Divest in Non-Core Business and Reduce Debt - Notes | FIN 4360, Study notes of Finance

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FIN 4360 MWF 1pm GROUP #2 Bill Floyd Jake Golvach Michal Kokta Robert Sosebee Chris Wasik April 12th 2006 TABLE OF CONTENTS Executive Summary...............................................................................................................3 Recommendation 1: Divest in Non-Core Business and Reduce Debt..................................4 Recommendation 2: Restructure of Management Compensation........................................6 Appendix A: Company Overview........................................................................................11 Appendix B: Financial Strength Ratios................................................................................14 Appendix C: Calculation of Dana’s EVA.............................................................................15 Appendix D: Works Cited....................................................................................................16 2 segments: engine hard parts, fluid products, and pump products. Revenues from these three businesses in 2004 amounted to approximately $1.3 billion. Dana C.E.O. Michael Burns said, “We expect to use the proceeds from these divestitures to reduce debt and reinvest in those businesses that will be key to profitable growth in the future” (dana.com). Also, on March 29, 2005, Dana received final court approval for $1.45 billion in debtor-in-possession financing. This will aid in funding the company’s ongoing operations including employee salaries, supplier payments, and operational and restructuring costs (dana.com). Once Dana emerges from the restructuring of the bankruptcy process, we recommend that the company continue its efforts to reduce its debt. Dana defines its core products as axles, drive shafts, structures, and bearing and sealing products (Dana 10-k). Dana should look to product lines and business segments that do not fall under these categories for opportunities to divest and raise cash. These non-core business segments should continue to be sold and the cash to be used to retire debt. With this reduction in debt, Dana will still receive the benefit of a tax-shield on its interest payments; however, the company will not be faced with as great of a risk of losses from another bankruptcy if profits are less than optimal. Therefore, a lower level of debt liability will reduce the impact of lower profit margins. The high commodity cost of steel and pressure by struggling customers (i.e. GM, Ford) to keep prices low may continue to cut into Dana’s profits. In order to combat this reality, Dana should continue with its plans to diversify its markets, especially targeting expanding economies such as China, India, and Eastern Europe. In its 2004 10-k report, Dana stated a goal to increase its percentage of sales from outside the U.S. from 35% to 50% over the next five years (Dana 10-k). With diversified customers, Dana will not face as much pressure from the “Detroit Big 3” to keep its prices lower than is optimal. Once Dana is able to realize profits from operations, earnings that exceed financial needs should be used to contribute to 5 paying off a portion of the principal on long-term debt until a debt to equity ratio of around 1.0 is reached. This ratio is consistent with the industry average of other auto parts suppliers. In conclusion, the overextension of debt financing coupled with increasing market costs of raw materials was responsible for the financial distress and subsequent bankruptcy filing of Dana. By continuing to divest in its non-core business segments and diversifying its customer base, Dana can raise funds to retire a portion of its debt, thus reducing the risk of costs associated with financial distress while still maintaining a beneficial tax-shield. Recommendation 2: Restructure of Management Compensation According to John S. Shiely, CEO and Chairman of Briggs & Stratton, “there is one primary responsibility of business people in a free market society and that is the creation of value.” In order to create value, it is essential that management’s compensation be designed to facilitate decisions aimed at increasing the value of the firm. Therefore, we are recommending that the executive compensation program be restructured to include an Economic Value Added (EVA) based bonus and stock ownership requirements. These changes will bring the interests of management and stockholders together so that management will benefit while maximizing stockholder wealth. Simply put, “EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise.” By recognizing that when