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Thermo Electron Corporation. Cash Distribution Analysis. Thermo Electron Corporation. Craig Billings Tony Curry David Rice Zach Strobel Assisted by Ashok Vishnubhakta Doug Wilson. Team Members:. Our Recommendation. Initiate regular dividend combined with open market repurchase

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Thermo electron corporation

Thermo Electron Corporation

Cash Distribution Analysis


Thermo electron corporation1

Thermo Electron Corporation

Craig Billings

Tony Curry

David Rice

Zach Strobel

Assisted by

Ashok Vishnubhakta

Doug Wilson

Team Members:


Our recommendation

Our Recommendation

Initiate regular dividend combined with open market repurchase

  • Annual dividend of $50MM

    • $0.30 per share (based on 162MM sh OS)

  • $500MM 3 year open market repurchase

    • At or below $25.50 per share (3Q 2003 valuation)

    • Represents 3 years of projected FCF net of the recommended annual dividend


Agenda

Agenda

  • Framework for deciding on the best method of cash distribution

  • Cash distribution recommendation

  • Additional considerations


I framework for deciding on the best method of cash distribution

I. Framework for Deciding on the Best Method of Cash Distribution

  • Recent trends in cash distribution

  • Financial policy framework

  • Company characteristics

  • Types of cash distribution methods

  • Tax implications for investors


Recent trends in cash distribution

Recent Trends in Cash Distribution

17 S&P 500 companies have initiated dividends in 2003

  • vs. 4 in 2002

  • 16 are growth stocks

    According to Morningstarmetrics

    Average Results

  • Average market cap prior to initiation: $15B

  • Annual dividend size: $147MM - $0.38 per share

  • Announcement effect on share price: 0.6%

  • Company S&P adjusted return to date: 21.3%

Source: S&P

Addl. Info in appendix slides 44-50


Recent trends in cash distribution1

Recent Trends in Cash Distribution

13 S&P 500 companies have initiated or resumed share repurchases in 2003 to date

  • All open market repurchases

  • 10 are growth stocks

    According to Morningstarmetrics

    Average Results

  • Average market cap prior to initiation: $12.6B

  • Announced size $500MM

  • Completed size to date: $71MM

  • Announcement effect on share price: (0.2%)

  • Company S&P adjusted return to date: 11.1%

Source: Compustat

Addl. Info in appendix slides 44-51


Recent trends in cash distribution2

Recent Trends in Cash Distribution

5 S&P 500 companies have initiated dividends combined with a share repurchase in 2003

  • 4 are growth stocks

    According to Morningstarmetrics

    Average Results

  • Annual dividend size $99MM - $0.40 per share

  • Announced repurchase size $600MM

  • Announcement effect on share price: (1.3%)

  • Company S&P adjusted return to date: 26.3%

Source: S&P, Compustat

Addl. Info in appendix slides 44-51


I framework for deciding on the best method of cash distribution1

I. Framework for Deciding on the Best Method of Cash Distribution

  • Recent trends in cash distribution

  • Financial policy framework

  • Company characteristics

  • Types of cash distribution methods

  • Tax implications for investors


Financial policy framework

Financial Policy Framework

Cash Generation

WACC

- Organic Investment

= Free Cash Flow

M&A Investment

Debt Financing ( + / - )

Equity Financing ( + / - )

Dividend Decision


Cash generation

Cash Generation

Cash flow from operations expected to be positive for the foreseeable future

Source: ACFIN model


Cost of capital considerations

Cost of Capital Considerations

Current WACC

Credit Rating: BBB

  • Increase leverage-

  • Move towards minimal WACC

  • BBB credit rating

Source: ACFIN model based on 3Q 2003


Organic investment

Organic Investment

  • Difficult to evaluate incremental investment opportunities externally

  • Company is struggling to earn cost of capital – ROIC less than WACC

  • Projected single-digit revenue growth

  • Trend in M/B ratio declining

Limited internal reinvestment opportunities

Source: analyst reports, ACFIN model


Free cash flow

Free Cash Flow

  • Free cash flow expected to be positive for the foreseeable future

Free cash flow is either used for M&A, debt reduction, share repurchase, dividends OR accumulates on the balance sheet

Source: ACFIN model


M a investment

M&A Investment

Uncertain Economic Benefit

  • Unknown availability of future targets at attractive prices

  • In general, most M&A transactions do not add value to the acquirer

  • Thermo Electron’s M&A track record has been mixed


M a investment1

M&A Investment

Analysis of Thermo Electron’s M&A activity 1998-2003

* Pre and Post Announcement Date

Addl. info in appendix slides 52-53


Debt financing

Debt Financing (+/-)

