Sandvine Corporation privatization bid: What do the numbers say?

Any management-led private equity takeout of a public company immediately arouses my suspicions around ethics and fairness to the owners of the company – the shareholders.  After all, management works for, and is paid by, the shareholders to represent their interests, which is ultimately to maximize their share value.  So it seems an inherent conflict of interest for that management team to secure capital and lead and effort to acquire the company from their bosses so to speak. Think about it. Management is now leading a group to get the lowest price for a company that they are being paid by the owners of that company to maximize.  That said, fickle capital markets can often give rise to privatization opportunities.

An interesting segment on BNN aired in the morning of June 14, 2017, featuring host Amber Kanwar interviewing guest David Barr of PenderFund about how increased capital availability has led to takeover activity that has benefited the performance of the Pender Value Fund.  Things got very interesting just after two minutes into the segment, where the following discourse was heard:

Amber:     “So give us an example of a recent success story where you invested because you liked the business and it got taken out.”

David:       “… Sandvine is a company that’s still in play right now … I think we were buying it at —”

Amber:     “We could see competing bids, is that right?”

David:       “I think we probably will.  We were buying the stock down at $2.70, $2.80, which is at a really cheap multiple on a cash flow basis.  The company has some of the best technology in its space around the world.  The company just failed to deliver over the years.  The company has never delivered to management’s expectations.  [I think he meant to say “the market’s expectations” or “the shareholders expectations”].  So that’s why the company was cheap, and then, now we’re seeing a management-led private equity takeout of the company at a pretty cheap valuation.”

Amber:     “So why did you invest despite all that volatility?  Was it because you suspected that somebody would come in?”

David:       “In that situation we saw a lot of shares trading below $3.00.  In situations like that where you had continued disappointment in a stock, that’s when you can see activists get involved, so we kind of thought there might be some activists pushing the company towards this outcome.”

For those who don’t know of Sandvine Corporation (I hadn’t), Reuters provides a profile for Sandvine that I’d sum up as: Sandvine provides software solutions to broadband communications companies world-wide.

Given the price volatility (52 week range of CAD$2.45 – CAD$3.92), and given David’s comment that the “management-led private equity takeout of the company [is] at a pretty cheap valuation”, and given the suggestion that there might be some higher competing bids, I thought it might be interesting to do some analysis of this transaction to answer some questions:

  • What does the CAD$3.80/share (CAD$483 million) suggest as an implicit growth rate given required rates of return typically expected of private equity funds, and does this implicit growth rate make sense?
  • How ‘fair’ is the CAD$3.80? What might the prospects for competing bids be?

In order to do this, I head straight over to the FinanceStarter T12M online corporate finance program, developed and recently launched by Parametric Finance.  This ground-breaking online program can, among many other things, make quick work of a buyout valuation by developing a structured finance strategy for a recapitalization transaction, which is what a buyout transaction essentially is.

The first step is to enter the financial statements of the company being analyzed.  I obtained Sandvine’s most recent annual financial statements (for its year ended November 30, 2016) from the company’s website.  Exhibit A shows an excerpt of the FinanceStarter T12M input panel, which reflects the information entered from the financial statements.

Exhibit A – Financial statement information entered

In doing so, I made a number of tweaks to improve the quality of the results.  First, in order to get to a basic EBITDA number (Earnings Before Interest, Taxes, Depreciation and Amortization), I moved depreciation and amortization expense from general and administrative (G&A) expenses to a separate line below the EBITDA amount.  Second, I combined investments (among current assets) with cash because these liquid marketable securities are used for opportunistic business purposes.  Third, I went to note 6 of the financial statements to ensure the correct representation of property and equipment, which, in this case, did not include any real estate.  This is important because the financing available for real estate is generally more advantageous than for non-real estate.  Finally, I noticed that, excluding cash, the company actually had a working capital ratio (WCR) below 1.35, which is the default setting in the program.  Rather than adjusting the WCR to a more lenient one (which would have helped), a better strategy was to simply normalize the balance sheet at this point to apply some of the surplus cash to pay down accounts payable.  This simple change increased the indicated value by over CAD$30 million.  The FinanceStarter T12M can be a powerful corporate finance tool in devising ‘closable’ financing strategies that maximize value.

In order to pre-empt some of the criticisms: I have ignored Other Comprehensive Items as immaterial to the analysis.  I realize that there are other non-cash non-operating expenses that could be added back in computing EBITDA, but I wanted to keep things simple and tackle that in the normalization adjustments.  I realize that sustaining capital expenditures (or capex) enters into the analysis, which I have assumed to be equal to depreciation and amortization expense.  Finally, I realize that I have used 6-month old numbers in a valuation analysis that should probably use the current year forecast, but the historical numbers are audited and publicly available, and we can reflect growth rates in the financial inputs, as discussed below.

After the financial statement information has been entered, it’s time to look at the initial outputs.  Exhibit B shows a fuller picture of the FinanceStarter T12M program, including the financing parameters panel on the right side, and the indicated financing strategy information below.  All the green cells are inputs or variables – amounts to be entered or adjusted.

Exhibit B – FinanceStarter T12M including financing parameters and indicative buyout financing strategy

The first thing to notice is the indicated value of the business of US$195.238 million (approximately CAD$260 million, assuming an exchange rate of CAD$1=US$0.75).  How does this make sense given the bid of $483 million?  The answer lies primarily in the following areas (in order of financial impact):

  1. Growth rate assumptions,
  2. Normalization adjustments,
  3. Expected rate of return on private equity, and
  4. Debt financing assumptions.

Let’s tackle these in order.

Growth rate assumption

The initial valuation of CAD$260 million reflects a business that is not growing at all – income statement and balance sheet items to not change for five years in a row.  In other words, this is the maximum multi-tranche financing amount that can be satisfied with stable cash flows given the specified financing parameters regarding cost of capital, advance rates and financial covenants.

