Case, board chairman, president, and sole owner of the company, had informed his senior management group that he intended to retire from business and was about to initiate a campaign to sell the company. For several years, his physician had been urging him to avoid all stress and strain; now John Case had decided to sever his business connections and devote his time to travel and a developing interest in art history and collection. On the basis of previous offers for the company, Case decided to ask for $20 million, with a minimum of $16 million immediately payable in cash.
He thought acquisitive corporations should find this price attractive, and he believed it would be easy to dispose of the business. Case had assured the management group that their jobs and benefits would be well protected by the terms of any sale contract that he might negotiate. Despite his faith in Case’s good intentions, Anthony Johnson was quite apprehensive about the prospect of having his career placed in the hands of an unknown outsider. However, after some reflection, Johnson concluded that the sale decision should be viewed as an opportunity to acquire control of a highly profitable enterprise.
Purchase of the Case Company would not only ensure career continuity but also provide a chance to turn a profit in the company’s equity. Johnson realized that his personal financial resources were far too limited to allow him to bid alone for control of the company. Consequently, he had persuaded August Haverford, vice president?marketing, William Wright, vice president?manufacturing, and Richard Bending, the controller, to join him in trying to buy the corporation, rather than standing by while control passed to an outsider.
In response to Johnny’s request, Case had agreed to defer all steps to merchandise the many until he had accepted or rejected a purchase proposal from the management group, provided this proposal was submitted within six weeks. This case was prepared as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright 0 1990 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163.
No part of this publication may be reproduced, stored in a retrieval system, used in a broadsheet, or transmitted in any form or by any means?electronic, mechanical, photocopying, recording, or otherwise?without the permission of Harvard Business School. 291-008 Because of his background in finance and his role in initiating the project, Johnson had assumed primary responsibility for assessing the profit potential of the opportunity and for structuring a workable financial plan for the acquisition.
Since Case had not yet solicited bids from other potential purchasers, Johnson believed that it would be most realistic to regard Case’s stated sale terms as fixed and nonnegotiable. Johnson, then, needed to determine whether he could meet the asking price and still realize a profit commensurate with the risk in this purchase. Moreover, he needed to figure out how the management group, with roughly $500,000 among them, could finance the purchase and at the same time obtain voting control of the company.
Thus far, Johnson had managed to obtain a tentative commitment for a $6 million unsecured bank term loan, and he had persuaded Case to accept unsecured notes for the noncoms portion of the purchase price. He was still faced with the problem of raising close to $10 million on an equity base of 500,000 without giving up control to outsiders. Johnson now had three weeks in which to come up with a workable financial plan or lose the deal. He was acutely aware that his own life savings and those of his associates would ride on his judgment and ingenuity. The Company The John M.
Case Company was the leading producer of business calendars in the Lignite States. The company was established in 1920 by Uriah Case (John Case’s paternal grandfather) to do contract printing of commercial calendars. John Case had joined the organization in 1 946 upon graduation from college, and in 1951 he had inherited the company. Under Case’s leadership, primary emphasis was placed on controlled expansion in the established line of business. By 1 984, the company, with an estimated 60% to 65% share of its market, had been for over a decade the largest company in a small but lucrative industry.
Operations had been profitable every year since 1932, and sales had increased every year since 1955. In 1 984, the most recently completed fiscal year, earnings had amounted to $1 on sales of approximately SSL 5. 3 million. The return on average invested capital in 1984 was around 20%. Over the past five years, sales had increased at a 7% impound rate, while earnings, benefiting from substantial cost reductions, had more than doubled. Exhibits 1, 2, and 3 present financial figures for the company. Products As noted, the John M.
Case Company’s principal products were commercial desk calendars of various types. The company designed and manufactured disposable-page and failover-page desk calendar pads in a variety of sizes. The company also sold desk calendar bases, which were purchased from Outside suppliers that manufactured to Case?s specifications. In 1 984, standard desk calendar pads had contributed approximately 80% of net sales and 90% of earnings before taxes. Bases accounted for of sales, and miscellaneous merchandise, chiefly wall calendars, accounted for the rest.
