Forecasting ESOP Repurchase Obligations

Transcription

1 Forecasting ESOP Repurchase Obligations Presented by Ashleigh Newlin, ESOP Economics and Linda Luckenbaugh, Wexco Incorporated

2 Agenda Introduction to the Repurchase Obligation Background on Wexco Incorporated The Forecasting Process Defining the issues Gathering data Developing assumptions Modeling a base case and additional scenarios Analyzing results/developing conclusions Concluding Thoughts

3 What is the Repurchase Obligation? Repurchase obligation is the requirement of an ESOP sponsor to buy shares back from participants who are entitled to distributions. Retirement, death or disability Other terminations (turnover) Exercise of diversification rights Shares must be repurchased at fair market value determined by an independent appraisal

4 Why plan for repurchase obligations? The repurchase obligation can represent a significant liquidity requirement that affects cash flow, earnings, and the value of a company s stock Many appraisers now ask for repurchase obligation projections With advance planning, you can develop strategies for meeting these obligations that are consistent with corporate goals such as: Benefit levels ESOP sustainability Availability of stock for future participants

5 What is a repurchase obligation study? It is a long-term projection of ESOP distributions and the associated cash requirements a company will face Intended to provided answers and potential solutions May include an analysis of strategies for managing and funding the resulting obligations Tool to help ESOP companies make informed decisions about how best to manage and fund their repurchase obligations Important component of financial planning for ESOP sponsors

6 Do you have to do a study? No No statutory or regulatory requirement Appraiser might not ask for it But Board of directors has obligation to make sure that repurchase obligations can be met

7 Some of the things you can learn from a Study Number of shares to be repurchased Cost of repurchase obligations Repurchase obligations relative to contribution limits Benefit levels provided to participants Sufficiency of planned contribution strategy Effect of redemptions on ESOP ownership and participants accounts Flow of shares available for future participants

8 When should you do a Study? Do first Study early in the life of the ESOP Review assumptions annually Update as necessary Whenever there are material changes in your business or the Company s strategic plans Assumptions or census change significantly ESOP is considering transaction that will affect repurchase obligations Otherwise, update every 2 to 3 years

9 Do it yourself, or hire a consultant? It depends on your resources and experience: Doing it in-house You can run additional scenarios and update results more readily Hands-on involvement may provide a deeper understanding of the ESOP and RO issues A consultant brings Experience Reasonableness of assumptions Data setup and review The ability to analyze the results and their implications for you Using a consultant does not mean: Here is the data, call me when you are done Your input is critical to the process!

10 Wexco Incorporated

11 Wexco Incorporated 2 Manufacturing Facilities York, PA Independence, OR 4 Distribution Facilities Mokena, Illinois Burlington, Ontario Felixstowe, U.K. Rotterdam, Netherlands 7 Retail Stores York, PA Lancaster, PA Burlington, Ontario Beaverton, Oregon Portland, Oregon Salem, Oregon Camarillo, California

12 Countries where Wexco Incorporated products are currently sold Canada Italy United Kingdom Germany Norway Iceland Sweden Czech Republic Denmark Nigeria The Netherlands Trinidad Belgium Turkey France Panama Bermuda Chile Switzerland Slovenia Hungary Slovakia Israel Saudi Arabia Oman

13 Wexco Incorporated ESOP ESOP formed in 2000 Leveraged Transaction Acquired 70% of Company Loan paid off in % ESOP-Owned in participants Company is taxed as an S Corporation ESOP Distribution Policy Participants are paid in up to five installments Accounts of terminated participants may be segregated (converted out of company stock)

14 Wexco Incorporated: Recession and Recovery : Pool & Spa Industry sales declined 65-70% : Wexco Incorporated sales declined 65% 2012 Wexco Incorporated sales were approximately 50% of sales in sales were 11% above prior year Steady growth in sales continues +2% in % in % expected in 2016

15 Wexco Incorporated: Repurchase Study Completed our last study in March 2016 To update projections for 100% transaction To explore the impact of segregating the accounts of terminated participants Why we do studies regularly Important planning tool - future liabilities should be taken into account for corporate cash flow planning Part of the study is developing future business assumptions, which stimulates thinking in areas you may not look at as you focus on daily operations.

