Aerotubing, Inc., a Specialized Manufacturer of Air Flow Tubing and Hydraulics for The

Fit-Rite, Inc.

Aerotubing, Inc., a specialized manufacturer of air flow tubing and hydraulics for the aerospace industry, has the opportunity to acquire a complementary firm (Fit-Rite, Inc.) in a related line of business. Relatively minor economies will result from the acquisition, but the industry is in the throes of consolidation and the purchase represents a chance for Aerotubing to increase its presence as a supplier. Any purchase, however, would necessitate a complete refinancing package of both Aerotubing's existing debt plus any additional debt needed for the acquisition.

Keith Wm. Fairchild Associate Professor of Finance The University of Texas at San Antonio Fit-Rite, Inc.

“Kevin, Fit-Rite is in play again!” Robert O’Connor exclaimed over the phone.

“Aerotubing wants us to take another look at them, so let’s see if it’s a worthwhile opportunity.”

Robert O’Connor was an entrepreneurial deal-maker who thrived on brokering acquisitions and coordinating workouts. O’Connor relied upon a handful of associates with expertise in the numerous areas that were required to successfully consummate an acquisition or turnaround, including marketing, operations, law and finance. Kevin Findler had worked with

O’Connor off and on for almost twenty years, beginning in commercial real estate and land development, start-up venture capital investment, and, for the past seven years, mergers and acquisitions. While O’Connor possessed the knowledge of the process of bringing together the necessary parts as well as a superb ability to negotiate, Findler’s expertise was in financial analysis and he had developed a spreadsheet model for acquisitions that was routinely recognized for its detail in financing alternatives. Their relationship took a more serious turn when they began engagements in acquisitions and workouts. In return for waiving most or all of their consulting fees, they received ownership positions in the firms as compensation with the intent of building a portfolio of investments in the companies.

Aerotubing, Inc., is a firm operating in the aerospace industry. O’Connor and Findler had previously assisted Aerotubing with the sale of a division in 2005 and, in 2009, the acquisition of another firm as well as arranging the financing for the merger. Aerotubing's primary products have traditionally been providing specialized tubing to aircraft manufacturers (primarily Boeing and Cessna, as well as a limited amount of military aircraft) for hydraulics and air flow. Given the space constraints on commercial aircraft and the safety requirements, the manufacture of such tubing is restricted to a relatively small number of companies that have been certified by the

Federal Aviation Administration. Aerotubing uses specialized equipment to bend the tubing to the precise purposes required for the many different aircraft.

Prior to 2009, Aerotubing had five manufacturing plants located throughout the United

States and were headquartered in San Francisco. In late 2009, following twelve months of negotiations with lenders and venture capitalists, Aerotubing completed the acquisition of the

RFV Company. RFV was a competing manufacturer of aerospace tubing with approximately twice the sales of Aerotubing but whose owner was approaching retirement and looked favorably upon a means of liquidating his position in the company he had built. Exhibits I - III (located on the tab labeled "Buyer" on the spreadsheet) contain the consolidated financial statements of the combined companies for the years 2003-2010. (Note that the Covenant Not to Compete payments were completed in 2010. Also, the Extraordinary Expenses are related to restated financial statements of RFV as a result of the merger in 2009 and are not expected to continue.).

In the process of acquiring RFV, Aerotubing restructured its financing with a new loan from the

Bank of Northern California (BNC) that allowed Aerotubing to pay off all of the remaining debts of both companies with the exception of one small loan of $250,000 that financed a software purchase under very favorable terms. The same bank also provided a loan of $1.75 million for capital expenditures made in 2009 and was committed to making additional capital expenditure loans for the almost $3 million in capital outlays projected for the years 2011-2013. The capital expenditure loans were based upon an interest rate of prime (currently 3.25%) +4% and were repaid on an amortized basis over a 48-month period. The bank also provided a line of credit based upon eligible receivables and inventories that Aerotubing carries at a rate of interest of

8.25%. (See Exhibit IV on the tab "BuyerInfo" of the spreadsheet) for effective percentages of receivables and inventories to collateralize the line of credit.) Additional financing for the acquisition came in the form of a $1.75 million note carried by the seller of RFV who agreed to carry it at a zero percent rate of interest with no maturity date other than "when the cash becomes available". Also, $12.5 million of 10% preferred stock (convertible into equity) was issued to the venture capitalists who provided the equity funding for the acquisition.

In addition to seven more tubing manufacturing facilities that the acquisition of RFV brought to Aerotubing, the firm also became the owner of a facility located in Austin, Texas, that specialized in manufacturing controls and tubing for the delivery and evacuation of gases used in the manufacture of semiconductors. Following the acquisition of RFV, the CFO of Aerotubing was considering the sale of the semiconductor facility in order to generate some cash that would allow the company to pay down some of the acquisition debt and thereby relieve the pressure from both the bank and the venture capitalists to meet liquidity requirements; however, the industry was still in a depressed state and a buyer willing to pay an acceptable price could not be found.

The terms of the various BNC bank loans were nearly identical. In addition to making the monthly payments for the various loans, the firm had to maintain a Quick Ratio of at least

1.25 and a Debt Service Coverage ratio (EBITDA/Loan Payments) greater than 1.75. The president of the company was required to submit monthly financial statements by the 18th day of the following month, as well as an affidavit affirming the accuracy of financial statements and the amount of qualified receivables and inventory. Annual audited financial statements were also required.

