The Timken Company Essay

Custom Student Mr. Teacher ENG 1001-04 12 April 2016

The Timken Company

THE TIMKEN COMPANY
Teaching Note

Synopsis and Objectives
The acquisition of Torrington from Ingersoll-Rand (IR) required a strategy that would meet both the investment and the financing objectives of the Timken Company. In that regard, the case provides an excellent example of the principle that investment and financing decisions can be considered independently. In effect, Timken captured the positive NPV of Torrington even though Timken was required to increase its leverage beyond its capital-structure objective. To retain its investment-grade rating, Timken used the capital market shortly after the acquisition to reduce its leverage by issuing equity and retiring debt. Because of Timken’s sequential financing strategy, the case illustrates the complexities of managing large-investment decisions that have a short-term impact on a firm’s capital structure. The case is best suited as a firm-valuation exercise in a first-year MBA finance course. It is also suitable for executive and undergraduate audiences.

Suggested Study Questions for Students
1. How does Torrington fit with the Timken Company? What are the expected synergies?

2. What is your stand-alone valuation of Torrington? Be prepared to explain and justify all the major assumptions used in your estimate.

3. What is your with-synergies valuation of Torrington? Be prepared to explain and justify all the major assumptions used in your estimate.
4. Should Timken be concerned about losing its investment-grade rating? How do Timken’s financial ratios compare with those of other industrial firms in 2002? How would those ratios change if Timken borrowed $800 million, for example, to buy Torrington? 5. If Timken decides to go forward with the acquisition, how should Timken offer to structure the deal? Is Ingersoll-Rand likely to want a cash deal or a stock-for-stock deal?

This teaching note was prepared by Professor Kenneth M. Eades. Copyright  2005 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected] No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 4/09.

618

Case 46 The Timken Company

6. What are the risks for Ingersoll-Rand of accepting Timken shares for some or all of the consideration?

Teaching Plan
The following teaching plan is for an 80-minute class period: 10 minutes

Examine the key characteristics of the bearing industry.

10 minutes

Discuss the strategic fit of Torrington with Timken. How important is Torrington to Timken? How motivated to sell Torrington is IngersollRand?

30 minutes

Using the financial projections provided in case Exhibit 5, estimate the stand-alone value for Torrington. Discuss the feasibility of the pro forma estimates. Also, value Torrington with potential synergies, as suggested in the case. Identify value drivers and conduct a sensitivity analysis of the respective valuations.

20 minutes

Discuss bidding and structuring strategies for The Timken Company and the implications that those decisions have for Timken’s financial leverage and bond rating. How can the deal be structured to satisfy both IngersollRand and Timken shareholders?

10 minutes Epilogue

Supporting Spreadsheet Files
For students:

Case_46.XLS

For instructor:

TN_46.XLS

Please do not share the instructor’s file with students.

The Bearing Industry
The bearing industry had matured into a global market with relatively few players in 2002. Most students will be surprised at the variety of bearings Discussion that were sold in the few principal markets. For example, it is clear that Timken question 1 was highly exposed to the auto industry, for which it produced bearings for both direct and indirect (Industrial Division) customers. It is not surprising that the auto producers were able to put significant pressure on bearing producers, given that a bearing

Case 46 The Timken Company

619

was a relatively minor component and one that could be provided by a number
of producers worldwide.

For the most part, economic conditions were weak for both the bearing and metal fabricating industries. With little prospect of significant top-line growth in new-product development or existing products, companies were focused primarily on cost savings to improve profits. Such actions as restructurings, headcount reductions, facility closures and consolidations, and the sale of noncore assets were common. Moreover, in anticipation of sluggish sales in the near future, companies were minimizing capital spending to keep capacity levels as low as possible.

