiple regression techniques, which implicitly assumes the factors affecting growth in the past will do so in the same way in the future.

Tables 9.3–9.7 illustrate the output of the Microsoft Excel spreadsheet model titled Target Valuation Model found on the website accompanying this text. The cells denoted in each worksheet in yellow represent input cells. Cells in black contain formulas. Entries into input cells change automatically the subsequent years to reflect the new data in the input cell. Changes to the model are made primarily by making changes in the worksheet labeled Target Assumptions (see Table 9.3), which contains the assumptions underlying the projected income statement, balance sheet, and cash flow statement. The analyst should input cell values one at a time using small changes to assess accurately the outcome of each change on valuation. It will become evident which variables represent key value drivers by noting their impact on firm valuation.

Note that the Target Valuation Model already contains input and output data and an estimated valuation for the firm. For our purposes, consider this projection the “base case” valuation. To simulate the impact of an assumption change, change the value in the appropriate input cell. For example, to assess the impact on valuation of an increase of one percentage point in the Target’s revenue growth rate, change the Target’s revenue growth rate assumption on the Target’s Assumptions Worksheet by one percentage point during the planning period (2014–2018) from 5.5% to 6.5% in the yellow input cell on the Sales Growth line for the year 2014. The model will increase automatically the growth rate annually from 2014 to 2018 by one percentage point. The model also accommodates a variable growth rate forecast. For example, if the growth rate in 2015 is expected to increase by an additional one percentage point and to continue at that higher rate in subsequent years, the analyst simply increases the growth rate by from 5.5% to 6.5% in 2014 and to 7.5% in 2015.

Worksheets labeled Target Income Statement (Table 9.4) and Target Balance Sheet (Table 9.5) provide the input for the worksheet labeled Target Cash Flow (Table 9.6) reflect assumptions provided in the Target Assumptions Worksheet. If the balance sheet is in balancing properly, the values in the red cells at the bottom on the Target Balance Sheet should be zero, as they represent the difference between total assets and total liabilities plus shareholders’ equity.

Step 3: Estimate the Present Value of the Projected Pro Forma Cash Flows

This step requires the analyst to estimate the sum of the PV of the cash flows during the planning period (in this instance, 2014–2018) and the PV of those beyond the planning period. The PV of the cash flows beyond the planning period is commonly referred to as the terminal value which is estimated using the constant growth valuation method (see Chapter 7).

Income Statement

Typically, sales, cost of sales, gross profit, SG&A, other operating expenses, extraordinary (nonrecurring) expenses, and the provision for taxes are shown in a firm’s annual 10k. However, depreciation and amortization expense often are not shown as separate line items as they are frequently included in the cost of sales or in some instances such as for retailing businesses in sales, general and administrative expenses. These data usually are broken out separately on the firm’s cash flow statement. Note that it is not necessary to separate amortization expense from depreciation if they are included as one line item. It is only important that we add non-cash expenses back to net income in the calculation of cash flow. Earnings per share and fully diluted EPS also are commonly displayed. When we include depreciation and amortization expense as a separate line item on the model’s income statement, it is important to deduct such expenses from the cost of sales or S,G&A, if these line items taken from the firm’s 10k include depreciation and amortization expense.

A discontinued operation occurs when a business unit or product line within a company’s business has been sold, disposed of or abandoned and is subsequently reported on the company’s income statement as income separate from continuing operations. Discontinued operations are reported under GAAP as long as two conditions are satisfied: (1) the discontinued operation is completely removed from the financial statements and (2) the former parent has no ongoing relationship with the unit. Both current period and prior period operations are disclosed in the discontinued operations section and not under extraordinary items.¹⁸

The following observations are helpful in projecting discontinued operations. Firms are less liable to report divestitures on which they incur losses in the year of an acquisition and more likely to discontinue operations, especially those with recorded losses, two or three years after an acquisition. The magnitude of the acquisition has little influence on the timing of divestitures by smaller firms, but large firms are more likely to discontinue businesses showing gains in the year of or the year following a major acquisition. This is consistent with the observation that unwanted assets are often shed soon after large, complicated acquisitions. Highly diverse firms are more prone to divest assets, particularly following a period of significant diversification. The first announcement of a discontinued operation is usually a precursor to a series of similar announcements as part of a downsizing process.¹⁹

Table 9.9 identifies the income statement information usually available (Column 1) in a firm’s 10k and shows how this information corresponds to the input data requirements (Column 2) of the financial model discussed in this chapter. Column 3 indicates where data not available on the income statement may be found in the “Notes to the Consolidated Financial Statements.” Brackets in Column 1 indicate that multiple line items on the firm’s 10k are included in a single line item in the M&A Model. Similarly, brackets in Column 2 indicate that multiple line items in the model are included in a single line item on the firm’s 10k financial statements and that the detail is found in the Notes to the Financial Statements.