Increase debt (+ cash)

Preferable to debt reduction, but raises other issues

  • Some room to increase leverage ($485MM) and maintain investment-grade credit rating

  • Moves towards minimum WACC

  • Contributes additional cash for distribution to shareholders

  • Reduction of debt (- cash)

  • Not desirable

  • Moves company farther away from minimal WACC

  • Leasing strategy makes it difficult to reduce debt beyond a certain level

Source: ACFIN model


Equity financing

Equity Financing (-)

  • Share repurchase (- cash)

  • Desirable effects

  • Cash distributions discipline investment decisions

  • Reduces WACC by increasing leverage

Source: ACFIN model


I framework for deciding on the best method of cash distribution2

I. Framework for Deciding on the Best Method of Cash Distribution

  • Recent actions in cash distribution

  • Financial policy framework

  • Company characteristics

  • Types of cash distribution methods

  • Tax implications for investors


Distribution policy company characteristics

Distribution Policy & Company Characteristics

  • 3 Objectives of distribution policy:

  • Distribute cash generated by the company

  • Maintain financial stability & access to capital markets

  • Maintain flexibility & insure against downturns


I framework for deciding on the best method of cash distribution3

I. Framework for Deciding on the Best Method of Cash Distribution

  • Recent actions in cash distribution

  • Financial policy framework

  • Company characteristics

  • Types of cash distribution methods

  • Tax implications for investors


Equity financing repurchase

Equity Financing - Repurchase

Source: JP Morgan


Dividend decision

Dividend Decision

Source: JP Morgan


I framework for deciding on the best method of cash distribution4

I. Framework for Deciding on the Best Method of Cash Distribution

  • Recent actions in cash distribution

  • Financial policy framework

  • Company characteristics

  • Types of distribution

  • Tax implications for investors


Tax implications for investors

Tax Implications for Investors

For Institutions: Tax exempt; indifferent between methods

For Corporations: Strong dividend preference

  • Dividend:

  • Due to the dividend received deduction, corporations generally only pay tax on 30% of the dividend received.

  • Effective tax rate of ~10.5%

  • Stock Repurchase:

  • Capital gains for corporations are taxed at marginal rates ~35%.

  • Capital loss treatment available

  • Flexibility in timing of cash receipt

For Individuals: Slight preference for repurchase

  • Dividend:

  • Taxed at max 15%

  • Forced cash receipt

  • Stock Repurchase:

  • Taxed at max 15%

  • Capital loss treatment available

  • Flexibility in timing of cash receipt

Effects of 2003 dividend tax cuts already priced into the market


Agenda1

Agenda

  • Framework for deciding on the best method of cash distribution

  • Cash distribution recommendation

    • Dividend

    • Share repurchase

  • Additional considerations


Value in dividend policy

Value in Dividend Policy

  • In light of the cut in taxation and the greater visibility & security of the dividend, companies should distribute as much sustainable FCF as a dividend as possible

  • Growth in dividends should track growth in FCF (permanent & sustainable)

  • Share repurchase linked to potentially non-sustainable cash flows

  • Policy on future dividend prospects adds value to current dividends


Dividend recommendation

Dividend Recommendation

  • Free cash flow is the main driver of dividends

  • Recommended annual dividend size: $50MM

  • $0.30 per share, based on 162MM shares outstanding

  • Based on 2003 projections, payout ratio 27.3%, yield 1.4%, percent of FCF 30%

Source: ACFIN Model

Addl. Info in appendix slides 54-55


Dividend rationale

Dividend Rationale

  • $50MM annual dividend is below 10 year historic low in free cash flows

  • Reduces risk of having to lower dividends in the future

  • Leaves FCF for share repurchase or M&A activity in most years

Projected 1.4% dividend yield in-line with median S&P 500 dividend yield

Annual dividend size of $0.30 in line with 2003 initiations (average $0.38)

Source: Historic F/S, ACFIN model, S&P


Share repurchase recommendation

Share Repurchase Recommendation

Given annual dividend commitment of $50MM, residual FCF should be used for $500MM open market share repurchase up to $25.50 per share