16 The forecasting process Define issues and questions to be addressed Gather data Develop financial and actuarial assumptions, and assumptions about repurchase method and funding strategy Model a base case forecast Analyze results, identify any issues and challenges Identify potential strategies Model additional scenarios Develop conclusions and present results

17 Defining the issues What questions are you trying to answer? How big are the repurchases and when will they occur? Can we afford to meet the repurchase obligations and still grow the business? Is the current funding strategy adequate? What are the implications of the ESOP acquiring more shares? What are the implications of amending the current distribution policy?

18 Wexco Incorporated: Defining the Issues Debt reduction and repurchase obligations vs. Investment in business Impact of moving to 100% Additional shares contributed to the ESOP from treasury over 5 years Additional scenario to quantify the impact of segregating

19 Gathering data: What data will you need? Plan Document, SPD, Amendments, Distribution Policy (if separate from Plan Document) Most recent allocation file Historical allocation files (to perform an analysis of historical turnover rates) Most recent valuation report Business plan/financial forecasts ESOP loan amortization schedule

20 Developing assumptions: variables that affect repurchase obligations Plan provisions / distribution policy Demographics / actuarial assumptions Financial assumptions Repurchase method Funding strategy Some of these variables in turn are affected by the company s business and financial strategy and by exogenous variables (the economy, the industry, etc.)

21 Plan provisions Eligibility & vesting rules Allocation method Accounting method / rebalancing Distribution policy Segregating Accounts Diversification rules In-Service distributions Retirement age(s)

22 Plan provisions: distribution policy Main components of distribution policy: Immediate distributions vs. delays Lump sum vs. installments Segregating accounts at termination

23 Plan provisions: distribution policy Delays & Installments Delayed distributions and installment payments: Allow the company more time to develop the cash needed for repurchases Make repurchases more predictable Reduce year-to-year variations in the cash requirements However: Can result in higher distributions to participants, as terminated participants benefit from increases in stock value Unless accounts are segregated at termination Can make lump sum exceptions for small account balances

24 Plan provisions: segregating accounts Segregating accounts a terminated participant s account is cashed out of company stock as soon as possible; the account is invested in other investments until it is finally distributed Company can maintain distribution policy (with delays and installments) without terminated participants sharing in stock value fluctuations The drawback cash requirements are often equivalent to immediate lump sum distributions

25 Plan provisions: diversification & in-service distributions Diversification Age 55 and 10 years of participation Up to 25% of eligible stock over the first 5 years, then up to 50% in the 6 th and final election year Calculation is cumulative In-Service Distributions (an optional provision) Allows participants to take a distribution prior to termination from service Plan can dictate any age and/or service or participation requirements, as well as percentage of a participant s account balance that is available to be withdrawn

26 Wexco Incorporated: Key Assumptions Plan Provisions Diversification rights: statutory Distribution policy: accounts of terminated participants are paid in up to five installments Accounts may be segregated. Modeled a base case scenario without segregation, and an additional scenario with segregation

27 Demographic/actuarial assumptions Age profile of existing population - Will drive timing of age-related events like diversification & retirements Turnover rates/patterns - Consider analyzing 3-5 years of historical census data for turnover to develop assumptions for Study Death/disability Changes in size of workforce Salary Increases Age/compensation of future new hires Election rates of diversification rights

28 Wexco Incorporated: Key Assumptions Demographic assumptions Employee Groups a group for each company Retirement Age Assumed age 68, based on experience Specific assumptions for those already over 68, other top shareholders Turnover Assumed turnover consistent with historical averages (related to length of service) Future changes in headcount and salaries Assumptions differed by employee group based on business plans Diversification election rates Assumptions based on historical election rates

29 Financial assumptions: stock value Stock value is a critical variable When developing assumptions about share value for the Study, it may be helpful to: Look to your internal financial projections Understand the methodology used by your appraiser for valuing the ESOP shares If you have built a financial model, integrate the repurchase obligations into the model to develop stock value assumptions Adjust all related assumptions when adjusting stock value growth If you adjust assumptions about share value, what other assumptions for the forecast need to be adjusted?

