Repurchase Obligations Valuation and Financing Issues September 14, 2016 September 14, 2016 Isaiah Aguilar Director Stout Risius Ross Eric S. Zaiman Executive Director J.P. Morgan Joe Marx Vice President-Consulting Principal Financial Group Michael Borinski Chief Financial Officer Bradford White Water Heaters
2 Topics Introduction Mechanics and Tactics Strategy Development Importance of Monitoring Repurchase Obligations Tools Case Study Q&A
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4 Introduction Companies that sponsor ESOPs must provide eligible participants with a put option on shares held by the ESOP, giving participants the right to have the company buy back their shares at fair market value IRC 409(h)(1)(b) if the employer securities are not readily tradable on an established market, participant has a right to require that the employer repurchase employer securities under a fair valuation formula The obligation to buy back shares is the repurchase obligation and it can be a significant claim on cash flow for 100% or majority-owned ESOP companies Overwhelming repurchase obligation can be a driver of the sale of ESOP owned companies and the termination of their ESOPs
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6 Share Repurchase Mechanics When are shares repurchased - Distribution policy Delay vs. immediate Up to six year wait for start of repurchases from terminated employees Up to one year wait for start of repurchases from death, disability and retirement Lump-sum vs. installments Up to five years for all participants, with longer periods for larger account balances Segregation/reshuffling Immediate exchange of shares for cash, same impact as lump sum
7 Comparison of Redeem vs. Recycle and Redeem vs. Releverage Redeem Recycle Releverage Shares outstanding Reduced No impact No impact(*) ESOP Ownership Reduced if < 100% No impact No impact Additional shares to Employee ESOP accounts No Yes Yes, over time Per share value Anti-dilution Diluted Diluted Employer contribution No Yes and dividends/s distribution Yes and dividends/s distribution Employee group benefited most EEs with larger share balances Depends upon funding Contribution (EEs) Dividends (Participants) Contribution (EEs) Corporation s cash flow Reduce Not Reduced if =Benefit Expense Not reduced if =Benefit Expense Income tax No deduction Deduction for employer contribution Deduction for employer contribution * Assumes after redemption by the company all shares are sold to ESOP * Is a new securities acquisition loan needs an adequate consideration opinion at time of transaction
8 Valuation Implications Share redemptions impact on valuation: Redemptions are not an expense and do not affect operating cash flow; but they do reduce overall cash Enterprise value remains the same, equity value is lowered but share price remains unchanged because # shares are reduced in proportion Share recycling impact on valuation: Contributions are an expense & reduce operating cash flow; results in reduced enterprise value unless otherwise offset Dividends are not an expense and do not affect operating cash flow; but they do reduce overall cash. Enterprise value remains the same, equity value is lowered Benefits vs. Return on Capital
9 Valuation Implications - Indirect Impacts Adjustments to Value Multiple selection / discount rate Estimate present value of excess retirement benefits Marketability discount Significant repurchase obligations can limit cash available to: Finance business operations and reinvest in capital expenditures and other growth opportunities Results in lower growth and lower enterprise value Build balance sheet cash balances or repay debt Lower cash and higher debt results in lower equity value
Financial Statement Impacts of Funding Strategies 10
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12 Goals of Managing Repurchase Obligation Minimize the competition for cash flow and capital between repurchase obligation and reinvestment in the business while balancing between multiple objectives Provide ongoing retirement benefits to employees Fund repurchase obligations Ensure sufficient capital generation to provide for required reinvestments and pursue growth opportunities
13 ESOP Benefit Level Defined Cash going into plan Contributions Reallocation of forfeitures Dividends and S distributions on suspense shares Value allocated to participants Value of shares released Value of shares recycled Forfeitures Contributions not used for ESOP loans or repurchase Appreciation in share value and dividends and S distributions on allocated shares Really return on equity
14 What Contribution Level/Benefit Cost is Appropriate? What is normal benefit level? Industry and geographic norms Competitors and other ESOP companies What is desired benefit level? Corporate culture Employee expectations Desired incentive/motivation What is the entire benefit cost? ESOP debt service Wages All qualified plans Non-qualified deferred compensation
15 Managing Benefit Levels What drives the level of benefit in the ESOP? Newer ESOPs Loan amortization/share release Mature ESOPs Repurchase obligation, distribution policy and share repurchase strategy Key questions to address in managing benefit levels Is the benefit level sustainable/can the company remain competitive? Could contributions be better used for future operational or capital needs? What is the impact on valuation? Who decides the level of benefit? Management/Board of Directors Actively/Proactive? or Passively/Reactive to current repurchase obligation? Proper analysis and planning gives management more control
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17 Importance of Monitoring Repurchase Obligations Let s revisit the goals of managing repurchase obligation Minimize the competition for cash flow and capital between repurchase obligation and reinvestment in the business while balancing between multiple objectives Provide ongoing retirement benefits to employees Fund repurchase obligations Ensure sufficient capital generation to provide for required reinvestments and pursue growth opportunities
18 Impact of High Repurchase Obligation Is the projected repurchase obligation sustainable? Can the company remain competitive? Could contributions for repurchase obligation be better used for future operational or capital needs? What is the impact on valuation?
