The “value-gap” has two components: first, Seagate’s core disk drive operating assets are undervalued due to unfavorable investor preferences in the public market; second, the value of the Veritas share price has caused the Veritas stake to be much higher than the value of Seagate’s stand-alone market capitalization.
Seagate’s ownership stake in Veritas drops below 80%, preventing the distribution of wealth to shareholders due to a 34% corporate tax rate. This rate would greatly reduce the value of the distribution. Additionally, the market fails to acknowledge Seagate’s dominant position in the disk drive industry, evident by Veritas shares held by Seagate increasing in value compared to its own shares. As a result, management is compelled to take action.
The management of Seagate believed that the company’s value should be determined by the worth of its operating assets. However, due to the market’s high valuation of its investment in Veritas, Seagate appeared to be more of an investment holding firm rather than a player in the disk drives industry. This resulted in a perceived “value-gap” as the Veritas stake is connected to business risk in the software sector, while Seagate’s main operating assets carry business risk within the hardware manufacturing sector specifically focused on disk drives.
The value of Seagate’s stock primarily came from Veritas, which made it difficult to provide proper employee incentives and stock option compensation plans that would align employees’ interests with the company’s operations. As the Veritas stake became more influential, the company’s performance had less impact on its share price. Seagate did not want to solely depend on Veritas for its valuation and sought to unlock the value of the stake through a buyout. It is highly unlikely that Seagate’s core disk drive businesses have a negative market value.
The plausible assertions arise from two factors. Firstly, the erosion of value caused by taxes when attempting to unlock the value of the Veritas stake appreciation. Secondly, the absence of conventional stock price targets for employee compensation plans, as the stock performance is more tied to Veritas’ success rather than Seagate’s success.
The transaction has two main goals. First, the management aims to restructure Seagate to increase its market value and provide performance-based stock compensation. Second, the management wants to address shareholder concerns about Veritas stake appreciation by unlocking its value without incurring more corporate taxes. The transaction includes two parts.
As part one of the transaction, Seagate plans to sell all operating assets, including those of Silver Lake – a major member of the buyout consortium. The investors will receive $765 million in cash along with Seagate’s operating assets.
As part of the transaction, the remaining Seagate shell would receive cash at the buyout purchase price in order to compensate Seagate’s existing shareholders for the disk drives business. This stage of the transaction aims to separate Seagate’s operations from the uncertainty in valuation of the original firm. Furthermore, this transaction benefits both Seagate’s existing shareholders and provides a private equity consortium with an opportunity to achieve a high rate of return until their exit strategy is realized in the future.
The purpose of this action is to restructure the firm. In the second phase of this two-step process, the remaining Seagate Technology shell corporation will trade 128 million old Veritas shares for 109 million new Veritas shares with Veritas Software. Furthermore, the cash received from the acquisition of Seagate’s operational assets, along with any excess cash exceeding $765 million given to the buyout investors, will be distributed among Seagate’s current shareholders at the time of the buyout. This distribution occurs through a down-stairs merger.
In order to avoid double taxation through the corporate tax of 34%, the remaining shell is set to merge with Veritas. As part of this merger, Seagate’s existing shareholders will receive new Veritas shares in proportion to their holdings. This allows the shareholders to benefit from the value of the shares without facing the corporate tax. Instead, they will only incur a personal capital gains tax on their investment holdings. The ultimate goal of this transaction is to effectively deliver maximum value from the appreciation of the Veritas stake to Seagate’s existing shareholders.
Seagate had a BBB credit rating for its long-term debt by the end of 1999. The company’s leverage ratio has high volatility due to fluctuations in its market value of equity and operational performance. However, the current leverage ratio is considered higher than optimal because in 1998 the firm had a -2.72 EBIT interest coverage ratio with a debt load of $703 million. To maintain its BBB credit rating, Seagate will acquire a new debt load of $453 million during the leveraged buyout recapitalization.
By maintaining a minimum investment-grade credit rating, S&P will upgrade its credit rating. This upgrade will then provide Seagate with increased access to future debt financing. However, accurately valuing Seagate’s operating assets is challenging due to insufficient data, making it difficult to choose a leverage ratio based on recent operational performance. The market value of Seagate equity has been greatly affected by the Veritas stake. Instead, the EBIT interest coverage is a better metric for analyzing the credit rating. A minimum EBIT interest coverage of 3.9x is required for a BBB credit rating on long-term debt. Therefore, Seagate should leverage itself up to levels of debt that support a 4.0x interest coverage, such as the previously described recapitalization amount.
The proposed deal structure by CD&R involves dividing Hertz into two distinct companies. This would result in the establishment of FleetCo and OpCo. FleetCo would comprise of two bankruptcy-remote special-purpose entities, namely Hertz Vehicle Financing and Hertz International. Hertz Vehicle Financing would possess the domestic RAC rental fleets, while Hertz International would possess the international RAC rental fleets. On the other hand, OpCo would possess all other assets of Hertz, which include HERC, equipment fleet, and other domestic subsidiaries.
OpCo will handle all rental transactions with customers and lease the fleet from FleetCo. This arrangement allows FleetCo to receive payments that will cover depreciation costs and finance their ABS debt. Additionally, by legally separating FleetCo and OpCo, the assets of each subsidiary will remain protected from potential lenders of the other subsidiary if one of them defaults on their debt.
This text describes a structure similar to the Marriot Case, whereby one company owns the assets and another company operates them. In this case, FleetCo will own the essential assets to receive special ABS financing, while OpCo will operate the business and make lease payments to cover FleetCo’s interest payments.
Hertz has created a fleet for ABS financing to raise funds at a lower cost compared to its current capital structure. This is possible because the financing is perceived as less risky, which is evident in the indicative interest rates of only Libor plus 70 basis points. This separation of fleet assets from the operating business allows creditors to better assess the inherent risk associated with the assets, increasing their likelihood of providing loans. Additionally, since the debt is linked directly to tangible assets like the rental car fleet rather than the Hertz Corporation itself, it will be easier to determine the expansion of funded debt capacity when managing fleet volume demand.
This approach ensures that Hertz’s financing choices align with the patterns of its operational cash flows. By utilizing ABS financing, Hertz gains the ability to effectively handle variations in demand for rental cars due to seasonal, cyclical, and other factors, without the need for refinancing or securing additional capital, or the worry of having an excess fleet. This debt capacity offers a reliable means of financing, enabling Hertz to support future expansion and growth when required.
In addition, this has the advantage of restricting creditors from claiming assets that are not directly financed by them. As a result, the overall debt risk for the corporation decreases, as long as there is no spillover risk to other subsidiaries like OpCo in the new structure.
If we assume a Libor rate of 0.21%, the ABS financing would result in an interest rate of 1%, while the term loan financing would have an interest rate of 3.21%. With these assumptions, Hertz could save $166.27 million annually in interest payments by opting for ABS financing instead of facing the same conditions under the term loan.