  • Represents 3 years of projected FCF

  • Distributes cash in a flexible way

  • May be EPS accretive

  • Lowers cost of capital

  • Neutralizes dilution from exercise of management stock options

    Result: At $25.50, a purchase of 20MM shares, 12% of market float


Share repurchase target price

Share Repurchase – Target Price

Calculated Enterprise Value

$26.60 Basic

$25.50 Diluted

Repurchasing shares at greater than calculated price is value-destroying to non-tendering shareholders

Source: ACFIN Model

Addl. Info in appendix slides 56-57


Repurchase eps effects

Repurchase – EPS Effects

In a debt-financed repurchase, EPS is accretive to the extent that the earnings yield at the repurchase price exceeds the after-tax interest yield

22.8

P/E

Source: ACFIN Model


Repurchase eps effects1

Repurchase - EPS Effects

In a cash-financed repurchase, EPS is accretive to the extent that the earnings yield at the repurchase price exceeds the investment yield

25 P/E

50 P/E

16.7 P/E

12.5 P/E

Source: ACFIN Model


Agenda2

Agenda

  • Framework for deciding on the best method of cash distribution

  • Cash distribution recommendation

  • Additional considerations


Additional considerations

Additional Considerations

  • Is Thermo Electron a “growth” company?

  • What are the implications to Thermo Electron’s investor clientele?

  • What is the effect on management’s stock options?


Value vs growth stocks

Value vs. Growth Stocks

Benchmark definitions

  • Value Stock

    • A company that is considered under-priced relative to the industry. Common characteristics include a low market-to-book ratio and a high dividend yield.

  • Growth Stock

    • A company whose earnings are expected to grow at an above average rate relative to the market. Generally have high market-to-book ratios.

Source: Investopedia


Investor clientele implications

Investor Clientele Implications

Is Thermo Electron a growth company?

  • LowM/Bratio of 1.7

    • Median M/B ratio for mid-cap, growth firms is 4.29

      (Source: Morningstar Mid-Growth Index)

  • Low P/E ratio of 22-23

    • Median P/E ratio for mid cap, growth firms is 52.7

      (Source: Morningstar Mid-Growth Index)

  • Low salesgrowth

    • last 4 years - negative

      (Source: 10-K filings)

    • future growth projections – single digits

      (Source: compilation of analyst reports 10/2003)

  • Institutional ownership is

    primarily non-growth oriented funds

    (Source: Reuters Investor, top 20 investors)


Investor clientele implications1

Investor Clientele Implications

Effect on Thermo Electron being perceived as a growth or value company

  • Dividend is usually an indicator of a mature company and has both positive and negative attributes:

    • Implies reduced corporate risk

    • Suggests reduced investment opportunities

    • However, because of tax-law changes, most companies initiating dividends in 2003 were growth companies

  • A share repurchase could have varying effects on investors’ perceptions:

    • A “dividend-like” recurring share repurchase plan will have a similar effect as a dividend

    • A large tender offer may indicate that management believes the stock is undervalued; however, tender offers come at a premium.


Effect on management s stock options

Effect on Management’s Stock Options

Dividend

  • Signaling effect generally boosts stock price & stock option value

  • Signaling issues aside, a dividend lowers stock price / option value upon issuance of dividend

  • Most options not dividend protected

    Share Repurchase

  • Initial market reaction to announcements of open market programs is generally only about 4% (compared to about 15% for fixed-price offers)*

  • Relative to dividend, share repurchase will have a more positive effect on share price because it decreases the number of shares

  • Increase in leverage affects firm volatility; increasing the value of options

  • Signaling effect boosts stock price by amount depending on type of stock repurchase

  • Repurchased shares can be put in treasury and reissued upon exercise of management’s options

Source: Journal of Applied Corporate Finance Spring 2000


Effect on management s stock options1

Effect on Management’s Stock Options

  • Stock repurchases have no direct effect on the value of stock options and appreciation rights

  • Dividend payments reduce the value of stock options

  • This variation raises the issue that stock option grants are an important consideration for management in choosing between dividends and stock repurchases

  • Consequentially, managers who own stock options are more likely to distribute cash through open-market repurchase rather than an increase in cash dividends

Source: Journal of Applied Corporate Finance Spring 1998


Summary

Summary

Effects of a $50MM annual dividend and a $500MM 3 year open market share repurchase funded with projected free cash flows


Thermo electron corporation2

Thermo Electron Corporation


Appendix

Appendix


Recent trends in cash distribution3

Recent Trends in Cash Distribution

Source: JP Morgan, S&P, Compustat


Recent trends in cash distribution4

Recent Trends in Cash Distribution

  • 180 Companies have increased dividend in 2003

  • Dividend yield skewed to low end; most under 3%

  • Distribution yield not as skewed; lower-yield companies tend to augment distributions with share repurchase

