Description

It now looks like WHR will win MYG with a bid of $21/share. Upon completion of the deal, WHR can realize in excess of 300-400m in synergies, which translates to more than $3+ per share in EPS accretion. Additionally, there looks to be plenty of upside to consensus WHR estimates because of the recent fall in steel prices, WHR’s largest cost component. Thirdly, the company continues to make a lot of progress on more efficient sourcing and cost containment, driving margin improvement in the US and Europe. Street estimates for 2006 are in the $6.50-7.00 range. With synergies from MYG, steel price benefits and margin gains, it’s not hard to get to earnings power north of $11/share in the future. Applying a conservative 12x multiple to earnings results in a target price of $132 in 1-2 years.

Steel Upside. According to the company, unfavorable materials pricing (largely steel) has accounted for an approximate 500m hit to earnings in 2005 vs. 2004. WHR should get a lot of that back in 2006 as more than 1/3 of steel sourcing is renegotiated. A 200m reduction in materials costs would result in $2 of additional earnings upside. Analysts have not adjusted their 2006 estimates for the recent steel price decline.

MYG Merger Synergies. The synergies that will be created upon merger can be broken up into the following categories: 1) materials costs; 2) distribution; 3) direct labor; 4) SGA; 5) Warranty costs/R&D

1) Materials costs, parts, assemblies represent 55-60% of total sales for MYG. Currently MYG has around 60% of its sourcing in the US, which is 30-40% more expensive than sourcing overseas. When WHR absorbs MYG sales, they will a) move much of the sourcing overseas, and b) use its power over materials suppliers (steel, resin, etc.) and get better pricing. This should conservatively get them cost savings of $90-100m.

2) Distribution costs for MYG are around 8% of sales, whereas for WHR they are 5% of sales. While they probably will not realize the full 3% discrepancy, they should benefit significantly. A key area of efficiency includes shutting down overlapping distribution centers. Currently MYG has 9 centers while WHR has 11 centers, many of which are in overlapping regions. Since many of the WHR facilities are not running nearly at full capacity, they can combine many and shut down redundant centers. This should result in $60-80m in synergies.

3) Direct labor. WHR’s current labor mix is 50/50 US/abroad. MYG is 90% US. High cost union labor wages are $30/hr; US non-union labor is $20/hr; Labor in Mexico is $2/hr; labor in Asia is less than that. There is a clear benefit to shutting many of the manufacturing facilities in the US. Of course, they will have to incur the costs of closing these plants, but net-net it should benefit them greatly since direct labor represents 10% of sales.

4) SGA – right away, they can eliminate MYG’s US headquarters, which employs 3500 workers and at least 100 executive level managers with large salaries. Also, each company employs around 300 salespeople. Combined they would need no more than 400 people since both salesforces go to many of the same locations. These salesmen get paid in excess of $100k annually. We could see $150-200m of savings here.

5) Additional costs include warranty related costs and R&D. Difficult to identify at the moment, but there could be some room to eliminate redundant operations here.

6) There is a chance that retailers try to decrease their purchasing from the combined WHR/MYG, which could result in some leakage, but on the other hand, they could actually increase their business. Retailers have been disgruntled with MYG’s poor inventory turns, fill rates, profit margins per product, while WHR is generally best-in-class in virtually every category. Under WHR’s umbrella, MYG will be fortified in all of these categories which could persuade retailers into increasing MYG appliance volumes. (There are rumors that Best Buy might bring MYG back in). We would consider this a net-neutral at the moment until we learn more from the retailers.

Conservatively, these areas of cost savings could benefit WHR by at least 300-400m.

Pro forma analysis.
So these two events which should occur within the next 6-12 months should
boost earnings power to over $11 per share. See pro forma analysis below:

WHR MYG Adj. Adj.
2006E 2006E Deal Steel Pro Forma
Inc St:
Sales 14,629 5,080 19,709
EBITDA 1,307 311 400 200 2,218
D&A 452 166 618
EBIT 855 145 400 200 1,600
EBIT Margin 5.8% 2.9% 8.1%
Interest Expense 184 59 50 293
Pretax Income 671 1,307
Income Tax (218) (425)
Net Income 453 882
EPS $6.66 $11.26
Shares out 68.0 10.4 78.4
EPS Acc/(Dil) 69%

Cap Structure:
Price $80.50 $80.50
Shares out 68.0 10.4 78.4
Mkt Cap 5,474 6,311
Debt 1,636 977 837 3,450
Cash (188) - (188)
Net Debt 1,448 3,262
EV 6,922 9,572

Ratios:
EV/EBIT 8.1x 6.0x
EV/EBITDA 5.3x 4.3x
PE 12.1x 7.2x


Assumptions
Deal Price 2,650
Assumption of MYG Debt 977
MYG Debt int rate 6.0%
Remaining price for equity 1,673
Financing - Debt 837 (50% debt)
New Debt Int Rate 6.0%
Financing - Stock 837 (50% stock)
Current stock price $80.50
New shares issued 10.4



Regulatory. While there is still some uncertainty how the FTC will ultimately rule on the deal, we are fairly confident that they pass the regulatory hurdles for the following reasons:
1) WHR can argue that Kenmore, which is Sears’ private label brand and sources 60% of its products from WHR, should not be included in overall market share. Sears can at any time terminate its deal with WHR and get another supplier, so in laundry, pro forma MYG/WHR would control less than 50%.

2) In overall appliances, the combined entity will have less than 50% market share, including Kenmore.

3) WHR will make the argument that this is now a global industry with virtually no barriers to entry, and Asian competitors such as LG, Samsung and Haier are all growing competitors and getting stronger by the day.

4) And most importantly, WHR has received a letter of support from 17 of their top 20 retail partners, proving that this should not be considered anti-competitive by the FTC. It is still unclear whether or not Sears is included in this list; but given how much the WHR relationship means to Sears (WHR is their largest vendor by far), it would be in Sears’ best interest to support the deal.

With a reasonably high probability the deal gets done, upside from a more favorable raw materials environment, and an opportunity for massive synergies to drive EPS, the stock looks very cheap at current levels.

Catalyst

Synergies from merger with MYG, steel price decline benefits