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IMBA Course – Corporate Finance 2

Valuation of Kohler

INSTRUCTOR

PROFESSOR LIU QIAO

PROJECT TEAM

10928183 冯梅 Ariel 10928335 孙媛 Flora 10928497 黄旭哲 Leo 10828517 王美玲 Marie

18 December, 2009

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Table of Contents

I. Executive Summary ... 3

II. Background and Problem Framing ... 4

III. Methodology of Analysis ... 6

IV. Valuation ... 7

1. Multiples Approach ... 7

2. DCF approach ... 9

3. Reconciliation ... 11

V. Lack of Liquidity Discounting ... 12

VI. Dividend based valuation ... 13

VII. Trial and Settlement ... 14

VIII. Tax Controversy ... 15

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I.

Executive Summary

In our report, we will use two methods—DCF model and multiples to evaluate the enterprise value and equity value of Kohler Co.. The two methods are expected to generate a similar result, which implies the book value of the company. As we can read in this case, Kohler Co. estimate that the share price is $55,400, while the dissenting shareholders estimate that the share price is $270,000. The reason behind the big gap is something we should take an investigation in. we will find the reason why there is difference between our own valuation and their estimation. What is the fair value? What is the market—based value?

According to the decision tree, we can also see some rationale about why we prefer settlement rather than bring the issue on trial. Should Kohler decide to move the case to the court, the maximum share price that would be demanded to pay would be $120,680. This is supposing that the plaintiffs actually win, if not, then the result would be based on the $55,400 as stipulated by the company. Therefore the maximum settlement price that Kohler will be willing to offer the shareholders will be $120,680.

However, the case becomes slightly more complicated once the IRS (Internal Revenue Services) comes into the picture. Based on the information provided, the IRS would be very likely to demand that there would be tax levied upon the share price. Depending on the result of the trial, it seems favourable that Kohler should settle at $315,786.96 per share for the shareholders. This being higher than the price that shareholders are asking, Kohler should settle at $273,000. Ultimately, taking all into account, it is unwise and unfavourable for Kohler to bring the case to court as being a time-honoured brand, it would be detrimental to their reputation as the share price that they are valuing it at appears to be grossly undervalued. A settlement would be in the best interest of both parties, given the parameters of the case. Adding the potential lawsuit and the tax implications, Kohler should be even more inclined to settle, the settlement price being higher as well.

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II.

Background and Problem Framing

Founded in 1883, Kohler Co. was a manufacturer of plumbing fixtures in Sheboygan. The Austrian immigrant John Michael Kohler hit on the idea of enamelling a cast iron horse trough/hog scalder, adding legs to it, and selling it as a bathtub. In 1900 the manufacturing opearations moved four miles west into the countryside to the village of Riverside. In 1905, Walter J. Kohler, the president and CEO of Kohler Co., started the conversion of Riverside into American Club, to house immigrant factory workers and help their social integration into the U.S. in 1912, the name was changed into Kohler Village. During the excellent leadership of Walter Kohler, Kohler Co. became the leading manufacturer in plumbing fixtures and electric

generators. The peak time was coming for both its fame in business and their charitable enterprises. In the late 1950s, the company expanded beyond its Wisconsin roots, building a new plant in Spartanburg, South Carolina. In 1972, Herbert V. Kohler, Jr. became Chairman and CEO. He guided Kohler Co.’s development, diversification and international expansion in the following years. In 1977, the Frank Lloyd Wright Foundation designed a new master plan and Kohler decided to develop The American Club as a luxury inn. After the inn proved successful, the company went on to develop world class golf courses. In 1984, the company began a series of acquisitions aimed at expanding its product line and gaining entry into new markets. Kohler Co.’s diversification and international expansion brought its revenue growth.