Strategic Fit
Within an industry that was searching for operational efficiencies, Torrington was a good opportunity for Timken. In addition to serving Timken’s ongoing efficiency objectives, Torrington offered a unique opportunity for further cost savings resulting from the added scale. The two companies’ product lines had little direct overlap, but they did share many of the same customers, which should have allowed Timken to better serve existing clients at a lower cost with a broader, more complete product line. Moreover, Timken estimated that $80 million in annual savings could be extracted from the operations of the two companies after consolidation. When valued as a perpetuity, the cost savings alone were worth $480 million, assuming a 40% tax rate and a 10% cost of capital.

Students might view such a large acquisition as running counter to the company’s strategy of reducing capital investment and conserving cash. The true measure of the merits of an acquisition, however, boils down to the price paid for the assets and the expected cash flows. Timken viewed the acquisition of Torrington as both a strategic and a financial play: a company that provided complementary product lines as well as the opportunity to buy significant cost savings. The cost savings made Torrington much more valuable to Timken than to IR, making it likely that both seller and buyer would increase firm value because of the transaction.

Valuation
Torrington’s realized and forecast sales and operating profits for 1999–
Discussion
2007 are provided in case Exhibit 5. Exhibit TN1 reproduces those numbers and question 2 adds other data useful for the valuation. Students should recognize that Torrington’s operation margins are projected to be higher than Timken’s recent margins. At 13.7%, however, the EBITDA margins are not dramatically higher than the industry’s median of 12.8%. Although we do not know the expected growth impounded in the valuations, it would appear that Torrington should carry a value similar to the average firm in the industry. In any case, students should flag operating margin as a variable for further examination.

620

Case 46 The Timken Company

The first step in the discounted-cash-flow analysis is to estimate the appropriate discount rate. Exhibit TN2 computes WACC for Timken and the rest of the industry. The estimates use debt rating, capital structure, and beta information from case Exhibit 8. The industry median WACC of 8.9% is slightly lower than Timken’s WACC of 9.4%. Although both estimates have their merits, a good starting point is to use Timken’s WACC to value Torrington’s cash flows for both the standalone and with-synergies valuations.

It is important for students to understand that Timken’s WACC is appropriate only because of the similarity of the operating risks between Timken and Torrington. Theoretically, it is Torrington’s cost of capital that should be used to value Torrington’s cash flows. If Torrington were publicly traded, we would simply use its own WACC as the discount rate. Without publicly traded debt and equity, however, we must use a proxy for Torrington’s cost of capital, and Timken happens to match Torrington well enough to serve that purpose. If we had determined that Timken’s risk profile differed significantly from Torrington’s, we should choose the industry median WACC or a more comparable company’s WACC for valuing Torrington.

The instructor should make sure that inexperienced students do not erroneously conclude that the acquiring firm’s WACC is the appropriate discount rate for merger valuations. The target’s WACC is clearly the most appropriate discount rate for the target’s cash flows. Using the acquiring firm’s cost of capital is appropriate, however, for scale-expanding/highly related combinations such as that of Timken and Torrington.

To estimate the annual free cash flows, students will need to take into account the impact of taxes and changes in net working capital. The cash flows in Exhibit TN3 use the projections presented in case Exhibit 5 and assume a tax rate of 40%, close to Timken’s reported rate in 2002. Net working capital is estimated as a percentage of sales, using Timken’s average of 13.5% for 2001–02.

The terminal value represents a high percentage of the total valuation, and therefore deserves special analytical attention. The terminal value estimated in Exhibit TN3 uses a constant-growth model. The key input to this calculation is the growth rate that reflects the company’s long-term sustainable growth potential. The bearing industry was mature, with low margins and strong competition. Under any circumstances, the growth of such an industry will be modest at best. My preference is to assume a relatively conservative growth rate that is neither value-destroying, nor value-creating. A good, middle-of-the-road estimate is the long-term government bond yield. This rate of return captures the market’s estimate of the long-term real rate plus inflation.

