Objective of the study The primary objective of the study is to gain practical insights of the business world. Case analysis truly fulfills this objective. It is one of the most general and applicable methods of analytical thinking, depending only on the division of a problem, decision or situation into a sufficient number of separate cases. The derived objectives of this particular case study of ‘Zimmer Holdings (A): Acquisition of Centerpulse, Switzerland’ are the following: To ascertain the business vicinity of Zimmer Holdings * To assess whether it should counter offer for Centerpulse * To evaluate whether it is worthwhile to consider a higher bid * To assess how the company would manage associated risks * To identify whether the offer will be perceived as hostile * To evaluate how would they make the merger work, given the cultural differences between US and Swiss companies * To determine the synergistic benefit Scope of the study This case study analysis has been prepared through extensive discussion of all the group members.
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This report covers the elements of Zimmer Holdings business and whether it should counter offer for Centerpulse Limitations of the study The limitations of the study are defined by the extensity of the facts covered by the study and those that are left out. However, these limitations can be presented in the following lines: * The main constrain of the study was insufficiency of information * Some assumptions are made based on judgment Methodologies This case study analysis is based on secondary data. The data analysis was conducted using following procedure: Qualitative Analysis Industry analysis is conducted through porter’s five forces model and company analysis through SWOT analysis, country risk analysis through ICRG model. * Quantitative analysis The data are analyzed using simple tools like ratio analysis, free cash flow to firm approach for valuation, and simulation analysis for measuring variability in valuation. For valuing real option, Black-Scholes-Merton model is used. Introduction Company at a Glance| Nature of Industry| Belongs to medical technology industry| Nature of Firm| Orthopedic devices firm|
Incorporated| February,2001 | Listed| New York stock exchange| Market Cap| $ 6 billion| Principal Products| Knee joint system, hip joint system, trauma products| Top Managemnet| Ray Elliott-chairman, president and CEO, Sam Leno-Executive vice president and CFO| Zimmer Holdings is a leading orthopedic devices firm based in Warsaw, Indiana. The firm is contemplating to place a counter offer for a Swiss firm Centerpulse; a spin-off of Sulzer Corporation for which an UK based competitor Smith and Nephew Plc (S&N) has announced a takeover.
According to Swiss corporate takeover law, any takeover announcement could be countered by a competitive bid within 40 days of the announcement. So Zimmer has only 40 days to assess all the aspects. Zimmer is also a spin -off of Bristol Myers, a pharmaceutical company which acquired Zimmer in 1972 and spun it on 2001. It is listed in New York stock exchange with a market capitalization of $ 6 billion. It has positioned itself as second in the global knee market, third in the global hip market and forth in the global trauma market. It has net earnings of $ 80. 2 million and net assets of $ 979 million in the 1st quarter of 2003.
Overall ,it is third in the industry. The following two pie chats shows Zimmers’s and other compititors market share in the knee and hip implant products. Zimmer covets to acquire Centerpulse because the merge firm would be the number one pure play orthopedics company in the world. It would give the combined firm leading market position, technology and scale through which Zimmer can capitalize on the attractive growth in the industry. On the other hand, Centerpulse has established a world wide presence in biomedical implants for orthopedic, cardiovascular and dental application.
Despite some product liability it has regarding the products it had to recall for surface contamination, it has a leading share in spine and joint replacement market not only in Switzerland but also in all except for few European countries. Zimmer do not have a strong position in Europe and spine, which is a growing business in orthopedics, Zimmer do not have a spine business at all. So, Centerpulse is an attractive target for Zimmer. Zimmer placed a bid for Centerpulse before but it was turned down by Centerpulse after 4 meetings stating the offer insufficient.
But Centerpulse agreed to US based S & N’s offer without issuing any confidential memorandum to Zimmer. But according to Swiss takeover law Zimmer can place a counter bid for Centerpulse within 40 days after S&N’s offer made public, paying ‘break fees’ to the initial bidder S & N. So, Zimmer has to decide quickly on the course of action it has to take such as whether it is worthwhile to consider a higher bid, how the product liability risk would be assessed and whether shareholders of both the companies be convinced of the potential synergy.
Evaluation of Orthopedic Devices Industry Porter’s Five Forces Model Product design, buyer behavior, and the competencies and activities of rival firms play major roles in shaping the orthopedic devices industry. Beyond this, the structure of the industry itself affects the strategic opportunities available to key players. The five forces model used in this report will explain the industry profitability by assessing the degree of actual and potential competition and by determining the bargaining power in input and output markets.
The model will also show in detail the industry’s relationship with suppliers and customers and how this affects profit structure of the industry firms. * Threat of new entrants- Low to Moderate With moderate government and intellectual property barriers, a moderate learning curve, moderate differentiation, and low integration and high barriers to exit, as well as high capital requirements, the Orthopedic Devices Industry faces a low to moderate threat of entry. * Government Barriers- Moderate * Patents and proprietary knowledge- Moderate to high Learning curve- Moderate * Economies of Scale- High * Capital requirements- High * Differentiation- Moderate * Barriers to Exit- High * Intensity of rivalry among existing competitors- High The Orthopedic Devices Industry shows some spectacular growth. High growth rates and the lack of a dominant product for most spinal procedures make it an attractive market. Rapid growth in the practice of orthopedics has created a vibrant orthopedic industry with the top seven firms generating revenues of US $9 billion in 2002. The sector underwent a period of industry consolidation.
This is a high competition industry. * Number of firms- Low * Market Growth- High * Fixed Costs- High * Switching Costs- Low * Differentiation- Low to moderate * Bargaining power of suppliers-Low Sodium chlorate is produced via the electrolytic decomposition of salt, water and energy. The widespread availability of inputs would likely prevent any single supplier from holding up a producer. Furthermore, because firms hold the patents and intellectual property rights for their products, and have access to specialized workers, suppliers are unlikely to integrate backward.
As firms protect innovation via patents and contracts, employees may pose little credible competition. * Inputs- Freely Available * Labor- Available * Bargaining power of buyers- High The important factors for us to consider regarding sodium chlorate is where the demand for this chemical comes from. 85% of demand for the product is derived from the paper and pulp industry, where it is used in the production of the bleach that is used to whiten the paper. The remaining 15% comes from its use as a soil sterilant, in uranium mining and in the production of other chemicals.
