Case 9 & 10 Analysis Seagate Technology Buyout The Hertz Corporation Advanced Corporate Finance MW 2:00-3:15 PM Question 1 On page 1, the “value-gap” is two-fold. It signifies an under-valuation of Seagate’s core disk drive operating assets due to unfavorable public market investor preferences. Furthermore, the value of the Veritas share price has caused the Veritas stake to far outweigh the value of Seagate’s stand-alone market capitalization.
Since Seagate does not own at least 80% of the voting stock in Veritas, distributing the wealth intrinsic in that stake to Seagate shareholders would prove difficult due to the hefty corporate tax rate of 34% that would erode its full-value.
From a sum of the parts perspective, it seems that since the Veritas shares held by Seagate appreciated by more than 200%, while Seagate’s shares only increased by 25%, the market assigned relatively no value to Seagate’s market leading position in the disk drive business. This lack of market recognition for the true value of Seagate’s assets forced management to seek action.
The management believed that the value of Seagate should be attributed to the value of its operating assets. Since the market was attributing such a high value to its Veritas stake, the market made it appear that Seagate was an investment holding company, rather than being in the disk drives business. There also seemed to be a “value-gap” in the sense that the Veritas stake is attached to business risk in the software sector while the core operating assets of Seagate have business risk in the disk drives segment of the hardware manufacturing sector.
Since the value of Seagate’s stock seemed to come completely from Veritas, it could no longer give proper employee incentives and stock option compensation plans to tie one’s interests to the firm’s operations. The performance of the firm would slowly have no affect on its share price as the Veritas stake took over as its direct impact. Seagate did not want to be valued solely by the performance of Veritas. It needed to find a way to unlock the value of the stake and a buyout seemed the most effective method. The notion that the market value of Seagate’s core disk drive businesses is negative lacks plausibility.
The plausible assertions come from the value erosion due to taxes from attempting to unlock the value of the Veritas stake appreciation. Also the lack of traditional stock price targets for employee compensation plans due to the stock performance being more linked to the success of Veritas than the success of Seagate. Question 2 Essentially there are two purposes of the overall transaction. The management seek to restructure Seagate to its optimal setup where it is most fairly valued by the market and able to properly incentivize performance tied to stock-based compensation.
Furthermore, the management would like to alleviate existing shareholder concerns about the vastly large appreciation in the Veritas stake by discovering a way to unlock the value of that stake without facing the additional corporate taxation. In part one of the two-part transaction, Seagate will sell all of its operating assets to a group of investors including Silver Lake amongst the largest of the buyout consortium. The buyout investors would acquire $765 million in cash as well as all the operating assets of Seagate.
In exchange, the remaining Seagate shell would receive cash quoted at the buyout purchase price that would ultimately seek to fairly compensate Seagate’s existing shareholders for the core operations of the disk drives business. The focus of this stage of the transaction is to spin-off Seagate’s operations from the valuation uncertainty behind the original firm. At the same time, this transaction not only favors Seagate’s existing shareholders, but also it gives a private equity consortium the potential to realize an extremely high rate of return until realizing its exit strategy down the road.
This is done for the purpose of firm restructuring. In part two of the two-part transaction, the remaining Seagate Technology shell corporation will exchange 128 million old Veritas shares for 109 million new Veritas shares with Veritas Software. In addition, the cash proceeds of the buyout of Seagate’s operating assets will be distributed, along with all the cash in excess of the $765 million delivered to the buyout investors, among the existing shareholders of Seagate at the time of the buyout. This happens through a down-stairs merger.
The remaining shell would be merged with Veritas and in exchange Seagate existing shareholders are distributed new Veritas shares proportionally. This unlocks the value of the shares without facing double taxation through the corporate tax of 34%. The existing shareholders only incur a personal capital gains tax on their investment holdings. The purpose of this part of the transaction is to successfully deliver the maximum amount of value from the appreciation of the Veritas stake to Seagate’s existing shareholders. Question 3 By the end of 1999, Seagate had a BBB credit rating issued by S&P for its long-term debt.
