IMBA Course Corporate Finance 2

Valuation of Kohler

INSTRUCTOR
PROFESSOR LIU QIAO

PROJECT TEAM

10928183 10928335 10928497 10828517

Ariel Flora Leo Marie

18 December, 2009
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Table of Contents
I. II. III. IV. 1. 2. 3. V. VI. VII. VIII. IX. Executive Summary ................................................................................................................. 3 Background and Problem Framing .......................................................................................... 4 Methodology of Analysis ..................................................................................................... 6 Valuation ............................................................................................................................. 7 Multiples Approach ............................................................................................................. 7 DCF approach ...................................................................................................................... 9 Reconciliation .................................................................................................................... 11 Lack of Liquidity Discounting ................................................................................................. 12 Dividend based valuation .................................................................................................. 13 Trial and Settlement .......................................................................................................... 14 Tax Controversy ................................................................................................................. 15 Recommendations and Conclusions ................................................................................. 16

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I.

Executive Summary

In our report, we will use two methodsDCF model and multiples to evaluate the enterprise value and equity value of Kohler Co.. The two methods are expected to generate a similar result, which implies the book value of the company. As we can read in this case, Kohler Co. estimate that the share price is $55,400, while the dissenting shareholders estimate that the share price is $270,000. The reason behind the big gap is something we should take an investigation in. we will find the reason why there is difference between our own valuation and their estimation. What is the fair value? What is the marketbased value? According to the decision tree, we can also see some rationale about why we prefer settlement rather than bring the issue on trial. Should Kohler decide to move the case to the court, the maximum share price that would be demanded to pay would be $120,680. This is supposing that the plaintiffs actually win, if not, then the result would be based on the $55,400 as stipulated by the company. Therefore the maximum settlement price that Kohler will be willing to offer the shareholders will be $120,680. However, the case becomes slightly more complicated once the IRS (Internal Revenue Services) comes into the picture. Based on the information provided, the IRS would be very likely to demand that there would be tax levied upon the share price. Depending on the result of the trial, it seems favourable that Kohler should settle at $315,786.96 per share for the shareholders. This being higher than the price that shareholders are asking, Kohler should settle at $273,000. Ultimately, taking all into account, it is unwise and unfavourable for Kohler to bring the case to court as being a time-honoured brand, it would be detrimental to their reputation as the share price that they are valuing it at appears to be grossly undervalued. A settlement would be in the best interest of both parties, given the parameters of the case. Adding the potential lawsuit and the tax implications, Kohler should be even more inclined to settle, the settlement price being higher as well.

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II.

Background and Problem Framing

Founded in 1883, Kohler Co. was a manufacturer of plumbing fixtures in Sheboygan. The Austrian immigrant John Michael Kohler hit on the idea of enamelling a cast iron horse trough/hog scalder, adding legs to it, and selling it as a bathtub. In 1900 the manufacturing opearations moved four miles west into the countryside to the village of Riverside. In 1905, Walter J. Kohler, the president and CEO of Kohler Co., started the conversion of Riverside into American Club, to house immigrant factory workers and help their social integration into the U.S. in 1912, the name was changed into Kohler Village. During the excellent leadership of Walter Kohler, Kohler Co. became the leading manufacturer in plumbing fixtures and electric generators. The peak time was coming for both its fame in business and their charitable enterprises. In the late 1950s, the company expanded beyond its Wisconsin roots, building a new plant in Spartanburg, South Carolina. In 1972, Herbert V. Kohler, Jr. became Chairman and CEO. He guided Kohler Co.s development, diversification and international expansion in the following years. In 1977, the Frank Lloyd Wright Foundation designed a new master plan and Kohler decided to develop The American Club as a luxury inn. After the inn proved successful, the company went on to develop world class golf courses. In 1984, the company began a series of acquisitions aimed at expanding its product line and gaining entry into new markets. Kohler Co.s diversification and international expansion brought its revenue growth. Ownership and control Kohler Co. had 7,445 outstanding common shares in April 1998. Herbert Kohler directly owned only 12.4% of the common stock and beneficially owned an additional 6% through trusts established by his father. His sister, Ruth, directly owned 13.1% and beneficially owned 6% through similar trusts. The Estate of Frederic C Kohler owned 13.1%. The Kohler Foundation owned 12.9% of the common stock. The two charitable trusts owned 17.7% of the stock. About 20 other Kohler family members owned 13.7% of the shares. Outside shareholders owned 4% of Kohler Co. stock, or 300 shares, among which there are two largestSoGen International and Franklin Mutual Discovery Fund.