Table 9.9

Historical Income Statement

Col. 1: Typical 10k income statement	Col. 2: Financial model income statement input requirements	Col. 3: Notes to financial statements
Revenue/sales (consolidated and by major business segment)	Sales	See note on business segment data
Cost of product/service sales (consolidated and by major business segment). May include depreciation and amortization expense	Cost of goods sold	See note on business segment data
S, G & A (consolidated and by major business segment)	S, G & A	See note on business segment data
Research & development expenses restructuring & other costs, net	Other operating expenses
	Depreciation	See 10k’s cash flow statement
	Amortization	See 10k’s cash flow statement
Operating income	EBIT
Total other expense, net Unusual (gain) loss Income from affiliates Interest (income) Interest expense	Unusual (gain) loss (Income) from affiliates Other expense (income) Interest (income) Interest expense	See note on other expense, net for detail on interest income and interest expense
Income from continuing operations before income taxes	Earnings before taxes
Taxes	Taxes
Net income (loss) before extraordinary items	Net income before extraordinary items
Loss (income) from discontinued operations after tax	Extraordinary items
Loss (gain) from disposal of discontinued operations after tax
Net income after extraordinary items	Net income after extraordinary items

Balance Sheet

Current asset items such as cash and cash equivalents, short-term investments, accounts receivable, inventories, the current portion of deferred tax assets, and other current assets are readily available on 10ks. Long-term asset categories provided on 10ks often include net property, plant and equipment (i.e., gross property, plant and equipment less accumulated depreciation), other assets, and goodwill. See Table 9.10. Current liabilities usually displayed on 10ks include short-term obligations and current maturities of long-term obligations (i.e., the current portion of long-term debt), accounts payable, accrued payroll and employee benefits, deferred revenue, and other accrued expenses. Long-term liabilities contain deferred income taxes (i.e., taxes owed but not paid because of timing differences), other long-term liabilities, and long-term obligations (e.g., long-term debt).

Table 9.10

Historical Balance Sheet

Col. 1: Typical 10k balance sheet	Col. 2: Financial model balance sheet input requirements	Col. 3: Notes to financial statements
Assets
Current assets
Cash and cash equivalents Short-term investments	Cash (includes short-term investments)
Accounts receivable (net of reserves)	Accounts receivable (net of reserves)
Inventory	Inventory
Deferred tax assets (current portion) Other current assets	Other	See note on income taxes for details
Long-term assets
Net property, plant and equipment	Property, plant and equipment Less accumulated depreciation  = Net property, plant & equip.	See note on property, plant and equipment for accumulated depreciation
Other assets	Intangible assets Deferred taxes Other
Goodwill	Goodwill
Liabilities and shareholders’ equity
Current liabilities
Accounts payable	Accounts payable
Short-term obligations Accrued payroll and employee Benefits Deferred revenue Other accrued expenses	Other
Long-term liabilities
Deferred income taxes	Deferred taxes (long-term portion)	See note on income taxes for details
Other long-term liabilities		See note on pensions
Long-term obligations	Revolving credit facility Senior debt Subordinated debt
Shareholders’ equity		See consolidated statement of shareholders’ equity
Preferred stock, par value, shares authorized and issued	Preferred stock
Common stock, par value, shares authorized and issued	Common stock
Retained earnings	Retained earnings
Treasury stock (at cost)	Treasury stock
Capital in excess of par Accumulated other comprehensive items	Other adjustments
Noncontrolling interest (if any)	Noncontrolling interests
Total shareholders’ equity	Total stockholders’ equity
Liabilities and shareholders’ equity	Liabilities and shareholders’ equity

The components of shareholders’ equity shown on the 10k balance sheet include preferred stock (par value and the number of shares authorized and the number issued) and common stock (par value and the number of such shares authorized and the number issued). Authorized shares have been approved by shareholders and the SEC but have not yet been issued by the firm. Capital in excess of par value (also called “additional paid in capital”) shows the value of the issued shares when issued in excess of their par value when authorized. The remaining shareholders’ equity items include retained earnings (i.e., accumulated historical net income after preferred dividends), treasury stock, and accumulated “other comprehensive items” (e.g., corrections made due to prior accounting errors and restatements).