Since firms would face enormous regulatory and other barriers, buyers in this industry have strength and influence over producers and distributors. Switching costs between products are also low. Most hospitals bought through distributors and some distributors are independent third parties. Physicians have a great influence in the purchase decision. Strong surgeon relationships and excellent professional knowledge are critical to market success. Moreover, as government offers health services or funds hospitals, the decisions of government may affect demand for products. Concentration- Becoming High * Customization needs- Moderate * Industry’s ability to save buyers money- Low * Switching costs- Low * Threat of substitute products- Low There is not any popular alternative which can lure away customers. Demand for medical devices, stems from an increasing patient population, high interest in preventative therapies, and a focus on health care cost containment. The larger the population, the greater the opportunity for surgery. And, as patients seek to avert future health problems and improve quality of life, health care providers will innovate to meet demand. Availability of Substitutes- Low Company Analysis * SWOT Analysis The biggest strength of Zimmer Holdings is its dominant leadership in the hip and knee segment. Zimmer Holdings is well known for the high profile of their company and for their excellent workforce. Two major weaknesses of Zimmer Holdings are geographic imbalance and no involvement in spine business. The uncertainty regarding future product liability posses a significant threat for Zimmer Holdings. The main opportunity is that it can expand sales domestically and perhaps more importantly internationally.
Below are the summarized strengths, weaknesses, opportunities and threats of Zimmer Holdings: Strengths * Dominant leader in the hip and knee segment * Becoming the biggest orthopedics company in the world * Strong cash flow generation * Pioneer of Advanced Surgical Techniques * High volume of sales reflecting strong growth * Approximately 40 to 50 cents of economic profit for each new sales dollar * An excellent workforce to develop ideas ; execute them quickly Weaknesses * Vulnerable to collective bargaining power of healthcare institutions and governmental policies * Imbalance in Europe versus Asia versus the U.
S * No involvement in spine business * Undiversified product line Opportunities * Global demographic changes, which shifts dominant market share to outside of USA * Increasing demand for medical devices as global affluence is on the rise * Spinal ; trauma treatments are growing in double digits in recent years * Spinal product segment is emerging as a lucrative market. * Fulfilling key priorities by strengthening its European market position * Increasing its presence in the reconstructive dental market Threats Regulatory process generally required longer lead times * Any suspension or product defect posses a significant threat * Changes in insurance and healthcare policies * Government regulation and quality system * Uncertainty of product liability issues ————————————————- Risk Analysis Zimmer Holdings Centerpulse In case of Zimmer Holdings, The Company’s degrees of operating leverage have decreased from last year meaning that business risk is lower compared to last year.
Degree of financial leverage is almost same from last year. Except year 2001, Centerpulse’s DOL and DFL remain almost same. So, there is no substantial change in the business and financial risk for Centerpulse. Z score Zimmer Holdings Centerpulse In Zimmer Holdings the Z- Score decreases in the 1st quarter of 2003 from last year meaning bankruptcy risk is increasing though it is still at satisfactory level. For Centerpulse the Z-score is has decreased meaning deteriorating credit quality. Ratio Analysis Activity Ratios
Activity ratios reflect how efficiently the company manages its various activities, particularly assets. Among several activity ratios here we can see that DOH is very high meaning in the 1st quarter of 2003 relative to the previous year meaning that recourses are tied up in inventory and there is inefficiency in inventory management in general. But since the company is operating in orthopedic devices industry there DOH will be higher. But how high it should be that will depend on industry median ratios. But compared to previous years DOH increased in the last year so there is evidence of inefficient inventory management.
And the same scenario exists in the Centerpulse Company; DOH is very high to the last year which also means the inefficient inventory management. Zimmer Holdings Centerpulse In Zimmer Holdings, Since the DSO increases in the last year at a high rate meaning that there is inefficiency in the company’s credit and collections procedures. And days of payables are also increases but not that at high rate. And in Centerpulse, Days of payables is increasing and this also show the inefficiency. Cash Conversion Cycle
Zimmer Holdings Centerpulse The cash conversion cycle has increased significantly In Zimmer Holdings meaning that the liquidity is lower. So, the company must finance its inventory and receivables for a longer period of time, possibly indicating a need for a higher level of capital to fund current assets and so as in case of Centerpulse. Du Pont Analysis NET PROFIT MARGIN| 16. 91%| 12. 71%| 18. 78%| 20. 56%| SALES/ASSETS| 1. 74| 1. 58| 1. 60| 0. 40| FINANCIAL LEVERAGE| 2. 29| 9. 47| 2. 34| 1. 80| ROE| 67. 43%| 190. 34%| 70. 8%| 14. 77%| By Du Pont analysis we can see that ROE decreases and it is mainly due to decrease in ROA. So Zimmer Holdings have to take strategy to increase the ROA. And also leverage decreases slightly that have little impact on ROE NET PROFIT MARGIN| 14. 11%| -84. 15%| 22. 92%| 14. 18%| SALES/ASSETS| 0. 53| 0. 49| 0. 63| 0. 14| FINANCIAL LEVERAGE| 1. 26| 3. 51| 1. 79| 1. 69| ROE| 9. 47%| -145. 83%| 25. 86%| 3. 43%| In Centerpulse, we also see that ROE decreases at 3. 43% due to decrease in Net Profit Margin and also leverage decreases by a little percentage. Liquidity Ratios
Zimmer Holdings Centerpulse In Zimmer Holdings and Centerpulse, Current ratio and quick ratio both increases slightly in 1st quarter of 2003, meaning there is satisfactory level of liquidity to meet short term obligations. Profitability Ratios Zimmer Holdings Centerpulse In Zimmer Holdings, The Gross Profit Margin and Net Profit Margin both increase at a low level in the last year and in Centerpulse, Operating Profit Margin slightly increases but net profit margin decreases. Coverage Ratio
Zimmer Holdings Centerpulse Zimmer’s interest coverage ratio increases from last years so it will not be so costly if firm have to raise fund by issuing debt. And in Centerpulse, it is also show almost the same condition. Financial leverage Ratios Zimmer Holdings Centerpulse Financial leverage in Zimmer Holdings though decreased but it is still at low level. And in Centerpulse this ratio also decreased in low rate so The Company the business risk is high for both the companies. ———————————————— The Biddings October 2002: Zimmer’s First Bid for Centerpulse 26 percent premium to the trading price 30 days prior Zimmer’s First Bid for Centerpulse A total consideration of approximately CHF250 per share Offer included a combination of 3. 77 shares of Zimmer common stock and CHF25 in cash Centerpulse turned down the offer March 2003: Smith & Nephew Announcement Bid through a confidential memorandum March 2003 S&N announced tender offer Each Centerpulse share=25. 15 new S&N group shares and CHF73. 42 in cash Both of the boards approved the 1. billion deal CP and S&N joint press release- the deal would position it at number three S&N offer would retain much of the top management Problem Statements * Would it be worthwhile to consider a higher offer? * How should Zimmer assess the product liability risk of Centerpulse? * Whether Zimmer executives chose to pursue with a hostile takeover * How could Zimmer convince the shareholders of both the Centerpulse and Zimmer of their superior synergy potential? * How would Zimmer manage the cultural differences between the U. S. and Swiss Companies? * How would Zimmer make the Acquisition bid?