Based upon historical operating performance, it would seem that Seagate’s leverage ratio has high volatility due to its high volatility in market value of equity and operational performance. However, we believe that the current leverage ratio is above its optimal leverage because in 1998 the firm had a -2. 72 EBIT interest coverage ratio using the greater debt load of $703 million on its books. In the recapitalization for the leveraged buyout, a new debt load of $453 million will ensure that Seagate maintains its BBB credit rating throughout the term of the investment.
This will also ensure that S&P will upgrade its credit rating upon maintenance of this minimum investment-grade credit rating. Subsequently an upgrade of Seagate’s credit rating will also increase Seagate’s access to additional debt related financing in the future. Since we have insufficient data for accurately valuing Seagate’s operating assets, it is difficult to choose a leverage ratio based on recent operational performance since the market value of Seagate equity has been greatly skewed from the effects of the Veritas stake. Instead, the EBIT interest coverage serves as a better metric for the credit rating analysis.
Since 3. 9x is the minimum for a BBB credit rating on long-term debt, Seagate should leverage itself up to levels of debt that support 4. 0x interest coverage, such as the previously described recapitalization amount. Question 4 The deal structure proposed by CD&R divides Hertz into two separate companies. It creates a FleetCo and an OpCo. The FleetCo would consist of two bankruptcy-remote special-purpose entities, Hertz Vehicle Financing and Hertz International. Hertz Vehicle Financing would own the domestic RAC rental fleets while Hertz International would own the international RAC ental fleets. The Operating Company, OpCo, would own all other Hertz assets, including HERC and equipment fleet and other domestic subsidiaries. OpCo would conduct all rental transactions with customers, and lease the fleet from FleetCo. This would provide FleetCo with payments to cover depreciation of the fleet and finance FleetCo’s ABS debt. Furthermore, due to the legal separation of FleetCo and OpCo, the assets of each subsidiary would not be reachable by lenders from the other subsidiary in case the indebted subsidiary in question defaults.
This is a similar structure to the Marriot Case where one company owned the assets and the other company operated them. FleetCo will own the key assets in order to receive special ABS financing while the OpCo will operate the business and make lease payments to cover the cost of FleetCo’s interest payments. Question 5 Hertz’s fleet for ABS financing achieves the objective of raising funds at a lower cost than under Hertz’s existing capital structure due to the lower risk perceived by the financing itself.
This lower risk is reflected in the indicative interest rates charged on the ABS financing of only Libor plus 70 basis points. By separating the fleet assets from the operating business, creditors can more easily value the intrinsic risk surrounding the assets and will be more likely to lend as a result. Furthermore, since the debt is directly tied to hard tangible assets such as the fleet of rental cars and not the Hertz Corporation itself, the expansion of the funded debt capacity will be easier to determine when managing the fleet volume demand.
This way Hertz’s financing decisions match up with the behavior of its operational cash flows. ABS financing gives Hertz the flexibility to deal with seasonal, cyclical, and other fluctuations in demand for rental cars without having the concern for refinancing, additional capital, or that the fleet is over-funded. This debt capacity will provide a stable source of financing to continue to accommodate for future expansion and growth when necessary. It has the additional benefit that the creditors will only be able to lay claim to the assets that they are directly funding rather than the overall business.
This lowers the debt risk of the overall corporation if such a huge debt capacity does not have spillover risk into other subsidiaries of the firm, such as OpCo in the new structure. Question 6 If we assume a Libor rate of . 21%, then the ABS financing implies an interest rate of only 1%, while the term loan financing implies an interest rate of 3. 21%. Under these assumptions, Hertz would save $166. 27 million per year in interest payments by using ABS financing, rather than suffering from financing under the same conditions of the term loan.
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