The Note on Debt and Long-term Obligations describes the types of debt outstanding, maturity dates, associated interest rates, and usually gives a five year projection of the annual debt repayment schedule. Principal repayments beyond the fifth year are shown as a total figure. Interest expense and principal usually can be estimated by using a weighted average of each type of debt (i.e., senior, subordinate, etc.) and applying the applicable amortization rate (i.e., annual principal repayment) for the largest amount of debt outstanding in each category.

Cash Flow Statement

The firm’s cash flow statement (see Table 9.11) typically shows the key cash inflows and outflows from operating, investing and financing activities. This financial statement determines ending cash balances for the firm which is also reported on the firm’s balance sheet.

Table 9.11

Historical Cash Flow Statement

Col. 1: Typical 10k cash flow statement	Col. 2: Financial model cash flow statement input requirements	Col. 3: Notes to financial statements
Operating activities
Net income Loss (income) from discontinued operations Loss (gain) on disposal of discontinued operations Income from continuing operations	Net income
Depreciation and amortization	Depreciation and amortization
Change in deferred income taxes	Deferred taxes (current portion)	See note on income taxes
Changes in assets and liabilities
Accounts receivable	Accounts receivable
Inventories	Inventory
Other assets
Accounts payable	Accounts payable
Other liabilities	Other liabilities
Net cash from operating activities	Cash flow from operating activities
Investing activities
Acquisitions, net of cash acquired	Acquisition	See note on acquisitions
Purchases of property, plant and equipment	Capital expenditures
Proceeds from sale of property, plant and equipment Proceeds from sale of investments Proceeds from sale of businesses Other investing activities, net	Sale of assets
Net cash from investing activities	Cash flow from investing activities
Financing activities
Net proceeds from issuance of long-term debt Redemptions and repayments of long-term debt	Net change in debt
Purchases of company common stock Net proceeds from issuance of common stock	Net change in equity
Dividends paid	Dividends paid
Other financing activities, net
Net cash from financing activities	Cash flow from financing activities
(Decrease) increase in cash and cash equivalents	Net change in cash
Cash and cash equivalents at beginning of period	Beginning cash balance
Cash and cash equivalents at end of period	Ending cash balance

Risk Measures: Betas and Credit Ratios

Historical betas for public firms and industry credit ratios are available from a number of sources: Yahoo Finance, Google Finance, Morningstar, Value Line Research Center, Standard & Poor’s Net Advantage, One Source, and Thomson One Banker. Go to the Yahoo.com/finance website and search in the “look up” block for a specific firm. The firm’s beta is located below the day’s closing price in the table of daily trading activity. Or, go to google.com/finance and search for your firm; the firm’s beta will be at the top of the page among the daily trading data.

Background

Life Technologies (Life Tech), a leading global life sciences firm, had rewarded its shareholders by almost doubling the firm’s share price from its 2009 low of $26 per share to $51 by mid-2012. Despite this stellar performance, Gregory T. Lucier, Life Tech’s Chairman of the Board and Chief Executive Officer since 2008, felt uneasy about the firm’s future financial performance.

The life sciences industry is facing major challenges. Foremost is the increasing pressure on profit margins stemming from the escalating cost of healthcare due to the growth in chronic diseases, an aging population, and new medical therapies. Efforts to control healthcare costs are resulting in a reduction in the reimbursement rate for healthcare providers such as hospitals, testing laboratories, and physicians. Furthermore, pressure to reduce runaway government deficits is reducing the funding of scientific research.