Would it be worthwhile to consider a higher offer? The SWOT analysis of Zimmer Holding indicates two major weaknesses. The first one is their weak operation in Europe – which is a major market. Secondly, they do not have Spine business at all which is one of the fastest growing business orthopedics as a segment. To overcome these two weaknesses Zimmer bid for Centerpulse in October of 2002. But the offer was rejected by Centerpulse. Since then the top executives of Zimmer have been searching for new opportunity to make a strong presence in Europe and also searching spine business. But they are not successful yet.
According to the Swiss law, the target firms were required to consider any competing bids that were offered within the legislated offer period of 40 days. So, here comes the opportunity for Zimmer. Even if S;N submitted its bid, Zimmer had the opportunity to give a higher bid. Now the question arises, would it be worthwhile to consider a higher offer? The offer made by S;N brought not only another opportunity for Zimmer but also some threats as well. There are two outcomes were waiting for Zimmer. One is the favorable outcome if they could acquire Centerpulse and the other is the adverse results if S;N would acquire Centerpulse.
Favorable results if Zimmer would acquire Centerpulse – | Market Share Position| Product Line| Presence in Europe | Before Acquisition| 3rd| 3| Weak| After Acquisition| 1st| 6| Strong| Adverse results for Zimmer if S;N would acquire Centre | Market Share Position| Product Line| Presence in Europe | Before Acquisition| 3rd| 3| Weak| After Acquisition| 4th | 3| Weaker| The above scenario indicates that Zimmer would be loser if they do not go for a new bidding with a higher offer then that of S;N. Other reasons are technology and scale of production through which Zimmer could capitalize on the attractive growth in the industry.
So Zimmer should consider a tender offer in response to the new founded S;N offer. Country Risk Analysis Country risk refers to the risk of investing in a country, dependent on changes in the business environment that may adversely affect operating profits or the value of assets in a specific country. For example, financial factors such as currency controls, devaluation or regulatory changes, or stability factors such as mass riots, civil war and other potential events contribute to companies’ operational risks.
The country risk here is analyzed by using International Country Risk Guide (ICRG). The three risk categories in ICRG model are – 1. Economic risk: The likelihood that fundamental weakness in a country’s economy will cause adverse development for an investor. 2. Political risk : Political risk is a non-business risk arising out of political events and conditions in a country that could cause loss to international business, has been an important component of country risk analysis.
Political events and conditions such as wars, internal and external conflicts, government regime change, terrorist attacks, and political legitimacy may seriously affect the profitability of international businesses and therefore constitute crucial elements in assessment of country risk. Sometimes external factors also influence the political environment in a country and therefore the political risk. 3. Financial risk: Financial risks are associated with conditions and performances of the overall economy and the financial system. The financial factors that affect the risk are the outcomes of government’s policies.
Each of these risks is discussed below with some key variables Factors| Total points| Category| Points| Score| Political Risk| 100| Government Stability| 15| 14| | | Corruption| 10| 9. 5| | | Democratic Accountability | 10| 9. 5| | | Business Environment | 15| 14| | | Labor Flexibility | 10| 8| | | International Diplomacy| 10| 9| | | Social Stability | 10| 10| | | Regional Stability | 10| 10| | | Legal System| 10| 9| | | Total| 100| 93| Economic Risk| 50| Monetary Policy | 10| 9| | | Fiscal Policy | 10| 9| | | International Transactions Policy| 15| 14| | | Government Finance| 10| 9| | | Inflation rate| 5| 5| | Total| 50| 46| Financial Risk| 50| Exchange rate stability| 15| 14| | | Reporting Standards & Regulations| 15| 15| | | Account convertibility| 10| 10| | | Sovereign debt| 5| 5| | | External dependence| 5| 5| | | Total| 50| 49| Composite Ratings| 0. 5 (93+46+49)| | =94| Predictable and transparent legal environment, legal system and business infrastructure; sophisticated financial system regulation with deep capital markets| Rating Risk| Range| Very High| 0-49. 5| High| 50-59. 5| Moderate| 60-69. 5| Low| 70-79. 5| Very Low| 80-100| The country risk of Switzerland is very low.
Factors Affecting the Acquisition Decision Zimmer has to confront several issues before entering in to preparation of formal acquisition proposal. These are – * Product liability issues surrounding Centerpulse * Significance of timing and Swiss Takeover Board (STB) regulations * Whether Zimmer executives chose to pursue with a hostile takeover * Management of cultural differences between the U. S. and Swiss companies * Product Liability Issue Surrounding Centerpulse At the beginning of December 2000, Centerpulse (then Sulzer Corporation) faced severe product liability.