Sales were highly seasonal. Most final consumers did not start using calendars for the forthcoming year until November or December of the current year. Consequently, about 90% of Case’s total shipments typically took place between June and December, with about 60% of shipments concentrated in the third quarter and 25% in the fourth quarter. Since calendar pads were dated, any merchandise remaining in stock at the end of the selling season was subject to rapid obsolescence. 2 291 -008 Manufacturing
The production process was relatively simple, employing widely available skills and technology. High-speed offset presses were used to print appropriate dates on paper purchased in bulk from outside suppliers; the printed sheets were then trimmed to the required sizes and stored for shipment. The entire process was highly automated and was characterized by high fixed costs, high setup costs, and low variable costs. In spite of highly seasonal sales, the Case Company operated on level production schedules.
Since the product lines were for all practical purposes undifferentiated from competing lines, and the relevant production genealogy was well known, the capacity to sell on the basis of price, while achieving a good return on invested capital, was regarded by management as a critical success factor in the industry. Minimum production costs were therefore imperative. Level production enabled the company to take advantage of extremely long production runs and thus to minimize down time, the investment in equipment, expensive setups, and the use of transient labor.
Level production, in conjunction with the company’s dominant market share, provided scale economies well beyond the reach of any competitor. The combination of seasonal sales and level production resulted in the accumulation of large seasonal stocks. However, by concentrating the sales effort in the middle six months of the year, the Case Company was able to circumvent most of the risk usually associated with level production in a seasonal company in return for modest purchase discounts.
Since customers could easily predict their needs for Case products as their budgets for the forthcoming year took shape, they were willing to place their orders well in advance of shipment. As a result, Case could manufacture against a firm cackle in the last few months of the year and thus circumvent the risk of Overproducing and ending the year with large stocks Of outdated finished goods. The Case Company maintained production facilities in nearby Wilmington, Delaware, and, through a wholly owned subsidiary, in Puerco Rich. Earnings of the Puerco Rican subsidiary, which sold all its output to the U.
S. Parent, were entirely exempt from U. S. Taxes and until 1992 would be exempt from all Puerco Rican taxes. The tax exemption on Puerco Rican production accounted for Case’s unusually low income tax rate. All Case plants and equipment were modern and excellently maintained. A major capital expenditures program, completed in 1983, had resulted in Case having the most up-to-date facilities in the industry. At the predicted rate of future sales growth, William Wright, the chief production officer, did not anticipate any need for substantial capital expenditures for at least five or six years.
None of the company’s work force was represented by labor unions. Marketing Because its products were undifferentiated, Case’s marketing program concentrated on providing high-quality customer service and a uniformly high-quality product. Case products were sold nationwide. Geographically, he company was strongest in the Northeast, the Southwest, and the far West. Large accounts were handled by the company’s five-person sales force, and smaller accounts were serviced by office supply wholesalers. Roughly 10% of sales had historically gone to the federal government.
Even though the product was undifferentiated, August Haverford, the marketing vice president, believed that it did have some significant advantages from a marketing viewpoint. Selling costs were extremely low, as consumption of the product over the course of a year automatically generated a large replacement demand without any effort on the part of Case. About 95% of total sales generally consisted of reorders from the existing customer base, with only 5% of sales going to 3 new customers. Historically, over 98% of the customer base annually reordered Case pads and, as needed, additional Case bases.
By dealing with only one source of supply, the customer was able to take maximum advantage of discounts for volume purchases. Because the product was virtually immune to malfunction and the resultant customer dissatisfaction, once Case bases had been installed the typical buyer never had any incentive to spend time and money on a search for alternative sources. Consumption of Case products was, in addition, extremely insensitive to budget cuts, economy drives, consumer whims, and the like. The desk calendar Was a small-ticket but historicity item.
It was an essential element in the work routines of most of its users, and it was not expensive enough to yield a meaningful reward in savings to would-be budget cutters. As a dated product, the desk calendar, unlike many other office products, represented a nontransferable purchase. If Nan sees John Case had been greatly influenced by his father’s and grandfather’s memories of the Great Depression, and he steadfastly refused to consider averaging his equity in the company. Accordingly, the company operated with an all-equity capitalization.
The size of the capital budget was determined by the volume of internally generated funds in conjunction with Case’s decision on how much to withdraw in the form of dividends. Dividend payments had sometimes been sharply contracted to accommodate capital investment opportunities. Over the past three years, however, internally generated funds had been plentiful, and dividends had averaged 70% of net earnings. Like the capital budget, the seasonal accumulation of inventories and receivables was financed from internal sources.