These developments are driving consolidation among Life Tech’s customers. Such consolidation reduces the number of potential new accounts and enables customers to increase their negotiating leverage with vendors such as Life Tech. There is also a growing trend for customers to reduce the total number of vendors they use. Customer consolidation is driving consolidation among life science companies in an effort to realize economies of scale, scope, and purchasing. Underway for several years, consolidation among Life Tech’s competitors is expected to continue as companies attempt to strengthen or hold their market positions. Increased concentration within the life sciences industry is expected to result in stronger competitors that are better able to compete as sole-source vendors for customers.

The combination of customer and competitor consolidation could put significant downward pressure on Life Tech’s profit margins. Mr. Lucier and the Life Tech board faced a dilemma: whether to continue to pursue the firm’s strategy of growing market share through customer focused innovation or to consider alternative ways to maximize shareholder value such as selling the firm or aggressively growing the firm.

Founded in 1987, Life Tech had established itself as a leading innovator of life science products and services that improve the effectiveness and efficiency of professionals in the pharmaceutical, biotechnology, agricultural, clinical, government and academic scientific communities. The company’s products also are used in forensics, food and water safety, animal health testing and other industrial applications. Life Tech produces lab analytical and testing instruments; robotic systems to automate labor intensive research, research consumables including glassware, plastic ware, vials, tubes, and syringes; equipment from centrifuges to microscopes; lab furniture; and lab information management and testing systems.

On January 18, 2013, Life Tech announced that it had hired investment banks Deutsche Bank and Moelis & Co. to explore strategic options for the firm as part of the board’s annual strategic review. Mr. Lucier offered additional details in a subsequent earnings-related telephone conference call to investors and Wall Street analysts saying that the review has begun in the summer of 2012 and that “all ideas were on the table.” Sensing the possibility of a sale, investors drove the share price up by 10% to $58 by the end of February.

Mr. Lucier and the board’s decision would be based on a continued analysis of industry trends and the firm’s overall competitive position. Mr. Lucier directed his accounting and finance department to assess the impact of the results of this analysis on the value of the firm under different sets of assumptions. What follows is a discussion of these considerations.

The Life Sciences Industry

The life sciences comprise fields of science involving the study of living organisms such as plants, animals and humans. While biology remains the centerpiece of the life sciences, technological advances in molecular biology and biotechnology have led to a burgeoning of specializations and new interdisciplinary fields. Because of the extremely high research and development costs coupled with little revenue in the initial years of development, many life sciences firms partner with larger firms to complete product development. However, the industry tends to be dominated by handful of big companies. Table 9.12 lists the major market segments of the industry.

In general, the ratio of R&D spending to revenue drives new products in this industry. The key to successful companies is achieving a proper balance between R&D spending and expense control. Because of the long R&D phase, during which there is very little revenue being generated, projecting earnings requires looking at both a firm’s products under development and in production. For firms already selling products, looking at sales trends makes projecting revenue growth rates easier. Firm value in this industry is largely driven by their intellectual property and the ability to derive commercial products from their proprietary knowledge to generate future profits and cash flows. Because life sciences firms require substantial amounts of capital, they are prone to maintaining substantial amounts of cash on hand. Table 9.13 provides an overview of the factors contributing to the intensity of industry competition.

For firms to succeed in this industry they must be able to innovate cost effectively. Furthermore, to minimize product distribution costs and to gain access to needed R&D capabilities, firms need to be able to work collaboratively with product distributers, universities, and government agencies. Finally, because of the long lead time in developing new products and services, firms must have continuing access to financing. These three success factors ultimately drive future cash flow and firm value in this industry.

Life Technology’s Business Overview

Life Tech’s business is described in terms of its targeted markets; products, services, and after sale support; research and development activities; license agreements; and suppliers. These factors (in italics) are discussed next.

Life Tech’s targeted markets include life sciences, applied sciences, and medical sciences. Customers within the life sciences segment consist of laboratories generally associated with universities, medical research centers, government institutions, and other research institutions as well as biotechnology, pharmaceutical and chemical companies. Researchers at these institutions use Life Tech products to conduct research, clinical trials, and to improve the efficacy of drugs. The applied sciences segment serves a diverse range of industries, with a focus in the areas of forensic analysis; quality and safety testing; animal health testing, and the commercial production of genetically-engineered products. The medical services segment includes customers in clinical labs and medical institutions that use commercial technology for clinical and diagnostic purposes, and medical researchers that use Life Tech’s research-related technologies to search for new discoveries. Approximately 20% of the Life Tech’s revenues are derived from federal, university and/or research institutions funded by the US government.

