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1.
Square D was a major supplier of electrical equipment, services, and systems in the U.S.
One of the strongest divisions of Square D was residential and independent electrical network
distribution. The company had grown steadily since 1903. Its relatively stable net operating
profit margin, asset turnover, ROA, and financial leverage brought a small increase in return on
equity (ROE) of 20.0% in 1990. However, Square D faced a substantial decline in sales growth
from 1988 to1990. Its growth rate declined from 12.5% in 1988 to 3.4% in 1990. (See A and B
in the Appendix.) The reasons for this decline included a shift in product mix resulting in a lower
share of high-margin products, increased efforts at internationalization resulting in a higher share
of low-margin products, higher selling expenses (14% of sales), and a loss of $30 million from
some business segments.
Schneider was one of the world's largest manufacturers of equipment for electrical power
distribution and for industrial control and automation. From 1988 to 1990, Schneider’s net
operating profit margin increased from 1.4% to 1.9%, which resulted in a slightly decreased
return on equity (ROE) of 12.3% in 1990.
In 1990, globalization and industry concentration trends dominated the industry.
Schneider planned a “friendly cash merger” with Square D. The combination of these two giants
would create enormous benefits for both parties. First, barriers to entry in these different markets
have been perpetuated by differences in standards across countries; the merger would help both
companies improve their market shares. Second, the companies can share existing technologies,
resources, and free cash to develop new products and provide more opportunities to create new
economic value for their stockholders. Schneider and Square D can access larger distribution
channels and reduce operating expenses for both companies, such as costs of Research and
Development (R&D) for new products and costs of translating technologies for different regional
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standards. Finally, rationalization of manufacturing capabilities and benefits from cross-selling
products are also enhanced by consolidating companies. If the acquisition were to occur,
Schneider estimated that Square D would incur $60 million per year in expense and receive $150
million cash for disposal of unrelated assets after the combination. Square D could also affect
Schneider’s income, considering the estimation of significant goodwill amortization charges over
40 years.
However, at the beginning of the acquisition period, Square D disallowed Schneider’s
takeover. Square D treated Schneider’s actions as a hostile takeover, became defensive, and
organized legal defenses against Schneider. There were some concerns about Schneider’s
takeover plan. Schneider moved to Delaware, where state law requires that hostile bidders must
have at least 85% of shares tendered to effect a takeover. Furthermore, Square D created
amendments including a common stock plan specifically to fight against unsolicited bids. Failure
of the joint venture discussion could lead to an increase in Square D’s stock price, and other
competitors would very likely step in and bid for Square D.
2.
The value of Square D’s equity assumed by Lazard Frères is $66.69 before acquisition by
Schneider. Assuming cost savings from the merger of $60 million after tax per year, the value of
equity changes to $85.36. (See Appendix C and D for calculations.) The value of Square D’s
equity assumed by Lazard Frères is too high. It is reasonable using the net sales growth rate of
3.5% in 1991, but 7% per year thereafter was optimistic. Using EBITDA margin to calculate
Square D’s equity value can be potentially misleading because it ignores depreciation and
amortization expenses. This profitability margin was equal to 11.2% in 1990, and it never
exceeded 11.6% over the last three years. (See Appendix G.) Networking capital would continue
to be 11-13% of sales, which might be appropriate based on the 12% figure in 1989 and 23% in
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1990. That the depreciation expense would remain is a reasonable assumption for Square D. The
cost of capital for Square D is 15.9% (calculated as 8.25%+0.95*8%). Therefore, to assume that
the expected return is over 14.4% is an underestimate. The $210 million of acquisition cost could
realistically be paid off. If the acquisition is successful, the economies of scale and combining
complimentary resources will significantly reduce costs, and the combined company would
control at least 15% of the U.S. market share in the electronic equipment industry and could
penetrate new markets.
3.
My estimate of the intrinsic value of Square D’s stock as of December 31, 1990 is
$29.23 before any takeover rumors. Square D is valued at around $66.57 per share considering
the effect of improved operating performance from the merger. (See Appendix E and F.) If I was
Schneider, I would place $12.13 billion when making the offer for Square D. (See Chart A for
the equity value calculation.)
4.
In order to make a successful acquisition, sale growth must increase. The ROE for Square
D was 18.3% in 1989 and 20% in 1990. In comparison, Schneider had ROE of 13% in 1989 and
12.31% in 1990. A successful acquisition must have an ROE of at least 16%, or the acquisition
will not be considered profitable.
Other issues need to be considered, including the differences between accounting
principles for both parties. Both companies use the purchase method, but under French rules,
Schneider would have to amortize goodwill. Based on Lazard Frères’ assumptions, there would
be significant goodwill amortization charges even if goodwill is amortized over a maximum of
forty years based on estimated useful life. (See Appendix H.) However, under U.S. GAAP
goodwill does not have to be amortized and it needs to be tested each year for impairment.
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Appendix
A.
Square D's Historical NOPAT Margin
1990
1989
1988
Interest Expense
Effective Tax rate
28,760
36.7%
31,438
37.2%
22,082
36.30%
Interest Expense after tax
18,205
19,743
14,066
Net Earnings
120,725
101,904
118,934
NOPAT (NE- Net Interest expense after tax)
102,520
82,161
104,868
Net Sales
NOPAT Margin (NOPAT/ Net Sales)
Average NOPAT Margin
1,653,319 1,598,688 1,497,772
6.2%
5.1%
7.0%
6.1%
B.
Return on Equity
Square D (Dollars in thousands)
1990
1989
1988
Net sales
Net earnings
Total assets
G.
Schneider (in FF
million)
1990
1989
1988
1,653,319 1,598,688 1,497,772 49,884 45,127
120,725
101,904
118,934
924
40,493
877
560
1,459,749 1,372,585 1,300,723 49,577 45,946
63,990
Total stockholder equity
603,594
556,123
636,029
7,506
6,742
4,193
Net sales growth rate
Net profit margin (NPM)
Asset turnover (AT)
Return on assets
(ROA = NPM × AT)
Financial leverage (FL)
Return on equity
(ROE = ROA × FL)
3.4%
7.3%
1.13
6.7%
6.4%
1.16
12.5%
7.9%
1.15
10.5%
1.9%
1.01
11.4%
1.9%
0.98
N/A
1.4%
0.63
8.3%
2.42
7.4%
2.47
9.1%
2.05
1.9%
6.60
1.9%
6.81
0.9%
15.26
20.0%
18.3%
18.7% 12.3% 13.0%
13.4%
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Square D's Financial Performance in Prior Years
Sales Growth
EBIT Margin
NOPAT Margin
Operating working capital / Sale
Capital Expenditures / Sales
Depreciation & amortization / Sales
90
3.4%
11.2%
6.2%
23.6%
5.7%
3.6%
89
6.7%
10.1%
5.1%
12.1%
5.0%
3.1%
88
12.5%
11.6%
7.0%
11.9%
4.8%
3.0%
H.
Square D
Effect of Acquisition on Goodwill
Stockholder Equity
Inventory revaluation (LIFOFIFO)
603,594
603,594
138,120
138,120
Revalued Stockholder equity
741,714
741,714
25,088
$66.9
25,088
$85
1,678,387
2,141,512
936,673
1,399,798
Numbers of shares
stock price
Market value of Equity
Goodwill