Description
One quick warning before I start, this analysis is longer than recommended, however, the first few paragraphs lay out my analysis you can decide whether to continue reading.
Cooper Industries is a boring stock that is going through an exciting process. Cooper is a diversified, worldwide manufacturer of electrical products, tools and hardware. Cooper has leading brands in all of these areas. In August, the management announced a plan to reincorporate in Bermuda in an effort to lower their tax rate. Danher subsequently announced its intention to acquire Cooper for cash and stock, value $54-$59 per share. Finally, Federal-Mogul (“FMO”) announced they do not plan to honor their contractual commitment to indemnify Cooper from asbestos liability. (In 1998, FMO purchased Abex, a brake manufacturer, from Cooper, as part of the sale FMO agreed to indemnify Cooper for asbestos liability resulting from Abex. Recently, however, FMO filled for bankruptcy and as a result, they now plan to cancel the contract to indemnify).
Cooper’s recent experiences have cleared out most buyers and left an undervalued company. The risk arbs are unsure of what’s going to happen with the Danher acquisition, therefore I believe most are staying away, they don’t want to be the guy who got it wrong. The pension funds and other low risk funds probably don’t want to hold it either. Whoever was left, ran when they herd the words asbestos. In addition, Cooper still does not apply to classic growth investors because it is so damn boring.
That’s all fine and good, but what’s it worth? Well, I completed a discounted cash flow analysis and if one believes that Cooper’s future cash flows are not shrinking and that they will remain solvent despite the asbestos liability then their stock is extremely undervalued. Sounds great, but those are two big assumptions. I hope that my analysis will assuage any fears that these assumptions are misguided.
First, I will address the asbestos liability. I believe that the asbestos liability will not significantly affect Cooper’s business for two reasons. One, the CEO of Cooper stated that the asbestos liability would not materially affect earnings. No, seriously, these guys seem stand-up. As you will see, they do not manipulate their earnings like most companies. Two, my own analysis of the publicly available information leads me to the same conclusion (see the analysis below titled Asbestos).
Second, free cash flow has been consistently increasing over the last several years. In addition, despite their drop in earnings this year their free cash flow still increased. Finally, the independent analysts at Valueline and the S&P believe that Cooper business will increase modestly in the coming years, not a ringing endorsement, but we don’t need blockbuster growth.
Next, I would like to discuss why Dahner is looking at acquiring Cooper. Most of my information comes from letters sent from Dahner to Cooper and a conference call by the CEO and CFO of Dahner addressing the proposed acquisition (it is important to note that the letters and call took place before Cooper’s asbestos liability came to light). All of these are available on Edgar.
The CEO of Dahner stated that he views Cooper as a good investment, and all of their analysis was done assuming only modest synergies. Cooper has a large amount of cash and needs to put it to work. In his conference call, the CEO continually referred back to FCF. He noted that Cooper is not a sexy company and as a result gets a bad rap. He further revealed that his company has calculated Cooper’s organic growth at 4.5% over the recent past. Further, he expects to achieve an incremental increase in FCF of $1 billion over the next three years, including debt service, if the deal is completed. One important point he made was that Cooper has high quality earnings. Thumbing through Cooper’s 10K one can clearly see that is true. Cooper uses LIFO accounting (less earnings more cash), their pension fund is fully funded and the projected return on their pension assets is between 7.5 and 8.5%, many companies have projected 10 or 11% in order to boost earnings (Dahner is at 10%), and their employee stock options are modest, about 2% per year of net income. With more aggressive accounting, Cooper could increase their earnings, which makes their forward P/E of 12, an industry low, is even more appealing. Their P/Sales is also very low, .85, in fact, all of the valuations are low, and historically cheap stocks outperform the market. Back to Dahner, I don’t know what the chances are that they will acquire Cooper, but I do know that the managers at Dahner view Cooper as undervalued and if they do acquire Cooper all shareholders will receive a significant premium over current prices.
If Dahner does not acquire Cooper and no other buyers step up then Cooper plans to reincorporate in the Bahamas. The S&P predicts this would add $8.5 of value per share. Dahner, however, made a valid point in their press release, the markets did not respond to the re-incorporation news. I am not sure why the market did not respond, but in the end people pay for cash, so I think it should add value.
In closing, this is very uncertain time for Cooper and subsequently a prime opportunity. It appears that the Cooper’s current price is attractive without taking into account the merger premium and value added from the re-incorporation. Before any of this occurred, Copper was trading between $38 and $39, a price I think is still attractive. Below is a discussion of the asbestos liability. I have left a lot out of relevant details due to space considerations. Please post any questions and I will try to answer them.
Asbestos Liability
In 1998 Cooper sold two wholly owned subsidiaries, Abex and Wagner to Federal-Mogul Corporation (“FMO”). Both of these companies had exposure to Asbestos liability. They were both subsidiaries of Cooper, so, if Wagner and Abex operated as independent companies than their corporate veils are in tact and Cooper is not liable for any of their asbestos liability . However, when Cooper purchased Abex in 1994 it agreed to indemnify the seller against asbestos litigation arising from Abex. Conversely, when Cooper sold Abex to FMO in 1998, FMO agreed to indemnify Cooper from any such claims. Now, however, FMO is bankruptcy and has the ability to cancel any contracts, with the resultant claim holders becoming general unsecured creditors. So, now Cooper is on the hook for any Abex asbestos litigation not covered by insurance. Cooper, however, will become a general unsecured creditor of FMO and therefore, will recoup a portion of their costs.