Life Tech’s services and support activities provides limited warranties on equipment it sells for periods of up to two years from the date of the sale. The firm also offers service contracts to customers that are generally 1–5 years in duration after the original warranty period. Life Tech provides both repair services and routine maintenance services under these arrangements, and it also offers repair and maintenance services on a time and material basis to customers without service contracts.

Life Tech’s continued growth in market share is heavily dependent on research and development. Its core R&D skills include expertise ranging from biology to chemistry to engineering. The Company invested $341.9 million, $377.9 million and $375.5 million in research and development for the years ended December 31, 2012, 2011 and 2010, respectively. These expenditures comprise about 10.5% of annual revenue, slightly above the industry average. As of December 31, 2012, the Company had approximately 1200 employees engaged in research and development activities in the United States, Singapore, India, Germany, Norway, France, and the Netherlands.

Life Tech’s sales and marketing activities include a direct sales force of 3700 employees and a presence in more than 180 countries. The company also has over 1000 supply centers worldwide based in close proximity to customers’ laboratories to provide convenient access and an e-commerce website to provide easy online ordering of Life Tech products.

The firm manufactures and sells some of its existing products under the terms of license agreements that require it to pay royalties to the licensor based on the sales of products containing the licensed materials or technology. Although the company emphasizes its own research and development, its ability to license new technology from third-parties is, and will continue to be, critical to Life Tech’s ability to offer competitive new products.

The firm buys materials from many suppliers and has contracts with many third-parties for the manufacturing of products sold under the firm’s brand. The firm is not dependent on any one supplier as raw materials are generally available from a number of suppliers.

Life Technologies Competitor Profile

Competitor profiling consists of subjectively ranking a firm against its primary competitors in terms of critical success factors (i.e., those factors most responsible for determining success in an industry). A common technique is to create detailed profiles on each of major competitors. These profiles give an in-depth description of the competitor’s background, finances, products, markets, facilities, personnel, and strategies.

Table 9.14 provides a ranking of Life Tech compared to its primary competitors by those factors critical for success in the life sciences industry. These include the ability to innovate, collaborate with research and distribution partners, and to finance ongoing R&D spending. The critical success factors are weighted by their presumed importance and sum to one. Each competitor is ranked on a scale of one to ten with respect to each success factor. These scores are then totaled to create a competitor ranking in terms of the success factors. The primary competitors were selected from among twenty competitors each of which had a market value at yearend 2012 of $2.4 billion or more (see Table 9.15). Of those twenty firms, only those having a market value of greater than $9 billion were included the comparison of Life Tech and its competitors. Unlike the other firms listed as competitors, Thermo Fisher Scientific, Agilent Technologies, Quest Diagnostics, and Laboratory Corporation of America share many products and services in common with Life Technologies. Based on this subjective ranking, Life Tech has a slight competitive edge over Thermo Fisher Scientific and Agilent Technologies, its largest competitors in terms of size.

Life Technologies’ Historical Financial Performance

Life Tech’s historical performance in terms of its gross profit margin has been remarkably stable over time at approximately 56% (see Table 9.16). This table displays simple averages over different time periods as well as that estimated using regression analysis. The historical resiliency of the firm’s gross margin caused Mr. Lucier to use the historical gross margin in valuing the firm, despite anticipated future pricing pressures. The firm’s revenue growth rate has averaged a 6.5% compound annual average growth rate since 2008 when the firm completed an acquisition that nearly doubled the size of the company. Mr. Lucier directed his financial staff to evaluate the impact of different revenue growth rate, cost reduction, and asset utilization assumptions, as well as increasing Life Tech’s leverage, to assess the impact of alternative strategies on the firm’s market value.

The firm’s historical performance has exceeded major financial benchmarks. Life Tech’s price to earnings, cash flow, and sales ratios exceeded both the life sciences industry average and the S&P 500 average as of the end of 2012 (see Table 9.17). Table 9.18 shows Life Tech’s historical data for selected financial metrics.