managers employ capital they must pay for it, EVA is able to show the dollar amount of wealth created or destroyed in each reporting period. The EVA method incorporates the primary objective of finance which is 6 the maximization of shareholder wealth. EVA is also an effective method in a turnaround situation such as Dana’s. This is because the level of EVA does not matter as much as continuous improvement in EVA (Stewart). Implementing an EVA based bonus system will help Dana’s managers make decisions that will truly increase the value of the firm into the future. Since it is easy to understand and use, EVA can be used throughout the whole company so that every employee is working toward the same goal. Management will be more concerned about asset use efficiency rather than focused solely on revenues and profits because EVA encompasses the whole spectrum of managerial decisions: strategic planning, allocation of capital, valuating acquisitions and divestitures, and tying annual goals to day-to-day operations. Because EVA considers the cost of capital and is consistent with the time value of money, it could help management to see potential problems—such as insufficient cash to meet interest payments—earlier. This would allow management to evaluate why the assets are not generating enough return and take action to remedy the situation before it becomes a real problem. An EVA based bonus system will also help in evaluating executives’ performance over the course of the year by mitigating the reliance on traditional accounting-based performance measures such as net income. Dana’s current Board of Directors has selected “net income and return on invested capital (ROIC) as the corporate business criteria for determining 2004 bonuses” (Dana DEF 14A 15) and justify bonus payments “primarily on the success of Dana and/or its operating units in attaining specified levels of performance” ( Dana DEF 14A 14). An EVA based bonus system will help Dana’s board appropriately measure the “success” of Dana Corp. while shifting management’s focus from attaining performance goals unique to each operating unit to creating wealth that benefits the entire firm. 7 executives to utilize this method is that a portion of the principal and interest due can be earned back if certain EVA goals are met (Herman Miller DEF 14A 25, 27). In conclusion, an EVA based bonus system and the implementation of executive stock ownership requirements would benefit Dana Corp. by ultimately aligning the interests of management and shareholders in creating and maximizing the firm’s value. The addition of EVA to traditional performance measurements will help the Board specify and accurately measure management’s decisions and their impact on the firm’s value. The emphasis on long-term growth will encourage management to focus on the strategic direction of the firm and discourage sacrificing potential value-added projects in favor of the bottom line. 10 Appendix A: Company Overview Dana Corporation was initially incorporated in 1905 in New Jersey under the name ‘Spicer Universal Joint Manufacturing Company’. In 1928 it was relocated to its current headquarters in Toledo, Ohio and renamed to Dana Corporation. Dana is currently ranked #234 in the Fortune 500 companies list even though it filed for bankruptcy on March 3 rd, 2006. Dana also ranks 15th in top 100 global automotive suppliers. The stock price has varied from “as high as $60 per share in 1998 to about $1 by the time bankruptcy was declared” (Wikipedia). Products and Services Dana Corporation is a major global player in the auto parts manufacturing industry, with worldwide sales topping $9 billion in 2004. It operates in 28 countries primarily in North America, Europe, South America and Asia-Pacific. Even though Dana’s sales outside the USA increased from 22% 5 years ago to 35% in 2004, Dana is still relatively far away from reaching its vision of having US sales equal the sales around the world by the year 2009 (Dana 10-k). Dana specializes in supplying parts for automotive, commercial and off-highway vehicles. The distribution of these in 2004 in the United States was: 60% automotive, 25% commercial vehicle and 15% off-highway (Dana 10-k). The main products for Dana include axle, driveshaft, engine, frame, chassis and transmission technologies. Of those, the axles are the most important product, constituting 43% of US sales, with driveshaft coming second at 14% (Dana 10-k). Facilities and Employees 11 Overall, Dana owns 254 facilities around the world; of these 169 are manufacturing, 33 distribution and 52 sales branches and offices. Out of the 254 facilities, 142 are located in North America (Dana 10-k). However, due