By May of 2010, Aerotubing was approached by a semiconductor customer that offered to sign a contract that would add approximately $5 million of sales annually to the semiconductor business if Aerotubing had the facilities to produce and deliver the additional product in a timely manner. This opportunity to increase sales and profits was extremely attractive, in particular due to the fact that the amount of equity that the preferred stock was convertible into depended upon the extent to which the company met certain goals of sales and

EBITDA. It also required a significant expansion of facilities which necessitated the plans for the bulk of the $3 million in capital expenditures projected for 2011-2013. This contract, and the recovery of the semiconductor industry and the Austin facility’s diversification into unrelated specialized milling contracts, made the retention of the division more desirable in order to meet the financial goals that had been set.

Fit-Rite, Inc., is also in the aerospace industry and produces the fitting joints that connect the various tubing products used throughout airplanes. Located in San Diego, Fit-Rite was only fifteen minutes away from its primary competitor, Airtite, which it had considered buying in late

2006. Those plans were put on hold when it discovered that its competitor had bounced checks to many of its sales agents who subsequently approached Fit-Rite about potential employment.

Thus, the firm felt that it could essentially acquire the sales of its competitor without the need to buy the firm itself and its assets (many of which were redundant to those of Fit-Rite). With the market for fittings essentially split by Fit-Rite and its competitor, the projections of growth in

Fit-Rite's sales (see projected sales for 2011 - 2013 in Exhibit V on the "Target" tab of the spreadsheet), averaging almost 20% per year for the next two years, represents the anticipation of

Fit-Rite’s management of the consequences of its competitor's financial difficulties. The defection of Airtite’s customers to Fit-Rite was expected to take approximately two years, after which sales were projected to increase at the industry average of 5% per year. Although the future looked good for Fit-Rite, it had been having its own share of financial difficulties since purchasing a division of another firm for $1 million in January of

2009 (see the financial statements of Fit-Rite in Exhibits V - VII on the "Target" tab of the spreadsheet). In fact, it had fired its Comptroller in January of 2010 and did not find a replacement until April of that year. Within two months, the replacement had left to work for an internet start-up firm. By this time, Fit-Rite found itself in continual violation of two of its bank loan covenants and was actively seeking a new bank to refinance its existing debt (details of Fit-

Rite's financing are outlined in Exhibit VIII on the "TargetInfo" tab of the spreadsheet). Thus, when approached by the CFO of Aerotubing about a possible buyout in mid-2010, the owner of

Fit-Rite felt that it was an opportune time to both liquidate his ownership position as well as put an end to the misery of being in financial difficulties and at the mercy of the bank. The transition of ownership would be relatively easy since Aerotubing was familiar with the business and was relocating its management to the San Diego area where a large facility acquired from RFV was located.

Aerotubing's interest was two-fold: first, it would be acquiring the facilities to produce a necessary component that would complement its line of tubings. Secondly, the consolidation of the aerospace industry was rapidly progressing to the point of "grow through acquisitions or be acquired" and the management of Aerotubing was both relatively young and eager to be

"players" rather than employees. Aerotubing could foresee the day when the combined sales would break the $100 million barrier and put it "in the big leagues".

While there was no overlap in the products produced by Aerotubing and Fit-Rite and, thus, no operating efficiencies that could be realized, there was an estimated $500,000 per year of managerial salary savings that could be achieved since there was no need for two presidents, etc. Both companies, however, bought the majority of their raw materials from MT Metals who purchased them from a manufacturer in Israel. The president of Aerotubing had been in talks with the Israeli company about purchasing the materials directly from them rather than paying

MT Metals for the same goods but with an added mark-up. Since MT Metals did not have any contract or distributorship agreement, and the Israeli firm maintained large inventories within the

United States for quick delivery, Aerotubing would be able to save 20% of its raw materials costs by buying directly from the Israeli manufacturer. If Aerotubing were to buy Fit-Rite, it would also realize the savings in materials purchases. For both companies, direct raw materials, most of which were ultimately purchased from the Israeli company, accounted for approximately

40% of Cost of Goods Sold.

Should Aerotubing purchase Fit-Rite, it would do so only on the basis of an asset purchase in order to avoid assuming any potential legal liability that might be related to Fit-

Rite’s operations. This would also allow Aerotubing to amortize any goodwill associated with the purchase for tax purposes. The terms of Fit-Rite’s debt required that it be repaid in the event of a major sale of assets and, thus, it was not assumable and could not be used to help finance the acquisition.

Financing the acquisition would be achieved through a combination of debt and additional equity from venture capitalists. O’Connor’s and Findler’s experience with venture capitalists indicated that they preferred to see 50-60% of the purchase financed through debt and wanted a rate of return of 30-35% on their equity investment. Since the majority of Aerotubing’s debt is with the Bank of Northern California (the Subordinated and Acquisition debt, as well as the revolving line of credit and certain equipment loans) and the BNC loans do not allow any additional debt to be taken on as long as money is owed to BNC, an acquisition will require that Aerotubing’s debt be repackaged with any new debt related to the purchase of Fit-Rite. The only exception to the refinancing requirement of all of Aerotubing’s existing debt would be the $1.75 million owner-carry note from the RFV acquisition. The terms of the line of credit and long- term debt were anticipated to be similar to those of Aerotubing’s current loan structure; that is,

Quick and Debt Service Coverage ratios of 1.25 and 1.75, respectively, would have to be maintained, and an interest rate of approximately prime +4% was anticipated. The line of credit would be subject to limitations on availability based upon qualified receivables and inventories in roughly the same proportions as currently. A long-term acquisition loan would be limited to a five-year term at prime +4%, repayable on an installment basis.

Although negotiations with Fit-Rite were in the initial stages, Findler needed to determine the maximum value to pay for Fit-Rite and develop a financing package for the debt

(line of credit and term loan) that would work for the company, the bank, and venture capitalists.

The financial plan would then be used to shop the deal to various investors while negotiations with Fit-Rite continued.