It had to recall specific lots of product. Product| Liability| Consequences| Inter-Op acetabular shell| Surface contamination had lead to premature loosing of the prosthetic| Recalled the products| Tibial knee replacement component| Surface contamination| Recalled the products| Due the product liability created for patients’ health hazard a suit was field in the USA. A settlement trust was funded at close to US$1. 1 billion. It was a big junk of money. At that time settlement entailed the company a $725 million cash settlement. And the remaining portion was funded by insurers and Sulzer AG.
Cost of Product Liability| Country| Surgical Revision| Cost per patient (US$)| Total Settlement (US$)| USA| 3400| 200,000| 680 million| Canada| 780| | | Outside North America| 140| | | This product liability issue is a risk for the acquiring companies. So Zimmer should take this risk into consideration at the time of setting the required rate of return. * Significance of timing and Swiss Takeover Board (STB) regulations Swiss Takeover Board (STB) was a federal commission of Switzerland had the jurisdiction too issue general rules and ensure compliance with the provisions applicable to public takeover offers.
There are two laws in Switzerland that govern Merger and Acquisition (M&A) – corporate law and takeover law. There are certain specific provisions set by STB that has to be maintained by both the target firm and acquiring bidders. * The board of the target firm has to keep the shareholders fully informed about the potential takeover attempts. * Any potential takeovers were to be maid public by the respective acquiring company. * The target firms are required to consider any competing bids that were offered within the legislative offer period of 40 days. A bidder does not need the approval of the board to make an offer to the shareholders. * The takeover law prohibited any type of lock-up agreement entailing greater than 10% of gross assets without shareholder approval. The ruling prevented an initial bidder and target firm from dispersing key assets or shares at a discount in an effort to reduce the attractiveness of the targeted firm in hostile situation. The above provision provides some opportunity for Zimmer. First of all, the law prevented the initial bidder and the target from making the targeted firm less attractive for acquisition.
Moreover, Zimmer can negotiate with the shareholder bypassing the management. Though it should have seen like hostile bids, Zimmer could use this opportunity as the last resort. The discussion related to hostile bidding will be discussed in broader framework later in the study. Another significance of the STB regulations is the legislative offer period of 40 days for any competing bids. The proposals for M&A require a great deal of homework and involve huge transaction cost. Moreover, the bidders need to arrange the necessary financing for the acquisition. So, legislative offer period of 40 days is a big challenge for Zimmer. Consideration for Hostile Takeover A hostile takeover allows a suitor to take over a target company whose management is unwilling to agree to a merger or takeover. A takeover is considered “hostile” if the target company’s board rejects the offer, but the bidder continues to pursue it, or the bidder makes the offer directly after having announced its firm intention to make an offer. Hostile bids often reveal a serious conflict of interest between shareholders and directors. Shareholders are offered a chance to sell their shares, usually at substantially above the market price prior to the bid.
Directors stand to lose their jobs. Zimmer versus Centerpulse: If Zimmer place a counter bid it may perceived as hostile because of the following reasons The bid will be perceived as hostile If Zimmer place counter bid, they have to go directly to the shareholder’s if Centerpulse bypassing the management. Though it is allowed by law, it may not be taken positively by Swiss shareholders. So, Zimmer has to be careful to place counter bid and make sure that it is perceived as friendly take over by asserting that * It did not place a re-bid after being turned down by Centerpulse’s management It’s only considering a counter offer at this moment because Centerpulse has already agreed to S;N’s offer and Zimmer has to go for counter offer in 40 days. * Management of cultural differences between the U. S. and Swiss companies In most takeovers, both companies’ staff loses some productivity (and people) as employees divert their attention to their own place in the future, merged company. Also the Culture – the shared values, beliefs, and preferred ways to behave – is hard to control, and in most mergers, nobody tries very hard to do it.
The end result is that the culture usually is not as productive as it should be in the combined organization, molded primarily by the leader’s actions and politically adept or powerful people in each organization. But in case of Zimmer and Centerpulse, there is no tremendous amount of difference in the culture of two companies. Both the companies’ exhibit performance oriented culture and believe strongly in managing with local country nationals rather than through expatriates. So the merger will work. Considerations in International Acquisitions
A bidder typically considers the following target specific factors when estimating the cash flow that will be provided by the foreign target by the parent. Zimmer Holdings must consider the factors also when bidding for the foreign target Centerpulse: 1. Target‘s lead factors: The bidder belongs to medical technology industry and the target belongs to same industry but is has more diversified products. Zimmer’s sales include 100% orthopedic products where Centerpulse’s sales include around 60% of these products. Centerpulse has significant advantage in the following factors: * Loyal surgeon relationship Highly respected brands * The Winterthur manufacturing facility * Its platform in spine and dental market * Strong following with European physicians 2. Target’s currency condition: If a company plans to acquire a foreign target, it must also consider how future exchange rate movement may affect the target’s local currency cashflow which the firm may remit. The following chart shows the Swiss Franc is getting stronger over the years in terms of US dollars which is good for Zimmer because although their initial outlay when converted into Swiss Franc will be higher, the strengthen Franc will be favorable when remitted to US parent. . Target’s stock market clause: potential target firms that are publicly held are continuously valued in the in the market, so their stock prices can change rapidly. As the target firms stock price changes, the acceptable bid price necessary to buy the firm will likely change as well. The presence of Centerpulse in the stock market is shown below in a chronological order: Sulzer Medica listed in Swiss stock exchange(SM) in an IPO with 2. 6 million shares 1997 The shares were traded on the NYSE as ADR 10 ADR equaled 1 Swiss share 2001 Sulzer span off SM as a separate legal entity Current stock price 21. 30 per ADR . Taxes applicable to target: The tax laws applicable to foreign target are used to derive after tax cashflow. The acquisition of Centerpulse will give Zimmer tax benefit because Zimmer’s tax rate for this year is 33. 7 percent, and Centerpulse’s corporate tax rate as a stand-alone company is 29 percent. So it will give Zimmer a better effective blended tax rate. Better effective tax rate Tax rate of Centerpulse 29% Tax rate of Zimmer 33. 7% + = 5. The product portfolio of the target: Centerpulse has established a world wide presence in biomedical implants for orthopedic, cardiovascular and dental application.