FMO does not differentiate between Cooper and Wagner in the SEC fillings when discussing asbestos liability. From the number of cases filled against each company it appears that Abex accounts for 65% of the costs. To be conservative I will assume that Cooper will be on the hook for all of the liability. As of September of 2001, FMO had a recorded liability of $226 million. The company also had a corresponding insurance asset of $177 million. FMO’s fillings do not speak to the division of the insurance liability between Abex and Wagner, but their Sept 2001 10Q does say that Abex maintained insurance coverage for most of the time it manufactured products containing asbestos, while Wagner maintained insurance coverage for some of the time. Since, I assumed that all of the liability was associated with Abex I will now assume that all of the insurance is associated with Abex, however, this again is a conservative estimate because it appears that a disproportionate amount of the insurance coverage is associated with Abex. Subtracting the two yields $49 million. FMO expects to pay the claims over 11 years. Insurance coverage appears to cover between 70-80% of the claims. FMO’s fillings state that Abex has substantial additional layers of asbestos coverage.
One important point about Abex’s asbestos liability is that it relates to asbestos from brake pads. These types of claims are the most benign type of claim. Therefore, much of the concern about huge judgments that the some companies have faced lately should not apply to Abex.
DCF
The first step for DCF analysis is to determine the discount rate. The WACC is 8.7%. Cooper’s long term debt is 1.22 billion. The pretax cost of the debt is 6.5% the after tax cost of the debt is 4.2%. The cost of equity is 10.5%(risk free 5.5%, risk premium 5%, beta 1). Shares are about $34 and 93 million shares outstanding.
The next step is to estimate the sales growth for Cooper over the next several years. The high and the low estimates from the S&P and Valueline is 2% and 8%. I estimated the operating profit margin at 16% from recent performance. I estimated the incremental fixed capital investment rate at 48%. I estimated this rate by excluding M&A from sales growth and cap ex. Previous incremental working capital investment rate was erratic in the past; therefore, I used the industry average of 20%.
Future cash tax rate is estimated at 23%. Last year it was 16% but historically it falls around 23%. Cooper cites their tax planning for contributing to last years decline, however, there is no indication that there situation changed to allow them to minimize tax payments, so I ignored last years return.
I used 2% as the long-term rate of inflation.
All of the liabilities were pulled off the balance sheet except for employee stock options and asbestos liability.
Debt $ 1,224.00
Post retirement benefits $ 200.00
Outstanding ESO liability $ 100.00
Accrued (Envirnmental) $ 100.00
Other $ 192.00
Short term debt $ 181.00
Asbestos Liability $ 250.00
Debt & other liabilities $ 3,047.00
Cash $ 26.00
Non-operating assets $26.00
To determine the value of Cooper I first determined the future net operating profit (EBITA). Then the increase in incremental fixed assets and working capital is calculated in relation to the estimated sales increases. Free Cash Flow is left. The FCF is discounted using the WACC to determine PV. Next, the PV of residual value is determined in two ways: 1. By treating net operating profit as a perpetual payment; and, 2. By treating net operating profit as a perpetual payment assuming that the payment keeps increases with inflation. The inflation-adjusted method appears to be the most appropriate method because although the space Cooper operates in is not growing rapidly, Cooper is one of the leaders which should allow it to maintain the real value of their profits over time. Then the sum of the PV of the FCF, non-operating assets, and the PV of the residual value is determined to arrive at the corporate value. Lastly, the liabilities are subtracted from the corporate value, which equals shareholder value. The shareholder value divided by the outstanding shares equals the value of shares. (FCF does not include interest payments because the analysis did not discount the Cooper’s debt)
Years in Future 0 1 2 3
Date 2001 2002 2003 2004
Sales $4,270.00 $4,355.40 $4,442.51 $4,531.36
Operating profit
555.10 696.86 710.80 725.02
Less: Cash taxes on operating profit
127.67 160.28 163.48 166.75
Net operating profit after tax (NOPAT)
427.43 536.59 547.32 558.26
Incremental fixed capital investment
40.99 41.81 42.65
Incremental working capital investment
17.08 17.42 17.77
Free cash flow 478.51 488.08 497.85
Present value of free cash flow
440.21 413.08 387.62
Cumulative present value of free cash flow
440.21 853.30 1,240.92
Present value of residual value (Inflation)
8,920.14 8,370.32 7,854.40
Corporate value $9,360.35 $9,223.62 $9,095.31
Add: Non-operating assets
26.00 26.00 26.00
Less: Debt & Other Liabilities
(1,997.00) (1,997.00) (1,997.00)
Shareholder value $7,389.35 $7,252.62 $7,124.31
Shareholder value per share
$79.46 $77.99 $76.61
Present value of residual value (Nominal)
6,167.65 5,674.01 5,324.28
Corporate value $ 6,607.86 $ 6,527.30 $ 6,565.19
Add: Non-operating assets
26.00 26.00 26.00
Less: Debt & Other Liabilities
(1,997.00) (1,997.00) (1,997.00)
Shareholder value
$ 4,636.86 $ 4,556.30 $ 4,594.19
Shareholder value per share
$ 49.86 $ 48.99 $ 49.40
Catalyst
Acquisition by Dahner, re-incorporation in the Bahamas