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Herbert V. Kohler

Ruth De Young Kohler

Estate of Frederic Kohler

John Michael Kohler

Kohler Foundation

Kohler Trust for the Arts and Education Kohler Trust for Preservation

other Kohler Family Members

Kohler Employee Plan

Outside Shareholders

Discrepancy According to its Chairman and CEO, Kohler Co.s private status resulted in its success. In Kohlers opinion, private ownership and privacy of results help focus on big ideas and excellent long-term performance. In order to ensure Kohlers private status, Herbert Kohler proposed a recapitalization of Kohler Co., with the purpose of buying out all the outsider shareholders and restricting future sales of stock to outsiders. The final buyout price was set at $55,400 per share. Outside shareholders, joined by some family shareholders, exercised their dissenters rights to have the fair value of the Kohler Co. stock. In May 1998, over 100 owners of 811 shares exercised their right to challenge the companys valuation of their shares and brought suit against the company. The group claimed that Kohler Co. shares were worth $273,000, which is five times as the price offered by the company. Challenge Now, the case was to be heard by the Wisconsin circuit court. The conflict in Herbert Kohlers heart is whether he should let the court determine the value of Kohler Co. share or settle with the dissenting shareholders at a much higher price, which can balance the interests of the company, the family, and the charitable foundations that owned shares in Kohler Co.? 5|Page

III.

Methodology of Analysis

We will proceed to analyze the case in the following steps 1. Multiples Using the comparable firms in the industry taking into consideration that Kohlers scope of industry spans a few fields with different weighting 2. DCF Using discounted cash flow method to come up with our own valuation of Kohler taking into account a few basic assumptions based on the information available. 3. Reconciliation Due to the nature of the controversy in the case, we will attempt to resolve the discrepancy by adjusting the DCF taking into account different assumptions so support the conclusions from the two parties, Kohler and the disgruntled shareholders. 4. Lack of marketability discount and Dividend based valuation We take into consideration other methods of valuing Kohler based on lack of marketability/liquidity and also Gordons Constant Growth Model. 5. Trial and settlement Next we will use basic decision theory to make suggestions for Kohler to resolve the dispute with the shareholders pending the possibility of court case, this will take into consideration the controversy with the IRS and possible tax implications.

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IV.

Valuation 1. Multiples Approach

Multiples approach is widely used when IBs do valuation for M&A and IPO. For this case, because Kohler is not a public company, so it is hard to find the true market fair value on stock market. In the case, it provides some basic financial and stock market data for companies comparable with Kohler in the same industry. We will use those data to settle down the stock price of Kohler by average multiples. The following illusion shows the calculation process. And this could be evidence shows that the stock price that dissenter claimed is much higher than what we estimated, which should be the true fair value of Kohler private company.

But as Kohler Co. has cross business sectors in household fixtures, cabinets, small engines, generators, and resorts, etc. So actually Kohler Co. is diversified and should be considered as a conglomerate. And comparing a conglomerate to other businesses is difficult to do because it is unlikely that any other company would truly match their corporate structuring.