Conclusions

The Life Tech CEO, Greg Lucier, and the Life Tech Board, were at a cross roads. The ongoing trend toward customer consolidation would require increased consolidation among life science companies. The strategic options available to the firm were clear: continue the firm’s current strategy, acquire a sizeable competitor to achieve economies of scale, scope, and purchasing, or to sell the firm to a competitor. The firm lacked the financial resources to acquire a major competitor. Therefore, that option was dismissed. Of the remaining two options, maintaining the current strategy or selling the firm, which would maximize shareholder value? In April 2013, the firm announced that it had agreed to merge with the industry leader, Thermo Fisher Scientific. The merger, discussed in detail in Chapter 14, was completed in 2014.

Discussion Questions

Use the Microsoft Excel model entitled Target Firm Valuation Model Case Study Final Version on the companion site to this book to answer the following questions. Please see “Chapter Overview” section of this chapter for the site’s internet address. The model already contains data and an estimate of Life Tech’s enterprise and equity valuations based on this data and a set of assumptions about the planning period spanning 2014 through 2018, as well as the years beyond. In answering the following questions, assume the valuation provided in this model represents the firm’s base case and reflects what the firm could do if it continued the business strategy in effect in 2012.

1. 1. Note the enterprise and equity valuations for Life Technology in the Excel spreadsheet model entitled Life Tech Undertakes Strategic Review Financial Model on the companion website accompanying this book. View this as the base case. The CEO Greg Lucier asks his chief financial officer (CFO) to determine the impact of plausible assumption changes on the firm’s valuation. The CFO asks you as a financial analyst to estimate the impact of a change in the firm’s revenue growth rate and cost of sales as a percent of sales. On the Target Assumptions Worksheet, make the following changes and note their impact on Life Tech’s enterprise and equity values on the Valuation Worksheet:
   1. a. Increase the sales growth rate in 2014 by 2 percentage points
   2. b. Retaining the assumption change made in (a), decrease the cost of sales as a percent of sales by 2 percentage point in 2014
   
   What is Life Tech’s enterprise and equity value resulting from these changes? How do they compare to the base case? Briefly explain why each of these changes affects firm value. Do not undo the results of your changes to the model’s base case.
2. 2. Using the model results from question (1), the CFO believes that in addition to an increase in the sales growth rate and an improving cost position, Life Tech could employ its assets more effectively by better managing its receivables and inventory. Specifically, the CFO directs you as a financial analyst to make the following changes to days sales in receivables and days in inventory. On the Target Assumptions Worksheet, make the following changes and note their impact on Life Tech’s enterprise and equity values on the Valuation Worksheet:
   1. a. Reduce receivables days by 10 days starting in 2014
   2. b. Reduce inventory days by 10 days starting in 2014
   
   What is Life Tech’s enterprise and equity value resulting from these changes? How do they compare to the results in question one? Briefly explain why each of these changes affects firm value. Do not undo the changes to the model you have made.
3. 3. Given the results of the model from questions (1) and (2), assume Mr. Lucier and the Life Tech board raised their target debt to equity ratio from 30% to 60% to reduce their weighted average cost of capital. Such a reduction would make projects that would not have been undertaken at a higher cost of capital attractive. Recalculate the firm’s weighted average cost of capital assuming that none of the assumptions about the cost of capital made in the base case have changed, with the exception of the levered beta. (Hint: The levered beta needs to be unlevered and then relevered to reflect the new debt to equity ratio). Without undoing the assumption changes made in questions (1) and (2), use your new estimate of the firm’s WACC during the planning period to calculate Life Tech’s enterprise and equity values given on the Valuation Worksheet. Explain why the change in the debt to equity ratio affected firm value.
4. 4. Based on your answers to questions 1, 2, and 3, what do you believe are the most important value drivers for Life Tech based on their impact on the firm’s enterprise and equity values? Which are the least important? (Hint: Calculate the percentage increase in enterprise and equity values over the base case due to each assumption change.)
5. 5. The base case valuation reflects a constant 57% gross margin throughout the planning period. Based on the information given in the case study, do you believe that this is realistic? Why? Why not? How might this assumption have biased the estimates of enterprise and equity valuation in your answers to questions (1) to (4)? If they were biased, what would be the direction of the bias?

Solutions to these case study discussion questions are available in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).