EQUITY VALUATION OF CRYOLIFE. ALPHA TEAM Peter Brady, Mason Tiffin, Grayson Blank, Koviessou Kotokou

Transcription

1 2015 EQUITY VALUATION OF CRYOLIFE ALPHA TEAM Peter Brady, Mason Tiffin, Grayson Blank, Koviessou Kotokou 0

2 Table of Contents Executive Summary... 6 Industry Analysis... 7 Accounting Analysis... 8 Financial Analysis... 9 Valuation Analysis Introduction to Analysis Company Overview Industry Overview and Analysis Rivalry among Existing Firms Industry Growth Concentration Differentiation and Switching Costs Conclusion Threat of New Entrants First Mover Advantage Distribution Relationships Legal Barriers Conclusion Threat of Substitutes Relative Price and Performance of Substitutes Customers Willingness to Switch Conclusion Bargaining Power of Suppliers Switching Costs Product Differentiation Quantity of Suppliers Conclusion Bargain Power of Customers Switching Costs Differentiation

3 Importance of Products for Cost and Quality Number of Customers and Volume per Customer Conclusion Classification of Industry Analysis of Key Success Factors Differentiation Research & Development Product Quality Customer Service and Relationships Competitive Advantage Analysis for CryoLife Differentiation Introduction to Accounting Analysis Key Accounting Polices Type One Accounting Policies Product Quality Brand Image Risks and Risk Practices Type Two Accounting Policies Relative Mix and Use of Operating vs. Capital Leases Accounting for Pensions Assessing Degree of Accounting Flexibility Operating/Capital Leases Pension Liabilities Goodwill Conclusion on Flexibility Evaluation of Actual Accounting Strategy Quality of Disclosure Risk Factors Products and Processes Goodwill Research and Development Conclusion Conservative vs. Aggressive Policy

4 Goodwill Operating and Capital Leases Pension Plan Research and Development Conclusion on Evaluation Quality of Disclosure Qualitative Measure of Accounting Quality Research and Development Goodwill Quantitative Measures of Accounting Quality Restated Financial Statements Identifying Potential Red Flags Goodwill Research and Development Leases Conclusion Introduction to Financial Analysis Ratio Analysis Liquidity Ratios Current Ratio Quick Ratio Operating Efficiency Ratios Inventory Turnover Accounts Receivable Turnover Working Capital Turnover Days Supply of Inventory Days Sales Outstanding Cash-to-Cash Cycle Property, Plant & Equipment Turnover Conclusion Profitability Ratios Gross Profit Margin Operating Profit Margin

5 Net Profit Margin Asset Turnover Return on Assets Return on Equity Conclusion Capital Structure Ratios Internal Growth Rate Sustainable Growth Rate Altman Z-Score Conclusion Table of CryoLife s Ratios Table of CryoLife s Restated Ratios Financial Forecasting Income Statement Dividends Forecasting Balance Sheet Statement of Cash Flows Cost of Capital Estimation Cost of Equity Backdoor Cost of Equity Cost of Debt The Weighted Average Cost of Capital (WACC) Conclusion Summary of Financial Analysis Price Multiples Valuation & Analysis EPS P/E Trailing P/E Forward Price to Book Dividend to Price P.E.G. Ratio P/EBITDA P/FCF per Share

6 EV/EBITDA Enterprise Value Valuation Models Discounted Dividend Model Free Cash Flow Model Residual Income Model Long-Run Residual Income Model Abnormal Earnings Growth Model Appendix Works Cited

7 Executive Summary Analyst Recommendation: SELL (OVERVALUED) CRY - NYSE ( 5/5/2015) Cost of Capital 52 Week Range $ 8.40 $ Estimated Adj. R 2 Beta Size Adj. K e Revenue M 3-Month 18.83% % Market Capitalization M 1-Year 18.68% % Shares Outstanding 29.23M 2-Year 18.84% % 7-Year 18.85% % As Stated Restated 10-Year 18.83% % Book Value Per Share Return on Assets 4.19% 3.70% Return on Equity 5.06% 4.40% Backdoor K e 5.78% WACC BT 14.28% Financial Based Valuations Published Beta 1.51 As Stated Restated Trailing P/E Lower Bound Center Value Upper Bound Forward P/E K e 5.76% 11.88% 18.04% Dividends to Price Size Adjusted K e 8.66% 14.78% 20.94% PEG Ratio WACC BT 8.47% 14.28% 20.09% Price to Book Intrinsic Valuations Price to EBITDA Restated EV/EBITDA Discounted Dividends $ 1.76 Altman Z-Scores Free Cash Flows $ Residual Income $ 2.63 Initial Scores Long-Run Residual 8.98 Income $ 4.26 Revised Scores Abnormal Earnings 8.95 Growth $

8 Industry Analysis CryoLife is one of the leading medical supplies company providing cardiac and vascular tissues, surgical adhesives, and sealants. The selected benchmark competitors chosen is composed of Merit Medical Systems, Lemaitre Vascular Inc., and Vascular Solutions. We, the analysts, chose those firms because of the similarities of products offered and the level of performance in the industry relative to Price-to-Earnings (P/E), Earnings per Share (EPS), and revenue growth. From the analysis of the industry we reach the following results through use of Porter s Five Forces: CryoLife Rivalry among existing firms Threat of New Entrants Threat of substitutes Products Bargain power of Suppliers Bargain Power of customers Level of Competition Mixed Low Low Mixed Mixed The rivalry among the existing firms is mixed due to the impact of innovation. Each firm competes based on product innovation and tries to gain a larger market share from other firms. In addition, the industry tries to develop relationships with hospitals to establish brand loyalty with its customers. This brand loyalty ensures future benefit and builds preferences over competitors products. Entering in the medical industry is really difficult because of the regulations implemented by health departments and standards imposed by the International Standards Organization (ISO). The Food and Drug Administration (FDA) standardizes the conditions for which a product can be sold to the public. To survive competition firms in the industry need to acquire many patents, trademark and licenses in order to perform in U.S. and abroad. 7

9 Because of fewer substitutes available to customers, the demand of the products offered by the industry is inelastic. Consequently, customers will always prefer higher quality products for their health care needs. The bargain power of suppliers is mixed because there is a significant number of suppliers for certain products offered, such as human tissues. However, for new product technologies developed, the number of suppliers is smaller than established product line. The bargain power of customers is mixed because health organizations have buyer groups to negotiate the prices, but because of the few substitutes available in the market they cannot exclusively dictate the terms of contracts. Overall, the industry is highly competitive because each firm is always innovating and tries to develop a relationship with hospitals in order to ensure future benefits. The industry uses the differentiation technique by investing in research and development, ensuring product quality, and developing customer relationship. Accounting Analysis After looking at the industry analysis, we the analysts have examined the accounting aspect of CryoLife as well as the industry. This is necessary because the flexibility allowed by U.S. GAAP can lead to the misleading of financial statements. The accounting analysis consists of identifying the key accounting policies. There are two types of accounting policies: type one and type two. Type one for CryoLife regroups disclosure about the product quality, brand image and the risk practices associated with the business. We conclude that CryoLife discloses more information about its products, services, and business operations than the selected benchmarks. Type two accounting policies include disclosure regarding capital leases and operating leases, pension liabilities, and Goodwill. The industry, as well as CryoLife, has a moderate disclosure concerning those elements and can be sources of Red Flags. Red flags are business practices that might cause distortions in accounting statements due to a misunderstanding of the structure. 8

10 Overall, CryoLife has implemented a conservative method of accounting and has a high level of disclosure regarding its accounting policies. Financial Analysis The third major point in our valuation of CryoLife is financial analysis. The financial analysis consists of ratios analysis, financial forecasting, and the determination of the cost of capital before and after tax. For the ratio analysis, we study the liquidity ratio, the operating efficiency ratio, the profitability ratio, and the capital structure of CryoLife. After we have determined these ratios for CryoLife they are compared to the benchmark competitors. Doing this allows for analysis on an absolute and relative basis. By definition, the liquidity ratios are quick measures of a firm s ability to provide sufficient cash to conduct business over the next few months. On average the liquidity ratio of the industry is greater than one. That means that the industry has enough liquidity to cover its short term debt; however, due to the fluctuation of these ratios over the period, comparisons vary widely. The quick ratio of CryoLife is steady between 2011 and 2013 compare to the average of industry. Quick Ratio Current Ratio CryoLife Lemaitre CryoLife Lemaitre Vascular Solutions Merit Medical Vascular Solutions Merit Medical Exclusion Mean Exclusion Mean Operating efficiency ratios are also used to determine how quickly a firm can convert their products and services into cash. The following table shows the operating ratio compare to the trend. 9

11 Operating efficiency ratio Ratios Performance Trend Inventory Turnover Outperforming Stable Account Receivable turnover Decreasing Increasing Working capital turnover Underperforming Stable Days Supply Turnover Outperforming Decreasing Days sales outstanding Outperforming Decreasing Cash to cash cycle Outperforming Decreasing The profitability ratios measure how effectively a firm s management is generating profits on sales, total assets and most importantly stockholders investment. The following chart summarizes the profitability ratio of the industry. Profitability Ratio Ratios Performance Trend Gross Margin Underperforming Stable Operating Profit Margin Underperforming Stable Net Profit Margin stable decreasing Asset Turnover stable decreasing Return on Asset Stable and underperforming decreasing Return on Equity Stable and underperforming stable Internal Growth rate Stable decreasing Sustained Growth rate Stable decreasing After conducting the ratios, we were able to forecast the net income, the balance sheet and the statement of Cash Flows over a period of 10 years. We recognize that forecasting is not an exact science, and our forecasting includes many assumptions based on the structure of the organization. We started the forecast by determining the 10

12 sale growth and the trend of different components of the income statement through ratios. After completing the income statement forecast we use the information of the income statement such as the net income to input values in the balance sheet. For example the net income impact the retained earnings in the balance sheet. We also forecast the statement of cash flow that is very volatile and very hard to do. We analysts use the property, plant and equipment turnover ratio to forecast the investing cash flows and the CFFO/Sales ratio for the operating cash flow. Concerning the cost of capital, we analysts determine the cost of equity thanks to the security market line (SML) model and run some regressions over different time period of the Treasury bond. Finally, we determine the WACC before and after tax of the company. This table summarizes our finding of the WACC that is 14.28% before tax and 14.18% after tax. Amount in thousand weight rate Weight*rate WACC MV Liability 16,130 5% 4.75% 0.24% MV Equity 303,105 95% 14.78% 14.04% MV Firm 319, % WACC BT=14.28% WACC AT =14.18% 11

13 Valuation Analysis Our analysis used five valuation models: discounted dividends, the free cash flow model, the residual income, the Long Run ROE and the abnormal earning growth model. The discounted dividends consists of determining the value of the shares based on the dividends. After that, we analysts, compared that amount to different level of cost of capital and growth rate. The free cash flow consists of determining the value of the price based of the free cash flow, and because the free cash flow includes taxes from net income; we need to use the WACC before tax for the computation. However, the residual income uses the cost of capital and a decay rate to make the model work. The long run ROE established a relationship between the market to book value and ROE, cost of capital (k e ) and growth rate (g). It gives two sets of information between today s information and the present value of future growth. Finally, the abnormal earnings growth gives information about what the firm delivers in earnings and what it should deliver (the expected earning). For all five of the models we ran a sensitivity analysis to determine how much the model may change if our base assumptions change. Overall, from the valuation analysis, we analysts, conclude that CryoLife is overvalued. 12

14 Introduction to Analysis Our team of analysts has been looking at the company CryoLife and the medical devices industry. In this draft we set out to perform an in-depth analysis of how a firm can create a competitive advantage in the medical devices industry using the five forces model developed by Michael Porter. In addition, we have also used the five forces model to analyze threats to firms in the industry. In our view, the Threat of New Entrants is low, largely due to significant barriers to entry in the industry. The Threat of Substitutes is relatively medium, while most products have a substitute available, customer willingness to switch is lower than most industries due to preferences among buyers. When looking into the bargaining powers in the industry we concluded that suppliers in the industry have a great deal of bargaining power over those who purchase intermediate goods. The buyers, however, have relatively low buying power, largely because of the nature of the products in the industry and the high levels of demand that exist. Our analysis of the industry using the five forces model leads us to the conclusion that Research and Development, Product Quality, Brand Image and Customer Relations are the factors that create value in the medical devices industry. Looking in relation to CryoLife we have determined that the firm s competitive advantages are Quality Tissue from Human Sources, Exclusivity Rights and Patents, Innovation, and Product Awareness. Company Overview CryoLife was founded in 1984 just outside of Atlanta Georgia with the purpose of meeting the market demand for high quality biomedical supplies and tissues. CryoLife started with 6 employees in a small facility; however, today CryoLife has a 21 acres campus right outside Atlanta with more than 500 employees on staff in addition to those at CryoLife Europa, a fully owned subsidiary of CryoLife that is based outside London England and services the European and Mediterranean markets. In February of 13

15 2014 CryoLife opened a Sales and Marketing Center in Singapore to support their business in Pacific Rim countries such as Japan, China, South East Asia, Australia, Malaysia and Indonesia. 14

16 CryoLife provides many countries with state-of-the-art biomedical supplies and services. Their products and services range from human vascular and cardiac tissues to surgical sealants and adhesives to even hemodialysis access grafts for end-stage venal disease patients. CryoLife has been regarded as the world leading medical devices company offering products such as BioGlue, BioFoam, HeRo Grafts, and PerClot to over eighty different countries around the world. In addition to CryoLife s state-of-the-art products, the company also provide revascularization technologies and tissue preservation services. These services consist of high-tech laser consoles and human vascular and cardiac tissues. CryoLife s PHT Platform consists of their BioGlue, BioFoam, and PerClot products that surgeons use for cardiac and vascular surgery and also for the surgical healing and sealing of wounds. BioGlue is a proprietary product designed and manufactured by CryoLife. It is a bovine blood protein polymer used to heal wound edges in order to facilitate natural body healing. CryoLife created BioGlue to be a natural alternative for using staples or sutures as these sometimes cannot consistently eliminate fluids and air leakage from the site of a wound that is under pressure. With the use of BioGlue to seal the exposed area of pressurized tissue, much like that of vascular tissue, fluids and air cannot leak from the tissue and cause added risk from depressurization. The product will actually polymerize in only twenty to thirty seconds and will fully bond in two minutes. BioGlue has many surgical uses in vascular tissue, human lungs, Dural membrane around the spinal cord and brain, as well as in the gastrointestinal tract of the human body. BioFoam, another proprietary product designed and manufactured by CryoLife, is an expansion agent made of protein hydrogel that generates multi-cell foam. The foam that it creates allows for a barrier to lower blood flow, while also creating pores for which blood can pass through. This barrier helps to promote cellular aggregation and hemostasis resulting in quicker recovery and a decrease in levels of complications. 15

17 Once the foam sets, it potentially will seal vital organs and promote hemostasis while preventing trauma to organs. PerClot is a hemostatic agent for use in controlling inter-operative bleeding. It can be used during surgery in order to lower blood loss of the patient and for surgeons to maintain visibility of the operation sites. This product reduces operation times and the amount of blood transfusions needed for procedures. This product is very easy to incorporate because it is a powered hemostatic agent that is absorbed within saline. A patient can be given the PerClot saturated saline for several days prior to operation in order to reduce blood loss during the proposed operation. CryoLife s revascularization technologies consist of Holmium, a YAG laser console used for patients suffering from coronary artery disease with severe angina. The patients that these technologies are used for, have had adverse responses to the conventional therapies for their disease. The use of Holmium in the procedure called transmyocardial revascularization allows these patients to be treated for their ailment when other therapies have failed. CryoLife acquired Cardiogenesis, developer of this technology, in May 2011, who now provides the servicing and the maintenance of their product on CryoLife s behalf. CryoLife takes part in the distribution of human vascular tissue and cardiac tissue. They sell these tissues to different implanting institutions around the United States, Europe, and Canada. CryoLife must process these human tissues from donor institutions and preserve them with their proprietary process called, CryoPreservation. There are many advantages to using preserved human tissue in surgery such as natural blood flow, lower amounts of long-term drugs needed to prevent the clotting of blood, and reduced risk of failure, calcification, or stroke from the recipient of the tissues. CryoLife preserves two different types of cardiac tissue CryoValve SGPV and CryoPatch SG. They also have two different types of vascular tissues CryoVein and CryoArtery. 16