to the recent financial pressures and lack of funds, Dana plans to close three plants in North America and Australia. Dana employs 46,000 workers as of December 31st 2004, which represents a 35% reduction when compared to the 2001 numbers (Dana 10-k). These layoffs can be contributed to the restructuring efforts of the company. This trend can be expected to continue in the near future – there is an expectation of a further 5% cut in the workforce in 2005 (CBS News). Industry Trends and Competitors The main competitors of Dana Corporation in the United States include Delphi, Magna, Visteon and Rockwell. The whole transportation industry as well as auto parts manufacturers industry has struggled to achieve profits over the past couple of years. In the transportation industry, General Motors (one of the biggest customers of Dana) has announced its intensions to close plants in the United States along with cutting 25,000 jobs by 2008. The demand for products of Dana is derived from the demand for products of Dana’s customers (such as GM) and if these experience a drop in sales, Dana suffers as well. More specifically, in the auto manufacturers industry, Dana’s main competitor, Delphi, has filed for bankruptcy in October 2005. The future outlook does not look brighter either, with companies looking to cut costs by both laying off workers as well as outsourcing some of the activities overseas. Customers 12 Sources: Wharton Data Services Mergent Online Securities Exchange Commission 15 EVA=NOPAT(t) - k(t-1) * Capital(t-1) Year 2005 2004 Operating Profit ($81) $170 Plus: Interest on Cash Balances 35 9 Goodwill Amortization 0 0 R&D Expense 0 0 Change in LIFO Provision 0 0 Less: Cash Taxes (935) 205 Amortization of Capitalized R&D 0 0 NOPAT (t) (981) $384 Cost of Capital, k(t) Cost of equity is r(e) = r(f) + Beta x MRP r(f) 4.61% 4.85% Beta 1.64 1.64 MRP 6% 6% r(e) 14.45% 14.69% Cost of debt is r(BAT) = r (B) (1-Tc) r(B) 6.33% 9.09% Tc 35% 35% (1-Tc) 65% 65% r(BAT) 4.11% 5.91% Total Market Value of Equity and Debt Value of equity $2,599.5 $2,734.15 Value of debt $2,209 $3,098 Minority interests $123 $96 Weight of equity 55.21% 47.74% Weight of debt 44.79% 52.26% Cost of Capital = [(Xe)(r(e))*(Xd)(r(bat))] 14.69% 21.66% Capital(t-1) Operating Cash $634 $731 Plus: Receivables $1,710 $1,374 Inventory $907 $743 Other Current Assets $128 $259 Plant and Equipment $2,153 $2,210 Intangible Assets $593 $558 Capitalized R&D $619.4 $450.4 Other Assets $1,361 $1,013 Less: Current Liabilities $2,330 $2,311 Capital(t-1) $5,775.4 $5027.4 Capital Charge $848.41 $1,088.93 EVA=NOPAT(t) - k(t-1) * Capital(t-1) ($1,829) ($705) Appendix D: Works Cited “Dana Corporation Announces Series of Operational & Strategic Initiatives to Enhance Financial Performance.” Dana Corp. 20 Oct. 2005. http://dana.mediaroom.com/index.php/press_releases/2014?printable “Dana Corp. Files for Bankruptcy.” CBS News. 3 March 2006. http://www.cbsnews.com/stories/ 2006/03/03/business.printable1367076.shtml “Dana Corp. – Ratios.” Reuters.com. 9 April 2006. http://www.investor.reuters.com/MG.aspx? country=US&ticker=DCNAQ.PK&coname=DANA+CORP&mxid=100085449%2c1000 88601%2c100301958&target=%2fstocks%2ffinancialinfo%2fratios %2fvaluation&cotype=1&page=default "Dana Corporation Reports Preliminary Fourth-Quarter and Full-Year 2005 Results.” Dana Corp. 22 March 2006. http://dana.mediaroom.com/index.php/press_releases/2054 “Dana Corporation.” Mergent Online. 11 April 2006. http://www.mergentonline.com/compdetail.asp?company=- 1&company_mer=2298&type=compdetail Dana Corporation. “SEC Form 10-K.” United States Securities and Exchange Commission Filing. 9 March 2005. Dana Corporation. “SEC Form DEF 14A.” United States Securities and Exchange Commission Filing. 3 March 2005. Dana Corporation. “Summary.” Scottrade. 11 April 2006. https://trading.scottrade.com/quotesresearch/DetailedQuoteSummary.aspx?Symbol=Dana %20Corp. “Dana Corporation.” Wikipedia. 24 March 2006. http://en.wikipedia.org/wiki/Dana_Corporation “Dana Europe Continues Business as Usual.” PRNewswire. 6 March 2006. http://prnewswire.co.uk/cgi/news/release?id=165487 Economic Value Added (EVA). New York University. <http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html> Herman Miller, Inc. “SEC Form DEF 14A.” United States Securities and Exchange Commission Filing. 24 August 2005. Rich, Steve. “Capital Structure Notes.” Spring 2005. Baylor University: 16-21. Shiely, John S. “Economic Value Added: A Conscience for Business.” Interview Acton Institute 2001 < http://www.acton.org/publicat/randl/interview.php?id=478> Stewart, Bennett. “What is EVA?” Stern Stewart & Co. <http://www.sternstewart.com/evaabout/whatis.php> 17