Ownership and control

Kohler Co. had 7,445 outstanding common shares in April 1998. Herbert Kohler directly owned only 12.4% of the common stock and beneficially owned an additional 6% through trusts established by his father. His sister, Ruth, directly owned 13.1% and beneficially owned 6% through similar trusts. The Estate of Frederic C Kohler owned 13.1%. The Kohler Foundation owned 12.9% of the common stock. The two charitable trusts owned 17.7% of the stock. About 20 other Kohler family members owned 13.7% of the shares. Outside shareholders owned 4% of Kohler Co. stock, or 300 shares, among which there are two largest—SoGen International and Franklin Mutual Discovery Fund.

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5 | P a g e Discrepancy

According to its Chairman and CEO, Kohler Co.’s private status resulted in its success. In Kohler’s opinion, private ownership and privacy of results help focus on big ideas and excellent long-term performance. In order to ensure Kohler’s private status, Herbert Kohler proposed a

recapitalization of Kohler Co., with the purpose of buying out all the outsider shareholders and restricting future sales of stock to outsiders. The final buyout price was set at $55,400 per share. Outside shareholders, joined by some family shareholders, exercised their dissenters’ rights to have the “fair value” of the Kohler Co. stock. In May 1998, over 100 owners of 811 shares exercised their right to challenge the company’s valuation of their shares and brought suit against the company. The group claimed that Kohler Co. shares were worth $273,000, which is five times as the price offered by the company.

Challenge

Now, the case was to be heard by the Wisconsin circuit court. The conflict in Herbert Kohler’s heart is whether he should let the court determine the value of Kohler Co. share or settle with the dissenting shareholders at a much higher price, which can balance the interests of the company, the family, and the charitable foundations that owned shares in Kohler Co.?

Herbert V. Kohler Ruth De Young Kohler Estate of Frederic Kohler John Michael Kohler Kohler Foundation Kohler Trust for the Arts and Education

Kohler Trust for Preservation other Kohler Family Members Kohler Employee Plan Outside Shareholders

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III.

Methodology of Analysis

We will proceed to analyze the case in the following steps 1. Multiples

Using the comparable firms in the industry taking into consideration that Kohler’s scope of industry spans a few fields with different weighting

2. DCF

Using discounted cash flow method to come up with our own valuation of Kohler taking into account a few basic assumptions based on the information available.

3. Reconciliation

Due to the nature of the controversy in the case, we will attempt to resolve the discrepancy by adjusting the DCF taking into account different assumptions so support the conclusions from the two parties, Kohler and the disgruntled shareholders.

4. Lack of marketability discount and Dividend based valuation

We take into consideration other methods of valuing Kohler based on lack of marketability/liquidity and also Gordon’s Constant Growth Model.

5. Trial and settlement

Next we will use basic decision theory to make suggestions for Kohler to resolve the dispute with the shareholders pending the possibility of court case, this will take into consideration the controversy with the IRS and possible tax implications.

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IV.

Valuation

1. Multiples Approach

Multiples approach is widely used when IBs do valuation for M&A and IPO. For this case, because Kohler is not a public company, so it is hard to find the true market fair value on stock market. In the case, it provides some basic financial and stock market data for companies comparable with Kohler in the same industry. We will use those data to settle down the stock price of Kohler by average multiples. The following illusion shows the calculation process. And this could be evidence shows that the stock price that dissenter claimed is much higher than what we estimated, which should be the true “fair” value of Kohler private company.

But as Kohler Co. has cross business sectors in household fixtures, cabinets, small engines, generators, and resorts, etc. So actually Kohler Co. is diversified and should be considered as a conglomerate. And comparing a conglomerate to other businesses is difficult to do because it is unlikely that any other company would truly match their corporate structuring.