18 CryoLife Total Assets 120, ,000 80,000 60,000 40,000 20, TA 95, ,490 83,870 77, , ,028 Figure #1 (Source: 10-K) Through a mix of new product creation, acquisitions, and improved distribution channels, CryoLife s assets have grown from the 2009 level to the 2014 level, shown in Figure 1. The exception to the growth is in years 2011 and 2012 when CryoLife facilitated all cash tender offers for Hemosphere and CardioGenesis. CryoLife s current market capitalization is $ Million; this is comparatively small for the medical devices industry average market cap of $ million. Historically, the company s stock has underperformed compared to the industry as a whole. 17

19 Stock Performance /2/2009 1/2/2010 1/2/2011 1/2/2012 1/2/2013 1/2/2014 1/2/2015 CryoLife LeMaitre Merit Medical Vascular Currently the stock trades in the upper $11 range, indicated by the blue plot in the chart above; however, in the past CryoLife was often trading over $40 per share. The sharp fall from the $40 price point in the summer of 2002 was due to a lawsuit resulting from a fatality which was caused by a CryoLife orthopedic tissue. Even though this lawsuit and negative publicity did not bring about the end of the company, the event had repercussions that CryoLife is still recovering from. Regardless, the company s stock has remained stable recently and has seen moderate growth, below the level of market growth. It is a safe assessment to declare that the company has yet to see the growth patterns that it experienced earlier before the fatality that occurred in The distinction between different types of revenues is in coordination with the type of benefit that they bring to the end client. Defining these revenues breaks down into products for surgery and traumatic wound care and revascularization, as well as services in the field of preservation and distribution of human cardiac and vascular tissues. We, the analysts, believe that it is important to distinguish the different revenues in conjunction with the corresponding products and product segments for the purpose of quantifying potential opportunities for CryoLife and its subsidiaries, Hemosphere and Cardiogenesis, as well as acknowledge potential weaknesses. 18

20 Competition in the medical appliances and equipment sector is very strong, with a high demand for these products comes a large amount companies ready to provide the necessary products and services. In relation to CryoLife, we believe that the companies Merit Medical Systems, Lemaitre Vascular Inc., and Vascular Solutions are an optimal population to represent the competitive nature of the industry. The reasons that we have picked these competitors for revenue comparison are due to their similar product offerings as well as the fact that their levels of performance in regards to Priceto-Earnings (P/E), Earnings Per Share (EPS), and revenue growth all fall within one standard deviation of those belonging to CryoLife. For CryoLife, the majority of their revenues are based off of products that they provide to hospitals, clinics, and other health providers. Included in this product class are the aforementioned BioGlue, BioFoam, PerClot, revascularization technologies, and HeRO Graft. In the chart seen below, Figure #2, it can be seen that revenues from BioGlue and BioFoam comprise the largest portion of total product revenue. The other major sources of product revenue for CryoLife are going to be Revascularization Technologies and HeRO Graft, a product which replaced HemoStase in Services are also going to be a source of revenue for CryoLife. These services break down into tissue preservation and transportation. Due to the lawsuit in 2002 orthopedic tissue services were discontinued in 2009 because of shrinking revenues. The major services that CryoLife offers are going to be the preservation of cardiac and vascular tissue. These tissues services together comprise of the vast majority of all services revenue in the earlier years and then all of services revenue after the year

21 Products: Preservation Services: BioGlue and BioFoam 96.19% 88.45% 84.06% 83.28% 78.84% 76.13% 75.83% PerClot 0.00% 0.00% 0.47% 4.26% 4.56% 4.59% 5.24% Revascularization technologies 0.00% 0.00% 0.00% 9.61% 11.99% 11.77% 10.04% HeRO Graft 0.00% 0.00% 0.00% 0.00% 4.62% 7.52% 8.71% HemoStase 3.03% 11.09% 15.60% 2.86% 0.00% 0.00% 0.00% ProCol 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.18% Other 0.77% 0.46% -0.12% 0.00% 0.00% 0.00% 0.00% Total Product Revenue: % % % % % % % Cardiac Tissue 47.79% 46.18% 46.88% 44.52% 46.78% 45.77% 46.91% Vascular Tissue 50.85% 53.49% 53.12% 55.48% 53.22% 54.23% 53.09% Orthopaedic Tissue 1.36% 0.32% 0.00% 0.00% 0.00% 0.00% 0.00% Total Preservation Services: % % % % % % % Product Revenue: 48.19% 48.50% 48.33% 49.64% 51.24% 54.13% 56.61% Preservation Services: 50.95% 50.55% 51.20% 49.98% 48.29% 45.82% 43.39% Total Revenue: % % % % % % % Figure # 2 (Source: 10-ks 2008, 2009, 2010, 2011, 2012, 2013, 2014) The Chart above, Figure #2, shows many changes that have occurred within the company over the past seven years. Acquisitions of Hemosphere and CardioGenesis resulted in the introduction of new revenue sources. These revenue sources are Revascularization Technologies and HeRO Graft. Because of the introduction of these new sources of product revenue Hemostasis and revenue tiled Other have been discontinued. This is important because it shows that CryoLife is adapting to new market demands for innovative products. The change in the company is also reflected in the percentages of product revenue and service revenue to total revenues. In 2008 CryoLife was a fairly mixed company, receiving nearly half of its revenue from products with a slight majority of revenues coming from services. Since this time period there has been a shift in CryoLife from a company that received most revenues from services to a company that thrives off of product revenue. 20

22 Share of Product Revenue 70,000 60,000 50,000 40,000 30,000 20,000 10, , BioGlue and BioFoam Revascularization technologies HemoStase Other PerClot HeRO Graft ProCol Figure #3 (Source information from company 10-ks 2008, 2009, 2010, 2011, 2012, 2013, 2014) Shares of Total Revenues products Preservation services others revenues 21

23 Figure #4 (Source information from company 10-ks 2008, 2009, 2010, 2011, 2012, 2013, 2014) CryoValve, a division of the company, is a major source of revenue for CryoLife through preservation and distribution services. These services are responsible for on average forty-six percent of average total revenues over six years while offering the most stable form of growth for the company, shown in Figure #4. 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 Share of Service Revenue Cardiac Tissue Vascular Tissue Orthopaedic Tissue Figure #5 (Source information from company 10-ks 2008, 2009, 2010, 2011, 2012,2013, 2014) Concerning the effect of these products on such a large amount of revenues for CryoLife, year-over-year growth rates appears to be stable for product revenue, total revenues and preservation services, with exception for the termed other revenues, which has seen marginally increasing declines in revenues over the course of our six year time horizon, Shown in Figure #5. 22

24 Year-Over-Year Growth Rate 60.00% 40.00% 20.00% 0.00% % % % % % % Product Revenue Other Revenue Services Revenue Total Revenue Figure #5 (Source information from company 10-ks 2009, 2010, 2011, 2012, 2013) CryoLife operates and distributes their products to the medical industry around the world. For BioGlue, CryoLife distributes to over eighty countries, excluding the United States. Their distribution is used for repairing soft tissue within the European Economic Area includes twenty-eight European Union countries, four European Free Trade Association countries, and Turkey. They also distribute to Japan for aortic dissection. BioFoam was given a $5.4 million grant from the United States Government. CryoLife s facilities in London and Atlanta are located close to major Airports, this is crucial for CryoLife s preservation business as it often provides faster transfer of tissues and products to customers. Initially CryoLife would send tissue to the hospitals with a representative, but as their customer base grew it was no longer possible to send someone to ensure proper delivery and thawing of tissue. CryoLife began purchasing liquid nitrogen freezers and installing them in hospitals that had the largest accounts so that surgeons could keep inventory on hand. Operationally the company is run out of the office in Georgia and is assisted by a large staff of sales representatives and the two international offices. 23

25 Industry Overview and Analysis To accurately analyze the medical devices industry, three benchmark companies have been selected to compare and contrast to CryoLife. The process for selecting competitor benchmarks was quite simple; select companies in the same industry that produce similar products and exhibit similar metrics. These metrics were price to earnings, earnings per share, dividends paid, and market capitalization. As a result, the companies Lemaitre, Merit Medical Solutions, and Vascular Solutions have all been selected. Rivalry among Existing Firms The rivalry between existing firms in an industry is a key component of profitability. Knowledge of how much competition exists in the industry is pivotal in order to build a business strategy that will properly suit each individual firm. The level of competition is determined by the level of concentration within the industry. Industries with high rivalry and low concentration usually fight over price, which result in lower profits, as the prices also get lower. Industries with low rivalry and high concentration usually compete on things other than price such as quality and innovation. Criteria that are factored into rivalry among existing firms include: industry growth, concentration, differentiation and switching costs, scale/learning economies, fixed-variable costs, excess capacity, and exit barriers. Industry Growth The medical supplies industry that CryoLife operates in is currently composed of over 12,000 companies. This industry is very broad and diverse, which allows companies to specialize in in specific product markets. Global revenue in the industry was approximately $350 billion in 2014, which rose from $322 billion in 2013 and $304 billion is 2012 (kurmannpartners.com). It is believed that the industry will continue to grow due to advances in technology and a rapidly aging population. Advances in technology will allow for companies to create new products for the consumer at a lower cost, while an aging population will demand more health care products. 24

26 Revenue growth for CryoLife and the benchmark competitors are vary from year to year, as seen in the chart below. The reason for this level of variation can be attributed to changing regulatory environments and phasing in of new products % Revenue Growth 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% Total Revenue CryoLife LeMaitre Merit Medical Vascular Solutions Concentration Concentration refers to the number of companies that compete in an industry and the companies size in terms of market share relative to its competitors. Competition levels will be lower in highly concentrated industries than those of lower concentrated industries. The top 50 companies in the industry control around 60% of the market, which means the industry is highly concentrated (firstresearch.com). Market Share is the metric that will be used to determine concentration in the industry. For the purpose of this analysis the industry will be represented by CryoLife, Lemaitre, Merit Medical, and Vascular Solutions. As can be seen in the chart below market share between Lemaitre and Vascular solutions remains stable over the six year horizon. Market share between CryoLife and Merit Medical changes quite significantly. From analysis of the chart it can be determined that CryoLife is losing market share to Merit Medical. Segmentation between Merit Medical and the other companies is 25

27 attributed to high levels of revenue growth, superior distribution channels, economies of scale, and a broad range of products offered. The result is that firms like Merit Medical have high levels of power among the industry due to their market shares % 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% Market Share (Sales) 0.00% CryoLife Lemaitre Merit Medical Vascular Solutions Differentiation and Switching Costs Differentiation is very crucial in the medical devices industry. The reason for this is that the industry is driven by product innovation. The companies that provide more innovation capture more market share and strategically position themselves as industry leaders. An example of this is CryoLife introducing HeRO Graft in 2012 through the acquisition of Hemosphere. The higher the level of differentiation in products, the higher the switching costs for buyers. This is due to lower levels of product substitutions and product preferences among buyers. CryoLife seeks to create this effect by using human tissues instead of animal tissues, like the benchmark competitors. The preference among physicians for the human tissues offered by CryoLife increases switching costs and creates brand loyalty. 26

28 Conclusion industry. Levels of competition are mixed among existing firms in the medical supplies Conclusion Existing Rivalry Mixed The firms that do not have a major market share in the industry must compete at high levels. This competition is done primarily through product differentiation. The higher the level of differentiation in products the higher the switching costs will be for customers. Successful firms in the industry are those that are able to distinguish themselves from the competition and increase market share. Threat of New Entrants New entrants to an industry can impact the profitability of the companies that are already in operation. Because of this, new entrants can be a potential threat that should be monitored by existing firms. There are three factors that can affect the level of new firms to an industry. These factors are the first mover advantage, distribution relationships, and the legal barriers that exist. Below we will analyze each of these factors and explain the effect that they have on the level of new entrants. First Mover Advantage In the medical devices industry firms that utilize the first mover advantage can gain a significant advantage over their competition and firms that would be entering into the industry. Research and development provides a key in producing new products and cutting edge research. The new products provide future benefits to the firms and 27

29 help ensure their survival. CryoLife has achieved a first mover advantage by being the first company to offer human tissues instead of bovine or swine tissues. Distribution Relationships The medical devices industry distributes products almost exclusively through the medical community to doctors and hospitals. The nature of these distribution channels makes the relationships between the firms and the medical community critical for being successful. Having better distribution channels to buyers and access to suppliers can help a company prevent new entrants. The reason for this is because there is an existing relationship between suppliers and distributers. These established relationships will require new entrants to expend more capital to gain the same level of distribution access. CryoPreservation placements in hospitals by CryoLife is one example of distribution access. The presence of these units in hospitals gives physicians the convenience of having CryoLife products on hand. Legal Barriers The largest barrier to entry for firms hoping to enter the medical devices industry are the regulations that exist. These regulations focus on quality, safety, and operation standards. The oversight of companies in this industry is primarily provided by the Food and Drug Administration (FDA) and International Organization for Standardization (ISO). Due to the high risks associated with medical devices legal costs are high and regulations are strict. New products being introduced to the public go through a long process, usually lasting four to five years, to ensure safety. During this time period the companies expend amounts in research and development, FDA approval testing, and general expenses, all without receiving revenues from the products. 28

30 Conclusion Threat of new entrants into the medical supply industry are low. Conclusion Threat of Entrants Low Because of first mover advantages, existing distribution relationships, and high legal barriers threats of new entrants are low. The first mover advantage will allow a company to have an advantage over any firm entering into the market. Existing distribution relationships and product preferences among customers can prevent new firms from establishing product lines. Legal barriers and high levels of regulation add resistance to firms that might want to enter the industry. These regulations add costs and would diminish profitability. Threat of Substitutes The medical devices market in the United States alone is a $110 billion industry, consisting of many companies vying for a position. By 2016, the industry is estimated to increase to a $133 billion market. The best medical devices are constantly changing as companies continue to create more state-of-the-art equipment and technologies to satisfy the market. Relative Price and Performance of Substitutes Prices for products will always drive the consumers in need of them. For example, pharmaceutical substitutes generic brands are usually lower in price compared to name brand. Substitutes, however, are only practical if they achieve the same function as the original product. A substitute can be a cheaper alternative, but if it does not function as well as the original product, then there is no reason to risk using a substitute. For medical devices, relative price for the product will never outweigh the actual quality and function of the medical device. Increasing the research and development 29

31 sector of these companies allows for innovative and quality products to be distributed into the market faster than competing companies. In regards to CryoLife, for the year 2013, expenditures on research and development increased by 16% - focusing on PerClot clinical trials. By increasing spending on a certain product or products, CryoLife, and medical devices companies in general, create a superior product when compared to any substitutes increasing their customer loyalty to their product. Preferences among physicians are for higher quality products. Higher quality products can result in smaller chances of complications in the future. Human tissues are preferred among these physicians as they result in higher levels of blood flow, less strain on the patient, faster healing times, lower probability of rejection, and a decrease in the levels blood clotting. Human tissues offer lower future costs in drugs, physical therapy, and recovery time. According to CryoLife a single human aortic valve will cost $11,545. The artificial replacement value will cost anywhere from $5,000 to $7,000 for a single valve. Clearly the value offered by CryoLife runs at a substantial premium than the artificial counterpart (7). The difference in total operational and recovery costs will vary from patient to patient. We believe that the difference in costs is low risk because of the benefits offered by the CryoLife human tissues. Additional costs associated with artificial arteries include extended recovery time in the hospital, blood thinning medication, and antibiotics. The extra costs and strain put on the patient will outweigh the cost benefit of the artificial tissues. Customers Willingness to Switch In the medical supplies industry the primary customers are physicians and health organizations. Because of provisions in the Affordable Care Act health organizations will move from profitability metrics for evaluations to quality metrics for evaluation. What this means is that physicians will now be measured on the level of care that was provided to the patient instead of the amount of profits received. Quality 30