19 Repurchase Obligation Impact on Valuation Repurchase obligation studies should be performed on a regular basis. Compare projected repurchases and contributions with a normal benefit level How does the retirement benefit that the Company provides its employees compare to market levels?
20 How does Actual Compare to Projections Compare financial projections to actual results Re-evaluate cash flow assumptions Re-evaluate repurchase obligation study assumptions Monitor funding projections compared to results Review corporate strategic plans Understand the roles and responsibilities of board, trustee and senior management in repurchase strategy and process ESOP benefit levels and benefit delivery should be reassessed periodically
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22 Projection Tools/Software Use consultant to run studies Utilize available software to run study with guidance/review by consultant Internally developed models
23 Assumptions in Typical Study Actuarial analysis - how many shares to be repurchased Employee demographics Salary/Workforce size Age/Compensation of new employees Distribution policies Turnover and on-site risks of death or disability Actuarial tables included in commercial software Future share price critical to analysis Distribution policy Diversification
24 Analysis and Strategy Use results to assess cash needs and determine impact on availability of cash and capital to finance reinvestment requirements Strategic development mix and match methods Contributions set benefit levels Redemptions and dividends Dividends reduce share price without value dilution and provide cash for repurchases Re-leveraging have ESOP buy back shares with borrowed funds Buys back large block at one time reduces near term repurchase need Dilutive impact to share price, depending upon benefit levels
25 Analyzing the Results/Implement Strategy Do the results look reasonable based upon past history and the employee census? Test strategies and assess impact Determine benefits / drawbacks of each (if any) Assess impact on valuation and financing needs Do we want to change assumptions or other factors involved? Drawing conclusions from the study Strategic planning for future
26 Lender s Perspective Repurchase obligation can be a big cash flow variable Potential to adversely impact ability to repay term debt or absorb too much working capital financing capacity Analysis helps put parameters around near term costs to company Multiple repurchase study scenarios can be run to demonstrate Best case vs. worst case Efficacy of long term strategy to achieve sustainability and moderate funding risks Things lenders look at: Cash flow cushion impact repurchase obligation fluctuation has on cushion Valuation multiple to cash flow higher multiples can make it more difficult to fund repurchase obligation and reinvestment needs out of cash flow
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28 Case Study Bradford White Created in July 1992 now 24 Years Old! Initial employees = 604, ESOP = 134 (non-union) 2016 Total = 1,541, ESOP = 210 (no subs either) Became an S Corp owned by an ESOP in 1998 BWC Sales and Earnings have grown significantly over 1992 levels A successful company makes a successful ESOP. BWC uses lawyers, accountants, actuaries, bankers, and a valuation firm to assist in properly executing our ESOP responsibilities
29 Case Study Bradford White Really did not get serious in MONITORING Repurchase Obligation until late 2000 s Upcoming departure of 2 significant shareholders Solution: Successful Borrowing & Successful Operations Similar Circumstances in Early 2010 s Initial Modeling with Advisor (no longer used) Utilized Diversification 2012-14 Significant Capital Expenditures 2012-15
30 Case Study Bradford White Early 2010 s Solution: Significant Increase in Borrowing Capacity Continued Successful Operations Releveraged ESOP / 409(p) Concerns Post-2015 Situation: Current Borrowing Capacity should be sufficient Staged Departures / Smoothing of Liability In-house Model periodically refreshed to Monitor
31 Q&A September 14, 2016 Isaiah Aguilar Director Stout Risius Ross Eric S. Zaiman Executive Director J.P. Morgan Joe Marx Vice President-Consulting Principal Financial Group Michael Borinski Chief Financial Officer Bradford White Water Heaters
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33 Isaiah Aguilar Isaiah Aguilar is a Senior Vice President in the Valuation & Financial Opinions Group at Stout Risius Ross, Inc. He has experience in the valuation of securities for a variety of purposes, including fairness and solvency opinions, mergers and acquisitions, corporate strategic planning, stock options and warrants, and estate and gift taxation. He has particularly strong experience in the structuring and valuation of business ownership interests held by Employee Stock Ownership Plans (ESOPs) and has performed analyses related to ESOP security formation and transactions, determination of transaction fairness and adequate consideration, repurchase obligation studies, and annual employer security valuation updates. Director Valuation & Financial Opinions iaguillar@srr.com 703-848-4942 Among the many industries that Mr. Aguilar has served are agriculture, construction, education, engineering, financial services, forest and paper products, government contracting, healthcare, information technology, insurance, manufacturing, oil and gas, paint, retail, and specialty chemicals, among others. Mr. Aguilar earned an MA in Applied Economics and a BA in International Studies from The Johns Hopkins University in Baltimore, Maryland. Mr. Aguilar has earned the right to use the Chartered Financial Analyst designation.