If Torrington invests sufficiently to meet demand as the economy expands, it should experience growth in demand as well as growth due to price increases. The second step in estimating a growth-based terminal value is the estimation of the longterm relationship between capital expenditures and depreciation. It is unrealistic to assume that Torrington would continue to either gain or lose capital efficiency in perpetuity. Thus, the cash flows estimated for 2008 assume that the ratio of net PPE to sales is equal to the 2007 ratio of 53.6% (see Exhibit TN1). If this ratio remains constant in perpetuity, the company should be positioned for middle-of-the-road growth assumed in the growth rate. The instructor can help

Case 46 The Timken Company

621

students understand this technique by asking them to compute Timken’s net PPE-to-sales ratios for 2001 and 2002 as shown in Exhibit TN1. The average of this ratio (50.7%) is then used to estimate Torrington’s net PPE for 2002. Future net PPE balances are computed by adding capital expenditures and subtracting depreciation expense each year. The net PPE-to-sales ratios in Exhibit TN1 show that the expectation is to invest heavily in Torrington during the early years and then taper back toward a steady-state relationship in the later years. To the extent that this ratio can be driven lower, more value will be created. The terminal value calculation, however, assumes that all the efficiency gains occur during the planning period (i.e., prior to the terminal year).

The with-synergies valuation is shown in Exhibit TN4. The mechanics Discussion of that valuation are identical to the stand-alone valuation presented in question 3

Exhibit TN3. The sole difference lies in the treatment of the cost savings and the integration costs. The cost savings serve to increase the cash flows dramatically and therefore increase the enterprise valuation despite the $130 million spent during the first two years for integration. The cost savings are assumed to increase gradually before reaching the full $80 million per year in steady state. The substantial savings over the long term create a significant increase in the enterprise-value estimate relative to the stand-alone estimate. When exploring the key value drivers, students should look no further than the projected cost savings, which are responsible for the premium over the stand-alone estimate.

For example, if the synergies are divided in half so that the long-term expected savings are only $40 million, the value falls to $567 million, which is less than the $800 million asking price. Thus, Timken could think of its offer price in terms of the amount of synergies it expects to realize. In order to realize the full $800 million, the annual synergies must equal $64 million, or 80% of the estimated $80 million, in order to reach a break-even for Timken’s shareholders. Some students will argue that the with-synergies valuation is conservative in that it assigns no value to Timken’s ability to increase sales across the complementary product lines gained from Torrington. A good use of time during the class is to explore other value drivers by conducting a sensitivity analysis.1

Multiples Analysis
Case Exhibit 8 shows enterprise-to-EBITDA multiples for the industry. The average multiple is 7.1 (the median is 6.6) and Timken’s average multiple is 5.9. That information provides an interesting insight into the market’s view of Timken. Given Timken’s lower-thanaverage multiple, the market may be viewing Timken’s current EBIT as high relative to future expectations. In other words, the market does not see as much earnings growth or sustainability for Timken as it does for the rest of the industry. Timken management expressed the view that the stock price was low at the time of the deal and that it would likely improve as the market realized the value of the Torrington acquisition. This would support Timken’s interest in using as 1

The instructor’s spreadsheet allows any number of sensitivity analyses to be run—varying WACC, growth rate, operating margin, and cost savings, for example.

622

Case 46 The Timken Company

much debt as possible, rather than equity, to finance the deal, with the thought that issuing shares later to pay down the debt would allow Timken to issue fewer shares for the same amount of funding.

The EBITDA multiples can also be used as an alternative method for computing terminal value. Exhibit TN5 is a summary of the valuation estimates as a function of using Timken’s multiple (5.9) and the industry median multiple (6.6) for 2007 terminal values. The multiples consistently give higher valuations than the growth model. Torrington’s projected margins at 13.7% are much higher than Timken’s (10.1%) and slightly higher than the industry median of 12.8%. Case Exhibit 8, however, shows no particular relation between margins and multiples, such that neither multiple seems unreasonable. The growth model produces closer results for the with-synergies scenario, but remains lower than either multiple.

The explanation for the difference between these valuation methods might be found in the market’s expectation of future capital efficiency. If we allow Torrington to gain efficiency in the use of its PPE, the growth model will yield a higher valuation. In general, these methods often yield different estimates. For Torrington, the multiples uniformly suggest higher values, which should give the analysts confidence that the growth-model-based valuation is a conservative estimate of Timken’s potential upside.