It has a leading share in spine and joint replacement market not only in Switzerland but also in all except for few European countries. Zimmer do not have a strong position in Europe and spine, which is a growing business in orthopedics, Zimmer do not have a spine business at all. So Centerpulse is an attractive target for Zimmer. But the target faced some product liability suits regarding the products it had to recall for surface contamination which concerns Zimmer. Company Valuation – Centerpulse The overall value of the target firm and its ability to generate positive cash flow in future has been always a big issue for the acquiring firm.
The financial statements of Centerpulse indicate that the overall financial position of the company is reasonably unstable. The company had to recall many of its products during the year 2000 with had negative impact on the earning before tax of the company in the year 2001. But the company had changed its management recently and has well distributed product line including the spine products. The overall orthopedic industry demand has been increasing at a good pace and expected to grow at a double digit. And the company is back on track. It reported positive earning before tax for the year of 2002 and the first quarter of 2003.
Valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business. In the case of Centerpulse, the basic valuation of the company- the valuation made based on companies current scenarios and views, are conducted using Free Cash Flow to the Firm (FCFF) approach. The key assumptions and their explanations are given below Assumptions Sl. | Variables| Assumptions| Remarks| 1. Sales Growth | 13%| Revenues increased 1. 52% in fiscal 2001 compared to fiscal 2000, and 25% in fiscal 2002 but the prediction of lower earnings were made because of outstanding product liability| 2. | Cost of Goods Sold| 25%| COGS is considered as a percentage of sales based on historical observation| 3. | Research and Development Cost| 8%| R;D costs are considered as a percentage of sales based on historical observation| 4. | Selling, general ; administrative| 30%| SG;A costs are considered as a percentage of sales based on historical observation| 5. Depreciation and Amortization| 5%| D;A costs are considered as a percentage of sales based on historical observation| 6. | Capital Expenditure| 8%| To keep the pace with the sales growth Centerpulse has to invest more in capital machinery| 7. | Investment in Working Capital| 5%| Investment in working capital is considered as a percentage of sales based on historical observation| 8. | Terminal Growth Rate| 1%| | Determination of WACC of Centerpulse Cost of Debt| | Cost of debt | | Before Tax| 10%| Tax rate| 35%| After tax | 6. 5%| | | Cost of Equity| |
Before tax cost of debt| 10%| Equity risk premium| 6%| Cost of Equity| 16%| | | Target Capital Structure| | Debt to Asset| 35%| Debt to Equity| 65%| | | WACC| 12. 68%| Weighted average cost of capital is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. The calculation of the weighted average cost of capital of the company is shown on the table. Value of the firm (in millions) | | SF| US $| Enterprise Value| 3009| 2222| Add: Cash| 144| 106| Less: Debt| 261| 193| Equity Value| 2892| 2136| No. of Shares| 11. 86| 11. 86|
Value per Share| 244| 180| Value of Centerpulse Applying the above assumption and necessary calculation we get the following value of the firm. The exchange rate is 1. 354 SF per US $. Positive equity value of Centerpulse indicates that Zimmer can consider this company for acquisition. Simulation Analysis Simulation has been conducted using crystal ball software with 10000 trials. From our simulation analysis we get the following results: Mean Enterprise Value: The mean equity value is 2208 million. So if we use a point estimate we are predicting that mean value of the equity is US$ 2208 million.
Standard deviation: The standard deviation of the mean value of equity is 300 million. So, if we assume normal distribution then we can be 95% confident that the value of the enterprise will lie between plus and minus US$ 300 million. Statistics:| Forecast values| Trials| 10,000| Base Case| 2136| Mean| 2208| Standard Deviation| 300| Variance| 90271| Skewness| 0. 4022| Kurtosis| 3. 24| Coeff. of Variability| 0. 1361| Coefficient of Variability: The coefficient of variability is 0. 1361 so for each unit of return the risk is 13. 61 percent higher. So, the risk is lower per unit of return.
Company Valuation – Zimmer Holdings Zimmer Holdings has a very good presence in the USA orthopedic industry with the third highest marker share. Company’s operating profit has been increasing since it was listed in the NYSE. The statement of financial position also indicates the presence of strong asset base with lower debt to total asset. It indicates that the firm has excess debt capacity. In the case of Zimmer, the basic valuation of the company- the valuation made based on companies current scenarios and views, are conducted using Free Cash Flow to the Firm (FCFF) approach.