34 Eric S. Zaiman Eric Zaiman is an Executive Director in the ESOP (Employee Stock Ownership Plan) Advisory Group. He is dedicated to advising bankers and their clients on the benefits of executing ESOP transactions and understanding ESOP-related issues. Zaiman has a leadership role managing ESOP financing transactions, including evaluation, structuring, underwriting and execution. Executive Director ESOP Advisory Group Eric.s.zaiman@jpmorgan.com 212-270-5402 Zaiman joined J.P. Morgan in 2009 with 23 years of experience in the finance industry. Prior to joining Chase, Eric was with financial advisory firm Duff & Phelps for 11 years. Eric has structured ESOP transactions and raised financing for many companies and sellers. In addition, Eric has represented ESOP trustees, issuing transaction and valuation opinions. Eric began his career in banking, holding roles in relationship management and credit/risk management. Zaiman received a Bachelor degree in Economics from the Yeshiva University and holds a Master of Business Administration in Finance and International Business from New York University. He is licensed by FINRA with a Series 79 and Series 63. Zaiman is very active in the ESOP community. He is a member of the ESOP Association sitting as an associate member of their Valuation Advisory Committee and serving as an executive board member of their New York/New Jersey Chapter. He is also active in the National Center for Employee Ownership and the Association for Corporate Growth. This material is provided to you for informational purposes only and any use for any other purpose is disclaimed. The information herein is a summary and does not purport to set forth all applicable terms or issues and is not intended to constitute advice on legal, tax, investment, accounting, regulatory or any other matters. [JPMorgan Chase][J.P. Morgan] makes no representations as to such matters or any other effects of any transaction and shall have no responsibility or liability to you with respect thereto. You should consult with your own advisors regarding such matters and the suitability, permissibility and effect of any transaction. In no event shall [JPMorgan Chase][J.P. Morgan] nor any of its directors, officers, employees or agents be liable for any use of, for any decision made or action taken in reliance upon, or for any inaccuracies or errors in, or omissions from, the information herein.
35 Joseph Marx Joe is a Vice President of Consulting in Retirement and Investor Services of the Principal Financial Group (Principal ). He specializes in assisting companies in the analysis, design, implementation, and operation of ESOPs including repurchase obligation planning and retirement plans. He has over 28 years of experience in employee benefits and consulting on ESOPs. Prior to joining Principal in 2003, Joe was an employee benefits consultant for Ernst & Young. His experience also includes tax and executive compensation consulting for companies throughout the United States. Vice President of Consulting Retirement and Investor Services marx.joseph@principal.com 716-710-4134 Joe is a Certified Public Accountant. He earned his Bachelor of Business Administration degree from Niagara University, New York, where he graduated with high honors. Joe is a member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants, The ESOP Association (TEA), and the National Center of Employee Ownership (NCEO). He also sits on the Finance Committee of TEA and is Vice President of the New Jersey/New York Chapter. Joe has conducted numerous pension and benefit seminars, written articles and presented at national and regional events for TEA, NCEO, the Ohio and Vermont Employee Ownership Centers, and the NYS Society of CPAs.
36 Michael Borinski Senior Vice President and Chief Financial Officer mborinski@bradfordwhite.com 215-641-2106 Mike Borinski is the Senior VP & Chief Financial Officer for Bradford White Water Heaters, a designer, manufacturer, distributor, and marketer of water heaters, boilers, and large steel tanks for residential and commercial applications throughout the world, with its principal markets being the continental United States and Canada. Bradford White has been a 100%-owned ESOP since 1992, and has been an S-Corp since 1998. Mike graduated from Widener University in 1982, majoring in Accounting, and spent five years working in the tax and audit departments of KPMG. He joined Bradford White in 1999 as their Controller before being promoted into the CFO role in 2008.
37 The presenters gather their data from sources they consider reliable; however, they do not guarantee the accuracy or completeness of the information provided within this presentation. The material presented reflects information known to the presenters at the time this presentation was written, and this information is subject to change. The presenters make no representations or warranties, expressed or implied, regarding the accuracy of this material. The views expressed in this material accurately reflect the personal views of the authors and do not necessarily coincide with those of their employers. The presenters do not provide accounting, tax, or legal advice. The information and material presented herein is provided for educational and informational purposes only and is not intended to constitute accounting, tax, or legal advice or to substitute for obtaining accounting, tax, or legal advice from an attorney or licensed CPA. Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of Principal Financial Group (Principal), Des Moines, IA 50392. SRR, J.P. Morgan, and Bradford White are not affiliated with any company of Principal. T16082904m4 8/2016