Timken’s Bidding Strategy
It is important for students to understand why Timken needs to estimate both a standalone and a with-synergies valuation. The standalone value should approximate the value of Torrington to Ingersoll-Rand because IR was holding Torrington as a passive investment, much as an individual holds shares of stock. With no apparent or expected sources of synergies between the two companies, Torrington’s value to IR was unlikely to differ from its value as an independently run company. The with-synergies valuation should represent the value of Torrington to Timken, which is substantially higher than the standalone value owing to the expected cost savings. Therefore, IR should not sell for less than the standalone value, and Timken should not offer more than the with-synergies value. If the two companies agree on a price between those two extremes, the values of both companies will be enhanced.

In large part, the actual agreed-upon price depends on the negotiation abilities of the buyer and seller. It also depends on how quickly IR wants to get rid of Torrington and whether IR has another company bidding for Torrington. In fact, IR’s position in the negotiation would be strengthened so long as Timken thinks there is the possibility of another bidder. This helps explain why most acquisitions are not economically successful: Acquiring firms compete to win the deal and end up paying too much to justify the realized cash flows. The key to success for Timken or any acquiring firm is to stick closely to the with-synergies valuation as a walk-away price. Timken should use the range of values created by a sensitivity analysis of the key value drivers as a guide for the confidence management should have in the valuation estimates.

Case 46 The Timken Company

623

Deal Structure
Timken needed to consider a variety of issues when deciding how to Discussion structure the deal. A primary concern was the impact on both its capital structure questions and bond rating. At the time of the deal, Timken’s BBB rating was under 4 and 5 review. Exhibit TN6 compares key financial ratios for Timken relative to the median values for industrial firms. A few of the ratios suggest that Timken is lucky to have a BBB rating: EBIT coverage and EBITDA margin are well below investmentgrade values. Total debt-to-capital and EBITDA coverage ratios, however, suggest that BBB or higher was appropriate. Recomputing the ratios under the assumption that Torrington is 100% debt financed with $800 million in new debt pulls all the ratios below the investment-grade medians so that a downgrade to BB would almost certainly occur. At 50% debt financed, the ratios are improved enough to likely allow Timken to preserve a BBB or BBB- rating.

Based on the ratio analysis, most students will propose a structure whereby IR accepts half the consideration as equity with the other half coming from a debt issuance. While this structure is perfectly plausible, students should be reminded that Timken management was convinced, at the time of the deal, that the stock was undervalued so that any issuance of equity was likely to be viewed as dilutive. Moreover, to the extent that the Torrington purchase represented a significant positive NPV, the postacquisition stock price would increase as soon as the value of the deal was fully recognized by the market. Therefore, to capture as much of the value created as possible, Timken would be better served by issuing the equity several months after the deal, which is exactly what actually happened.

Epilogue
Ingersoll-Rand was highly motivated to dispose of Torrington. Because IR management did not consider Torrington a strategic fit, the company had not been investing in Torrington for several years. This ―harvesting‖ mentality created discontent for Torrington’s management and less than stellar results for IR. Moreover, as consolidation in the bearing industry had progressed, it was clear that few, if any, buyers remained that would be interested in buying Torrington in its entirety. In fact, the acquisition would test Timken’s financial limits to the extent that even Timken would have difficulty making the deal a reality without creative structuring. As the months of negotiating and due diligence passed, it became increasingly apparent to Timken management that it could take advantage of IR’s motivation in terms of both the price paid and by persuading IR to accept Timken stock in lieu of cash.

Timken announced the acquisition of Torrington on October 16, 2002.2 Exhibit TN7 shows that both Timken and IR stock prices reacted favorably to the announcement, with

2

Note that the case is written as if the acquisition will take place in early 2003. This assumption allows the 2002 financials to be presented as actual, rather than as ―estimated.‖ The consummation of the deal actually occurred months later, in February 2003, after Timken secured the funds needed for the purchase.