32 metrics will include the level of failures, recovery time, and satisfaction among the patients. Failure rates among arteries are significantly higher for artificial tissues than human tissues. A reason for this are that donor human tissues can be matched to the blood type of the patient, artificial tissues cannot be matched. Having a matched blood type allows for faster recovery and a decrease in the risk of immune body rejection. Because of the shift from profitability metrics to quality metrics for physicians, we believe that physicians will continue to use human tissues over artificial tissues. Doing so will allow physicians to have higher evaluations from peers because of the lower risk of infection, rejection, and expenses. Conclusion Analysis for the threat of substitutes in the medical supplies industry show that levels are low. Conclusion Threat of Substitutes Low For almost every medical device there will be another company making a substitute; however, the demand for higher quality medical products will prevent high levels of substitution. Bargaining Power of Suppliers The level of power that a firm s suppliers has can drastically impact the level of profitability for the firm. Suppliers that have large amounts of power over firms in the industry are able to charge higher costs on supplied goods. Factors that contribute to higher levels of supplier power include switching costs, level of product differentiation, and the number of suppliers that exist. Switching Costs Switching costs vary due to the products offered throughout the industry. These costs will be higher when a smaller number of suppliers exists. Product segments that 31

33 will exhibit larger switching costs are those that are specialized and have fewer suppliers. This is due to the law of demand. Lower levels of supplies accompanied with high levels of demand will result in firms paying more to acquire supplies. The ability of suppliers to charge higher costs is a form of power. Product Differentiation Because of the high degree of regulation in the industry, most products are standardized. This results in the industry suppliers having lower levels of power. Regulations implemented by the FDA and ISO require that products be made to a certain level of quality and use certain materials. Suppliers with exceptions to lower levels of differentiation are going to be those that use newer technologies. Technology will be required to meet standards, but how the effect is rendered will vary from product to product. These suppliers will be able to exhibit higher levels of power because of the differentiation of technology products. Quantity of Suppliers The quantity of suppliers is going to depend on which product group of the medical supplies industry the firm is operating in. There are currently over thirty-five suppliers of human tissue for the industry. This results in suppliers of human tissue having low levels of pricing power. Other sections of the industry do not have this large level of suppliers. Specifically, sections that use newer forms of technology, such as revascularization, have a small number of suppliers. Therefore, those that supply these newer technologies have larger levels of power. Conclusion We found that the level of power among industry suppliers is mixed. Reasons for this are due to the broad range of products that are created. Conclusion Power of Suppliers Mixed 32

34 Those suppliers that are on the cutting edge of new technology will have higher levels of power because of product differentiation and the smaller number of suppliers. Suppliers that offer standardized products, such as tissues and adhesives, will have lower levels of power. This is due in part to the large amount of suppliers that exist in the market and lower switching costs for firms in the industry. Bargain Power of Customers In the field of the medicine, customers do not have a lot of power for several reasons. The reason is because of the large amount of customers that exists in the market. This high amount of customers for firms in the industry means that pricing power ultimately rests with those firms in the industry. Health organizations have buyer groups to negotiate the prices but because of the few substitutes available, they cannot exclusively dictate the terms of contracts. Consequently, we analysts, conclude that the bargain power of customers is moderate. Switching Costs By definition, the switching cost is the cost incurred by consumers when they change their suppliers. Most firms in that industry operate through contracts to be competitive. Contracts establish the terms of the agreements such as the price to sell and the length of the terms. Consequently, each party can sue the other in case of breach. In addition, customers will not benefit from a breach of contract because of the limited resources for the organs and the essential place of vascular and surgery devices in their business. Furthermore, final customers pay more attention to the quality and expertise of the surgeons instead of the costs. We can argue that consumers are less price sensitive because they allocate more importance to the quality of their care instead of the costs due to a few number of substitutes. Therefore, they are ready to pay a larger amount to guarantee their health and switching costs are higher. 33

35 Differentiation The capacity to differentiate products in the medicine industry is very important to keep a competitive advantage. There are many ways to insure the perpetuity of the products such as the research and development, politics and the physicians training. Indeed, the improvement of products will permit to the industry to be a leader and better respond to the demand of the physicians. The industry also bases its value on patents, copyrights, licenses and others proprietary rights. In truth, the fact to get licenses is very important because the industry protects itself against competitors and obtains ownership and exclusivity of their products. Finally, the industry provides training to surgeons to make sure that they will offer good care to their patients. The implementation of seminars and educational videos for physicians are excellent because they can receive feedback from them for the purpose to improve their products. Importance of Products for Cost and Quality There is a positive correlation between the cost and quality in the medicine field because the higher is the cost, the better is the products. Nevertheless, to insure the quality of products, the FDA regulates the industry. The regulation consists of the inspections of their facilities, and the deliverance of quality systems. The inspection of the facilities is very meticulous because the FDA needs to insure the protection of the customers and guarantee the industry products. Regarding the quality systems, hospitals require a number of quality standard from their suppliers in order to purchase such as Quality Systems Regulations, ISO 13485, and Medical Device Directive Requirements. Finally, concerning the distribution of tissues, the industry provides liquid nitrogen freezers to certain hospital to insure that the products are readily available for usage. 34

36 Number of Customers and Volume per Customer The industry markets primarily its products through intermediaries such as hospitals in U.S. and its subsidiary in overseas. We can argue that the industry does not sell a lot at the individual level, but it sells to physicians through contracts. Consequently, the number one customer of the industry are hospitals because they stand between the industry and final costumer. Therefore, intermediaries are necessary in the sales process. The volume per costumer is defined by the volume of sales divided by the number of quantity purchased. Concerning the industry, we do not have information regarding the sales and volumes of each customer. Consequently, we cannot estimate the volume per buyer for the industry. Nevertheless, the main costumer of the industry products is hospitals. Conclusion We can conclude that the bargain power of customers in the industry is mixed because of the nature and the very few substitutes of products and services and the role of group purchasing organizations. Conclusion Power of Customers Mixed In addition, the industry maintains a competitive advantage by educating and training surgeons, to insure the quality in the treatment of their patients. The use of worldwide agreement is important to maintain itself in the business and ensure the continuity of it. 35

37 Classification of Industry Analysis of the industry indicates that companies benefit from levels of product differentiation and relationships with customers. Differentiation is most effective for technology products, such as revascularization technologies. Relationships with customers benefits companies when products are standardized through regulation. These products will be tissues and surgical adhesives. Analysis of Key Success Factors For a firm to be successful in the medical devices industry the firm must compete on differentiation. The primary driving force behind firms competing on differentiation and not cost is the nature of the products being sold. None of the products sold in the medical devices industry are commodities thus firms compete on the quality of the products being sold. The products that firms are producing save the lives of patients and quality is the most important factor. Thus firms compete with each other for product differentiation. Differentiation A company that uses a differentiation strategy depends of uniqueness of their products to stand out from their competitors. To effectively use this strategy the company must identify the needs of the market, provide a unique solution, and use effective pricing. For the medical supplies industry, differentiation is achieved through the use of research and development, high product quality, image branding, and building relationships. Research & Development For a firm to be competitive in the medical devices industry it is important that the firm is investing in research and development. Every firm in the industry makes a point of continually investing in research in an effort to remain competitive in the field. Many firms in the industry strive to bring more of their operations and product components in house, to lower their risk of being constrained by suppliers of the components to their devices. Often times there is only one supplier of a given 36

38 component which puts the firms at risk of that supplier shutting down of ceasing production of that component. Thus any firm that can produce more of the components to its product in house or at subsidiaries has a strategic advantage in this industry % 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% R&D/ Total Revenues 0.00% Cryolife Merit Medical systems Lemaitre vascular inc Vascular solution inc The chart above illustrates the level of research and development in relation to total revenues for CryoLife and the benchmark competitors. As can be seen, all firms invest in R&D to set themselves apart from others. The R&D is vital in differentiation because it provides the company with future economic benefits. Product Quality The nature of medical devices makes the industry heavily driven by product differentiation and thus product quality is one of the key success factors. A large majority of the products in this industry is placed inside a patient to support their health in a major way. This inclines the doctors that are purchasing products to seek the firm that is selling the highest quality product. Successful firms utilize strong quality assurance departments to ensure that every product produced measures up to a proper standard. Firms in the medical devices industry are heavily regulated by the Food and Drug Administration (FDA) as well as being bound by the FDA s Good Tissue Practices (GTP). This regulation further drives product quality, if a firm fails to comply with these 37

39 standards, they not only face severe repercussions but their brand image will likely suffer as well. Customer Service and Relationships Customers, especially physicians play an essential role in the sale process. Therefore, the industry thrives to maintain a positive relationship between the business and surgeons; the fact that the industry is constantly innovating demonstrated that the customers are in the center of their activities, and the business wants to ease the process. Customer services can be a huge element from differentiating a company to another. Consequently, every business tries to keep a good relationship with customer. In addition, the industry offers different seminars to educate physicians about new process and techniques to be more efficient. Indeed, the more a company gives seminars the more it creates a connection between both parties. Finally, the industry provides some unique service concerning the distribution of tissues to insure that the products are readily available for usage to physicians for time management. Competitive Advantage Analysis for CryoLife To gain a competitive advantage in the medical supplies industry firms must differentiate themselves from competitors and build relationships with customers. In differentiation firms use superior product qualities, investments in research and development, customer service relationships, and creation of innovation. Differentiation CryoLife operates as a price setter by offering its customers human tissue products rather than lower quality artificial tissues. The company achieves this advantage over their competitors by having a high quality assurance program staff consisting of experienced professionals that aim to gather the highest quality materials through microbiological testing and review of the donor and tissue charts. In the medical supplies industry products as well as the processes and technologies used to produce those products are a valuable commodity. Since these products, processes, and technologies create value for companies, it is a necessity to have protection in place. CryoLife has protected its processes and products through the 38

40 use of extensive patents. These patents last upwards to seventeen years on the processes used for products such as BioGlue, BioFoam, and preservation services. In total CryoLife has over one hundred proprietary patents in place and thirty-four pending approval in the United States and abroad. In addition to these patents CryoLife has protected their operations with trade secrets. The benefit that these trade secrets provide to CryoLife is that they do not expire as a patent would, therefor CryoLife will maintain a competitive advantage over their competitors in regards to the preservation services of human tissue. CryoLife has also entered into distribution agreements with Starch Medical Incorporated (SMI) for the distribution of PerClot to foreign markets that SMI would not have had access to beforehand. This distribution agreement puts CryoLife in the position to expand brand recognition to new regions and thus could possibly result in distribution of other CryoLife Products. A key component of maintaining a competitive advantage in the medical devices industry is the manufacturing of quality innovative products. CryoLife strives to manufacture and implement innovative products operating with expertise in molecular biology, chemistry, engineering, biomaterials, and overall understanding of vascular and cardiac surgery. In May 2011, CryoLife acquired Cardiogenesis. Cardiogenesis is the developer of a state-of-the-art YAG laser console for treatment in severe angina procedures, when conventional therapy has not been responsive. Transmyocardial revascularization is a minimally invasive procedure to increase the blood flow to a patient s heart to alleviate pain and discomfort brought on by severe angina. Acquiring Cardiogenesis allows CryoLife to distribute an innovative product for the treatment of a rare ailment, which few treatments relieve. This acquisition, ultimately, presents a doorway to a company with high intelligence in innovative laser consoles in conjunction with medical devices. Cardiogenesis provides CryoLife with added expertise in a science and trade they previously did not have increasing their competitive advantage in the medical devices industry. Acquiring addition expertise, in the medical devices industry, is key to maintaining competitive advantage in innovation. 39

41 Patents Active and Pending CryoLife 121 Merit Medical Systems 600 Lemaitre Vascular Inc. 12 Vascular Solution Inc. 43 Patents can be a great indicator of innovation for firms in the medical supplies industry. Using the level of patents as an indicator of innovation shows that CryoLife outperforms Lemaitre and Vascular Solutions, but fails to innovate at the level of Merit Medical Systems. Introduction to Accounting Analysis Now that we have examined the industry that CryoLife operates in using the five forces model, we will use this portion to analyze the accounting practices and policies of the company along with the benchmark competitors that we have chosen. Throughout the accounting analysis we will be looking at key accounting policies, degrees of flexibility, accounting strategies, and potential red flags of CryoLife. Using the information that we will be obtaining through this analysis we will revise and restate the appropriate accounts to remove any distortions that could materially affect our evaluation. By revising and restating the financial information of the company we will gain a better understanding of how accounting policies affect CryoLife and her operations. Key Accounting Polices The purpose of analyzing CryoLife s Key Accounting Policies is to gain a better understanding of the company itself, as well as the industry as a whole. To analyze these key accounting policies we will be looking at items that may distort CryoLife s financial statements. By finding these accounts that usually have distortions we will be 40

42 able to understand the real financial condition of the company and the industry as compared to their stated condition. To determine this information we will be looking at both Type One and Type Two accounting policies. Type One policies cover the presentation of and information disclosure practices that the company uses. Additionally, Type Two policies informs us about items that have the potential to lead to distortions on the financial statements. Type One Accounting Policies The policies associated with Type One accounting looks into the disclosure practices that the firm utilizes. For CryoLife these disclosure policies come from product quality, operations, and risk and risk practices. By looking at these factors we will be able to determine underlying policies that affect the performance of the firm. Product Quality In the medical devices industry high quality is a necessity. The reason that product quality is so important for this industry is because of the necessity for reliable tissues, product recommendation by physicians to patients, and regulatory policies. Not acknowledging and complying with the factors just listed would result to a loss of market share, lawsuits, and eventually failure in the industry. CryoLife continually stresses the need to find high quality tissues in order to produce high quality products. In order to produce the high quality products that the industry demands CryoLife additionally pursues acquisitions of companies with proven technology and products. The purpose of this is to add possible future economic benefit to the company. In recent history CryoLife has acquired companies CardioGenesis and Hemosphere. Purchasing CardioGenesis provided CryoLife a high quality product to enter the revascularization technology segment of the industry. The reason for the acquisition of Hemosphere was for the superior product, HeRO Graft, which led to the replacement of CryoLife s own hemostatic agent ( k pg.6). Another way that the company pursues high quality products is by creating an environment of excellence. How this is done is by having high level professionals that 41

43 oversee the products from the research and development phase to the when the products are sent to the physicians. These high level professionals for the company are seven Ph.Ds each accredited and licensed to practice medicine. By having these Ph.Ds on staff CryoLife adds validity to their products by associating them with the education and experience of these Ph.Ds. The final way that CryoLife creates high quality products is through the process of selection for incoming tissues. The company has implemented many quality control processes to make sure that only the highest quality tissues coming from tissue banks are selected for their products. By having higher quality standards than the regulating agencies CryoLife sets itself as an industry leader in reliable, high quality, and innovative products. Overall, CryoLife has created superior products that boast higher quality standards than the industry. As a result the company has created value for themselves and this allows them to charge a premium for their products, leading to an increase in profitability. Brand Image Brand image is a major focus for companies in the medical devices industry as reputation has a direct impact on sales. Companies like CryoLife and the benchmarks that we have selected expend a great deal of energy, money, time, and focus into the quality of their brand image. CryoLife has sought to improve their brand image by branding themselves as the leader in high-quality and durable innovation. This is done by putting their products and information in the physicians hands and in the medical services buildings so that physicians have the convenience of knowing about the products while having them in close proximity. Advertising their specialized doctoral staff, CryoLife increases their brand image in the medical devices industry. Specifically, the company has seven Ph.Ds on staff that oversee multiple phases of every product. By having these physicians on staff that test 42

