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Equity Analysis and Business Evaluation of OM Group

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Equity Analysis and Business Evaluation of OM Group Equity Analysis and Business Evaluation of OM Group Kelsey Cottrell [email protected] Nancy Hoang [email protected] Zach Scott [email protected] George Ramirez [email protected] TABLE OF CONTENTS EXECUTIVE SUMMARY 7 INDUSTRY ANALYSIS 8 ACCOUNTING ANALYSIS 10 FINANCIAL ANALYSIS 11 VALUATION ANALYSIS 13 COMPANY OVERVIEW 15 INDUSTRY OVERVIEW 20 FIVE FORCES MODEL 21 RIVALRY AMONG EXISTING FIRMS 22 INDUSTRY GROWTH RATE 23 CONCENTRATION 24 DIFFERENTIATION 25 SWITCHING COSTS 26 LEARNING AND SCALE ECONOMIES 26 FIXED-VARIABLE COSTS 28 EXCESS CAPACITY 29 EXIT BARRIERS 29 CONCLUSION 29 THREAT OF NEW ENTRANTS 30 ECONOMIES OF SCALES 30 FIRST MOVER ADVANTAGE 31 ACCESS TO CHANNELS OF DISTRIBUTION AND RELATIONSHIPS 33 LEGAL BARRIERS 33 CONCLUSION 33 THREAT OF SUBSTITUTE PRODUCTS 34 RELATIVE PRICE PERFORMANCE 34 BUYER’S WILLINGNESS TO SWITCH 35 CONCLUSION 35 BARGAINING POWER OF CUSTOMERS 35 DIFFERENTIATION 36 PRICE SENSITIVITY 36 NUMBER OF CUSTOMERS 37 CONCLUSION 37 BARGAININGN POWER OF SUPPLIER 37 2 NUMBER OF SUPPLIERS 38 SWITCHING COSTS 38 CONCLUSION 38 KEY SUCCESS FACTORS FOR THE INDUSTRY 39 CUSTOMER RELATIONS 39 INNOVATION AND ADVANCED TECHNOLOGY 40 MERGERS AND ACQUSITIONS 40 INVESTMENT IN RESEARCH AND DEVELOPMENT 40 COMPETITIVE ADVANTAGE ANALYSIS 41 KEY SUCCESS FACTORS FOR OM GROUP 41 DIFFERENTIATION 43 INVESTING IN RESEARCH AND DEVELOPMENT 43 SUPERIOR PRODUCT QUALITY 44 CONCLUSION 45 INTRODUCTION TO ACCOUNTING ANALYSIS 45 KEY ACCOUNTING POLICIES 46 TYPE ONE ACCOUNTING POLICIES 47 CUSTOMER RELATIONS 47 MERGERS AND ACQUISITIONS 47 RESEARCH AND DEVELOPMENT 48 TECHNOLOGICAL ADVANCEMENTS AND INNOVATION 48 TYPE TWO ACCOUNTING POLICIES 49 GOODWILL 49 RESEARCH AND DEVELOPMENT 50 LEASES 50 DEFINED PENSION PLANS 51 CONCLUSION 51 ASSESS DEGREES OF POTENTIAL ACCOUNTING FLEXIBILITY 52 GOODWILL 52 RESEARCH AND DEVELOPMENT 53 ACTUAL ACCOUNTING STRATEGIES 54 GOODWILL 54 RESEARCH AND DEVELOPMENT 55 PENSION 56 OPERATING LEASES 57 CONCLUSION 57 3 QUALITY OF DISCLOSURE 57 QUALITATIVE ANALYSIS 58 CONCLUSION 59 IDENTIFYING POTENTIAL RED FLAGS 59 GOODWILL 59 RESEARCH AND DEVELOPMENT 59 UNDOING ACCOUNTING DISTORTIONS 60 GOODWILL 60 RESEARCH AND DEVELOPMENT 61 FINANCIAL STATEMENTS 62 BALANCE SHEET 64 INCOME STATEMENT 64 CONCLUSION 66 INTRODUCTION TO FINANCIAL ANALYSIS 66 LIQUIDITY RATIOS 66 CURRENT RATIO 67 QUICK ASSET RATIO 68 CONCLUSION 69 OPERATING EFFICIENCY 69 INVENTORY TURNOVER 70 ACCOUNTS RECEIVABLE TURNOVER 71 WORKING CAPITAL TURNOVER 72 DAYS SUPPLY INVENTORY 73 DAYS SALES OUTSTANDING 74 CASH TO CASH CYCLE 75 CONCLUSION 76 PROFITABILITY RATIOS 76 GROSS PROFIT MARGIN 77 OPERATING PROFIT MARGIN 78 NET PROFIT MARGIN 79 ASSET TURNOVER 80 RETURN ON ASSETS 81 RETURN ON EQUITY 82 CONCLUSION 83 CAPITAL STRUCTURE RATIOS 83 4 DEBT TO EQUITY 84 DEBT SERVICE MARGIN 85 TIMES INTEREST EARNED 86 ALTMAN Z SCORE 87 CONCLUSION 88 FINANCIAL FORECASTING 88 INCOME STATEMENT 89 RESTATED INCOME STATEMENT 92 DIVIDENDS 95 BALANCE SHEET 95 RESTATED BALANCE SHEET 99 STATEMENT OF CASH FLOWS 99 COST OF CAPITAL ESTIMATION 104 COST OF DEBT 104 COST OF EQUITY 105 BACKDOOR COST OF EQUITY 107 WEIGHTED AVERAGE