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Case 46 The Timken Company

Timken shares rising 19% and IR shares rising 14% during the announcement week.3 While it is common for the selling company to enjoy a positive stock-price reaction, it is much less common for the buying company’s stock to increase. Clearly, the stock market agreed with IR’s strategy of disposing of assets in order to allocate its capital to higher potential growth and higher return service businesses. And, more important to Timken, the market was also signaling its agreement with Timken’s projections of significant synergies associated with Torrington. The final terms of the deal included an $840 million purchase price, $700 million of which was to be paid in cash to IR, with the $140 million balance in the form of 9.4 million Timken shares. Exhibit TN8 lists the sources and uses of funds for the deal.

To finance the cash portion of the deal, Timken used a variety of public-, private-, and bank-debt financings, plus $165 million from a public issuance of 11 million shares. As part of the deal, IR agreed to a lockup period of six months for the Timken shares it received to avoid undue selling pressure on the stock price. Timken also insisted on other provisions, including that IR would not have the right to elect directors to board seats, and could not sell the shares to a single buyer after the lockup period.

As the lockup period came to an end, Timken’s stock price appreciated by approximately $1 a share. Timken management decided to be proactive about IR’s shares and devised a second equity offering, which one Timken manager described as a ―bought deal.‖ Unlike the predeal equity offering, this offering would have no road show or preselling. Timken shopped the deal among several investment banks until one bank agreed to buy all of IR’s 9.4 million shares plus 3.5 million new shares from Timken and then resell all the shares the next day in the market. The bank would receive no commission and would buy the shares at a 1.0% discount from the closing price on the day of the offering. A more typical arrangement with an investment bank would have been a 4.0% discount plus a 4.0% commission for shares presold in a ―road show.‖

Thus, Timken management had arranged a true underwriting in which the bank bought and sold the shares from its own account so that a downward market movement of more than 1.0% would have resulted in a loss for the bank. Timken management argued that the banks should be willing to accept much more risk and much less compensation when selling shares that the market fully expected to be sold so that little price impact should occur after the announcement. Timken used the $55 million in proceeds from the new shares to reduce its debt outstanding and to bring its debt ratio closer in line with the company’s long-term objective of maintaining an investment-grade rating.

The structure of the Torrington acquisition provides evidence of several important lessons for deal-making. The first is the effect of the motivated seller. IR was eager to dispose of Torrington, which allowed Timken to pay a price approximating the standalone value and substantially below the with-synergies value. Given the deal price of $840 million, Timken management must have felt very confident that the deal would create value for Timken shareholders. The second lesson is the importance of deal structure as evidenced by the mix of cash and securities paid by Timken. Although IR, on the one hand, was selling Torrington to rid 3

The Timken share price rose to $18.85, from $15.83, and IR’s stock closed at $38.46, up from $33.73.

Case 46 The Timken Company

625

itself of risk in the bearing market, it accepted Timken shares to get the deal done. In effect, that meant that IR simply traded a large exposure to the bearing market for a smaller exposure to the bearing market in the form of Timken shares. Timken, on the other hand, was hedging itself by using shares as consideration. If there were problems about Torrington that IR did not divulge during the due-diligence process, both IR and Timken would take the hit once the problems were revealed.

This made the sale more incentive-compatible than would an all-cash deal, for example, in which IR would have no direct stake in the value of the deal after the assets were transferred to Timken. And finally, the deal structure demonstrates that Timken was willing to make short-term compromises with its capital structure in order to take advantage of acquiring Torrington. Timken reasoned that the short-term impact on its leverage ratios could be reversed relatively quickly, whereas the acquisition of Torrington was likely to be a one-time chance: a real-life example of how the financing and investment decisions can be separated, just as assumed by financial theory.