44 and research the impacts and effectiveness of their products, buyers have a sense of trust knowing that the products are of high quality. Risks and Risk Practices When studying CryoLife s financial statements we found no defensive accounting in the form of hedging positions in regards to interest rate, commodity, and foreign exchange risk. We, the analysts, believe that certain conditions have resulted in this practice and have drawn conclusions about the necessity for these practices. The purposes for not hedging interest rates is due to the fact that CryoLife currently does not have any long-term debt outstanding. Instead, CryoLife has shortterm debt obligations in the form of accounts payable due within one year. Because of the short nature of these accounts, along with the low and stable interest rates that have existed over the past five years. All of these factors make hedging interest rates an ineffective process. In regards to commodity risk, commodity hedging practices are not used by CryoLife. According to the company s 10-k the practice of collecting human tissues is done by tissue banks and then taken in by CryoLife. After this transfer has happened CryoLife determines the quality of the tissues received and if those supplied match the quality standards that are in place. The only risk that is acknowledged by the company on this entire process is if the tissues do not match the standards required then the tissues are destroyed in an appropriate manner, resulting in loss of capital and resources. Finally, the risk tied to the fluctuations in exchanges rates is a risk that has the potential to result in losses of company profit. When analyzing the financials and 10-k for CryoLife we found no practice of exchange rate risk hedging. Due to the fact that CryoLife has many of its customers, operations, and distribution channels outside the United States, the company is subject to substantial amounts of this risk, thus resulting in fluctuations of company revenues and expenses. 43

45 Type Two Accounting Policies Distorted accounts on the financial statements of a company can often lead to variations in perceived and actual performance. Items included in Type Two policies are operating and capital leases, goodwill, pension liabilities, and research and development. The reason that these items can lead to distorted finical reports is because of the lack of standards in place to report them. Because of this, companies in many industries often use different methods from one case to another and from one company to another. The items that we will be looking at for CryoLife involve, the mix of operating and capital leases, pension plans, goodwill, and research and development. By analyzing these accounts we believe that we can gain a better understanding of the company in order to give a more accurate assessment on accounting policies and conditions. Relative Mix and Use of Operating vs. Capital Leases Operating leases only transfer the right of use for a certain property without assuming risk. Capital leases, on the other hand, transfer the right of use, while also assuming some risk of ownership; however, the lessee of a capital lease enjoys the benefits from the property allowing the lease to be both an asset and a liability. CryoLife holds operating leases for land and buildings for use as their corporate headquarters and manufacturing facilities. They also hold operating leases for additional office, manufacturing, and warehouse space, as well as, leases on company vehicles and equipment. The company, as of December 31, 2013, has a capital lease obligations account of zero signifying that they do not hold any capital leases. In regards to the operating lease for the land and buildings used for the company s corporate headquarters, these accounts were amended in 2010 to extend the lease till The Company has deferred rent obligations of $1.6 million and $1.7 million, respectively, as of December 31, 2014 and December 31, 2013 and total rental expense for both 2014 and 2013 was $3.0 million. 44

46 CryoLife s benchmark competitors Merit Medical, LeMaitre Vascular, and Vascular Solutions hold only operating leases as well. For Merit Medical, total rental expense for 2013 and 2012 were $5.5 million and $4.8 million, respectively ( K Pg. 72). For LeMaitre Vascular, total rental expense for 2013 and 2012 was $1.3 million and $1 million, respectively ( K Pg. F-22). Lastly, Vascular Solutions total rental expense for 2014, 2013, and 2012 was $1 million, $1.4 million, and $1.3 million, respectively ( K Pg. 58). In comparison, CryoLife s operating lease expenses is relatively the same as the company s three main competitors. Looking into CryoLife s leasing strategy, as well as the selected benchmark firms, articulates the medical device industry s strategy of holding only operating leases instead of capital leases. There are some advantages to holding only operating leases such as operating leases carry almost no risk. Risk, in the medical devices industry in relation to leasing, can be associated with obsolescence. Holding only operating leases allows a company to be protected from holding or owning obsolete equipment or marooned in obsolete locations. Medical device companies need to have the flexibility to replace or update their equipment or their locations quickly in order to keep a competitive advantage in the industry. Overall, CryoLife, and the medical devices industry in general, does not utilize a mix of operating leases and capital leases, but instead prefers to hold flexible and lowrisk operating leases. Accounting for Pensions CryoLife does not offer pension plans to their employees so there is not pension liability. The company does offer matching for a 401(k) plan, however the company contributions are not material to the finances. The last three years the company contributed $541,000, $500,000, and $204,000 respectively. The only compensation payment obligation the firm has is a one-time payment to the CEO at the end of his contract, which is approximately $1.9 million. 45

47 Assessing Degree of Accounting Flexibility Accounting flexibility is the practice of using accounting policies set forth by management to align performance of the firm with set goals. The measurement of flexibility is based on the estimation of each firm. As a result the measurement policies belong to the firms to choose the procedures that they think best reflects their performance. Furthermore, Financial Accounting Standards Board (FASB) through the Generally Accepted Accounting Principles (GAAP) requires companies to have substantial disclosure provisions because of the complexity of the business environment, the necessity for timely information, and the accounting as control and monitoring device. The three activities that we analyze are leases, pensions and goodwill. Operating/Capital Leases According to the Statement of Financial Accounting Standards (SFAS) 13, leases are transferred by the end of the lease term. A capital lease occurs when the lessor transfers ownership to the asset to lessee. However, an operating lease is a contract in which the lessor lets the lessee to use the local. There are four criteria to distinguish operating lease from capital lease: the transfer of ownership, the bargain purchase option, economy life, and recovery of investment. From analyzing the industry we see that firms disclose only operating leases Pension Liabilities FASB requires that companies disclose information about their pensions. Therefore the responsibility is the firm s to determine their amounts and come up with plans that are beneficial for their employees. CryoLife does not disclose information about their provisions since no pension plans are in effect. Goodwill Goodwill is the intangible result of when a firm acquires another firm for a price above net assets. Due to the intangible nature of this account, management decides the amount of the goodwill that they want to amortize annually based on estimations 46

48 they set forth. From analyzing the industry, we concluded that firms often carry over more goodwill than amortizing them over time. Conclusion on Flexibility The level of accounting flexibility is left to the discretion of the firm s upper level management. Nevertheless, FASB requires that companies disclose provisions concerning their policies. Therefore CryoLife, as well as the medical products industry, show a moderate provisions concerning their accounts. Evaluation of Actual Accounting Strategy It is important to evaluate CryoLife s accounting strategy to get an intuitive understanding of how the accounting practices of the firm affect the operations themselves. In this analysis of CryoLife s accounting strategy we the analyst look at the level of disclosure the firm takes. Another aspect that we look at is the degree of flexibility that the firm uses in both an absolute and relative basis to the benchmark firms. The purpose of this is to determine if the company uses an aggressive accounting strategy or a conservative accounting strategy. Quality of Disclosure Looking through the CryoLife annual reports it can easily be determined that the company is in fact a high disclosure firm due to the amount of information they provide on products, services, and factors that affect the firm. The form of this high disclosure does not come by means of quantitative knowledge regarding ratios, indexes, or additional metrics, but rather the form of disclosure is brought forth by verbal format. In this section we will discuss the qualitative forms of disclosure for the benefit of determining the actual accounting strategy, as compared to quantitative in the following section. One of the benefits of this form of high disclosure is that CryoLife has explicitly detailed risk factors that are associated with their business, information regarding their products, and possible negative events in the future. Other forms of high disclosure for CryoLife include goodwill, as well as with research and development. 47

49 All of this information guides us into a deeper understanding of CryoLife and the business setting. Risk Factors Due to the disclosure examples CryoLife provides of risk factors that may affect revenue from BioGlue such as, adverse developments with quality that would challenge production levels, expiring patents leading to an increase in competition, and the threat of substitute products ( k pg.23). Other forms of disclosure for risk involve health care policy changes through the Federal Government, inability to collect notes payable in the amount of two million dollars from ValveXchange, and the loss of business due to changing domestic and international economic conditions ( k pg.27). Even though these provided examples are not quantitative it does show that CryoLife discloses large amounts of information. Products and Processes Another form of disclosure that CryoLife provides information about their products and the production processes of these products. Specifically, the company goes into great detail about HeRO Grafts coming from the acquisition of Hemosphere and now being produced in their Atlanta, Georgia facility. Additionally the company discloses that PerClot is being supplied by SMI to CryoLife for distribution outside the United States ( k pg.16). The reason that disclosures about product origins coming from acquisitions is valuable is because it gives their reason for justifying the higher level of goodwill carried on their books. Goodwill Goodwill is the result of when a company aquiring another firm or asset for larger than the net asset value. In recent history CryoLife has purchased several companies starting in These purchased companies were Hemosphere and CardioGenesis. For Hemosphere, goodwill for the transaction was posted as over seven million dollars, while goodwill for the purchase of CardioGenesis was an estimated four million dollars ( k pg.f-21). As a result of paying additional amounts for these acquisitions CryoLife has disclosed amounts over eleven million dollars of goodwill since 48

50 2012. In comment, CryoLife suggests that annual evaluations and impairment takes place on this account ( k pg.f-15). Research and Development An important operation of CryoLife is research and development for the reason that this operation has the ability to produce future economic benefits. CryoLife spends approximately six-percent of company revenues each year on this operation ( k pg.15). As many of the company s most successful products have come from research and development it is absolutely a necessary and valuable operation. Conclusion In conclusion, we believe that CryoLife is a high disclosure firm due to the information that they supply through annual reports. Although this high level of disclosure comes in a verbal instead of numerical format, it still has provided a valuable insight into CryoLife. Conservative vs. Aggressive Policy The next portion of our evaluation over CryoLife s accounting strategy involves the analysis and conclusion over if the company has implemented a conservative approach to accounting or an aggressive policy. To provide a thorough analysis we will analyze both conservative and aggressive accounting policies that the firm has taken on a relative and then absolute basis. The way of determining the level of accounting conservativism to aggressiveness is to analyze pension plans, research and development, goodwill, and operating and capital leasing. Doing this will provide a more accurate evaluation over CryoLife to draw a conclusion on the degree of conservatism and aggressiveness. Goodwill As stated previously, goodwill is a measure of the excess payment over net assets for a company. This intangible asset on the balance sheet can have impacts on the financial statements if not properly evaluated and impaired. 49

51 GAAP rules allow firms to choose the method with which they discount intangible assets. The measure that we will be using to test for impairment is thirty percent of net fixed assets. Currently, CryoLife has over eleven million dollars accounted for in their goodwill accounts. Putting this in reference to their competitors over a six year horizon, see figure 1, we have found that CryoLife maintains a high level of goodwill on their books. However, compared to the benchmark competitors that we have chosen they have an average level. Since dispersions of this ratio are wide across CryoLife and the supplied benchmarks for the six year horizon figure 2 gives the average over the time period for a more thorough analysis. Fig.1 CryoLife LeMaitre Merit Medical Vascular Solutions 63.17% % 55.33% 72.17% Fig. 2 Analyzing these firms we feel that they all implement an aggressive accounting policy for their goodwill accounts; however, in relation to the industry it is normal practice. The reason that we have come to this conclusion is because we acknowledge a thirty-percent level in relation to net property plant and equipment. Specifically, 50

52 CryoLife has set the policy in action of not impairing any goodwill which further adds to our assessment of their aggressiveness on an absolute basis. As we will demonstrate further in this analysis goodwill needs to be written down at twenty-percent a year until the account has been fully expensed. Operating and Capital Leases CryoLife currently has operating leases on their financial statements. However, the company does not have any capital lease obligations that are reported. The operating leases that are reported on the financial statements do not meet the necessary level of impairment to deferred rent and long-term liabilities. This mark is going to be matching or an excess of over twenty-percent. In the years preceding 2012 CryoLife did have a ratio in excess of the twenty-percent. Meaning that impairment was necessary, as shown in Figure 3. Fig. 3 Due to the lack of capital leases and CryoLife not reaching our aggressive benchmark we conclude that CryoLife is conservative in regards to their lease obligations on both an absolute and relative basis. 51

53 Pension Plan Currently CryoLife does not offer any pension plans to their employees. As a result of this the company does not have any pension liabilities and is not relevant for this measure to their accounting strategy. Research and Development CryoLife does engage in research and development activities; however, these costs do not account for more than a twenty-percent reduction in operating income. As a result of research and development costs only reducing operating income by sixpercent this is an instance of conservative accounting policies on an absolute basis. Conclusion on Evaluation After having analyzed CryoLife s accounting policies in depth we the analysts conclude that the firm is a high disclosure firm. In coordination with a high disclosure level, we feel that the company has implemented a conservative approach to their accounting methods on both a relative and absolute basis. This conclusion was reached by assessing the policies for goodwill, leases, pension plans, along with research and development. In figure 4 it can be seen that CryoLife has implemented two conservative policies, as compared to one aggressive policy on an absolute basis; where as in figure 5 we see that all of the policies implemented are conservative on a relative basis. Because of this we are confident that CryoLife is a conservative accounting company. Absolute Goodwill Leases Pension Plans R&D Verdict Aggressive Conservative N/A Conservative Fig. 4 Relative Goodwill Leases Pension Plans R&D Verdict Conservative Conservative N/A Conservative Fig. 5 52

54 Quality of Disclosure Now that we have acknowledge the level of disclosure that CryoLife has implemented and know that they are in fact a high disclosure firm, we seek to know how well this disclosure informs us. The purpose of this section is to analyze the implications of the level of disclosure that the firm has implemented. The necessity of this comes from the fact that firms may even be able to hide behind high levels of disclosure by disclosing trivial instead of material facts. To get a better grasp on the quality of the disclosures we will analyze them in both a qualitative and quantitative measure. Qualitative Measure of Accounting Quality To measure qualitative measures of CryoLife s accounting policies, we look at how well the firm discloses information on research and development, goodwill, and leases, rather than looking at the specifics for each of these accounts. The reason that it is necessary to determine the qualitative measure of accounting quality is to see what CryoLife could disclose better and where they disclose enough to inform anyone reading their annual reports. Research and Development Research and development is a major component of any company in the medical devices industry as it does have the ability to generate possible future economic benefits. CryoLife does engage in research and development operations at a rate of sixpercent of total revenues. When analyzing the benchmark companies that we have chosen for our analysis we found that it is uncommon for companies to engage in this activity up into nine-percent of total revenue. As far as the qualitative disclosure for CryoLife s research and development, lots of information is given. Disclosures that the company readily gives about their activities in research and development is that the activities are conducted by Ph.Ds under the supervision of the company s medical and scientific advisory board ( k pg.15). Another disclosure on research and development is stating that products such as 53