To minimize warehousing expenses for finished goods, Case provided generous credit terms to customers who accepted early shipments. Payments for June through October shipments were not due until the end of November, although substantial discounts were offered for earlier payment. The collection period averaged 60 days. Credit experience was excellent, and generous credit terms were considered a key factor in the company s competitive success. Although the company had not resorted to seasonal borrowing in close to 10 years, it maintained for emergency purposes two $2 million lines of credit at major Eastern banks.
Exhibit 4 shows 1 984 working capital balances by month. ) The Case Company’s credit record with suppliers was excellent. All trade obligations were promptly paid when due. Management The senior management team consisted of John Case plus the four individuals interested in buying the corporation. Transfer of ownership to the latter would not occasion much change in the De facto management of the organization. Although John Case continued to exercise the final authority on all major issues of policy and strategy, over the past few years he had gradually withdrawn from day-to-day affairs and now spent much of his time in Europe and Puerco Rich.
As Case had relaxed his grip on the company’s affairs, he had increasingly delegated the general management of the firm to Anthony Johnson. Compensation Was generous at the senior executive level. Case drew an annual salary of $400,000; his four key subordinates received an average salary of $90,000. In addition, the four senior executives received annual bonuses that aggregated 10% of earnings before taxes and bonuses. The members of the purchasing group were all in their late thirties and early forties and between them represented more than 50 years’ experience in the business.
A graduate from a leading school of business administration, Johnson, age 40, had worked for five years in the venture capital 4 department of a large Eastern city bank and for two years in his own management consulting firm before join ins the Case Company. Company prospects The overall prospect was for continued growth at a steady, though unspectacular, pace. The rate of Case sales growth, management believed, was closely correlated with the rate of growth in the size of the domestic white-collar work force.
Given expectations of a continuing shift of labor out of agricultural and blue-collar occupations and into white-collar positions, this suggested that the company needed to grow somewhat faster than the economy as a whole. Assuming no material changes in product lines or market share, management thought sales growth would average about 5% to 6% per annum in the foreseeable future. Profit margins were expected to improve somewhat over the next few years, as volume expanded and an increasing proportion of new production was directed to the tax-exempt Puerco Rican facility.
Competition Although the commercial desk calendar industry was profitable indeed for its leading participant, it was not, in the opinion of Case management, an attractive area for potential new competitors. At present, the industry was divided between Case, with roughly a 60% to 65% share of market, and the Watts Corporation, a privately held company with an estimated 20% to 25% share. Watt’s strength was concentrated in the Midwest and Southeast. The remainder of industry sales was fragmented among a host of small, financially weak printing shops.
Case management found it difficult to imagine how a potential competitor could arrive at an economically justifiable decision to enter its market. Price was the only conceivable basis on which a ewe entrant could compete, but, lacking the scale economies available to Case, a new entrant would necessarily be a high-cost competitor. Haverford estimated that it would take a new entrant at least three to five years to reach break-even, assuming no retaliatory price cuts by Case. Furthermore, entering this market would necessitate a minimum capital investment of $2 million to $4 million, plus the working capital needed to support seasonal sales.
On balance, it seemed unlikely that a potential competitor would brave these obstacles in the hope of grabbing a share of a $25 million to $30 million industry with mediocre growth prospects. Case judged that the company’s financial strength, relative cost advantages, and entrenched distribution system had served to deter Watts from trying to invade any of Case’s prime market areas. Similarly, he thought Case could not take away a substantial market share from Watts without risking a price war that might seriously impair margins for a protracted period.
Unexploited Opportunities The business plan finally approved by John Case had not incorporated a diversification scheme vigorously advanced by the other members of senior management. The vice presidents had contended that the company could significantly boost both the rate of growth and level of earnings by using its cash flow and its production and distribution strengths to expand into related product lines. The proposal had called for expansion into other dated products, such as appointment books, planning books, and the like, imprinted with the name, logo, or other message of the customer, and into desk calendars similarly imprinted.
Johnson had estimated that this project would require an initial capital investment of $200,000 and special product development and merchandising expenses Of $900,000 spread over the first two years of the undertaking. It had been estimated that the new line should yield sales of approximately $1 million in the first full year of operation, with a growth rate of about 40% per annum in years two through four, as the line achieved nationwide distribution and 5 recognition. A 12% to 15% growth rate was anticipated in subsequent years. It was thought that this type of product line would have a profit margin before taxes of about 6%.
