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This was an interesting article.
It seems to me that Koala has not necessarily completely dropped the ball on these purchases. It really depends on the future compounding annual growth rate of the cash flows (cf).
For the sake of crunching some numbers, let us pretend Operating Income equals CF (in spite of logic).
Using some straightforward perpetuity pricing and a constant discount rate, we can determine whether value was created or destroyed. I'm going to use 13% as I see this being the opportunity cost of throwing $$ into VFINX. I've heard of much higher and much lower, and frankly, I haven't evaluated the risk of the business carefully enough to engage in an intelligent argument over the subject.
Here's what I get (keeping the $68,800,000 price tag in mind):
1) $3.5 million growing at 0.0% annually through perpetuity is worth roughly $26,923,000. Clearly, this is not what shareholders had in mind.
2) $3.5 million growing at 3.0% annually through perpetuity is worth roughly $36,050,000. Getting warmer, but again, clearly, this is not what shareholders had in mind.
3) $3.5 million growing at 7.5% annually through perpetuity is worth roughly $68,800,000. This is virtually getting exactly what Kola paid for, there is neither value creation or deterioration. Any growth above and beyond this will create incremental value under these assumptions. This could happen by not only growing at a faster rate but it could be related to onetime acquisition related expenses going away.
It seems that a fair amount of the transactions occurred in 1999 & 2000. There is definitely a transition period to ensue, the length is difficult to say. But one can imagine that there are expenses related to SG&A severance, corporate system/methodology training, asset integration, etc... that are onetime. Not only are the potential synergies outstanding, but, Koala has to pay even more early on to realize them, but they could & should ensue. This could understate the early results of the merged entities, rather than the results growing linearly, they could be moving along a curved line.
Even still, the opportunity may never be ceased for one reason or another. In which case, 7.5% annual, organic growth through eternity is a fairly tall order.
Food for thought. Cheers,
Nate
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Alright,
Having read my post after putting it on display (a nasty habbit), I must mention that I [obviously] meant seize versus cease.
Although, contextually, both may work...
What do you expect from a fool?
Cheers,
Nate
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Nate:
Are Habbits related to Hobbits?
Seriously, thanks for your insightful post.
Slee
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What do you expect from a fool?
Plenty, Nate! And you've done us all fellow Fools proud with your great post.
As a fan of Koala, I can see why it had to grow through acquisitions. The market just hasn't been as forgiving with the industrywide hiccups and Koala's inability to make it all gel together on a bottom line basis.
Rick
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Thanks Rick! It's nice to know the perspective is appreciated. It's a highlevel articulation, but the concept seems valid. Koala didn't simply trade $68.8 mil for a onetime $3.5 mil, but rather a growing annuity.
The market hasn't been too forgiving as of late, perhaps to extent where the selloffs are exaggerated. In any case, the punishment could very well be a shortterm phenomenon. Whereas the market may be overcomplimentary of success' in two years. If the market is punishing Koala for not creating a scenario of overnight gelling of a rather large series of asset integrations than it is quite possible that the market is acting in a shortsighted paradigm, which in turn creates opportunity for the longterm investor. It simply isn't reasonable to expect Koala to achieve it's merged operating potential over such short time frame, and if the price is based on the straightening of these shortrun results, the price may be artificially low.
I'd like to provide another example to sure up the thinking. Let's continue with the paradigm of a 13% annual discount rate and that NI equals $3.5 which in turn converts to cash. I'm oversimplifying here but time is of the essence in my particular case.
Typically invest bankers charge 1%  2% of the transaction value as does legal counsel (this is probably being amortized in the IS (but we're considering CF)). Using TMF Centaur's numbers, Koala paid $30 mil. during 2000 for future annuities. Using the greater in the aforementioned range, 4% (total) of $30 mil. ($1.2 mil.) would be spent in year 1 (2000) of the deal which would not occur in 2001 and beyond. This obviously affects the valuation.
I've revised my perpetuity to demonstrate $3.5 mil. in year 1 and $4.7 mi. in year 2 compounding into eternity.
At a 3% growth rate this scenario yields a present value of $46.3 mil.
At a 6.2% growth rate, this scenario yields a PV of $68.8 mil.
I've dropped my 0% growth rate scenario. Even if management maintains the status quo and fails to grow the business in real terms, the nominal results should follow the CPI to some extent, I'll use 3%.