55 PerClot, BioGlue, and BioFoam have all been the direct result of the research and development activities performed. Goodwill CryoLife has considerable amounts of goodwill on their balance sheet. Although the company does briefly explain that every year in October they evaluate and impair the account to what they deem is necessary, we do feel that the account is over stated. Our conclusion that this account is overstated comes down to a more than twentypercent of PP&E. One influencing factor for this excessive measure can be explained by the discussion in the previous section discussing the relative conservative basis that the industry uses on goodwill accounts. This comes from the acquisition of relationships and intangible accounts that the firm believes should not be impaired due to the future benefit that they provide. Regardless, we still believe that the accounts should be written down and will do so in a future section of this accounting analysis. Quantitative Measures of Accounting Quality The importance of the quantitative measures of accounting quality is that it reveals the possible pitfalls and concerns associated with the company s financial positions. To bring better insight into what factors we deem materially affect the company we have included a section of this analysis titled, Identifying Potential Red Flags. These red flags highlight the concerns that the have and why we have them. For CryoLife the red flags are goodwill, research and development, and leases. These accounts will be discussed in detail in the following section. Restated Financial Statements For CryoLife both Goodwill and Research and Development were significant enough to warrant restating the financial statements. The reason for this was due to impairments and levels being above the advised levels. Restatements will affect certain aspects of the financial statements. These changes will be discussed and illustrated below. 54

56 2010 Income Statement Stated and Restated 55

57 2010 Balance Sheet Stated and Restated 56

58 2011 Income Statement Stated and Restated 57

59 2011 Balance Sheet Stated and Restated 58

60 2012 Income Statement Stated and Restated 59

61 2012 Balance Sheet Stated and Restated 60

62 2013 Income Statement Stated and Restated 61

63 2013 Balance Sheet Stated and Restated 62

64 2014 Income Statement Stated and Restated 63

65 2014 Balance Sheet Stated and Restated 64

66 Identifying Potential Red Flags Red flags are elements of the financial statement which need to be restated. It is important to note that Red Flags are not attached to fraudulent activities, but are unusual or misstated. For example, they can consists of asset write-offs, fourth quarter adjustments or provisions and alike. Consequently it is very important to pay attention to red flags. From analyzing the 10K of CryoLife, we have three major red flags which are: goodwill, research and development and leases. Goodwill Goodwill appears in the balance sheet of CryoLife, for the first time, in 2011 when they acquire Cardiogenesis. After one year, the company raises its goodwill by 7,145 which leads to 11,365. Indeed the goodwill stays the same from 2012 to 2014; this result on an overstatement of the asset, equity and net income. Consequently, the goodwill needs to be revised Goodwill - 4,220 11,365 11,365 11,365 Net Fixed Assets 13,086 12,308 11,667 12,171 12,002 Goodwill/Net Fixed Assets The ratio of goodwill divided by net fixed asset is superior to 30% for 5 years period of time; consequently, the goodwill needs to be restated. In truth, the company needs to impair the goodwill to show the fair value of the market. 65

67 Research and Development CryoLife uses the R&D account to be on top from the innovation; the medical industry evolves at high pace, therefore companies should update their techniques to keep their comparative advantage R&D 5,923 6,899 7,257 8,454 8,699 Net Fixed Asset 9,868 11,643 12,612 13,820 8,838 R&D+ Net fixed asset 15,791 18,542 19,869 22,274 17,537 R&D/(R&D+ Net Fixed Asset) From CryoLife s 10K CryoLife s 10K reveals that their R& D lays between 36% and 50%; consequently, we need to restate the R&D because it reduces operating income for more than 20%. Leases From analyzing CryoLife s 10k we notice that the company does not have capital leases on its balance but nevertheless, they capitalized their leases as deferred rent obligations Deferred rent obligation 1,500 1,600 1,603 1,686 1,649 Long term liability 4,168 4,869 7,614 9,214 6,845 Deferred rent+ L.T liability Ratio (deferred rent obligation/(deferred rent+ L.T Liability)) From CryoLife s 10K 5,668 6,469 9,217 10,900 8,

68 The capitalized leases decrease the long term liability for more than 20% for 2010 and 2011; however, the capitalized lease is inferior to 20% for 2012, 2013, and 2014 Conclusion Red flags are elements of the financial statements which need to be restated; consequently, by analyzing CryoLife s financial statements we come up with 3 elements scary monsters : goodwill, pension and leases. Introduction to Financial Analysis In order to accurately value a company s performance, a financial analysis of the given firm must be performed. To facilitate this analysis, we the analysts, will employ ratio analysis, cross sectional analysis, forecasts of CryoLife s financials, and estimation of the weighted average cost of capital using estimates of the cost of equity and cost of debt. We will use ratio analysis to compare CryoLife s performance in the present with their performance in the past. By doing ratio analysis, we will be able to determine whether CryoLife can convert their revenues into profits, pay short-term obligations, and finance investing activities and operating activities. Then, the ratio analysis will allow us to financially forecast CryoLife s financial statements. Lastly, the values that are forecasted can then be used in the calculations and estimations of CryoLife s weighted average cost of capital, cost of equity, and cost of debt. Ratio Analysis Ratio analysis provides a comprehensive insight into the company. This type of analysis consists of measures for liquidity, operating efficiency, profitability, and capital structure. Comparing the measures across the industry allows us to evaluate the performance of CryoLife with respect to other companies. An additional benefit derived from this type of analysis is the ability to forecast, which will be discussed in a future section of this report. 67

69 Liquidity Ratios Liquidity, in financial terms is the ability and ease of assets to be converted into cash without reducing the assets value. An asset with high liquidity is more valuable than one with low liquidity because this asset will be a safer investment that allows an investor to receive the cash flow from the investment easily. For this section, we will be using two liquidity ratios: current ratio and quick ratio allowing us to determine if CryoLife can satisfy their debt obligations with their assets. Current Ratio With the current ratio, we can analyze CryoLife s ability to utilize their short-term assets in order to satisfy their short-term liabilities. In order to calculate the current ratio, the total current assets are divided by the total current liabilities. If the current ratio is greater than one, then an analyst can deduce that the company is able to cover their current liabilities of the year from the cash value of its current assets. If the current ratio is less than one, then an analyst is able to deduce that the company may not be able to cover all of their current total liabilities, making it a much riskier firm for investment purposes Current Ratio CryoLife Lemaitre Vascular Solutions Merit Medical Exclusion Mean 68

70 As can be seen in the chart above, the ratios for CryoLife, Merit Medical, and Vascular Solutions all show a similar trend structure. Elements of this structure can be seen in a drawdown starting in 2011 followed by a strong rebound in For analytical purposes a path has been created titled Exclusion Mean with the purpose of indicating the average of the sampled population without CryoLife. When comparing the CryoLife trend line to that of the Exclusion Mean we notice that the company tends to move with the liquidity of the market in the years up to 2012; however, after this period there appears to be no direct correlation to the Exclusion Mean. The change in the nature of the ratio comes with the reduction of current assets, with a considerable decline in cash, while current liabilities continue to increase. We believe that the primary change in the cash account comes from the purchases of Hemosphere through an all cash tender offer. Because of this one-time purchase we expect liquidity for CryoLife to continue to increase. As can be seen in the chart, there is no inclusion for ratios in regards to the adjusted financials. The purpose of this is because adjustments did not affect the current ratio of CryoLife. Quick Ratio Quick ratio is similar to the current ratio; however inventories are omitted from current assets. Omitting current inventories allows the ratio to only include the company s most liquid assets inventories being the least liquid of current assets. Quick ratio essentially serves the same purpose analytically as current ratio, exhibiting the ability of a firm to cover current liabilities with the cash from current assets. A quick ratio value greater than one displays that the company can satisfy their current liabilities and a value less than one shows the opposite. Even though inventories are the least liquid asset, it is still a large portion of current assets, so a quick ratio less than one is not as bad as a current ratio less than one since inventories are excluded. 69

71 Quick Ratio CryoLife Lemaitre Vascular Solutions Merit Medical Exclusion Mean The chart above displays the quick ratio for CryoLife, her benchmark competitors, and the Exclusion Mean discussed in the previous section. This chart shows the relation between all parties regarding this more stringent ratio. Analysis of this graph does not show a clear indication of a trend between all parties. Regardless, the saucer formation in the quick ratio for CryoLife is due in part to the expansion of the company through all cash acquisitions of companies, starting with the purchase of Cardiogenesis Corporation in 2011 and Hemosphere in Because of the nonrecurring nature of these acquisitions, we expect the quick ratio of CryoLife to continue building. Due to the adjusted financial statements having the same current ratio as the stated financial statements, no adjusted line for CryoLife is reported on this chart. Operating Efficiency Ratios To evaluate how quickly a company can convert their products or services to cash, an analyst will utilize operating efficiency ratios. The optimal level for these ratios is the point at which a company can efficiently keep up operations and cover any liabilities incurred. In regards to this analysis, we are using six operating efficiency ratios: inventory turnover, accounts receivable turnover, working capital turnover, day s supply inventory, days sales outstanding, and cash-to-cash cycle. 70

72 Inventory Turnover To calculate inventory turnover, the cost of goods sold within a period is divided by the period s inventory. This ratio represents the amount of times that the company s inventory they had on hand was sold. A company with a low inventory turnover suggests that they may have low sales numbers or too much inventory than is necessary. Low inventory turnover can tell an analyst that the company may over invest in their on hand inventory, which can be a risky strategy due to depreciation or price volatility and obsolescence in products or services. Alternatively, a high inventory turnover can suggest that the company has large sales for the given period. A company with high inventory turnover may have smart and efficient management of their inventories, protecting the company from overinvestment of unnecessary inventory. Inventory Turnover CryoLife Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean The trend lines for CryoLife regarding inventory turnover provide a clear downtrend from a high of in 2010 to in The drastic change in this 71

73 ratio is clearly isolated only to CryoLife when looking at the lines for Lemaitre, Vascular Solutions, Merit Medical, and the Exclusion Mean. Further analysis into the reason for this decline shows that although total revenue is increasing year-over-year, the rate at which inventories are growing outweighs that of total revenue. This effect decreases the inventory turnover ratio as the denominator grows at a faster pace than the numerator. Analysis of the corresponding accounts in the financial statements for CryoLife shows that the growth in inventories has increased since the acquisitions of Cardiogenesis and Hemosphere. As a result, we see the practice of carrying larger inventories on hand as a new norm for CryoLife. Due to the adjusted financial statements having the same inventory levels and total revenues as the stated financial statements, no adjusted line for CryoLife is reported on this chart. Accounts Receivable Turnover In order to analyze how efficiently a company collects their accounts receivable and outstanding short-term debts an analyst utilizes the company s accounts receivable turnover ratio. To calculate accounts receivable turnover, totals sales for a given period is divided by the company s accounts receivable. An analyst would prefer a high turnover ratio because it shows that a company is efficient and productive when it comes to their credit accounts. A high ratio yields a company that is proficient and timely in collecting cash for their accounts receivable balances. 72

74 A/R Turnover CryoLife Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean For the accounts receivable plot chart, there is a narrow range that the ratios trend through, being between six and nine percent. In 2011 there is a clear break away from the industry for CryoLife, as the ratio for all of the benchmark competitors increases while the ratio for CryoLife decreases. Analysis of the diversion from the industry average in 2011 is due to accounts receivable growing at a larger rate than total revenues. To be specific, accounts receivable grow by more than twenty-two percent while total revenue increases by just over two and a half percent. Once again looking at the acquisition that took place that year we presume that the increase in the consolidated accounts receivable is due to the acquisition of the accounts receivable to Cardiogenesis, due to the larger than normal percentage of growth for the accounts. Supporting the belief that acquisition activity is impacting the accounts receivables for CryoLife, the trend line shows an increase in the accounts receivable turnover in the following year as the accounts are fulfilled. Due to the adjusted financial statements having the same accounts receivable levels and total revenue as the stated financial statements, no adjusted line for CryoLife is reported on this chart. 73

75 Working Capital Turnover Working capital turnover ratio allows an analyst to visually see how efficiently a company uses its working capital in order to generate revenue. If a company operates with a high working capital turnover ratio, then it can be inferred that they have the capability and productivity to increase their sales output with a decrease in working capital. Also, a company with a high ratio has the ability to cover their operating costs, while continuing to efficiently purchase inventory. To calculate working capital turnover, the revenues for a given period is divided by that period s working capital. Working Capital Turnover CryoLife Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean The chart above shows a clear trend and range between one and a half percent and two and a half percent for CryoLife, Lemaitre, and Vascular solutions. The three previously mentioned companies working capital ratios all fall under the ratio for the Exclusion Mean. The reason for this occurrence is due to the impact that Merit Medical s working capital turnover has on the mean. Since the ratio for Merit Medical is much higher compared to the ratios of the other firms the Exclusion Mean is pulled upwards on the graph. 74

76 Regardless of the impact that Merit Medical has on the Exclusion mean, we the analyst acknowledge a clear trend between CryoLife and Vascular Solutions, while Lemaitre falls within the range of the plots for the two companies. Due to the adjusted financial statements having the working capital levels and total revenue as the stated financial statements, no adjusted line for CryoLife is reported on this chart. Days Supply of Inventory The measurement of the number of days a company needs to convert their on hand inventory into revenues is called the days supply of inventory ratio. In order to calculate the cash to cash cycle for a given company, the days supply of inventory ratio must be calculated first. This measurement will show how much time a company s inventory ties up company capital. An analyst will prefer to see a low days supply of inventory ratio, since a lower ratio signifies that a company is efficient in inventory management. The calculation for this ratio consists of dividing the period s inventory by cost of goods sold, then multiplying that by 365 converting the ratio into days Days Supply Inventory CryoLife Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean 75

77 Days supply inventory ratio plots in the chart above show that CryoLife is an outlier when compared to the benchmark competitors and the Exclusion Mean. Reasons for this are directly attributed to the higher rate at which CryoLife is able to turnover their inventory levels. Due to the nature of this ratio a higher ability to turnover inventory on hand leads to a shorter days supply inventory. Looking at the trend path for CryoLife in the chart, we do expect to see the days supply inventory ratio increase as the company starts to carry larger levels of inventory on their books. This can be attributed to the nature of the acquired companies that were discussed in the previous sections; however, we expect CryoLife to be able to remain efficient in their inventory processes. Due to the adjusted financial statements having the same inventory turnover rate as the stated financial statements, no adjusted line for CryoLife is reported on this chart since the ratios are exact copies of each other. Days Sales Outstanding The second calculation needed in the cash to cash cycle is the days sales outstanding ratio. Simply put, this ratio measures how many days it takes on average for a company to collect on their accounts receivable balances. A lower ratio will obviously be preferred since it signifies a shower time period in order to collect on accounts receivable. A company being efficient on collection of credit will correlate to an increase in cash flows, making the company favorable for an analyst. To calculate this ratio, the accounts receivable turnover is divided by

78 Days Sales Outstanding CryoLife Lemaitre Vascular Solutions Merit Medical Exclusion Mean Days sales outstanding ratios for CryoLife and its benchmark competitors all tend to move with the Exclusion Mean with no specific outliers. The reason for this trend is due in part to the medical supplies industry being primarily an on cash basis instead of taking large amounts of accounts receivable. When looking at CryoLife in relation to the Exclusion Mean we noticed that in the year 2011 the company increased its days sales outstanding ratio while the industry as a whole reduced this metric. Explanations for this can once again be attributed to the purchase of Cardiogenesis Corporation. The purchase of this corporation resulted in an increase in accounts receivable, which is directly related to days sales outstanding. Due to the adjusted financial statements having the same accounts receivable turnover rate as the stated financial statements, no adjusted line for CryoLife is reported on this chart since the ratios are exact copies of each other. Cash-to-Cash Cycle The cash-to-cash cycle measures the length of time in days a company sells their on hand inventory and efficiently collects on accounts receivable balances that are for sales. In other words, this ratio measure how quickly a company can liquidate inventory into cash. If a company is able to efficiently and quickly sell their inventory 77