The management group believed that the proposed line could serve as a profitable first step toward developing a full line of desktop products for commercial, industrial, and government markets. John Case had rejected the proposal on several grounds. He had observed that the proposal advocated entering a riskier line of business in which none of the management group had experience. In the proposed line of business, the customer could choose among a variety of competing designs, and manufacturers had to generate repeat sales actively.
He had also pointed out that the project would require a substantial investment in working capital for seasonal sales, if the new line grew as predicted. Finally, he had stated that he was quite content with his present income and, at his age, unwilling to invest earnings in the hope of achieving a strong position in a more competitive and less profitable business than the present one. With Case out of the picture, the management group would have the freedom to pursue its growth program.
Johnson believed that over a period of years the Case Company’s growth rate could be improved significantly if earnings were reinvested in related businesses rather than disbursed as dividends. The higher growth rate would be translated into profits for management if, for instance, the faster growth allowed it to take the company public at a relatively high price-earnings ratio. The Purchase Proposal Johnson recognized that a successful proposal would have to blend and reconcile the interests and goals of all parties to the transaction: the seller, the buyers, and external suppliers of finance.
The management group had determined that among them it could raise at most about $500,000 for investment in Case. Raising this amount would necessitate drawing down savings accounts, refinancing home mortgages, and liquidating positions in the stock market. Johnson was prepared to commit SSL 60,000; Haverford $140,000; and Wright and Bending $1 00,000 apiece. It had been tentatively greed that all members of the management group would buy stock at the same price. It had also been tentatively concluded that the group would not accept a proposal that left it with less than 51% of the shares.
With less than 51 % of the stock, the management group might not achieve the autonomy to establish corporate policy or to dispose of the company where and as it saw fit to do so. Valuation As mentioned previously, Johnson believed that John Case’s asking terms of $20 million with a minimum of S 16 million in cash would remain fixed, at least until the company had been shown to a number of prospective buyers. In the past year, Case had held discussions with two companies that had made unsolicited bids to purchase the company.
The first offer, $15 million in cash, had come from a medium-sized firm with a diversified line of office products. It had been rejected by Case on the basis of price. The second offer had come from a highly diversified medium-sized company sporting a price-earnings ratio of more than 20 and seeking to establish a position in office products through a series of acquisitions. The final offer had come to $32 million in letter stock of the 6 acquirer. Case had found this bid extremely tempting but had been unwilling to tie up his wealth in unmarketable shares of a company with which he was not intimately familiar.
The acquirer, lacking excess debt capacity and unwilling to float new stock to raise cash, had backed out of the discussions. Johnson had, in addition, assembled financial figures on the publicly traded companies he thought most comparable to the Case company. These data are presented in Exhibit 5. If Nan icing In terms of the mechanics of the transaction, Johnson planned to effect the purchase through a new corporation in which the management group would ay 500,000 common shares at $1. 0 per share. Given the management group’s $500,000 versus the $20 million asking price, the biggest problem facing Johnson was how to fund the new company at all, not to mention the objective of keeping control in the management group. Johnson had managed to obtain tentative commitments for $10. 5 million, including the management group’s $500,000. Prior to submitting a purchase proposal to Case, however, he would have to line up commitments for the entire $20 million in funds needed.
It was clear that the noncoms component of the purchase price would have to e met by issuing notes with a market value of $4 million to John Case. In order to maintain the maximum amount of flexibility and borrowing capacity for raising financing from outsiders, Johnson had proposed that Case take 4%, junior subordinated, amortizing notes. After some negotiation, Case had expressed his willingness to accept a $6 million amortizing, 4% five-year note that would be junior to all other debt obligations of the newly formed corporation.
The members of the management group, as well as the corporate acquirer, would have to endorse the note. It was agreed that events on the note would include (1 ) no additional debt or leases except debt incurred in the acquisition of the Case Company, short-term seasonal borrowings, or debt incurred to retire the verifier note; (2) no dividends and maintenance of at least $3 million in working capital; (3) no changes in management or increases in management compensation; and (4) no sale of Case shares by Johnson, Haverford, Wright, or Bending as long as the five- year note was outstanding.
If the borrower should default on any terms of this note or any other indebtedness, the junior subordinated notes would come immediately due and payable. If not promptly paid, ownership of the shares held by the management group would revert to John Case.