Students will recognize that Timken could have issued an extra 9.4 million shares in its first equity offering and used the proceeds to make an all-cash offer to IR. While preferred by IR, that strategy had a couple of drawbacks for Timken. First, it would have destroyed the posttransaction risk-sharing, which served to keep IR honest about the Torrington assets being purchased by Timken. And second, management’s feeling that the share price was undervalued at the time of the deal strongly favored postponing the equity offering until after the deal. Moreover, Timken wanted to reduce its leverage created by the Torrington acquisition so that if the company wanted to avoid returning to the equity market, it would have been necessary to issue more shares before the deal at the ―low‖ stock price. As it turned out, share price did increase so that Timken issued fewer shares in the subsequent equity offering, in October 2003. This also served to increase the value received by IR, albeit after suffering a good bit of risk during the six-month holding period.

Exhibit TN9 compares Timken, Ingersoll-Rand, and S&P 500 stock-price performances for 1998–2005. The graph shows that Timken and the S&P index performed similarly after the acquisition, but IR outperformed the market over the same period. Given Timken’s lackluster performance before 2002 as well as the challenges faced by the bearing industry and Timken, in particular, maintaining parity with the industrials index could be considered a strong turnaround. Arguably, IR could have reaped more of the synergy gains identified by Timken, but IR’s stockprice performance suggests that the sale of Torrington was greeted favorably by the market over the long run.

626

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Case 46 The Timken Company

THE TIMKEN COMPANY
Analysis of Torrington’s Projected Financial Statements

1999
$1,239.5
$145.7

2000
$1,161.0
$172.6

2001
$1,004.3
$78.0

11.8%

−6.3%
14.9%

−13.5%
7.8%

19.9%
7.1%

6.5%
7.1%

6.5%
7.1%

6.5%
7.1%

6.5%
7.1%

6.5%
7.1%

Capital expenditures
Depreciation expense

$84.0
$75.0

$85.0
$77.0

$45.0
$79.0

$41.0
$80.0

$175.0
$84.2

$130.0
$90.0

$140.0
$96.0

$150.0
$102.0

$160.0
$108.5

EBITDA margin
Net PPE (estimated)1
Net PPE/Sales

17.8%

21.5%

15.6%

13.7%
$610
50.7%

13.6%
$701
54.7%

13.7%
$741
54.3%

13.7%
$785
54.0%

13.7%
$833
53.8%

13.7%
$885
53.6%

Net sales
Operating income
Sales growth
Operating margin

2002
2003E
2004E
2005E
2006E
2007E
$1,203.8 $1,282.0 $1,365.3 $1,454.1 $1,548.6 $1,649.2
$85.2
$90.7
$96.6
$102.9
$109.5
$116.7

Timken PPE Efficiency 2001–02
2001
2002
Net sales $2,447 $2,550
Net PPE $1,305 $1,226
Net PPE/Sales 53.3% 48.1%

1

Average

50.7%

Torrington 2002 Net PPE estimated using Timken’s PPE/Sales ratio (average for 2001–02). Subsequent years of Net PPE for Torrington computed as Ending Net PPE = Beginning Net PPE + Capital Expenditure – Depreciation Expense.

Case 46 The Timken Company

Exhibit TN1

Case 46 The Timken Company

627

Exhibit TN2
THE TIMKEN COMPANY
Weighted Average Cost of Capital

Timken WACC
Kd
Risk-free rate
Beta
Market premium
Ke
Debt
Market cap
Debt/Total capital
Tax rate

7.23%
4.97%
1.10
6.0%
11.57%
$461 million
$1,062 million
30.3%
40%

Timken WACC

BBB debt yield, case Exhibit 8
Long-term Treasury yield, case Exhibit 8
Timken beta, case Exhibit 7
Assumed
CAPM => Risk free + Beta × Market premium
Interest-bearing debt, case Exhibit 8
Shares outstanding × price per share, case Exhibit 8

D/(D + E) = 461/1,523
Timken historical

9.38%

Bearing-Industry WACCs

Kaydon Corp.
NN, Inc.
Timken
Commercial Metals
Mueller Industries
Precision Castparts Corp.
Quanex Corp.
Worthington Industries
Industry Average
Industry Median