The key assumptions and their explanations are given below – Sl. | Variables| Assumptions| Remarks| 1. | Sales Growth | 13%| Revenues increased 13. 26% in fiscal 2001 compared to fiscal 2000, and 16. 44% in fiscal 2002 but the prediction of lower earnings were made because of outstanding product liability| 2. | Cost of Goods Sold| 26%| COGS is considered as a percentage of sales based on historical observation| 3. | Research and Development Cost| 10%| R&D costs are considered as a percentage of sales based on historical observation| 4. Selling, general & administrative| 35%| SG&A costs are considered as a percentage of sales based on historical observation| 5. | Depreciation and Amortization| 5%| D&A costs are considered as a percentage of sales based on historical observation| 6. | Capital Expenditure| 10%| To keep the pace with the sales growth Centerpulse has to invest more in capital machinery| 7. | Investment in Working Capital| 5%| Investment in working capital is considered as a percentage of sales based on historical observation| 8. | Terminal Growth Rate| 1. 5%| |
Determination of WACC of Zimmer Cost of Debt| | Cost of debt | | Before Tax| 8%| Tax rate| 35%| After tax | 5%| | | Cost of Equity| | Before tax cost of debt| 8%| Equity risk premium| 5%| Cost of Equity| 13%| | | Target Capital Structure| | Debt to Asset| 40%| Debt to Equity| 60%| | | WACC| 9. 88%| Weighted average cost of capital is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. The calculation of the weighted average cost of capital of the company is shown on the table. Value of the firm (in millions of US$) |
Enterprise Value| 9419. 12| Add: Cash| 15. 7| Less: Debt| 91. 8| Equity Value| 9343| No. of Shares| 200| Value per Share| 46. 7| Value of Zimmer Applying the above assumption and necessary calculation we get the following value of the firm. The exchange rate is 1. 354 SF per US $. Positive equity value of Centerpulse indicates that Zimmer can consider this company for acquisition. Simulation Analysis Simulation has been conducted using crystal ball software with 10000 trials. From our simulation analysis we get the following results: Mean Enterprise Value: The mean equity value is 9446. million. So if we use a point estimate we are predicting that mean value of the equity is US$ 9446. 9 million. Standard deviation: The standard deviation of the mean value of equity is 1282. 8 million. So, if we assume normal distribution then we can be 95% confident that the value of the enterprise will lie between plus and minus US$ 1282. 8 million. Statistics:| Forecast values| Trials| 10,000| Base Case| 9343. 0| Mean| 9446. 9| Standard Deviation| 1282. 8| Variance| 1645520. 3| Skewness| 0. 3732| Kurtosis| 3. 19| Coeff. of Variability| 0. 1358| Coefficient of Variability:
The coefficient of variability is 0. 1358 so for each unit of return the risk is 13. 58 percent higher. So, the risk is lower per unit of return. Alternative Acquisition Techniques There are two alternatives for Zimmer Holdings to go for higher acquisition offer than S;N. The Alternatives are – Alternative 1: Acquisition of Assets Zimmer can acquire Centerpulse by buying all of its assets. If Zimmer would go for this alternative then a formal vote of the shareholders of the selling firm is required. Acquisition of assets involves transferring title to assets Alternative 2: Acquisition of Stock
Zimmer can offer a fresh tender to Centerpulse to purchase the firms common stock in exchange for cash, share of stock or other securities. Alternative – 1: Acquisition of Assets In an alternative attempt Zimmer can bid for acquisition of the assets of Centerpulse. The assumptions for asset acquisition are – Sl. | Assumptions| 1. | Market Value of Property, Plant and Equipment is 140% of the Book Value| 2. | Market Value of Intangible assets are 180% of the Book Value| 3. | Market Value of other assets are 90% of the Book Value| 4. Property, Plant and Equipment will generate cash flow for 1o years| 5. | Intangible will generate cash flow for 15 years| 6. | Other Assets will generate cash flow for 7 years| 7. | Assets will not have any salvage value| 8. | Required rate of return on the Cash Flow generated from PPE will be 10%| 9. | Required rate of return on the Cash Flow generated from Intangible assets will be 10%| 10. | Required rate of return on the Cash Flow generated from other assets will be 10%| 11. | Initial Investment will be | NPV of Asset Acquisition = – 252. 58 million US$
Value of Zimmer Applying the above assumption and necessary calculation we get the following value of the firm. The exchange rate is 1. 354 SF per US $. Positive equity value of Centerpulse indicates that Zimmer can consider this company for acquisition. Value of the firm (in millions of US$) | Enterprise Value| 9419. 12| Add: Cash| 15. 7| Less: Debt| 91. 8| NPV from Asset Acquisition| -252. 58| Equity Value| 9090. 44| No. of Shares| 200| Value per Share| 45. 45| Zimmer should not go for asset acquisition because it will generate negative NPV. Alternative – 2: Acquisition of Stock
Sources of Synergy Zimmer can obtain synergistic benefit from various sources by acquiring Centerpulse. The sources of synergy from this acquisition can be divided in three broad categories. 1. Revenue Enhancement 2. Cost Reduction 3. Tax Gain 1. Revenue Enhancement: After the acquisition of Centerpulse, the Company will operations in more than 24 countries and markets products in more than 80 countries, with corporate headquarters in Warsaw, Indiana, and manufacturing, distribution and warehousing and/or office facilities in more than 60 locations worldwide.
The Company manages its operations through three major geographic segments – the Americas, which is comprised principally of the United States and includes other North, Central and South American markets; Europe, which is comprised principally of Europe and includes the Middle East and Africa; and Asia Pacific, which is comprised primarily of Japan and includes other Asian and Pacific markets. The company will also be able to generate a strong brand.
The Company sells product through two principal channels: 1) direct to health care institutions, such as hospitals, which is referred to as a direct channel account, and 2) through stocking distributors and, in the Asia Pacific region, healthcare dealers. Through the direct channel accounts, inventory is generally consigned to sales agents or customers so that products are available when needed for surgical procedures The company will enhance revenue from the following sources – 1. Increased Market Share 2. Geographic Expansion . Strong Brand Appearance 4. Diversified Product Line | Increased market Share| Geographic Expansion| Strong Brand Appearance| DiversifiedProduct Line| WACC of Zimmer| 9. 88%| 9. 88%| 9. 88%| 9. 88%| Add: Country Risk premium| 0. 50%| 0. 50%| | 0. 50%| Add: Product Liability Risk Premium| | | | 1. 5%| Add: Exchange rate risk premium| 0. 25%| 0. 25%| 0. 25%| 0. 25%| Required Rate of Return| 10. 63%| 10. 63%| 10. 13%| 12. 13%| Determination of the Present value of Cash Flow from Revenue Enhancement In millions of US$|
Revenue Enhancement| | 2003| 2004| 2005| 2006| 2007| 2008| 2009| 2010| Period| 0| 1| 2| 3| 4| 5| 6| 7| 8| Increased Market Share| | 160| 150| 145| 125| 122| 115| 90| 15| Geographic Expansion| | 100| 110| 88| 73| 68| 32| | | Strong Brand| | 65| 60| 40| 15| | | | | Diversified Product line| | 55| 47| 42| 31| 18| | | | Present Value of Cash Flow| 954. 38| | | | | | | | | 2. Cost Reduction The Company has extensive research and development activities underway to introduce new surgical techniques, materials, and product designs intended to advance the field of orthopedics.
The product development function is integrated with strategic brand marketing, which allows the Company to understand its customers’ needs and to respond more quickly with top-quality products. The rapid commercialization of innovative new materials, product designs, and surgical techniques remains one of the Company’s core strategies and continues to be an important driver of sales growth. After merging with Centerpulse we assume that the merged company will be able to scale down its R ; D expense. The Company uses a diverse and broad range of raw materials in the design, development and manufacturing of its products.