However, it’s safe to say that a zero growth rate assumptions has a zero per cent probability of being the case here.  So what could it be?  Since the growth rate assumption is only one component of an overall value of $483 million bid, let’s just compute what it is in isolation, and then we’ll combine all the factors together at the end to see what the implied growth rate is.   The FinanceStarter T12M program computes that revenue would have to grow by about 12% per year for the next 5 years, all else being equal, to support a CAD$483 million equity value.

Normalization adjustments

Public companies incur significantly more compliance costs than private companies, such as share transfer costs, audit fees, legal fees, continuous disclosure requirements, as well as the staff and advisors to conduct these activities.  The miniscule US$0.08/year dividend being paid would undoubtedly be discontinued to save considerable administrative costs. As well, certain non-cash costs, such as stock based compensation expense are more typical of public companies than private companies.  I could go on and on, but suffice to say that many expenses could be greatly reduced in going private.

Given that stock based compensation alone averaged about US$2 million the last two years, and total indirect operating expenses were about US$67 million last year, I wouldn’t be surprised if folks at the boardroom table suggested that earnings could easily be increased by US$10 million per year.  If you change only that assumption, leaving all else unchanged (including revenue growth rate at zero), the value of the business increases from $US195.238 million to US$218.075 million – over CAD$30 million in enterprise value!

Expected Rate of Return on Private Equity

Equity will typically be a significant portion of a buyout transaction, especially companies with significant revenues, earnings and cash flows relative to assets, as is the case here.  Equity rates of return required by private equity investors can vary widely, ranging from mid-teens for asset rich, long-lived assets with stable earnings (think infrastructure) to well above 50% for ‘late-early’ to growth stage companies.  In between is the buyout category of private equity, with required rates of return typically in the 20% to 35% range, depending on the quality of assets and earnings.

Even though this company carries considerable technology risk, it is well-established, has significant revenues, and two acquisitions in recent years provide prospects for synergies and growth.  Given these factors, I’d estimate an IRR expectation of low 20’s, say 22%, applied to trailing earnings, such that the effective Internal Rate of Return (IRR) with future growth driven by the new shareholders will provide the outsized returns that private equity firms are interested in achieving.  If you change only that assumption, leaving all else unchanged (including revenue growth rate at zero and earnings un-normalized), the value of the business increases from $US195.238 million to US$209.733 million – almost CAD$20 million in enterprise value attributable to nothing but changing the private equity IRR expectation from 30% to 22%!

Putting it altogether

Having looked at some of the largest value drivers in buyout financing structuring, it’s time to put them altogether.  You might say: “Wait, what about the financing parameters? Shouldn’t we adjust interest rates, advance rates, repayment terms and financial covenants?”   My answer would be:  “Sure, but altogether these changes wouldn’t add up to much more then CAD$10 million”. For example, just adjusting the cash flow financing from an interest rate of 15% to 7%, and from being repaid in equal principal installments to being interest-only until repayment at maturity (i.e. 5-year bullet), improved value by about CAD$7 million.  OK, we’ll make that change too in putting it altogether.

Exhibit C reflects the following adjustments, applied in order:

  1. Reduced G&A expenses by US$10 million for expected savings as a private company;
  2. Decreased the IRR expectation by private equity from 30% to 22% to reflect the maturity and growth prospects; and
  3. Changed cash flow loan terms to 7% interest rate and interest-only for five years, which is reasonable for a mature cash flow rich company with private equity backing.

The last step now, is to plug in the growth rate such that the buyout price is borne out by the assumptions.  That growth rate, would you believe, is only 6% – only 3% to 4% ahead of inflation for a lower middle market technology company.  So with the above assumptions and a growth rate of 6%, the buyout price of CAD$483 million is supported.  I’d say that is probably conservative, given that the growth rate over the past 4 years was 8.25% (even though the last 3 years were flat), recent acquisitions suggesting accretiveness yet to be realized, and US$122 million (58% of their total assets!) in cash to deploy in growing the company.

Exhibit C – FinanceStarter T12M reflecting normalization and financing assumption adjustments, and implied growth rate of 6%.

Conclusion

So what’s our takeaway?  Based on a limited review of the company using the FinanceStarter T12M online corporate finance program provided by Parametric Finance, restricted primarily to an analysis of ‘the numbers’, I would say that this is a very doable buyout transaction.  Reasonable financing parameters suggest an expected growth rate of around 6%.

Is it a fair transaction? What’s the prospect for competitive bids?  This is more difficult to answer.  Value is in the eye of the beholder and we don’t know ‘the beholders’ out there.  Strategic buyers tend to pay more because of synergies they often believe they can realize to drive value beyond the financial structuring.  For example, if there is a strategic buyer that believes it can grow revenues by 10% annually and requires an IRR or ‘hurdle rate’ of 20% (which may be fine for a public company), then the fair value could be argued to be approximately US$470 million (approximately CAD$626 million, a further 30% to the current CAD$3.80/share bid.  Time will tell if this go-private transaction will be consummated as proposed by the management-led team, or whether there are third parties willing to advance competing bids.

Disclaimer: This article is for informational and educational purposes only and should not be construed to constitute investment advice. Nothing contained herein constitutes a solicitation, recommendation or endorsement to buy or sell any security. Prices and returns on equities in this article except as noted are listed without consideration of fees, commissions, taxes, penalties, or interest payable due to purchasing, holding, or selling same.  This article expresses my own opinions. I am receiving no compensation for it, and I have no business relationship with Sandvine Corporation or any affiliate of it.

 Disclosure:  I have no interest in any securities of Sandvine Corporation.

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