COST OF CAPITAL 107 METHOD OF COMPARABLES 109 PRICE TO BOOK RATIO 109 FORWARD PRICE EARNINGS RATIO 110 ENTERPRISE VALUE/EBITDA 110 ENTERPRISE VALUE/REVENUE 111 PRICE/EBITA 112 P.E.G. RATIO 112 ENTERPRISE VALUE/FREE CASH FLOWS 113 CONCLUSION 113 INTRINSIC VALUATION MODELS 114 DISCOUNTED DIVIDENDS 115 DISCOUNTED FREE CASH FLOWS MODEL 116 RESIDUAL INCOME MODEL 117 AS STATED RESIDUAL INCOME MODEL 118 RESTATED RESIDUAL INCOME MODEL 118 LONG RUN RESIDUAL INCOME MODEL 119 ABNORMAL EARNINGS GROWTH VALUATION 122 AS STATED ABNORMAL EARNINGS GROWTH VALUATION 123 5 RESTATED ABNORMAL EARNINGS GROWTH VALUATION 124 FINAL RECOMMENDATION 125 APPENDIX 126 BALANCE SHEET 126 INCOME STATEMENT 126 R&D CAPITALIZATION 127 GOODWILL IMPAIRMENT 127 DISCOUNTED DIVIDENDS APPROACH 128 DISCOUNTED FREE CASH FLOW 128 RESIDUAL INCOME 130 RESTATED RESIDUAL INCOME 131 AEG VALUATION 132 RESTATED AEG VALUATION 133 REGRESSIONS 134 6 Executive Summary Analyst Recommendation: SELL (OVERVALUED) OM Group-April 1, 2015 Altmans Z-Score Observed Price(04/1/2015 $ 3 0.87 Score 2010 2011 2012 2013 2014 As-Stated 3.46 2.02 2.34 3.47 3.74 52 Week Range 21.87-33.61 Re-Stated 2.89 1.64 1.71 2.46 2.61 Revenue 245263 Method to Comparables Market Cap 933.51 Shares Outstanding 30.24 Comparables Price Result As Stated Re-stated P/E N/A N/A Book value per Share $ 2 7.65 22.62 P/B 79.34 Undervalued Return on Equity -17.26% -0.73% Forward P/E 18.58 Overvalued Return on Assets 1.18% -0.004 Dividend Payout N/A N/A Cost of Capital P.E.G 7.35 Overvalued Adj R^2 Beta 2 Factor Ke EV/EBITDA 30.50 Fairly Valued 3 month 34.70% 1.91 19.60% EV/Revenue 43.34 Undervalued 1 Year 34.70% 1.91 19.60% EV/FCF 77.97 Undervalued 2 Years 34.70% 1.91 19.60% Price/EBITDA 24.30 Overvalued 7 Years 34.70% 1.91 19.62% Intrinsic Valuation Models 10 Years 35.75% 1.91 19.60% Valuation Model As-Stated Re-Stated Backdoor Ke 10% Discounted Dividends $ 1 5.56 N/A WACC BT 16.44% Discounted Free Cash Flows $ 4.29 N/A WACC AT 16.25% Residual Income $ 6.37 $ 5 .39 Beta(Yahoo Finance) 1.76 long Run Residual Income $ 2 3.30 $ 2 0.40 Lower Expected Upper Abnormal Earnings Growth $ 5.12 $ 3 .73 Bound Value Bound Size Adjusted Ke 15.10% 20.00% 42.19% WACC BT 12.60% 16.44% 33.85% 7 Industry Analysis OM Group Inc. is a diversified industrial growth company serving multiple markets including automotive systems, electronic devices, aerospace, general industrial and renewable energy. The company serves in three continents with the majority of its operations located outside the United States. They compete in the specialty chemicals industry with companies such as Huntsman Corporation, Quaker Chemical Corporation, and Olin Corporation. These companies are closely related in corporate structure and values, which is why we chose them to be in our sample industry. After six years of recovering from the Great Recession, the global demand for specially chemicals is finally growing, showing positive signs (Specialty Chemicals Magazine). In order to fully understand the industry, it is important to conduct a Five Forces Model, which can be seen below. 