30 Assumptions are inter-connected! Earnings and Cash Flow Stock Value Combined with Demographics, Distribution Policy, and Funding Method Repurchase Obligations

31 Wexco Incorporated: Key Assumptions Financial assumptions Growth in share price Cyclical business downturns every 5-7 years Long-term share value growth rate Factor in external debt schedules

32 Repurchase method: redeem vs. recirculate Redeeming company buys back shares Recycling shares are repurchased within ESOP with cash from the company Contributions, dividends, or S distributions Releveraging Shares are redeemed and then company sells them back to the ESOP Purchase is financed with internal loan between company and ESOP, typically with long (20-years+) amortization schedule Repurchase methods can be combined Repurchase methods can be changed - the board can decide each year

33 Funding strategy Typical funding methods: Pay as you go Reserves in ESOP accumulated from excess contributions, dividends, or S distributions Smoothes out cash requirements, but there are some inefficiencies Reserves in company Beware of potential impact on equity value! External debt Internal market

34 Wexco Incorporated: Key Assumptions Funding Strategy Large S distribution in 2015 expected to fund repurchase obligations for 3 years After the move to 100%, no longer paying S distributions Contribute cash to the ESOP Cash contributions as necessary so that all shares can be recycled

35 A note on developing assumptions Good assumptions are essential! Your projections will only be as good as the assumptions on which they are based Ever heard the phrase, garbage in, garbage out? Assumptions need to be: Reasonable Internally consistent Consistent with other financial planning Get buy-in on the assumptions from key members of management

36 Model a base case forecast Incorporate plan provisions, assumptions, current repurchase method and funding strategy into model and run forecast Check results for accuracy and reasonableness: Do the results make sense?

37 Analyze results/identify alternative strategies What are the answers to the questions that you initially identified? What other issues have emerged from the projections? Can repurchases be handled without interfering with growth? Should changes be considered in the plan or in distribution rules? What is the best method for handling repurchases? What funding methods are appropriate?

38 Model additional scenarios Analysis of the base case scenario may suggest additional scenarios/strategies to be explored You won t necessarily be able to determine the impact of making changes without modeling the alternatives Results and potential strategies should be stresstested by looking at a range of assumptions

39 Wexco Incorporated: Analyzing results Results of the study confirmed some tweaks to assumptions were necessary Adjusted retirement ages for actives beyond age 68 After tweaking assumptions, we finalized a base case The projected timing of retirements has a significant impact on the forecast. Cash requirement will be manageable

40 Wexco Incorporated: Additional scenarios Modeled a scenario in which the accounts of terminated participants are segregated in the year following termination Repurchase obligations are 12% higher over 20 years Segregation results in a faster turnover of shares Cash requirement (and benefit level) varies widely from year-to-year based on retirements since the segregation is assumed to occur in a lump sum

41 Develop conclusions/present results What have you learned from the analysis? What are the pros and cons of the alternatives? Prepare a final report, including a Board-friendly summary of the findings, which usually includes: Background information Summary of the issues Summary of the results and implications Pros and cons of potential strategies Recommendations and/or issues for further analysis

42 Remember... The repurchase study is not just a set of numbers. It is an analysis of potential problems and solutions. The study is a tool to help you make decisions about how you will manage and fund the repurchase obligations

43 Wexco Incorporated: Benefits of doing the Study Study provided visibility on future cash requirements so that excess cash could be invested efficiently (to grow the business). Study provided information about the impact of segregating terminated accounts. Helpful thinking through the assumptions. Make decisions or know that you need to make decisions about some of these factors.

44 Final words of wisdom Don t wait until the week before the board meeting to start the process it takes time to do it right Developing good assumptions is critical involve key members of management Understand how repurchase obligations are reflected in stock valuation and integrate into your financial model Stress test your strategy Update your Study whenever meaningful changes take place or you would like to evaluate alternative strategies

45 Questions? Linda Luckenbaugh, Controller Wexco Incorporated Ashleigh Newlin, Director ESOP Economics, Inc