Sterling Case

Sterling Overview: From its inception as a manufacturer of laundry products in the early 1920s, Sterling Household Products had successfully expanded into a to a wide variety of consumer household products. Despite producing steady financial returns for years, from 2010 to 2012, Sterling was facing nearly stagnant sales growth at just 4.5%. A majority of this meager growth rate stemmed from price increases, as its unit sales volume was nearly flat at 1% growth year-over-year. Many of Sterling’s mature product lines were also facing pressure from retail customers, who were actively producing private-label substitutes. These flattening trends elevated Sterling’s need to identify and shift into new growth markets. In January of 2013, Sterling’s management identified an opportunity to acquire a germicidal, sanitation, and antiseptic products unit owned and operated by Montagne Medical Instruments. Sterling felt this represented an intriguing opportunity for growth due to a budding trend in household cleaning, disinfecting, and sanitizing products. The acquisition would not only allow Sterling to gain a foothold into new market for a price of $265 million, but would also be a natural extension of their current products. Montagne’s infection-control products unit was for sale for $265M and appeared to make good strategic sense for both parties. Analysis of the Opportunity’s Risk: In our analysis of the business risk of the opportunity, we decided to look at the asset betas of both Chiron and Pathogen because they most clearly mirrored the opportunity with 80% of revenues coming from similar products. While there were six established companies with significant market share, four of them sold a wide variety of medical products (Teological, Labyrinth, Stratus, and Vortex). The two which we selected to use were had 80% of their revenues coming from germicidal, sanitation, and antiseptic products (Chiron and Pathogen). While Chiron and Pathogen’s equity betas were slightly different (.85 versus .9), their asset or ‘unlevered’ betas were identical at .74. Pathogen’s higher equity beta is due to their 25% debt financing, which was close but not exactly the same as the proposed 30% for Sterling’s future investments. However, the calculated asset betas allowed us to compare the volatility of Chiron and Pathogen compared to the volatility of the market overall. At an asset beta less than one, we concluded there is very little business risk associated with the acquisition (assuming all equity financing). Further, because Sterling’s acquisition of Montagne fits within the larger context of their business plan, being a household products brand, we believe the acquisition does little to increase the business risk. Using the asset beta of the competition and Sterling’s proposed capital structure of 30% debt and 70% equity financing, we calculated a levered beta of .95 (still <1), which led us to an equity cost of capital of 7.83%. Using this and the risk free rate of 3.1%, we came to a weighted average cost of capital (WAAC) of 6.47%. Future cash flows associated with the acquisition of Montagne’s business unit would need to be discounted using this WACC, not the WACC of Sterling’s current business. These calculations are shown in Exhibit 1. Using Montagne’s infection-control products unit WACC of 6.47%, we forecasted free cash flows for two different scenarios:1) the acquisition alone and 2) the acquisition plus the proposed$60M expansion. We performed sensitivity on what we felt were the key drivers for an Sterling NPV analysis, including the capital structure and purchase price. Both analyses are explored in more depth below. Scenario 1: Acquisition ● Acquisition Price: $265M ● Terminal Value (9x multiple): $196.8M ● NPV: -$22M In the first scenario, Sterling simply acquires Montagne’s products unit for $265M, and operates the products unit at its current capacity. This DCF analysis can be seen in Exhibit 2. Assumed in Sterling’s acquisition of Montagne’s product unit is that the unit was operating at nearly full capacity, and room for revenue growth would be driven by price increases rather than unit increases. In our analysis of the acquisition alone, we used a 9x multiple on the free cash flow in year 2022 to calculate a terminal value of $196.8M. Using a WACC of 6.47% and in looking at the future cash flows, an NPV of -$22M was found. We can conclude that while Montagne’s infection-control products unit appears to make strategic sense for Sterling and represents an opportunity with low risk, the acquisition alone would not add value to Sterling’s business. Not surprisingly, the primary driver of this NPV analysis is the sale price of $265M. At a purchase price of $265M, Montagne’s products unit is selling for a 9.33x EBITDA multiple. A quick sensitivity analysis shows that if the EBITDA multiple is closer to 8.28x, then the result is a positive NPV even without the expansion. WIth an 8.28x EBITDA multiple, the asking price would be closer to $235M, which results in an NPV of $7.9M. This sensitivity analysis can be seen in Exhibit 4. A further analysis of recent acquisition transactions to determine the appropriate multiple would be prudent in this scenario. Scenario 2: Acquisition + Expansion ● Acquisition Price: $265M ● Expansion Investment: $60M ● Terminal Value (9x Multiple) $289.8M ● NPV: $17.5M In the second analysis, Sterling acquires Montagne’s product unit for $265M and subsequently invests $60M in 2013 to expand the products unit with the purchase of new capital equipment in 2013. This analysis can be seen in Exhibit 3. For the second NPV analysis, we looked at the acquisition Montagne’s infection-control products unit and a subsequent $60M investment in expanding production capacity. The purchase and installation of new capital equipment during 2013 would allow Sterling to drive additional sales and therefore capture more value, ultimately making the acquisition valueadditive to Sterling, with an NPV of $17.5M. Given that the entire infection-control market in January 2013 was $2.5B in yearly sales, growing rapidly, and also ‘quite fragmented’ the expansion of the production capacity would Sterling allow Sterling to become a market leader in the space. If all goes according to plan and they are able to achieve the sales numbers they are predicting, sales in year 2022 of roughly $259M (with the expansion) would represent approximately a 10% market share (greater than the current market share of 7% held by the current leader. (Note: This assumes the growth rate of the industry sales is 5% and the competitor holding 7% does not grow above 10%). Among other benefits, market leadership in this space would empower Sterling from a pricing and distribution perspective. Conclusion Montagne Medical produced a wide array of products,‘ranging from anesthesia apparatus to veterinarian instruments’, however, an overwhelming majority of their revenues and net income came from medical examination and surgical instruments. It can therefore be concluded that the infection-control division remained outside the scope of their core business. Although the germicidal, sanitation, and antiseptic products unit was indeed a profitable one (14.6% margin) and also was growing at a rate of 12.2%, Montagne was concerned that it was taking resources away from their core business. As a result, it can be inferred that Montagne was not prepared or likely to invest in the $60M expansion that would allow it to attain market leadership. This is in stark contrast to the core competencies and aspirations of growth from Sterling, which is better suited to invest in the unit. The acquisition would accomplish Sterling’s original goal of finding a new growth market and allow Montagne to divest away from a business that ‘consumed scarce resources and management time’. Exhibit 1: Sterling Exhibit 2 Sterling Sterling Exhibit 3: Sterling