79 and collect cash receivables, then they will have a low cash-to-cash cycle for a given period a lower calculation correlates to a more liquid company. Both the days supply of inventory and days sales outstanding are needed for this calculation. The cash-tocash cycle can be calculated by adding the days supply of inventory and days sales outstanding Cash to Cash Cycle CryoLife Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean Due to the nature of the cash to cash cycle, the chart above is going to represent the combination of information contained in the previous two charts plotted in a single line for each company path. All of the competitors for CryoLife have cash to cash cycles that are above that of CryoLife. The main reason for this is going to be because of the impact of CryoLife s much shorter days supply inventory in the calculation for the cash to cash cycle. It can be easily determined from looking at this chart that CryoLife is more efficient in their operations than that of their competitors and consequently the Exclusion Mean. CryoLife clearly shows an increase in their cash to cash cycle, which could most likely be attributed to their increasing days supply inventory. 78

80 Due to the adjusted financial statements having the same accounts receivable turnover rate as the stated financial statements, no adjusted line for CryoLife is reported on this chart since the ratios are exact copies of each other. Property, Plant & Equipment Turnover Plant, property, and equipment turnover ratio is a measure of the ability of a company to generate sales from their investments in fixed-assets. A company with a high plant, property, and equipment turnover ratio excels in using their fixed-assets investments in order to generate company revenues. This ratio is widely used by investors in order to analyze how effective a company is at investing in fixed assets year-by-year. To calculate plant, property, and equipment turnover ratio, the yearly net sales of a company is divided by the yearly net fixed asset balance for plant, property, and equipment. Conclusion The operating efficiency ratios that have been calculated show that CryoLife operates at higher levels of efficiency that their benchmark competitors. This superior performance can be attributed to higher turnover rates for inventory and accounts receivable. Profitability Ratios Simply put, a company s profitability ratios show their capability in generating earnings. To be competitive in the industry, a high ratio value when compared to the competing companies is preferred. We, the analysts, utilized six profitability ratios consisting of: gross profit margin, operating profit margin, net profit margin, asset turnover, return on assets, and return on equity. These various ratios allow our team of analysts to deduce the overall efficiency of a company, in regards to their owned assets and their returns. Gross Profit Margin Gross profit margin is a measurement of the amount of revenues that is left over after the cost of all sales has been subtracted out. This margin indicates the extent to 79

81 which a company s revenues have exceeded their direct sales costs. A high ratio value for this indicates that the company can effectively and efficiently control their manufacturing costs for their products. Gross profit margin is calculated by dividing the gross profit in a given period revenues for that period minus costs of goods sold by the revenues for that period. Gross Profit Margin 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% CryoLife Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean The chart presented is going to provide information for the comparison for the gross profit margin between CryoLife, competitors, and the average of the competitors. Analysis of this chart show that the industry trends in a range between fifty-eight percent and seventy-five percent. The one exception to this trend is going to be Merit Medical, which trend around forty-four percent. Of the companies that trend in the industry range, CryoLife is the least efficient in constraining costs of products and preservation services with most of the cost growth pertaining to products rather than services. 80

82 Due to the adjusted financial statements having the same revenues and selling expenses as the stated financial statements, no adjusted line for CryoLife is reported on this chart since the ratios are exact copies of each other. Operating Profit Margin The operating profit margin measurement is comparative to the gross profit margin measurement; with the exception that operating profit margin is the percentage of the company s sales that is left over after operating expenses have been subtracted out. Like gross profit margin, operating profit margin includes variable costs and sales, general, and administrative expenses. The profit margin from this ratio allows a company to cover their taxes and interest expense. To calculate operating profit margin, the company s total operating income for a given year is divided by their total revenue for the same year % Operating Profit Margin 15.00% 10.00% 5.00% 0.00% CryoLife CryoLife Restated Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean As can be seen in the chart above, a new plot has been added titled CryoLife Restated. The nature for this data plot is due to the affect that financial statement adjustments have had on financial ratios and the difference that exists between them and the original statements. 81

83 Relationships between all parties included on the plot appear to have no set trend that they all follow. Reasons for this will vary from firm to firm. Factors such as level of administrative expenses, research and development costs, and goodwill impairment can all be attributed to reasons that the ratios vary as they do. Because of the restatements, specifically the accounts for goodwill and research and development, the adjusted plot line for CryoLife shows an improvement from nearly eight and a half percent to just over thirteen percent in In the years following after, the trend line for the restated financial follows that of the as-stated financials until 2014 when the operating profit margin for the restated dips below that of the asstated. Net Profit Margin Net profit margin is an exceptionally useful ratio that allows an analyst to decide if a company is profitable after all gains or losses and expenses are accounted for. This ratio s results helps to tell an analyst whether, when compared to a company s previous years, a given company has the ability to maintain and manage profit growth or the value added by sales. A high margin is preferred for this ratio, which reflects that the company employs effective cost controls that allow for a higher return on equity percentage. Net profit margin is calculated by dividing the company s net income for the year by their total revenue for the same year. 82

84 Net Profit Margin 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% CryoLife CryoLife Restated Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean The chart placed above will also include the data plot for the CryoLife Restated financial statements. The necessity for this plot is due to the changes that readjustments have caused to the financial ratios. The plot for CryoLife restated is clearly at a higher level for 2010 through 2013 than that of the original CryoLife statements. A contributing factor for this outcome is going to be the higher level of operating income, which with the same level of expenses, results in a higher level of net income. Comparing CryoLife Restated and CryoLife plots to those of the Exclusion mean, we notice that the industry average tends to be more volatile when CryoLife and CryoLife restated are more stable, and vice versa. Putting this another way would be that the company experiences counter volatility to the exclusion mean and thus is independent of competitor movements. Asset Turnover Asset turnover ratio allows an analyst to calculate how much revenue is generated by a company for every dollar in assets that are recorded on their yearly balance sheet. When a company yields a high asset turnover ratio, it can be conferred that for every dollar this company has in assets, they generate more revenue than a 83

85 company with a lower asset turnover ratio, which can display that the company does not manage their assets properly. To calculate asset turnover, current year s sales are divided by the total assets of the previous year displaying a lagged formulation. This ratio must be lagged because, in order to determine the beginning of the year s asset balance, the balance of assets for the previous year end will eventually be the balance of assets for the beginning of the next year. Asset Turnover % % % % 80.00% 60.00% 40.00% 20.00% 0.00% CryoLife CryoLife Restated Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean Asset turnover ratios in the presented chart show some common elements throughout all of the data plots, with the exception of CryoLife and CryoLife Restated. Examples of these similarities are going to be a decline in the ratio from 2010 to 2011, a small rise in 2012, and then a rebound from Both of the ratios for CryoLife and CryoLife restated give ratios with less year-toyear volatility that those of the competitors and Exclusion Mean. As can be seen in this chart as well, CryoLife tends to move independently in regards to profitability ratios than the industry. 84

86 Return on Assets Return on assets is the measure of the amount of net income a company generates by the beginning of the year total assets. In other words, this ratio tells an analyst whether the company s increasing growth does not only increase revenues, but also increases the company s net income. Just as asset turnover measures how much revenue is generated by a company for every dollar of assets recorded, return on assets is the measure of how much net income is generated for every dollar of assets recorded. Calculating return on assets is also a lagged ratio like asset turnover. To calculate return on assets, the net income of the current year is divided by the total assets of the previous year ending balance seen as the total assets at the beginning of the current year. Return on Assets 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% CryoLife CryoLife Restated Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean The plots for return on assets above shows a segmented industry. The trends on the chart show that Vascular Solutions and Lemaitre move in a similar fashion throughout the entire time frame of the graph. The other trend is shown in CryoLife, CryoLife Restated, and Merit Medical. While Vascular Solutions and Lemaitre show sharp declines in the early stage of the time frame CryoLife and Merit Medical show an 85

87 increase in their return on assets. Later in the chart there is a break where all of the industry converges to take the same path from 2013 to 2013 while CryoLife and CryoLife restated move to the lower end of the range. Return on Equity This ratio calculates how much profit a company can generate for the amount of money that is invested by their shareholders for a given year. A high return on equity is preferred by analysts and investors because it calculates the effect that reinvestment in the company has for its stockholders. Return on equity allows analysts to determine whether a company is efficiently using stockholder s equity in order to generate added revenues. Return on equity is another lagged ratio that is calculated by dividing the current year s net income by the stockholder s equity of the previous year end which effectively can be seen as the stockholder s equity at the beginning of the current year % 50.00% 40.00% 30.00% 20.00% 10.00% Return on Equity 0.00% CryoLife CryoLife Restated Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean Return on equity trends in the above graph indicate that all of the firms converge into a smaller range when compared to Although adjustments to the CryoLife financial statements do change the ratios, they tend to mirror the movements that the 86

88 original CryoLife ratios make. In regards to the Exclusion Median, CryoLife has a lower return and also experiences larger movements in Conclusion Profitability ratios calculated indicate that CryoLife trails its competitors in terms of profitability. Profitability in the forms of gross profit margin, operating profit margin, and net profit margin all indicate that the company has fallen behind the industry. Additional information provided by the firm s return on assets and equity confirms that the company is less effective at turning revenue into profits as the competitors selected. Capital Structure Ratios Determining the capital structure of firms in the industry is a necessity to properly evaluating CryoLife. This is important because components of the firm can determine profitability. Metrics used for this analysis are internal growth rate, sustainable growth rate, and the Altman Z-Score. Internal Growth Rate Internal growth rate can be defined as the greatest rate of growth a single company can have using only company earnings with no outside debt investments or equity. A company s internal growth rate takes the retention of net income not paid in the company s dividend s, then multiplies this value by the company s return on assets. The equation is computed as: Return on Assets * [1-(Dividends Paid/Net Income)]. A high internal growth rate can be seen in a company that has never paid any dividends to their shareholders. 87

89 Internal Growth Rate 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% CryoLife CryoLife Restated Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean The internal growth rate plots for CryoLife and CryoLife Restated follow an upward path through 2013 and then decline to year Although these two plots do follow the same path the effect of restating accounts causes the ratios for CryoLife Restated to be greater than the original ratios until year Ratios for CryoLife and CryoLife Restated move independently when compared to the benchmark competitors. Examples of this are CryoLife increasing from 2012 to 2013 while competitors decrease and an increase from 2013 to 2014 for competitors while decreasing for CryoLife over the same time period. Sustainable Growth Rate Sustainable growth rate can be defined as the greatest rate of growth a single company can have without its financial leverage increasing. In other words, a company cannot accrue anymore outstanding debt or increase capital by issuing stock. Sustainable growth rate, as opposed to internal growth rate, utilizes leverage for company growth, making sustainable growth rate to be the upper limit of growth for a company. Since leverage is included in sustainable growth rate, this rate is considered more realistic for an analyst to use to assess a company s growth potential. Sustainable 88

90 growth rate is calculated similarly to internal growth rate; however, the equation is defined as: Return on Equity * [1-(Dividends Paid/Net Income)] Sustained Growth Rate 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% CryoLife CryoLife Restated Lemaitre Vasuclar Solutions Merit Medical Exclusion Mean Analyzing the chart for the sustained growth rate the same pattern that was evident for the internal growth rate appears. Sharp declines for Vascular Solutions and Lemaitre occur from 2010 to 2011 while CryoLife and Merit Medical experience an increase. After this occurrence Vascular Solutions experiences a gradual decline for the rest of the graph and appears to be converging to ten percent. Outliers in the Industry are Vascular Solutions with the highest level of percentage growth under the model and Merit Medical providing the lowest level of growth until While both CryoLife and CryoLife Restated do stay within the range of the highest and lowest sustained growth rates, they do underperform in the Exclusion Mean with exception to

91 Altman Z-Score This metric acts as a credit score for the company. Higher scores indicate that the company is strategically positioned to handle financial strain. The ratio is a combination of five scores, each determining the health of a component for the company. CryoLife Altman Z-Scores Initial Scores Revised Scores As can be seen in the chart above, the z-score for CryoLife is increasing from 2011 to now. This change is due to the increasing stock price since the other four scores remain constant. As the stock price rises the market value of equity increases as well as the Altman Z-Score. Conclusion The capital structure of the company is underperforming the industry. This can be indicated through the internal growth rate and sustainable growth rate. Although these two metrics show that the firm is declining in its performance, the credit score of the company is increasing. The contributing factor to the increase in the Altman Z-Score is due to the rising market value of equity. 90

92 Table of CryoLife s Ratios Ratio Liquidity Current Ratio QUICK Asset Ratio Operating Efficiency(365 day) Inventory Turnover Accounts Receivable Turnover Working Capital Turnover Days Supply Inventory Days Sales Outstanding Cash to Cash Cycle Profitability Ratios Gross Profit Margin 58.61% 63.40% 64.55% 64.21% 63.12% Operating Profit Margin 8.46% 9.73% 9.58% 9.82% 6.11% Net Profit Margin 3.38% 6.16% 6.03% 11.49% 5.06% Asset Turnover 87.14% 87.04% 89.08% 89.57% 82.80% Return on Assets 2.95% 5.36% 5.37% 10.29% 4.19% Return on Equity 3.57% 6.47% 6.54% 12.62% 5.06% Internal Growth Rate 2.95% 5.36% 4.45% 8.40% 2.31% Sustainable Growth Rate 4.33% 7.80% 7.95% 15.49% 6.10% Debt to Equity Ratio 21.20% 20.62% 21.66% 22.67% 20.68% 91

93 Table of CryoLife s Restated Ratios Ratio Liquidity Current Ratio QUICK Asset Ratio Operating Efficiency(365 day) Inventory Turnover Accounts Receivable Turnover Working Capital Turnover Days Supply Inventory Days Sales Outstanding Cash to Cash Cycle Profitability Ratios Gross Profit Margin 58.61% 63.40% 64.55% 64.21% 63.12% Operating Profit Margin 13.13% 13.22% 11.80% 10.62% 5.87% Net Profit Margin 8.05% 9.65% 8.26% 12.29% 4.82% Asset Turnover N/A 83.72% 83.64% 82.94% 76.79% Return on Assets N/A 8.08% 6.91% 10.19% 3.70% Return on Equity N/A 9.67% 8.29% 12.30% 4.40% Internal Growth Rate N/A 8.08% 6.03% 8.45% 1.96% Sustainable Growth Rate N/A 11.61% 10.00% 14.62% 5.15% Debt to Equity Ratio 19.68% 20.07% 20.65% 18.90% 16.96% 92

94 Financial Forecasting In our analysis of CryoLife we have used financial forecasting as a tool to better understand the value of the company and what the company s financial statements may look like in the future. We recognize that forecasting is not an exact science and our forecasting includes many assumptions. The assumptions we made for our forecast are based on our knowledge of the company s operations and from looking at historical trends in the company s financial statements. In addition to forecasting out the company s financial statements, we also forecasted our restatements of CryoLife s financial statements in order to give us greater insight into what the company could look like in the future. A result of our forecasting methodology is that the most recent years forecasted will have a higher likelihood of being accurate, the farther out our model goes the less likely it is to hold all assumptions true, the further out the model is extended the more subject it is to sensitivity to any changes in the underlying assumptions. Income Statement To begin constructing our forecasting model we started with the income statement. The first major assumption we made for our model was regarding the sales growth of the business. This assumption is very crucial because it is used to calculate CryoLife s sales revenue, which in turn is used for forecasting the rest of the income statement. CryoLife has had a significant amount of volatility with its sales growth historically. Over the past five years CryoLife s sales growth has ranged from 2.5% to 10.1%. This volatility makes it very challenging to forecast the sales growth going forward. It is our view that CryoLife s sales growth will slowly and steadily increase to 4.5% by the year 2017, and subsequently flatten out at that rate. Our assumption is based on the fact that CryoLife s business model has been stabilizing recently and company has found products that consistently perform well in the market. The next step in forecasting the income statement was to create a common sized version of the income statement. The common sized income statement expresses all items on the income statement relative to the size of total revenue for the business. 93