Source: JP Morgan, S&P, Compustat


Recent trends in cash distribution5

Recent Trends in Cash Distribution

  • Wide range of dividend payout ratios; median 10%-20%

  • Distribution flattens with share repurchase; approx 30-40 companies in each band from 10% to 80%

  • 89 Companies distribute over 100% of earnings

    • Reflects depressed earnings

    • Use of share repurchase to recapitalize the balance sheet

Source: JP Morgan, S&P, Compustat


Recent trends in cash distribution6

Recent Trends in Cash Distribution

Completed repurchases increased dramatically to 2000

Dropped sharply as earnings and stock prices fell

Trend reversed in 2003

In 2002, 10 largest repurchasers accounted for 50% of total completed volume

5 of top 10 were technology companies, repurchasing to offset warrant dilution

2003 to date: $85.3B repurchases completed

Source: JP Morgan, Compustat


Morningstar growth ratings

Morningstar Growth Ratings

  • Criteria for Growth Grade

    • Raw Growth: historical sales growth over past 5 years

    • Consistency: steady YOY sales growth over past 5 years

    • Trend: reward accelerated sales growth

  • Ranking is relative to peers within sector

  • Distribution of grades: equal numbers of As, Bs, Cs, and Ds with bottom 10% getting Fs

Source: Morningstar


Open market repurchase sec rule 10b 18

Open Market Repurchase: SEC Rule 10b-18

Rule 10b-18 applies to share repurchases on the open market under normal market conditions (i.e. not during mergers, tender offers, or distributions). Specifically, the Rule states the following with respect to the conditions that must be satisfied:

  • Manner of purchase condition: shares must be repurchased by a single broker/dealer in a day so as to not mislead the market by creating the illusion of wide-spread buying[1]

  • Timing of purchase condition: shares cannot be repurchased at the beginning of trading nor at the end, because trading those periods are considered to be an indication of the direction of trading, strength of demand, and market value of the security

  • Price condition: the shares may not be repurchased for a price higher than the last independent published bid or transaction price, so as not to mislead the market

  • Volume condition: an issuer can purchase daily up to 25 percent of the average daily trading volume (ADTV) of its shares, but this does not include block purchases

    • Block purchases[2] have either a purchase price of $200,000 or more; at least 5,000 shares of the stock of at least $50,000; at least twenty round lots totaling 150 percent or more of trading volume; or twenty round lots totaling at least .1 percent of the outstanding shares of the security, exclusive of those owned by affiliates

  • Rule 10b-18 provides issuers with safe harbor from liability for manipulation under Section 9(a)(2) and 10(b), and 10b-5 under the Exchange Act. Rule 10b-18 is designed to minimize the market impact of share purchases, allowing the stock price to be “based on independent market forces without undue influence by the issuer.”

  • [1] The broker/dealer can arrangements with other broker/dealers, so long as the issuer has engaged only one broker dealer

  • [2] Block purchases are not included in ADTV

Source: SEC


2003 dividend initiation

2003 Dividend Initiation

Source: S&P, Morningstar


2003 repurchase initiation

2003 Repurchase Initiation

Source: Compustat, Morningstar


Thermo electron 1998 2003 m a

Thermo Electron 1998-2003 M&A


Thermo subsidiary acquisitions 1998 present

Thermo Subsidiary Acquisitions 1998-Present


Comparables dividends

Comparables - Dividends

Source: Compustat


Thermo electron dividend calculation

Thermo Electron Dividend Calculation

Source: ACFIN model based on industry data from Compustat


Share repurchase target price model 1

Share Repurchase – Target Price – Model 1

Source: ACFIN Model


Share repurchase target price model 2

Share Repurchase – Target Price – Model 2

Source: ACFIN Model


Competitors investor clienteles

Competitors’ Investor Clienteles

Most competitors perceived as growth companies

Source: Morningstar


Effect on management s stock options2

Effect on Management’s Stock Options

Cautionary Statements

  • In an efficient market, repurchases to fund employee options do not provide the positive signal that repurchases for undervaluation do

  • Return for repurchasing firms is significantly lower for firms with large amounts of employee stock options

  • Price increases could result in more exercisable options, the firm repurchases more


Thermo electron corporation3

Thermo Electron Corporation

www.bus.wisc.edu/acfin


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