8 The threat of new entrants in the specialty chemicals industry is low because this is such a competitive and highly specialized industry. Therefore, it takes a lot of time and dedication to break through into the industry. Existing firms already have their contracts in place and a distinct cost structure, while new firms will have to have a difficult time negotiating contracts. This causes the industry to have a lot more knowledgeable firms that are on a fairly competitive basis with each other. This then causes the rivalry among existing firms to be moderately high. This is due to the specialty chemicals industry being so highly competitive. In order for a firm to gain its customer base, it must be off of previous work accomplished. Therefore, in order to differentiate from firm to firm, they must create value that is worth more to the customer than its competitor. The threat of substitute products in this industry is low because it is based off of contract work. The firms in this industry function off of the specific needs of the customers, therefore, the products are more valued based off of quality rather than quantity. This causes the threat of substitute products to be low because most products are the only one of its kind. In this industry, the bargaining power of the customer is low because there are not many competitive firms in the specialty chemicals industry. Since the options are very limited, if a customer were to go to another firm for their needs, there is a possibility that the quality of the product is much lower than the initial. However, on the other end, the number of suppliers in this industry is even less. There are only a handful of supplier that are licensed to create the supplies that the needed in this sector. This causes the bargaining power of the supplier to be high because there are not many options for the buyer has to purchase from. Therefore companies in this industry have a greater bargaining power over its suppliers. Overall, the specialty chemicals industry is very competitive. Using the Five Forces Model, it can be concluded that the industry works highly off of differentiation to distinguish the different companies from one another. There are a lot more customers out there then suppliers, thus causing the industry to continue growing. 9 Accounting Analysis In order to conduct an accurate analysis, it was necessary to analyze the accounting practices and policies of OM Group. By doing an evaluating the accounting analysis, we are able to depict a more accurate value of the firm. This evaluation arises because of the degree of flexibility when it comes to reporting information under GAAP. A low level of disclosure means that a firm is not disclosing all their information and is concealing information that may hurt the value of the firm. However, firms with high levels of disclosure means that they disclose all relevant information that may either add or lower the value of the firm. We valued OM Group's level of disclosure through Type 1 and Type 2 accounting policies. Type 1 policies compare the amount of disclosure of a firm according to its key success factors. Type 1 policies for OM Group are disclosures of information regarding customer relations, mergers and acquisitions, research and development, technological advancement and innovation. In relation to the industry, OM Group discloses about the same amount of information regarding their key success factors as its benchmark competitors.
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