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So considering about this issue, we come out with another adjusted multiple approach to estimate the value of Kohler Co. We firstly identify the revenue ratio among its majority business sectors, such as Kitchen&Bath Group, and Power Systems Group as following exhibit:
Exhibit Majority Business Sectors of Kohler (in $ thousands)
Kitchen & Bath Group Weight Ratio Net Sales 73.33% 1,485,831 Power S ystems Group 26.67% 540,260

And then base on the different ratio weight to calculate the weighted average multiples. Coming out another set of data, as shown in the below exhibit:

So base on this adjusted multiple approach method, we estimate the stock price of Kohler Co. to reach about 158,948$ per share, which is far below the claimed price of 273,000$ per share. This would be another strong evidence to show the dissenter that the stock price couldnt be so high as 273,000$ and persuade them to accept the settlement price outside of the court.

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2. DCF approach
a) b) c) d) Unleveraged the from the list of comparables, use the average Find Leveraged for Kohler Use MRP of 5% as a standard Cost of debt 7.34% based on moody rating 1998 (A rating)

Corporate Bonds (10-year maturity) Rating Rate AAA 7.10% AA 7.18% A 7.34% BBB 7.70% BB 9.10% B 9.68%

( [ [ ] ]

WACC Bu Bl Tax rate Rf MRP Cost of Debt WACC

0.78 1.17 44% 5.64% 5.00% 7.34% 8.07% (Average proj) (10yr bonds apr 98)

Debt Equity Total D/D+E E/D+E

681,038 786,335 1,467,373 46% 54%

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Assume Perpetual Growth at 6% from historical value of firm

Invested Capital Operating Cash Inventory Accounts receivable Accounts payable Operating Working Capital Tangible Assets Operating Invested Capital Non-Operating Assets Total invested capital

63,512 258,962 351,713 225,771 448,416 476,419

56,838 261,669 355,124 225,664 447,967 498,839

55,621 272,065 376,927 239,481 465,132 516,899

70,976 281,550 393,929 251,384 495,071 531,993

95,207 294,261 410,560 261,007 539,021 554,161

924,835

946,806

982,031

1,027,064

1,093,182

316,767 1,241,602

304,841 1,251,647

301,903 1,283,934

299,270 1,326,334

294,695 1,387,877

Tax on EBIT NOPLAT Dep Inc in work Cap Cap Ex FCF

54,724 71,308 87,661 -449 110,081 49,337

74,518 97,101 91,786 17,165 109,846 61,876

81,621 106,357 94,593 29,939 109,687 61,324

87,537 114,067 97,355 43,950 119,523 47,949

50,826

Perpetual Growth Terminal Value NPV Debt Equity Value Share Price

6.00% 2,450,579 $1,704,272 681,038 $1,023,234.32 $134.85

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3. Reconciliation
Kohlers Perspective Based on Kohlers own valuation they came up with a value of $55,400 per share, this can be derived as follows Assumption : pessimistic estimation of perpetual growth 4.68%
FCF 49,337 61,876 61,324 47,949 50,193

Perpetual Growth Terminal Value NPV Debt Equity Value Share Price

4.68% $1,100,910 681,038 $419,871.54 $55.33

468 1,478,857

Shareholders Perspective Shareholders claim $270,000 per share Assumption : Optimistic estimation of perpetual growth 6.83%
FCF 49,337 61,876 61,324 47,949 51,224

Perpetual Growth Terminal Value NPV Debt Equity Value Share Price

6.83% $2,739,335 681,038 $2,058,297.15 $271.26

683 4,117,558

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V.

Lack of Liquidity Discounting

There are many concepts that we can tap from this case, one of which is the lack of marketability discount that is applied to stocks and equity that is not freely traded on the open market. Figuresx point to a 15% - 35% discount applied to the stock due to lack of marketability.

When we use a median discount of 25% to the current valuation by DCF we get the following:
Share Price Lack of Liquidity Discounted Stock $134.85 25% $101.14

This is closer to Kohlers valuation and one that we find more acceptable than the shareholders claim.