% Debt
10.6%
27.2%
26.0%
33.8%
2.0%
34.9%
11.7%
15.3%

% Equity
89.4%
72.8%
74.0%
66.2%
98.0%
65.1%
88.3%
84.7%

Kd (BBB)
7.77%
7.77%
7.77%
7.77%
7.77%
7.77%
7.77%
7.77%

Ke (CAPM)
12.67%
10.27%
11.77%
8.94%
11.63%
11.75%
9.66%
8.08%

WACC
11.60%
8.51%
9.38%
7.25%
11.28%
9.04%
8.86%
7.34%
9.13%
8.86%

628

Case 46 The Timken Company

Exhibit TN3
THE TIMKEN COMPANY
Torrington Standalone Valuation
($ millions)

Sales

2002
$1,204

2003E
$1,282

2004E
$1,365

2005E
$1,454

2006E
$1,549

2007E
$1,649

2008E
$1,731

6.5%

6.5%

6.5%

6.5%

6.5%

4.97%

91.0
(36.4)
54.6
84.2
(10.5)
(175.0)
(46.7)

96.9
(38.8)
58.2
90.0
(11.2)
(130.0)
6.9

103.2
(41.3)
61.9
96.0
(11.9)
(140.0)
6.0

109.9
(44.0)
66.0
102.0
(12.7)
(150.0)
5.2

122.9
(49.2)
73.7

($46.7)

$6.9

$6.0

$5.2

117.1
(46.8)
70.3
108.5
(13.6)
(160.0)
5.2
425
$430

Sales growth

Operating income
− Taxes
NOPAT
+ Depreciation
− Change in NWC
− Capital expenditures
Total
Terminal value
Free cash flow
Enterprise value
$246.1
Notes:

Sales estimated using 6.5% growth through 2007 and 4.97% beyond 2007.

Net working capital (NWC) = 13.5% of sales (historical Timken relation).

Cap Ex – Depreciation for 2008 computed to maintain 2007 NetPPE/Sales ratio.

Operating margin estimated as 7.1% (case Exhibit 5).

TV07 = FCF08 /(WACC − Growth).

WACC = 9.4% (Timken’s WACC from Exhibit TN2).

Growth ≈ Risk free rate = 4.97% => TV07 = $425

Present value (FCF + TV) @ WACC = Enterprise value = $246.

(11.0)
(44.0)
18.7

Case 46 The Timken Company

629

Exhibit TN4
THE TIMKEN COMPANY
Torrington With-Synergies Valuation
($ millions)

Sales

2002
$1,204

2003E
$1,282

2004E
$1,365

2005E
$1,454

2006E
$1,549

2007E
$1,649

2008E
$1,731

6.5%

6.5%

6.5%

6.5%

6.5%

4.97%

91.0
0.0
(65.0)
26.0
(10.4)
15.6
84.2
(10.5)
(175.0)
(85.7)

96.9
20.0
(65.0)
51.9
(20.8)
31.2
90.0
(11.2)
(130.0)
(20.1)

103.2
40.0
0.0
143.2
(57.3)
85.9
96.0
(11.9)
(140.0)
30.0

109.9
60.0
0.0
169.9
(68.0)
102.0
102.0
(12.7)
(150.0)
41.2

122.9
80.0
0.0
202.9
(81.2)
121.7

($85.7)

($20.1)

$30.0

$41.2

117.1
80.0
0.0
197.1
(78.8)
118.3
108.5
(13.6)
(160.0)
53.2
1,513
$1,566

Sales growth

Operating income
Cost savings
Cost of integrating businesses
Operating income w/synergies
− Taxes
NOPAT
+ Depreciation
− Change in NWC
− Capital expenditures
Total
Terminal value
Free cash flow
Enterprise value
$957.1
Notes:

Sales estimated using 6.5% growth through 2007 and 4.97% beyond 2007.

Annual cost savings reaching $80 million by 2007 and first-year restructuring cost = $130 million.