The Company purchases all of its raw materials and select components used in manufacturing its products from external suppliers. In addition, the Company purchases some supplies from single sources for reasons of quality assurance, sole source availability, cost effectiveness or constraints resulting from regulatory requirements. The Company works closely with its supplier to assure continuity of supply while maintaining high quality and reliability. After merging the company will be able to reduce the redundant overhead costs.
Also after acquisition, due to increase in size of the company the company will be able to obtain better credit rating which will reduce its cost of debt financing and also due to increase in size cost of equity will reduce. So, synergies from cost reduction are shown below: 1. Reduction of overhead costs 2. R;D Expenditure Reduction 3. Reduced Financing Cost | Reduction of Overhead Cost| R;D Expenditure Reduction| Reduced Financing Cost| WACC of Zimmer| 9. 88%| 9. 88%| 9. 88%| Add: Country Risk premium| 0. 50%| 0. 50%| 0. 50%| Add: Product Liability Risk Premium| 0. 5%| 0. 50%| | Add: Exchange rate risk premium| 0. 25%| 0. 25%| 0. 35%| Required Rate of Return| 11. 38%| 11. 13%| 10. 73%| Determination of the Present value of Cash Flow from Cost Reduction In millions of US$| Cost Reduction| | 2003| 2004| 2005| 2006| 2007| 2008| 2009| 2010| 2003| 2004| Period| 0| 1| 2| 3| 4| 5| 6| 7| 8| 9| 10| Reduction of Overhead Cost| | 45| 37| 22| 18| 11| 12| 8| 7| 5| 4| R;D Expenditure Reduction| | 32| 20| 18| 17| 14| | | | | | Reduced Financing Cost| | 28| 22| 18| 6| | | | | | | Present Value of Cash Flow| 190. 93| | | | | | | | | | | 3. Tax Gain
The effective tax rate for Zimmer is 33. 7%. On the other hand the effective tax rate of Centerpulse is 29%. So the firm can save 4. 7% tax by acquiring Centerpulse. It is assumed that the firm will enjoy tax gain for 5 years. WACC of Zimmer| 9. 88%| Add: Country Risk premium| 0. 50%| Add: Exchange rate risk premium| 0. 25%| Required Rate of Return| 10. 63%| Determination of the Present value of Cash Flow from Tax Gain In millions of US$| | | 2003| 2004| 2005| 2006| 2007| Period| 0| 1| 2| 3| 4| 5| Tax Gain| | 21| 24| 27| 30| 34| Present Value of Cash Flow| 58. 58| | | | | | Zimmer can generate $1. billion synergy by acquiring Centerpulse. This synergistic benefit will be added with the combined firm’s value. It is one of the major determinants of bidding price in case of acquisition. The overall synergistic benefit is given in the following table. In millions of US$| Sources of Synergy| Present Value| Revenue Enhancement| 954. 38| Cost Reduction| 190. 93| Tax Gain| 58. 58| Total Synergy| 1203. 89| Transaction Cost of Zimmer Transaction costs of acquisition involve several type of intermediary cost including fees to investment banker, legal fees, disclosure requirements and other costs.
Zimmer has to incur a special type of cost if it goes for acquiring Centerpulse. It will have to pay “break fees”. Often break fees occurred if circumstances caused an initial offer to fail. This fee, paid by the target firm, reimbursed the original bidder for costs associated with the bid. In the case of S;N/Centerpulse agreement, the break fee was set at CHF20 million, and in the S;N/Incentive Capital discussion, the fee was CHF4 million. Zimmer would pay this amount if it acquires Centerpulse. The current exchange rate is 1. 354 SF/US$. As a result Zimmer will bear $18 million as break fee. n millions of US$| Transaction Costs| Amount| Investment banker fee| 50| Legal fee| 32| Break fee| 18| Total| 100| Often break fees occurred if circumstances caused an initial offer to fail. This fee, paid by the target firm, reimbursed the original bidder for costs associated with the bid. In the case of S;N/Centerpulse agreement, the break fee was set at CHF20 million, and in the S;N/Incentive Capital discussion, the fee was CHF4 million. Zimmer would pay this amount if it acquires Centerpulse. The current exchange rate is 1. 354 SF/US$. As a result Zimmer will bear $18 million as break fee.
Combined Value of Zimmer before Final Offer Before going for acquisition bidding or offer it is important to identify the combined value of the firm. So the combined value of the firm before bidding proposal is given below – In millions of US$| Equity Value of Zimmer| 9343. 00| Add: Equity Value of Centerpulse| 2136. 00| Add: Value of Synergy| 1203. 89| Less: Transaction Cost| 100. 00| Less: Restructuring Cost| 160. 00| Less: Step-up Inventory| 250. 00| | | Combined Value before Bidding| 12,172. 89| Zimmer’s Final Bid to Centerpulse S;N offered CHF 282 for each share of Centerpulse.
As a result S;N will need CHF 3263. 4 million to acquire Centerpulse. So to Zimmer has to offer a higher bid to exceed S;N bidding. Here based on the value of Zimmer after acquisition of Centerpulse will offer CHF 3513. 52 million for acquisition of Centerpulse. The details of the Offering is given below – Value of the Deal | CHF 3513. 52 million| Exchange Rate| 1. 354 SF/US$| Value of the Deal| USD 2600 million| Zimmer offer should include a combination of 2 shares of Zimmer common stock and CHF 182 in cash in exchange for each Centerpulse share, for a total consideration of CHF 296 per share.
