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Proposed Leveraged Buyout of MedSource Technologies

Proposed Leveraged Buyout of MedSource Technologies

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Proposed Leveraged Buyout of MedSource Technologies

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  1. Proposed Leveraged Buyout of MedSource Technologies Jon Fellows Mike Holland Malik Shakur May 16, 2003

  2. Agenda • Description of MedSource • Valuation • Current • Current with Improvements • LBO Analysis • Characteristics • Valuation • Recommendation

  3. What is MedSource? • Began as a component manufacturer in 1998 built on acquisitions • Current product segments include: • Surgical Instrumentation • Electro medical Implants • Interventional Medicine • Orthopedics • Expanding to design and assembly to improve scale and profitability

  4. Where is MedSource? Operational Comparisons

  5. Where is MedSource?Financial Comparisons Source: MSN Money Central

  6. What is MedSource worth? • Current Situation without LBO: • No improvements • Improvements without LBO: • Include improvements • Improvements with LBO: • Include improvements • Take on debt through LBO

  7. Current Situation: Without LBO Operating Cash Flow Assumptions*: * Includes a NOL carryforward of $42 million Source: UBS analyst reports & common size statements

  8. Current Situation: Without LBO Beta = 1.90 Risk-free Rate = 3.98% Market Risk Premium = 6.18% Cost of Debt & Leases = 5.28% Cost of Preferred Stock = 6% Financial Assumptions: Cost of Equity = 15.72% WACC = 10.58% Source: UBS analyst reports & common size statements

  9. Current Situation: Implied Valuation • Enterprise Value - $122 million • Debt - $42 million • Equity Value - $80 million • Price per share - $2.88 Implications: • The market is not recognizing management’s ability to improve company—stock is fairly valued under these assumptions • Without improvements, an LBO would be impossible

  10. Value Creating Opportunities • Operational Improvements • Increase Gross Margins • Evolve business towards higher margin design areas • Relocate production from lower to higher margin locations • Improve Operating Leverage • Utilize excess capacity by increasing unit volume • Rationalize other capacity • Improve Working Capital Management • Extend payables to suppliers • Improve receivables collections • Reduce inventory • Goal: Move closer to more efficient of Medical Device Industry or Contract Manufacturing Industry

  11. Implied Valuation With Improvements Assumption: Improve COGS, SG&A, and NWC by 1% each Operating Cash Flow Assumptions* * Includes a NOL carryforward of $42 million Source: UBS analyst reports & common size statements

  12. Implied Valuation with Improvements • Enterprise Value - $178 million • Debt - $42 million • Equity Value - $136 million • Price per share - $4.89 Implications: • There is significant value to be gained from marginal improvements • Value-added is approximately 69% from 1% improvements in • COGS, SG&A, and NWC

  13. Attribution Analysis: Where’s the Value? The $55.9 million incremental value is primarily attributed to cost of goods sold and SG&A: • COGS: $25.9 Million • SG&A: $25.9 Million • WC: $4.1 Million

  14. What Makes for a Good LBO Candidate?  • Limited Vulnerability to Predatory Pricing • MEDT is already market leader • Diffuse Industry • 4,000 players in medical outsourcing industry • Areas for Improvement (Operating and/or Financial) • COGS, SG&A, NWC—efficiency improvements • Unutilized Debt Capacity • Acquisition strategy leads to uncertainty   ?

  15. What Makes for a Good LBO Candidate?  • High, Stable Cash Flows • Optimistic for the future, but unproven past • Low Business Risk (Low Asset Beta) • Asset beta = 1.34 • Low Reinvestment Requirements • Potentially very high for acquisition strategy • Mature Industry • Components side maturing, but design and manufacturing business in its infancy   

  16. LBO: Acquisition Cost Assumptions • Current Value • Market Cap: $80.6 million • Debt Level: $41.9 million • Enterprise Value: $122.5 million • Stock Premium Offered (30%) • Acquisition Cost = $146.7 Equity Value as of 5/9/03

  17. LBO: Deal Structure Assumptions Acquisition Cost $146.7 million • Represents anticipated maximum leverage available in HLT • Lower equity capital provides greater upside Equity Capital $36.7 million (25%) Debt Capital $110.0 million (75%) Source: High yield desk of major investment bank & our assumptions

  18. LBO: Debt Characteristics • Senior Debt: $38.8 million • Assets for Collateral • Accounts Receivable at 75% of value • Inventory at 50% of value • Property, Plant, & Equipment at 25% of value • Total = $38.8 million • Repayment Schedule • Principal payments equally over five years beginning in year two • Interest rate (5.28%) • LIBOR plus 400 bps Source: High yield desk of major investment bank & our assumptions

  19. LBO: Debt Characteristics • Mezzanine Debt: $71.2 million • Repayment Schedule • Principal payments equally for five years beginning in year three • Interest rate (12%) • 52-week average of Merrill Lynch High Yield Index Source: High yield desk of major investment bank & our assumptions

  20. LBO Valuation with Improvements Adjusted Present Value Framework • Enterprise Value - $176 million • All equity firm value: $161 Million (excludes NOLs) • Interest tax shields value: $15 Million • Unlevered Cost of Equity – 12.26% • Debt - $42 million • Equity Value - $134 million • Price per share - $4.82 Implications: • From a valuation standpoint, LBO is attractive • 28% return potential over and above 30% acquisition premium

  21. LBO: Debt Payment Capabilities Cash Deficits* • Free cash flow from operations is insufficient to support debt load from LBO *Cash deficits continue until 2012

  22. Simulation Analysis • Simulation assumptions • NWC, SG&A, COGS • Normal distributions • 10% standard deviations • Simulation Results • 3% chance for meeting interest and principal payments

  23. Simulation Results Based on assumptions, there is only 3% chance of success

  24. Risks: MedSource • Concentrated Customer Base • Few (4) customers account for 52% of revenue • Susceptible to Outsourcing Trends • Is trend toward outsourcing sustainable? • Length of Customer Contracts • Short – project by project; few long-term contracts • Reduce volume • Cancellation can occur anytime

  25. Risks: MedSource • Inability to Transfer Increased Costs • No pricing power over customers • Price volatility of raw materials • Evolving Business Strategy • See Revco LBO failure • Acquisition Strategy • Problems with integration • Diversion of management resources

  26. Possible Alternatives to LBO • Roll-up Strategy • Consolidate industry via acquisitions, primarily using equity • Due to depressed stock price, roll-up strategy would be too dilutive • Most effective when stock price is fairly valued • Leveraged Build-up • Consolidate industry via acquisitions, primarily using debt • Similar difficulties as LBO, but with added acquisition vs. debt payment conflict • Requires efficient integration of acquired companies

  27. Recommendation • Do not undertake an LBO • Improve operational efficiencies to align with respective industry benchmarks • COGS, SG&A, NWC • Successfully integrate past acquisitions • Assuming stock price appreciates, begin roll-up strategy using a fairly-valued equity currency