95 This is crucial for forecasting because it allows us to see the underlying structure of the business. When we looked at the structure of the business it is clear that the Cost of Revenue is structurally trending towards 37% of the total revenue, making the firm gross profit 63%. The common sized income statement also revealed that the firm s total operating expense is trending towards 53% of revenue, and the firm s operating income is trending towards 8.5% of revenue. We used these structural trends to forecast out numbers for Cost of Revenue, Gross Profit, Operating Expense and Operating Income. The most useful forecast we derived from the income statement was our forecast of CryoLife s Net Income. In our analysis of CryoLife s income statement we notice that most of the income statement maintains a stable structure, outside of the sales growth. The volatility of sales growth has made CryoLife s net income volatile but not to the same extent as the sales growth. The Net Income has a range of 3.38% to 11.49% of the Total Revenue of the firm. Because the firm has a stable structure and we have forecasted Sales growth to stabilize and increase, we believe that Net Income will increase to a level that is 7% of Total Revenue and will remain at the level for the rest of our forecasting period. Dividends Forecasting CryoLife began issuing dividends in 2012 and has issued quarterly dividends since that time. The Dividends has increased from.05 per share to.12 per share. CryoLife s dividends have also increased as a percentage of Net Income from 17% in 2012 to 45% in We believe that CryoLife will continue to steadily increase dividend payout as a percentage of net income until 2019 when it will level out at 50% of Net Income. 94

96 Income Statement Forecast 95

97 Restated Income Statement Forecast 96

98 Balance Sheet Using the information gained from forecasting the Income Statement, we proceeded to forecast CryoLife s Balance Sheet. For the purposes of forecasting, the Asset Turnover Ratio is the best way to link the Income Statement and Balance Sheet. Asset turnover is calculated by dividing our total revenue by the firm s total assets. We looked at CryoLife s historical Asset Turnover and found it to be rather consistent, we forecasted the Asset Turnover Ratio to remain at.85 for our forecasting period. We were then able to use the forecasted asset turnover ratio and our previously forecasted Sales Revenue to create a forecast for the firm s total assets. As we did with the Income Statement we also prepared a common sized Balance Sheet. Using our common sized balance sheet we forecasted forward the structure of Total Current Assets and Total Non-Current Assets. Looking at the historical structure of the balance sheet we forecasted the Current and Non-Current Assets would remain at 60% and 40%, respectively of Total Assets. We used this structural forecast to forecast numbers for Current Assets and Non-Current assets over the next ten years. After forecasting our Assets we then forecasted our Liabilities and Equity. The most reliable way to forecast our future Liabilities is to use CryoLife s Current Ratio we forecasted that CryoLife s current ratio would increase slightly over the next two years and level off at 4.5. Using our forecast of the ratio we were able to forecast our current liabilities forward. We were able to forecast our future Retained Earnings and Total Stock Holders Equity by adding our forecasted Net Income for that year and subtracting the dividends we forecasted distributing to stock holders. Once we had our forecast for stock holder s equity we could easily derive total liabilities and non-current liabilities with what we had already forecasted. 97

99 Balance Sheet Forecasted 98

100 Common Sized Balance Sheet Forecasted 99

101 Restated Balance Sheet Forecasted 100

102 Common Sized Restated Balance Sheet Forecasted 101

103 Statement of Cash Flows The final aspect of our forecasting was forecasting CryoLife s Statement of Cash Flows. As with the other two statements the first step in our process was to create a common sized statement so we could better understand the structure of the business. In order to forecast of Total Cash Flow from Operating Activities would looked at the CFFO/NI, CFFO/Operating Income, and CFFO/Sales. Looking at these metrics we determined that CFFO/Sales is the most stable for CryoLife and we give us the most reasonable forecast. CryoLife has had a growing CFFO/Sales that is relatively stable, we have forecasted that it will raise to $.14 and level off. We forecasted our dividends forward using the dividends/net Income and Net Income forecast from the Income Statement. Our Property, Plant and Equipment Turnover ratio seems to be the most reliable way to forecast future cash flows from investing activities. PPE Turnover has steadily risen with a slowing growth rate for CryoLife. Our analysis is that the PPE turnover ill continue to grow slowly until reaching in 2018 and then leveling off. We used this forecast of the PPE ratio to forecast our Cash Flows from Investing Activities forward. 102

104 Statement of Cash Flows Forecasted 103

105 Cost of Capital Estimation The cost of capital is the weighted-average, after-tax cost of a corporation's long-term debt, preferred stock, and the stockholders' equity associated with common stock. It represents the required rate of return on a company existing securities. It can also be determined by different methods. Cost of Equity It can be calculated using the Capital Asset Pricing Method (CAPM). The cost of equity is the required risk of return of an investment. There are three components regarding this model: the risk free (R f ), beta (B), and the risk premium (Rm-R f ). The CAPM equation is K e = R f + B (Rm R f ) From our analysis, we ran regressions over 72, 60, 48, 36 and 24 months by using the 3 months, 1, 2, 7 and 10 years Treasury bond yield. After that, we computed the summary in a table. For example, we suppose that the Market Rate Premium (MRP) is equal 8%, and from the formula K e = R f + B (Rm R f ) we compute the rate of return on investment. The R^2 represents the systematic risk, the non-diversifiable risk, and we conclude that the R^2 is the highest for the 48 months by using the Treasury bond. In addition, we conclude that our systematic risk is about 19% and the firm specific risk is 81%; consequently, the nature of risk of CryoLife is mainly linked to its activities and it is non- common to all businesses. From the table, our beta is equal to which is lower than 1.51 beta provided by yahoo finance. The size premium is determined by looking at the market capital. Our market capital is Million; therefore, we are in the second decile, and our size premium is 2.9%. In order to determine the 2 factor K e, we add K e and the size premium. Finally the lower bound K e and the upper bound K e are determined by using the lower beta and the upper beta in the CAPM formula. In conclusion, the K e of the 48 months regression for a treasury of 10 years is 14.78%. 104

106 3-Month Regression Months BETA Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 fact Ke Ke LB Ke UB % 8.00% 0.02% 7.40% 2.9% % 4.926% % % 8.00% 0.02% 8.84% 2.9% % 6.904% % % 8.00% 0.02% 9.96% 2.9% % 5.922% % % 8.00% 0.02% 12.05% 2.9% % 5.942% % % 8.00% 0.02% 9.67% 2.9% % 0.215% % 1-Year Regression Months BETA Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 fact Ke Ke LB Ke UB % 8.00% 0.26% 7.64% 2.9% % 5.166% % % 8.00% 0.26% 9.08% 2.9% % 7.145% % % 8.00% 0.26% 10.20% 2.9% % 6.974% % % 8.00% 0.26% 12.29% 2.9% % 6.179% % % 8.00% 0.26% 9.90% 2.9% % 0.455% % 2-Year Regression Months BETA Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 fact Ke Ke LB Ke UB % 8.00% 0.56% 7.94% 2.9% % 5.468% % % 8.00% 0.56% 9.38% 2.9% % 7.447% % % 8.00% 0.56% 10.50% 2.9% % 7.278% % % 8.00% 0.56% 12.59% 2.9% % 6.485% % % 8.00% 0.56% 10.21% 2.9% % 0.771% % 7-Year Regression Months BETA Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 fact Ke Ke LB Ke UB % 8.00% 1.71% 9.11% 2.9% % 6.631% % % 8.00% 1.71% 10.55% 2.9% % 8.613% % % 8.00% 1.71% 11.65% 2.9% % 8.431% % % 8.00% 1.71% 13.74% 2.9% % 7.629% % % 8.00% 1.71% 11.36% 2.9% % 1.910% % 10-Year Regression Months BETA Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 fact Ke Ke LB Ke UB % 8.00% 1.94% 9.340% 2.9% % 6.863% % % 8.00% 1.94% % 2.9% % 8.843% % % 8.00% 1.94% % 2.9% % 8.655% % % 8.00% 1.94% % 2.9% % 7.842% % % 8.00% 1.94% % 2.9% % 2.096% % Backdoor Cost of Equity The price to book value is another method used to determine the cost of equity. It also represents the backdoor technique to come up with an estimated cost of equity. It is measured by: P/B=1+ (ROE K e )/K e g 105

107 The use of the formula required a forecast of the balance sheet and income statement to determine the ROE and the growth rate. According to the yahoo finance, the P/B is equal to 1.96, our ROE is 7%, and our final growth rate is 4.5%. ROE P/B g K e As stated 7% % 5.78% This value falls slightly inside of the various regressions. Regressions using forty-eight periods give a lower bound cost of equity at 5.76%. Cost of Debt The cost of debt is defined as the effective rate paid on debt. It can be calculated by discounted the operating leases and determined the interest bearing on long term debt. In our case by comparing the operating leases to the market value for 2014, CryoLife has a minimum interest rate. In addition, CryoLife applied an interest rate of 4.75% in all their loans (from CryoLife K).Consequently, CryoLife s interest rate is 4.75%. The Weighted Average Cost of Capital (WACC) The WACC is the expected rate that a company will pay on average on all securities holders to finance its assets. The WACC is determined by the market value of the liability, equity and preferred stock. In our case, we do not have preferred stock; therefore, our WACC= MV liability + MV equity In addition, the WACC before tax is the expected rate of return before taxes and the WACC after tax is determined after subtracting the tax on the debt. There are calculated by: WACC before tax = (MVL/MVF)*Kd + (MVE/MVF)*Ke WACC after tax= ((MVL/MVF)*Kd) * (1 Tax Rate) + ((MVE/MVF)*Ke) We, the analysts, will also considered the 48 months regression of the 10 year treasury bonds for the calculations and a tax rate of 40%. 106

108 Amount in thousand weight rate Weight*rate WACC MV Liability 16,130 5% 4.75% 0.24% MV Equity 303,105 95% 14.78% 14.04% MV Firm 319, % WACC BT =14.28% WACC AT =14.18% The market value of equity is equal to the number of outstanding shares by the closing price of the stock. CryoLife has 29,229,000 shares outstanding and the closing price in March 2015 is 10.37; consequently, our market value of equity is equal to 303,105. CryoLife s market value of interest bearing debt from the 2014 balance sheet is 16, The market value of the firm is the summation between the market value of liability and equity and it is equal to 319,235. In conclusion, after computation, our WACC BT is 14.28% and WACC AT is 14.18%. We, analysts, also compute the WACC for the lower bound and the WACC for the upper bound. Amount in thousand weight rate Weight*rate WACC lower bound MV liability 16,130 5% 4.75% 0.24% MV equity 303,105 95% 8.66% 8.23% MV Firm 319, % WACC BT=8.47% WACC AT =8.37% 107

109 Amount in thousand weight rate Weight*rate WACC upper bound MV liability 16,130 5% 4.75% 0.24% MV equity 303,105 95% 20.90% 19.86% MV Firm 319, % WACC BT =20.09% WACC AT =20% From the above tables, we have the estimation of the lower and upper bound of WACC; consequently, we are 95% confident that true WACC is between (8.47%; 20.09%). Conclusion The cost of capital is composed of the cost of debt and cost of equity. There are many ways to come up with the cost of equity. However, using the regressions we have a cost of equity that is higher than the backdoor equity. CryoLife did not disclose high levels information concerning their cost of debt. Because of this we used the effective interest rate supplied by the 10-k. Implications of the cost of equity and debt indicate that it is cheaper for the firm to finance operations or tasks through debt. Summary of Financial Analysis As our team of analysts has examined the financial state of CryoLife we have gained significant insight into the operations of the company. Our ratio and crosssectional analysis has shown that amongst its competitors in the medical devices industry CryoLife remains competitive by most measures. We have found that crosssectional analysis is a strong tool for finding weakness in the business or exposing competitors that lack in certain areas. Our forecasting has helped us paint a picture of what CryoLife s financial future may look like under a given set of assumptions. This information is very pertinent to our valuation models. We also took the time to run regressions and analyze our cost of capital. Our financial analysis indicates that CryoLife is mixed in terms of improving and decreasing metrics. Liquidity ratios remain high due to large amounts of cash on hand. 108

110 Operational efficiency is strong relative to the competitors, whereas profitability trails the industry. Finally, the capital structure of the firm indicates low default probability and a trailing growth rate. Price Multiples Valuation & Analysis A Price Multiple refers to any ratio using a company s share price in conjunction with a per-share financial metric. These ratios allow analysts to value a company s financial wellbeing. In other words, a company s current measure of performance or a single forecast of their performance is converted into a value by using a price multiple that is derived from the values of comparable companies. To calculate Price Multiples, a specific market price variable is divided by a specific value driver. The Price Multiples approach to valuation is a three step process. First, a measure of a company s performance or value is selected to be the basis for the multiple usually earnings or book equity. Second, the comparable companies stock prices need to be deflated by the firms selected performance measure in order to created multiples. Lastly, the average multiple for all of the comparable companies are applied to the value or performance measure of the company that is being analyzed. The reasoning behind Price Multiples is that these values allow analysts to compare a certain company with similar companies in order to determine if the market has priced the given firm properly. If, after calculating, a company has been priced below the comparable companies, then the stock for the company has theoretically been undervalued. However, this may not be the absolute conclusion to why the company price is lower than the comparable firms. Another reason for a lower price multiple is that the entire market may be overpriced because of the market s failure to price in the level of risk for the market. For this analysis section, nine ratios will be utilized for Price Multiples 109

111 EPS Earnings per Share (EPS) can be defined as the amount of a firm s earnings, net of preferred stock dividends and taxes, allocated to every outstanding share of their common stock. Overall, EPS is used as an indicator of a firm s profitability. To calculate EPS, dividends paid on preferred stock is subtracted from a firm s net income, then this calculation is divided by the average outstanding shares of the firm for a given period. To be more accurate in this calculation, a weighted average of the number of shares outstanding is used because the number of the company s shares changes over time. However, the number of shares outstanding for the end of a period can be used in order to simplify the calculation. EPS CryoLife $ 0.25 CryoLife Restated $ 0.24 Lemaitre Vascular Inc. $ 0.22 Vascular Solutions $ 0.74 Inc. Merit Medical $ 0.53 Systems Exclusion Mean $ 0.50 For CryoLife, Earnings per Share, before restating financials, are $0.25. Even after restatement, CryoLife s EPS stays very close to $0.25, calculating at $0.24. Having an EPS of $0.25 is not overly profitable and not abundantly terrible. In regards to CryoLife s benchmark companies Lemaitre, Vascular Solutions, and Merit Medical CryoLife is below the average of all three of them, which is at an even $0.50. Conclusion Understated However, CryoLife and Lemaitre are the only companies in the benchmark population that tender dividends and their share prices are dismal compared to Vascular 110

112 Solutions and Merit Medical. A higher share price input in this ratio creates a higher Earnings per Share. P/E Trailing There are two calculations for a company s price earnings ratio trailing and forward. For price earnings trailing, the current share price of a company is divided by the past year s trailing earnings per share. The difference between the forward price earnings ratio and the trailing price earnings ratio is that, for trailing, the calculation uses actual historical earnings for the company other than the estimates for the future four quarters. The trailing price earnings ratio is the most commonly used because of the actual earnings used in the calculation are a more accurate value than estimates. The only problem with this ratio is that stock prices are always changing, which can make the calculation less relevant for a certain company. A company s trailing price-toearnings ratio is regarded as the most accurate measurement of a security s valuation in other words, the fair market value of the stock within a perfect market. CryoLife s price earnings ratio, prior to restatement, is at $41.04 while, after restatement, they are at a level of $ Comparatively, CryoLife s benchmark companies have an average price earnings ratio of $38.10 displaying that CryoLife has larger earnings than the other competitive companies. P/E Forward The forward price earnings ratio uses the forecasted earnings for a company when calculating the price earnings. These estimates, although less reliable than historical earnings, can be beneficial for valuation because of the ever changing prices of a company s stock. The forecasted value of earnings can either be an estimate of the next twelve months for a company or the next full-year earnings for the fiscal year. To calculate forward price earnings, the market price per share for a company is divided by the forecasted earnings per share. This formula is used to compare a company s current earnings to an estimated value of future earnings for the year. If a company believes that their earnings will grow in the future, then their estimated price earnings 111