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So considering about this issue, we come out with another adjusted multiple approach to estimate the value of Kohler Co. We firstly identify the revenue ratio among its majority business sectors, such as Kitchen&Bath Group, and Power Systems Group as following exhibit:

And then base on the different ratio weight to calculate the weighted average multiples. Coming out another set of data, as shown in the below exhibit:

So base on this adjusted multiple approach method, we estimate the stock price of Kohler Co. to reach about 158,948$ per share, which is far below the claimed price of 273,000$ per share. This would be another strong evidence to show the dissenter that the stock price couldn’t be so high as 273,000$ and persuade them to accept the settlement price outside of the court.

Exhibit Majority Business Sectors of Kohler (in $ thousands)

Weight Ratio 73.33% 26.67% Net Sales 1,485,831 540,260 Kitchen & Bath Group Power S ystems Group

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2. DCF approach

a) Unleveraged the β from the list of comparables, use the average b) Find Leveraged β for Kohler

c) Use MRP of 5% as a standard

d) Cost of debt 7.34% based on moody rating 1998 (A rating)

Corporate Bonds (10-year maturity) Rating Rate AAA 7.10% AA 7.18% A 7.34% BBB 7.70% BB 9.10% B 9.68% ( ) [ ⁄ ] [ ⁄ ] WACC Bu 0.78 Bl 1.17 Debt 681,038

Tax rate 44% (Average proj) Equity 786,335

Rf 5.64% (10yr bonds apr 98) Total 1,467,373

MRP 5.00% D/D+E 46%

Cost of Debt 7.34% E/D+E 54%

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Assume Perpetual Growth at 6% from historical value of firm

Invested Capital

Operating Cash 63,512 56,838 55,621 70,976 95,207

Inventory 258,962 261,669 272,065 281,550 294,261

Accounts receivable 351,713 355,124 376,927 393,929 410,560

Accounts payable 225,771 225,664 239,481 251,384 261,007

Operating Working Capital 448,416 447,967 465,132 495,071 539,021

Tangible Assets 476,419 498,839 516,899 531,993 554,161

Operating Invested

Capital 924,835 946,806 982,031 1,027,064 1,093,182

Non-Operating Assets 316,767 304,841 301,903 299,270 294,695

Total invested capital 1,241,602 1,251,647 1,283,934 1,326,334 1,387,877

Tax on EBIT 54,724 74,518 81,621 87,537 NOPLAT 71,308 97,101 106,357 114,067 Dep 87,661 91,786 94,593 97,355

Inc in work Cap -449 17,165 29,939 43,950

Cap Ex 110,081 109,846 109,687 119,523 FCF 49,337 61,876 61,324 47,949 50,826 Perpetual Growth 6.00% Terminal Value 2,450,579 NPV $1,704,272 Debt 681,038 Equity Value $1,023,234.32 Share Price $134.85

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3. Reconciliation

Kohler’s Perspective

Based on Kohler’s own valuation they came up with a value of $55,400 per share, this can be derived as follows

Assumption : pessimistic estimation of perpetual growth 4.68%

FCF 49,337 61,876 61,324 47,949 50,193 Perpetual Growth 4.68% 468 Terminal Value 1,478,857 NPV $1,100,910 Debt 681,038 Equity Value $419,871.54 Share Price $55.33 Shareholders Perspective

Shareholders claim $270,000 per share

Assumption : Optimistic estimation of perpetual growth 6.83%

FCF 49,337 61,876 61,324 47,949 51,224 Perpetual Growth 6.83% 683 Terminal Value 4,117,558 NPV $2,739,335 Debt 681,038 Equity Value $2,058,297.15 Share Price $271.26

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V.

Lack of Liquidity Discounting

There are many concepts that we can tap from this case, one of which is the lack of

marketability discount that is applied to stocks and equity that is not freely traded on the open market. Figuresx point to a 15% - 35% discount applied to the stock due to lack of marketability.

When we use a median discount of 25% to the current valuation by DCF we get the following:

Share Price $134.85

Lack of Liquidity 25%

Discounted Stock $101.14

This is closer to Kohler’s valuation and one that we find more acceptable than the shareholder’s claim.

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VI.