Now, these are two save areas, and there are potentially many more. If I assume there's another $1 mil. in saves outstanding to be realized in year 2, I yield $3.5 in year 1 and $5.7 mil. in year two compounding through eternity. To get back to the $68.8 mil. price tag, the nominal results must grow at 4.9% per annum, or 1.9% in real terms. This doesn't strike me as such a tall order, especially if they can get a couple of extraordinary years in the first 10 years of the deals. Obviously, this type of revenue/expense shifting would affect the ROA & P/E calculations TMF Centaur was cringing over. I do agree with TMF Centaur that in the short run, the debt:equity ratio does cause some heartburn. Although, as the old saying goes, 'if Koala owes the bank $1 mil., Koala (it's shareholders) has a problem. If Koala owes the bank $100 mil., the bank has a problem.' And Koala in turn may find itself with a collaborative partner.
If this were a duel and I put some more time into itemizing the real numbers, I believe I could nobly defend the bull argument. In fact, I may even be so bold to argue that Koala could very well be a value oriented buying opportunity.
More food for thought.
Cheers,
Nate
P.S.  Slee, I can't be too sure. What's your take? Have a nice day.
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Slee, I can't be too sure. What's your take?
I haven't digested all your analysis yet, but I think it is intriguing. One fly in the ointment is that, so far, the acquisitions are growing at approximately 0%, but I agree that they likely will resume growing at some point.
How much do your calculations change if you do not assume perpetual growth, but instead assume grwoth of X% for 10 years (for example), followed by perpetual growth at a lower rate (say 5% or 3%)?
Slee
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"How much do your calculations change if you do not assume perpetual growth, but instead assume grwoth of X% for 10 years (for example), followed by perpetual growth at a lower rate (say 5% or 3%)?"
I was actually asking about the hobbit/habit relationship! But to address your new questions (thank goodness I saved the spreadsheet this time!):
In the situation where the unidentified $1,000,000 (on top of IBanker and Attorney fees) in saves were realized pronto, the perpetual growth rate was less than 5%. Since I enjoy cooking up numbers and you left me with little in terms of specifics, I cooked up the following scenarios. In all examples, I'm using a 13% discount rate per annum and I'm discounting by halfyear, assuming the cash comes in over the course of the year (which may not be valid in a spoton analysis with the cash lagging on accrued revenue). In all scenarios, I solved to realize a present value of $68,000,000.
Scenario 1
Other than the Ibanker and Legal Fees, there are no synergies. Cash Flow at time .5 = $3.5 mil and at time 1.5 = $4.7 mil.
3% Perpetuity: Cash flow from years 210 must grow at 10% to break even.
4% Perpetuity: Cash flow from years 210 must grow at 9% to break even.
5% Perpetuity: Cash flow from years 210 must grow at 8% to break even.
Scenario 2
Other than the Ibanker and Legal Fees, there are incremental synergies totaling $1 mil. Cash Flow at time .5 = $3.5 mil and at time1.5 = $5.7 mil.
3% Perpetuity: Cash flow from years 210 must grow at 7% to break even.
4% Perpetuity: Cash flow from years 210 must grow at 6% to break even.
5% Perpetuity: Cash flow from years 210 must grow at 5% to break even.
Hopefully that effectively demonstrates the change. I'm more inclined to say scenario 2 should be closer to realistic expectation levels.
Incidentally, did you follow what I meant by nominal versus real? I simply meant that inflation will account for 3% reported growth (assuming constant margins). If that's the case, the 3% growth scenario assumes that there is zero real expansion.
Cheers,
Nate
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Nate,
I need your help. What is the formula for calculating the present value of an income stream of X, growing at an annual rate of Y against a discount rate of Z? In other words, how did you do the calculations of the value of KARE's acquisitions? This wasn't covered in my high school math class.
Slee
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Perhaps not in high school, definitely not where I learned it. Although, the algebra/calculus fundamentals were indeed instilled at this particular education level.
I think I was fairly clear on which growth rates I used and in which given years.
In any case I'm going to keep it simple for your sake. The perpetuity formula is not user friendly for your last round of sensitivities in changing growth rates etc….So I'll give you PV formula and the compounding growth formula. Christmas in July! The formula for a cashflow value at time T is:
PV = CF/(1 + discount rate)^year (annual compounding).
If you take the individual PV's sum them, you get the NPV of the inflow. Net it against the price (the NPV of the outflow @ time 0), and you get the project's NPV.
This assumes that the growth rate is embedded/demonstrated in CF.
CF with growth is CF(year b) x (1 + annual growth rate)^(year c year b) (annual compounding).
These are the formulas I used in my second round, your requested sensitivities.
I could throw some perpetuity formulas your direction, but my guess is that it's more simple to just use these and carry the formulas across excel 200 columns or so. Incidentally, do not do 400 calculations by hand, if push comes to shove, I can email you my spreadsheet which you can then play with. This way you can change your growth rates, see the timeline (etc...).
Hope this is relatively straightforward.
Cheers,
Nate
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