As a result Zimmer will make an offer for Centerpulse, at 53. 74% premium to the trading price 30 days prior. Financing Plan of the Acquisition The acquisition offer of Zimmer comprises both stock and cash. As a result Zimmer’s number of common stock and long term debt both will increase. The financing Plan of acquisition is given below: Issue of Common Stock | In millions| No of common share before acquisition| 200| New Issue| 23. 74| Total No of common share after acquisition| 223. 74| New share will be issued equivalent to current market price of $42. So the total additional paid in capital will be 23. 4*42 = US$ 997. 08 million. Long Term Debt Zimmer has to depend on the long term debt financing for payment of cash to the shareholders of Centerpulse. For this, it will borrow US$ 1,595. 52 million from USA. The exchange rate, SF/US$ = 1. 354. So it will pay CHF 2,160. 34 million to the shareholders of Centerpulse. Capital Structure after Acquisition | Equity| Debt| Debt to Equity| Before Acquisition| 543| 77| 0. 14| New Equity or Debt| 997. 08| 1595. 52| | After Acquisition| 1,540. 08| 1672. 52| 1. 08| *Figures in millions of US$ except Debt to Equity Combined Value of Zimmer after Final Offer
In millions of US$| Equity Value of Zimmer| 9,343. 00| Add: Equity Value of Centerpulse| 2,136. 00| Add: Value of Synergy| 1,204. 00| Less: Transaction Cost| 100. 00| Less: Restructuring Cost| 160. 00| Less: Step-up Inventory| 250. 00| Less: Zimmer’s Offer| 2,600. 00| | | Combined Value after Bidding| 9,573. 00| No. of Share Outstanding (in million)| 223. 74| Value per Share| 42. 80| For final tender offer Zimmer’s common stock will increase by 23. 74 million. So after acquisition total number of common share of Zimmer will increase to 223. 75 million. Simulation Analysis
Simulation has been conducted using crystal ball software with 10000 trials. From our simulation analysis we get the following results: Mean Enterprise Value: The mean equity value is 9658 million. So if we use a point estimate we are predicting that mean value of the equity is US$ 9658 million. Standard deviation: The standard deviation of the mean value of equity is 98 million. So, if we assume normal distribution then we can be 95% confident that the value of the enterprise will lie between plus and minus US$ 98 million. Statistics:| Forecast values| Trials| 10,000|
Base Case| 9573| Mean| 9658| Standard Deviation| 98| Variance| 9637| Skewness| 0. 5411| Kurtosis| 2. 50| Coeff. of Variability| 0. 0102| Coefficient of Variability: The coefficient of variability is 0. 0102 so for each unit of return the risk is 1. 08 percent higher. So, the risk is lower per unit of return. Opportunity to Expand in Dental Equipment Sector Zimmer does not have any product line related to dental medical equipment. If they become successful in acquiring the Centerpulse Zimmer would make a strong presence in Europe and also obtain Spine as is target product line.
At the same time Zimmer will be able to operate in dental medical equipment. But the share dental in Centerpulse’s sales was only 8. 9%. As the medical device industry is expected to grow at faster rate, the dental medical equipment will also grow at faster rate. So Zimmer can think about expanding this product line if they become successful in acquisition of Centerpulse. So here creates a real option. The valuation of the option is given below – Assumptions| | Initial Investment| 60| Growth of Sales of Dental Equipment| 10%| Cost of production| 30%| SG;A| 2%| Depreciation| 10%|
Interest Expense, net| 14%| Tax Rate| 35%| Risk free rate| 4. 8%| Before tax cost of debt| 8%| Equity Risk Premium| 5%| Cost of Equity| 13%| Cost of Debt| 5%| Target D/TA| 40%| Target E/TA| 60%| WACC| 9. 88%| Country Risk Premium| 0. 50%| Exchange rate risk premium| 0. 25%| Required Rate of Return| 10. 63%| Black-Scholes option pricing model has been used to generate the value of the expansion option Expansion Option in Dental Equipment Sector| | | | INPUT| | Initial investment | 60| Present value of all projects’ future expected cash flows| 97| Time before option expires| 2|
Risk free rate of return| 4. 84%| Standard deviation| 20%| OUTPUT| | d1| 2. 172665| d2| 1. 889823| N(d1)| 0. 985097| N(d2)| 0. 970609| Value of Option to Expand| 42. 44| Simulation Analysis Simulation has been conducted using crystal ball software with 10000 trials. From our simulation analysis we get the following results: Mean Enterprise Value: The mean equity value is 43. 59 million. So if we use a point estimate we are predicting that mean value of the equity is US$ 43. 59 million. Standard deviation: The standard deviation of the mean value of equity is 13. 37 million.
So, if we assume normal distribution then we can be 95% confident that the value of the enterprise will lie between plus and minus US$ 13. 37 million. Statistics:| Forecast values| Trials| 10,000| Base Case| 42. 44| Mean| 43. 59| Standard Deviation| 13. 37| Variance| 178. 82| Skewness| 0. 5344| Kurtosis| 3. 44| Coeff. of Variability| 0. 3067| Coefficient of Variability: The coefficient of variability is 0. 3067 so for each unit of return the risk is 30. 67 percent higher. So, the risk is moderately higher per unit of return. Here we assume that there is 50% probability that Zimmer will go for this expansion option.
So US$21. 22 million will be added with the Value of Zimmer. In millions of US$| Equity Value of Zimmer| 9,343. 00| Add: Equity Value of Centerpulse| 2,136. 00| Add: Value of Synergy| 1,204. 00| Less: Transaction Cost| 100. 00| Less: Restructuring Cost| 160. 00| Less: Step-up Inventory| 250. 00| Less: Zimmer’s Offer| 2,600. 00| Add: Value of the Expansion option| 21. 00| | | Combined Value after Bidding| 9,594. 00| | | No. of Share Outstanding (in million)| 223. 74| Value per Share| 43. 00| Recommendations Based on our analysis, we would like to make recommendations as follows: Most undamentally, a firm that is operating in the interests of its shareholders should try to accept all projects that increase the wealth of the shareholders. In case of Collinsville, we use NPV to approach to our recommendations. Based on our calculation, without the laminate addition, the NPV of Collinsville turns out to be negative (-3,703 thousand USD). Under this circumstance, we recommend not to invest in this project since it is against shareholders interests. But at the same time new Laminate Technology would allow company to considerably cut power cost and completely eliminate graphite costs.
Additional $2. 25 mln. USD is needed to install this new technology. We consider this technology as a subproject attached to Collinsville and calculate its NPV. The NPV of this new technology is 6,634 thousand USD. That means, by using laminate technology, NPV of Collinsville will change to 2,931 thousand USD. Under this new circumstances, our recommendation is to invest in Collinsville because it will not only increase the wealth of the shareholders, but also complement its strategy of supplying chemicals products to the paper and pulp industry.