113 are lower than their current price earnings. This calculation creates a clearer picture of the amount of earnings a company will have without any charges or other adjustments. Price to Book The price to book ratio for a company is simply the comparison between a company s market value of stock to their book value. To calculate it, the current closing price for common shares of the stock is divided by the nearest book value per share. Price to book is also referred to as the price-equity ratio. An undervalued stock will have a low price to book ratio, while an overvalued stock will have a high price to book ratio. This formula allows an analyst to find a low-priced stock that could have large upsides. If a price to book ratio is less than one, then the given market believes the company s asset value has been overstated or the given company has a very poor return on their assets. On the other hand, if the price to book ratio is greater than one, then the given company has a high rate of return on their assets making them valuable company for investors. P/B CryoLife $ 2.02 CryoLife Restated $ 1.85 Lemaitre Vascular Inc. $ 2.12 Vascular Solutions Inc. $ 4.57 Merit Medical Systems $ 1.93 Exclusion Mean $ 2.88 CryoLife s price to book ratio was calculated at $2.02. The financial analysis of this calculation is that CryoLife can be seen as being a relatively fairly valued company with an average rate of return on assets. When looking at the benchmark companies, Lemaitre and Merit Medical had ratios at the same level as CryoLife, while Vascular Solutions price to book ratio was calculated at $

114 Conclusion Understated Dividend to Price The dividend to price ratio, also referred to as dividend yield, calculates the amount a company pays in dividends per year relative to their share price. Absent of capital gains, the dividend to price ratio is the return on an investment for a given company s stock. To calculate this formula, the annual dividends per share for a company are divided by the stock price per share for the company. In simplest terms, this ratio measures the amount of cash flow an investor will receive for every dollar invested in equity that is spent. A company s stock price will depreciate with a reduction in the dividends paid by the company. A company needs to have a stable dividend yield ratio, which indicates that they have an efficient and consistent dividend policy. A well run and mature company will have a high ratio. D/P CryoLife $ 0.01 CryoLife Restated $ 0.01 Lemaitre Vascular Inc. $ 0.02 Vascular Solutions Inc. $ - Merit Medical Systems $ - Exclusion Mean $ 0.02 CryoLife s dividend to price ratio was calculate at $0.01, which is extremely low. Having a low dividend to price ratio, CryoLife does not tender large amount of dividends per share for their stock per year. As for the benchmark companies, only Lemaitre tenders dividends per year and their dividend to price ratio was calculated at $

115 P.E.G. Ratio (P/E)/(1-g) or price earnings to growth ratio (PEG) refers to a company s stock price-to-earnings ratio divided by the company s growth rate for their earnings for a given amount of time. This values a company s stock, while also taking into account the given company s growth overall creating a clearer picture of their price-toearnings. If a company has a high price-to-earnings ratio, then it can look like an undervalued stock; however, once their growth rate is taken into account, the company s stock value may display a different story. A low PEG ratio will correlate to an undervalued stock, given their earnings performance. To calculate PEG ratio, the company s price-to-earnings ratio is divided by their annual earnings per share growth rate (1-g). Both the trailing price-to-earnings ratio and forward price-to-earnings ratio can be used to calculate this, which creates a clear picture on a company s value in regards to historical growth rates and forecasted future growth rates. P.E.G. CryoLife $ CryoLife Restated $ Lemaitre Vascular Inc. $ Vascular Solutions Inc. $ Merit Medical Systems $ Exclusion Mean $ CryoLife s (P/E)/(1-g) was calculated at $43.71, while the benchmark companies have an average of $ Conclusion Overstated 114

116 A (P/E)/(1-g) calculated at the level that CryoLife has means that they are a relatively overstated company in regards to their price earnings multiple, when their growth rate is taken into account. P/EBITDA Price to EBITDA refers to the ratio of a firm s stock price to their earnings before interest, taxes, depreciation and amortization. This ratio is very similar to the normal price earnings ratio; however, it does not take into account the interest, taxes, depreciation and amortization that is deducted out of the company s earnings. The reasoning for doing this calculation is to compare relatively similar companies that have different amounts of debt and different amounts of upfront capital expenditures. To calculate the formula, a company s stock price is divided by their earnings before interest, taxes, depreciation and amortization. P/EBITDA CryoLife $ CryoLife Restated $ Lemaitre Vascular Inc. $ Vascular Solutions Inc. $ Merit Medical Systems $ Exclusion Mean $ CryoLife s P/EBITDA was calculated at $34, with a benchmark average of $ P/EBITDA at $34 can mean that, compared their benchmark companies, CryoLife has a lower amount of earnings comparatively the higher the EBITDA, then the lower the ratio. Conclusion Overstated 115

117 Since CryoLife comparatively has a lower EBITDA than the competition, their ratio is higher making them a less valuable company and making them a potential overstated company. P/FCF per Share P/FCF per share is a ratio method that is used when comparing a firm s current stock price to their per-share free cash flow. To calculate price to free cash flow per share, a company s market capitalization is divided by their free cash flow. A low P/FCF per share usually signifies that the company s shares have been undervalued and their stock price should increase with time the lower the ratio correlates to a cheaper stock. This calculation does not subtract the company s capital expenditure from their cash flows. The problem with the formula is that a company is able to manipulate their free cash flows by increasing the length of time they pay their bills or reducing the time the company takes to collect on receivables increasing their cash account which increases the company s cash from operations. A company could also hold off on investing in additional inventory to preserve their cash account. P/FCF Per Share CryoLife $ CryoLife Restated $ Lemaitre Vascular Inc. $ Vascular Solutions Inc. $ Merit Medical Systems $ Exclusion Mean $ CryoLife s P/FCF per Share was calculated at $49.83, with a benchmark average of $ CryoLife s ratio seems to be low at $49.83; however, Lemaitre s P/FCF was 116

118 calculated at $29.55, while Vascular Solutions and Merit Medical were calculated at $ and $111.12, respectively. The meaning behind CryoLife s ratio is that their Free Cash Flows may be larger comparatively than the benchmark companies. Conclusion Fairly Valued When comparing this ratio to the benchmark companies, CryoLife s ratio shows that they may be a fairly valued company or, at worst, a relatively overstated company. EV/EBITDA EV/EBITDA refers to the enterprise multiple of a company in order to value the said company. This multiple takes the company s debt into account, unlike other multiples like the price to earnings ratio. To calculate the enterprise multiple, the company s enterprise value is divided by their earnings before interest, taxes, depreciation and amortization. An undervalued company will have a low EV/EBITDA ratio. The advantage to this multiple is that it allows comparisons to be made between international companies with different taxation policies that affect their earnings. Companies in high growth markets with have a higher multiple in comparison to companies in low growth markets. Overall, a company s enterprise value multiple values a company better than price to earnings ratio because the changes in their capital structure does not affect the calculation. CryoLife $ CryoLife Restated $ Lemaitre Vascular Inc. $ Vascular Solutions Inc. $ Merit Medical Systems $ Exclusion Mean $ EV/EBITDA 117

119 CryoLife s EV/EBITDA was calculated at $33.23, with a benchmark average at $ This calculation for CryoLife can mean that they are slightly overstated when compared to the industry benchmarks. Conclusion Overstated A reason behind having a higher EV/EBITDA for CryoLife would be that they have a lower overall enterprise value than their competition as a whole or that they have a reasonable amount of debt. Enterprise Value A company s enterprise value is the measure of a firm s total value. This value is more often used because it is a comprehensive alternative to a company s equity market capitalization. While market capitalization is calculated as their share price multiplied by their number of shares outstanding, enterprise value is calculated as the sum of the company s market value of equity and debt subtracted by their cash and financial investments. In simplest terms, a company s enterprise value is their theoretical takeover price if they were to be bought at that exact moment. Compared to market capitalization, enterprise value is a more accurate reflection of the company s real value because it takes into account much more than the value of the company s outstanding debt. For this analysis, the enterprise value will be used to calculate CryoLife enterprise value multiple. 118

120 EV/EBITDA CryoLife $ 293,687, CryoLife Restated $ 293,687, Lemaitre Vascular Inc. $ 139,400, Vascular Solutions Inc. $ 505,318, Merit Medical Systems $ 1,145,737, Exclusion Mean $ 596,818, CryoLife s enterprise value was calculated at $293,687,120. Their EV when compared to the benchmark companies is much lower than Vascular Solutions and Merit Medical, but much higher than Lemaitre s at $139,400,700. Overall, CryoLife s EV signifies that they have a lower market value of equity and debt than some of the competition, which may be run solely on equity and debt. Valuation Models Continuing our equity analysis of CryoLife we the analyst used intrinsic valuation models to determine whether CryoLife is overvalued, undervalued or fairly valued. For every model we looked at we used a base share price of $10.28 which was observed on April 1 st For our intrinsic valuation model analysis we looked at five different models: Discounted Dividends Model, Free Cash Flows Model, Residual Income Model, Long Run Residual Income Model and the Abnormal Earnings Growth Model. It is important to note that all five of these models have many moving parts and rely heavily on assumptions. These models are all prone to forecasting errors from our previously discussed forecast. We ran sensitivity analysis on all five models to that it would be clear how changing difference variables effects the output of the model. Discounted Dividend Model The first valuation model that we looked at is the Discounted Dividends Model (DDM). This model utilizes our previously forecasted dividends to and an estimate of a 119

121 dividend perpetuity to estimate the value of the firm. This forecasted dividends stream is discounted to the present time period. This model suffers from a significant flaw in that it only values the value of the future dividends stream and completely ignores capital gains in the stock price that would be created by the business being run well. This is an important point, the value of the business is determined ultimately by three factors: The operations of the business, the dividend policy and the firm s leverage. The Discounted Dividend Model only factors one of these three factors into the valuation and thus frequently shows firm s to be overvalued. Running this model on CryoLife we found that the Discounted Dividends Model shows CryoLife is currently overvalued. Our current cost of equity and growth rate would indicate a value of $1.76 per share, significantly less than the observed share price of $ The sensitivity analysis showed very little significant variation with the share price. In our sensitivity analysis we extended the lower bound of cost of equity down to 5% which is close to our back door cost of equity and still the model shows that the company is still highly overvalued. $ % 1% 2% 3% 4% 5% $ 2.61 $ 3.00 $ 3.63 $ 4.91 $ % $ 2.05 $ 2.19 $ 2.37 $ 2.63 $ % $ 1.80 $ 1.87 $ 1.96 $ 2.07 $ % $ 1.70 $ 1.75 $ 1.81 $ 1.88 $ % $ 1.63 $ 1.67 $ 1.71 $ 1.76 $ % $ 1.57 $ 1.60 $ 1.64 $ 1.67 $ % $ 1.53 $ 1.56 $ 1.58 $ 1.61 $ 1.64 Free Cash Flow Model Where the Discounted Dividend Model relied on the forecasted dividends, the Free Cash Flow Model relies on the forecasted cash flows. The major advantage to this approach is that the cash flows tell a more complete story about the success of the firm than the dividend policy does. However this approach has a major drawback in that is has a high level of sensitivity to forecasting error. This model is susceptible to forecasting error because free cash flows are the most difficult part of the financial statements to forecast forward. 120

122 When applying this model to CryoLife we found it to be the most optimistic of all the models, under some of the most optimistic conditions the Free Cash Flow Model showed that the company may be fairly or undervalued. Largely what the sensitivity analysis shows is that CryoLife is an overvalued firm. $ % 1% 2% 3% 4% 5% $ $ $ $ $ % $ 7.78 $ 8.18 $ 8.72 $ 9.48 $ % $ 5.90 $ 6.06 $ 6.25 $ 6.49 $ % $ 5.10 $ 5.19 $ 5.30 $ 5.43 $ % $ 4.49 $ 4.55 $ 4.61 $ 4.69 $ % $ 4.01 $ 4.05 $ 4.09 $ 4.14 $ % $ 3.62 $ 3.65 $ 3.67 $ 3.71 $ 3.74 Residual Income Model The Residual Income model for valuation is the model that has the greatest level of explanatory power. A firm s Residual Income is the amount of income a firm makes in excess of what its shareholders demand as return on equity. This is calculated by taking the firm s net income and subtracting the firm s normal income, or the amount of income the shareholders would demand the firm make. As opposed to the previous two models this model does not use a standard growth rate but a decay rate. This decay rate is designed to bring the long run outputs of the model to zero. This intuitively makes sense because in the long run we would not expect a firm s return to exceed their or be below their cost of capital. As with previous models, the residual income model shows that CryoLife is an overvalued firm. Our sensitivity analysis shows that even under the most optimistic conditions for CryoLife the firm is still significantly overvalued by the market. 121

123 $ % -20% -30% -40% -50% 5% $ 7.02 $ 6.67 $ 6.52 $ 6.44 $ % $ 4.76 $ 4.79 $ 4.80 $ 4.81 $ % $ 3.51 $ 3.62 $ 3.68 $ 3.71 $ % $ 2.92 $ 3.05 $ 3.11 $ 3.15 $ % $ 2.46 $ 2.59 $ 2.65 $ 2.70 $ % $ 2.10 $ 2.22 $ 2.28 $ 2.32 $ % $ 1.81 $ 1.91 $ 1.98 $ 2.02 $ 2.05 Long-Run Residual Income Model The Long Run Residual Income model is based on the Residual Income model, with some slight differences. Where the residual income model is centered on forecasting the residual income forward. The long run residual income model uses a growth or decay rate and the forecasted return on equity to come up with a long run price for the shares of the company. To calculate this model we first calculate our B value by taking the ROE and subtracting Cost of Equity, then taking that number and dividing it by Cost of Equity minus the growth/decay rate. We then take one plus our B value and multiply it against our book value of equity to get the model value of equity. If B is a positive value, it will show that the firm has been adding value, if the B value is negative it will show that the firm has been destroying value. When this model was applied to CryoLife we found as with the other models that the market has significantly overvalued the firm. For this model we can nine sensitivity analysis, holding ROE consent at 6%, 7.5% and 9%, holding growth rate constant at - 20%, -30% and -40%, and holding our Cost of Equity constant at 13%, 15% and 17%. These sensitivity tables showed us that even in the most favorable circumstances the firm is still overvalued. 122

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125 Abnormal Earnings Growth Model The Abnormal Earnings Growth Model (AEG) is very similar to the retained earnings model. The basic mechanic of the AEG model is the dividends reinvested in the business. This model relies mostly on forecasting out the company s earnings and dividend payout rate. These forecast are discounted back to the present, we can use this discounted value and the perpetuity to calculate an average earning per share rate. Dividing this rate by our capitalization rate gives us an intrinsic value per share for the firm. When this model was applied to CryoLife it was consistent with the findings of the other models, CryoLife is overvalued very significantly. CryoLife s outlook did not vary significantly with the sensitivity analysis. The most optimistic scenarios, still had CryoLife very over valued by the market $ % -20% -30% -40% -50% 5% $ 5.53 $ 5.28 $ 5.18 $ 5.12 $ % $ 3.15 $ 3.13 $ 3.12 $ 3.12 $ % $ 2.20 $ 2.22 $ 2.23 $ 2.24 $ % $ 1.84 $ 1.87 $ 1.88 $ 1.89 $ % $ 1.59 $ 1.62 $ 1.63 $ 1.64 $ % $ 1.41 $ 1.43 $ 1.44 $ 1.45 $ % $ 1.26 $ 1.28 $ 1.29 $ 1.30 $ 1.30 Model Discounted Dividends Model Free Cash Flows Model Residual Income Model Long Run Residual Income Model Abnormal Earnings Growth Model Overall Conclusion Over Valued Over Valued Over Valued Over Valued Over Valued Over Valued 124

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