Dividend based valuation

Since the stock in not traded we can assume that the Price doesn’t fluctuate as much and in valueing the stock take into consideration only the constant growth model:

Gordon’s contant growth model

P0 = Div1 / ( r – g ) r: expected rate from inv; g : annual growth in div

Market Expected Returns

Bu 0.78 Bl 1.17

Rf 5.64% (10yr bonds apr 98)

MRP 5% Expected Returns 11.48% 1997 1998a 1999 2000 2001 2002 Dividends Paid 5,688 5,546 5,403 7,817 8,848 9,741 10,325.46 -3% -3% 45% 13% 10% Expected returns 11.48% Perpetual Growth 6.00% Terminal Value 188,395 NPV $152,505 Share Price $20.10

This value is generally under both valuations of Kohler as well as the shareholders, I believe that our assumption that lack of liquidity results in the stock following constant growth model is flawed.

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VII.

Trial and Settlement

Decision tree based on trial and settlement

$81,900.0 $273,000 $120,680.0 $55,400 $38,780.0 $120,680.0

Max price Kohler willing to settle for

trial no trial claim by plaintiffs 30% no claim by plaintiffs 70%

As shown in the decision tree, it is clear that should Kohler decide to bring the case to trial, he stands to lose a total of $273,000 should the plaintiffs win. However, given the probability that of 30% that Kohler would win the case, the probability weighted amount is $81,900.

On the other hand, should the plaintiffs lose the court case, then the total amount that he would have to pay would be $55,400, which is the price that was stipulated by the company. However, the likely chance of this is 70%, which though high, is not a guarantee. Weighted we get $38,780.

Hence, the maximum share price that Kohler should be looking to settle would be $120,680 per share, taking into consideration the probabilities and the discrepancy between the share prices.

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VIII.

Tax Controversy

$44,929,400.00

Win 30% $316,141.73 Price Per share

Lose

Trial 70%

$347,017,320.00

$384,010,984.33

$256,103,228.17

$315,786.96 Price per share

Settlement IRS

50%

No IRS 50%

$128,195,472.00

However, the case is not as simple as bringing the plaintiffs to court. Being a large company, the IRS too has their eye on Kohler. Hence regardless if Kohler goes to court or not, the base taxable amount would be $27 million, for the above analysis we only look at amounts in excess of $27 million for the taxable estate.

Depending on the result of the trial, it seems favourable that Kohler should settle at

$315,786.96 per share for the shareholders. This being higher than the price that shareholders are asking, Kohler should settle at $273,000.

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IX.

Recommendations and Conclusions

It appears to be that both Kohler and the shareholders are undervaluing and overvaluing the stock price respectively. Kohler is assuming that the growth rate of the stock price would be at 4.68% which is pessimistic, whereas the shareholders are being optimistic and assuming that there would be a growth of 6.83%. Both of which are unrealistic.

Given the state of things, the shareholders are feeling that they have been hoodwinked by Kohler and are disgruntled enough to bring Kohler to court to fight for their deserved rights. The closed door valuation of the stock price too does not inspire much interest as far as the shareholders are concerned. Realizing that Kohler wants to keep the shares within the family, the shareholders are also keen in extracting the maximum amount of money that they are able to from the company. Due to the difficulty in estimating the true value of Kohler, by weightage of similar industries, the estimated true value of the stock should be closer to $159,000 per stock price.

Given all the different scenarios and evaluations, it is definitely in the best interest of Kohler to bring the case to court given the large differences between the amounts of money involved. At trial, the total amount that Kohler would have to probably pay is estimated at $256 Million on top of the $27 Million that is required by IRS.

It is highly recommended to Kohler to revalue the stock price at a “fair” market value and re-propose this amount to the shareholders. Given that, although the tax payable to IRS is higher, but it is the trauma and the additional legal and administrative fees that will hurt the company more than a simple decision of settling or not. Failing which, the next best alternative would be to go to court.

References

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