Net working capital (NWC) = 13.5% of sales (historical Timken relation).

Cap Ex – Depreciation for 2008 computed to maintain 2007 NetPPE/Sales ratio.

Operating margin estimated as 7.1% (case Exhibit 5).

TV07 = FCF08 /(WACC − Growth).

WACC = 9.4% (Timken’s WACC from Exhibit TN2).

Growth ≈ Risk free rate = 4.97% => TV07 = $1,503

Present value (FCF + TV) @ WACC = Enterprise value = $957

(11.0)
(44.0)
66.7

630

Case 46 The Timken Company

Exhibit TN5
THE TIMKEN COMPANY
Torrington Valuation Summary
($ millions)

PV (FCF 2003-2007)
+ Growth TV
+ Timken EBITDA TV
+ Industry EBITDA TV

Standalone
Enterprise
Terminal
Value
Value 2007
($25.3)
$246
$425
$828
$1,336
$928
$1,492

Synergy
Enterprise
Terminal
Value
Value 2007
($9.4)
$957
$1,513
$1,146
$1,810
$1,282
$2,021

Timken Enterprise/EBITDA = 5.9 (case Exhibit 8)
Bearing Industry Enterprise/EBITDA = 6.6 (case Exhibit 8 median)

Exhibit TN6
THE TIMKEN COMPANY
Timken Financial Ratios and Debt Rating

EBIT interest coverage (×)
EBITDA interest coverage (×)
EBITDA/sales (%)
Total debt/capital (%)

AAA
23.4
25.3
23.4
5.0

AA
13.3
16.9
24.0
35.9

A
6.3
8.5
18.1
42.6

BBB
3.9
5.4
15.5
47.0

BB
2.2
3.2
15.4
57.7

B
CCC
1.0
0.1
1.7
0.7
14.7 8.8
75.1 91.7

Timken
Current
2.2
5.1
10.1
43.1

Timken + Torrington1
100% Debt 50% Debt
1.8
2.5
3.9
5.3
11.3
11.3
67.4
46.0

Case 46 The Timken Company

1

631

Timken + Torrington ratios computed assuming BBB borrowing rate of 7.23%.

Case 46 The Timken Company

Exhibit TN7
THE TIMKEN COMPANY
Stock-Price Reaction to Torrington Acquisition
(announced October 16, 2002)
22

Torrington Acquisition

21
20

IR
S&P

19
18
17

TKR
16
15

ov
11
-N

ov
4-N

t
-O
c
28

t
-O
c
21

t
-O
c
14

ct
7-O

ep
30
-S

ep
23
-S

ep

14

16
-S

632

Case 46 The Timken Company

633

Exhibit TN8
THE TIMKEN COMPANY
Sources and Uses for Torrington Acquisition1
($ millions)
Sources
$500-million revolver
Senior unsecured notes
Accounts receivable facility
Common stock issued to public (11
million shares)
Common stock issued to IR (9.4
million shares)

1

$223
250
125
165
140
$903

Case writer estimates and company information.

Uses
Cash to IR
Common stock issued to IR
Refinancing existing debt
Fees and expenses

$696
140
27
40
$903

634

Case 46 The Timken Company

Exhibit TN9
THE TIMKEN COMPANY
Stock-Price Performance, 1998–2005
(prices set equal to Timken’s price in January 1998)
70
Torrington Acquisition
60
IR
50
S&P
S&P

40
30
IR
20
10

TKR
TKR

Jan
-9
Ma 8
y-9
8
Sep
-98
Jan
-9
Ma 9
y-9
9
Sep
-99
Jan
-0
Ma 0
y-0
0
Sep
-00
Jan
-0
Ma 1
y-0
1
Sep
-01
Jan
-0
Ma 2
y-0
2
Sep
-02
Jan
-0
Ma 3
y-0
3
Sep
-03
Jan
-0
Ma 4
y-0
4
Sep
-04
Jan
-05

0

S&P = S&P 500; IR = Ingersoll-Rand; TKR = Timken

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