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VI.

Dividend based valuation

Since the stock in not traded we can assume that the Price doesnt fluctuate as much and in valueing the stock take into consideration only the constant growth model: Gordons contant growth model P0 = Div1 / ( r g ) r: expected rate from inv; g : annual growth in div
Market Expected Returns Bu Bl Rf MRP Expected Returns 0.78 1.17 5.64% 5% 11.48%
1997 Dividends Paid 5,688 1998a 5,546

(10yr bonds apr 98)

1999 5,403

2000 7,817

2001 8,848

2002 9,741

10,325.46

-3% Expected returns Perpetual Growth Terminal Value NPV Share Price 11.48% 6.00%

-3%

45%

13%

10%

188,395 $152,505 $20.10

This value is generally under both valuations of Kohler as well as the shareholders, I believe that our assumption that lack of liquidity results in the stock following constant growth model is flawed.

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VII.

Trial and Settlement

Decision tree based on trial and settlement

$81,900.0

claim by plaintiffs 30%

$273,000 $120,680.0

trial

no claim by plaintiffs 70%

$55,400 $38,780.0

no trial

$120,680.0 Max price Kohler willing to settle for

As shown in the decision tree, it is clear that should Kohler decide to bring the case to trial, he stands to lose a total of $273,000 should the plaintiffs win. However, given the probability that of 30% that Kohler would win the case, the probability weighted amount is $81,900. On the other hand, should the plaintiffs lose the court case, then the total amount that he would have to pay would be $55,400, which is the price that was stipulated by the company. However, the likely chance of this is 70%, which though high, is not a guarantee. Weighted we get $38,780. Hence, the maximum share price that Kohler should be looking to settle would be $120,680 per share, taking into consideration the probabilities and the discrepancy between the share prices.

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VIII.

Tax Controversy

$44,929,400.00

Win 30% $316,141.73 Price Per share

Lose Trial 70% $347,017,320.00

$384,010,984.33 $256,103,228.17 $315,786.96 Price per share Settlement IRS 50%

No IRS 50% $128,195,472.00

However, the case is not as simple as bringing the plaintiffs to court. Being a large company, the IRS too has their eye on Kohler. Hence regardless if Kohler goes to court or not, the base taxable amount would be $27 million, for the above analysis we only look at amounts in excess of $27 million for the taxable estate. Depending on the result of the trial, it seems favourable that Kohler should settle at $315,786.96 per share for the shareholders. This being higher than the price that shareholders are asking, Kohler should settle at $273,000.

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IX.

Recommendations and Conclusions

It appears to be that both Kohler and the shareholders are undervaluing and overvaluing the stock price respectively. Kohler is assuming that the growth rate of the stock price would be at 4.68% which is pessimistic, whereas the shareholders are being optimistic and assuming that there would be a growth of 6.83%. Both of which are unrealistic. Given the state of things, the shareholders are feeling that they have been hoodwinked by Kohler and are disgruntled enough to bring Kohler to court to fight for their deserved rights. The closed door valuation of the stock price too does not inspire much interest as far as the shareholders are concerned. Realizing that Kohler wants to keep the shares within the family, the shareholders are also keen in extracting the maximum amount of money that they are able to from the company. Due to the difficulty in estimating the true value of Kohler, by weightage of similar industries, the estimated true value of the stock should be closer to $159,000 per stock price. Given all the different scenarios and evaluations, it is definitely in the best interest of Kohler to bring the case to court given the large differences between the amounts of money involved. At trial, the total amount that Kohler would have to probably pay is estimated at $256 Million on top of the $27 Million that is required by IRS. It is highly recommended to Kohler to revalue the stock price at a fair market value and repropose this amount to the shareholders. Given that, although the tax payable to IRS is higher, but it is the trauma and the additional legal and administrative fees that will hurt the company more than a simple decision of settling or not. Failing which, the next best alternative would be to go to court.

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