August 2014 | Issue 75
NON-RECURRING CASH FLOWS COMPLICATE HESCO VALUATION
Patricia Laidler (Petitioner) was a 10% shareholder of Hesco Bastion USA, Inc. (“Hesco”). The remaining 90% interest in Hesco was owned by Hesco Bastion Environmental, Inc. (“Environmental”). On January 26, 2012, Hesco was merged into Environmental. Pursuant to the terms of the merger, Petitioner was offered $2,075,000 for her 10,000 shares ($207.50 per share). She declined the offer, and filed a Petition for Appraisal in Delaware Chancery Court. The resulting opinion is Laidler v. Hesco Bastion, C.A. No. 7561-VCG (May 12, 2014).
The Business of Hesco
Hesco designs and manufactures flood barriers. The barriers, called Concertainers, are rapidly-deployable units consisting of multi-cellular wall systems built from steel wire mesh coated with zinc-aluminum and lined with polypropylene geotextile. These are designed to be filled with sand and rock to create mobile barriers for military, asset, and flood protection. The products are manufactured in a plant in Hammond, Louisiana, under license from Hesco’s British parent.
Hesco’s customers are primarily architectural and civil engineering firms as well as governmental organizations providing storm and flood protection. Hesco’s revenue and cash flow are largely affected by the occurrence of various natural disasters.
Three Natural Disasters
At the valuation hearing, the parties pointed to three events that significantly impacted the revenues of Hesco in 2009, 2010, and 2011.
The first of these was the Howard Hanson Dam Project. In January of 2009, the Green River in Washington state flooded, exposing structural flaws in the Howard Hanson Dam. As a result, several companies with assets to protect from flood water (including Boeing) contracted with Hesco to provide $1.7 million worth of Concertainer units to serve as barriers in the event the dam failed. As it turned out, the barriers proved to be unnecessary, as the Corps of Engineers finished repairs to the dam before any leaks caused flooding.
In 2010, the Deepwater Horizon oil rig exploded in the Gulf of Mexico, resulting in one of the largest accidental marine oil spills in history. In that year, Hesco generated $7 million in revenues from experimental attempts to use Concertainer units in the clean-up effort.
In 2011, Hesco generated $22.5 million in revenues, largely due to a “500-year flood.” This flood, which occurred along the Red River and the Mississippi River, was declared a federal disaster in three states. Concertainer units were used as flood barriers throughout the flooded region.
Shown below are Hesco’s Revenues and cash flow (EBITDA) for the three years preceding the January 2012 valuation date.
Each party retained an appraisal expert to determine and support its opinion of value. As an initial matter, the Respondent suggested that the Court consider the merger price of the transaction as persuasive evidence of Hesco’s fair value. This approach had been followed recently by the same judge, Vice Chancellor Glasscock, in Huff Fund Investment Partnership v. CKx. In that case, the Court believed that the merger price had been generated from an arms-length transaction where a full market check had been conducted. Therefore, the Court believed that the merger price was the best available evidence of the fair value of the shares at issue.
In the view of the Court, this was not true in the case of the Hesco merger. Here, Hesco’s 90% controlling stockholder itself determined the price it would pay for the shares. Said the Court, “Under our case law, a statutory appraisal is the sole remedy to which the Petitioner is entitled, and to defer to an interested controlling stockholder’s determination of fair value in a transaction such as this would render that remedy illusory. I therefore decline to consider the merger price in determining the fair value of Hesco.”
The Court also concluded that the available data on comparable companies and transactions were not reliable enough to be used in the valuation of Hesco.
The Court concluded that the income approach remained the most appropriate way to determine the fair value of Hesco. The income approach is premised on the idea that the value of a company is equal to the present value of its future cash flows. The two most widely-used forms of the income approach are the discounted cash flow analysis (“DCF”) and the direct capitalization of cash flow method (“DCCF”). Under the DCF method, the analyst projects cash flow over a horizon period and estimates a terminal value at which cash flows can be valued in perpetuity, and then discounts those cash flows to present value over multiple periods. The DCCF method, on the other hand, starts with an estimate of the normalized level of cash flows in perpetuity and then multiplies the normalized cash flows by a capitalization multiple to estimate the present value of the business.
Although the DCF method is more prominently used in Delaware, both parties agreed that employing the DCF method was not feasible here because Hesco’s management never made cash flow projections in the ordinary course of its business.
Both parties, then, were in agreement with using the DCCF method.
At the valuation hearing, the bulk of both parties’ presentations focused on determining the appropriate cash flows to consider in a DCCF valuation. Petitioner’s expert calculated his cash flow figure by weighting Hesco’s actual revenues in 2010 and 2011 at 40% and 60% respectively and then deducting estimated costs and expenses.
Respondent’s expert constructed a cash flow by weighting actual and “normalized” EBITDA figures for 2009, 2010, and 2011, where the “normalized” figures excluded revenues from the Howard Hanson Dam project, the BP oil spill and the 500-year flood. These excluded revenues were characterized as “non-recurring.”
The Court was faced with the task of sorting out these competing visions of the appropriate treatment of these large recurring/non-recurring elements of revenue. Said the Court, “I find it suspect that [Petitioner’s expert] placed 60% weight on cash flows in 2011 despite the fact that 2011 was Hesco’s highest grossing year at more than double the revenue of any other year in Hesco’s history. [Petitioner’s expert] provided no compelling explanation as to why 2011, the Company’s highest grossing year, was a better indicator of future cash flows than 2009 or 2010.”
Ultimately, the Court concluded that that the best predictor of future cash flows was past actual cash flows in 2009, 2010 and 2011, weighted equally. Said the Court “It may be that within the next several years another announcement of structural flaws in the Howard Hanson Dam, another 500-year flood in the upper Mississippi, or another oil spill in the Gulf of Mexico is unlikely, but the Respondent has not demonstrated that the Company would not, as a going concern, have generated future revenues caused by structural problems in a different dam, floods in a different geographic region, or experimental uses in another context….I do not find it unlikely that, if the Company continued as a going concern, some future revenue-generating events, in themselves ‘non-recurring,’ would occur; notably, events which the Respondent deems ‘non-recurring’ occurred every year the entity was in existence.”
After further adjustments, the Court opined that the fair value of Petitioner’s 10% interest in Hesco was $3,642,400, or $364.24 per share (versus a merger price of $207.50). Other significant valuation findings were; weighted average cost of capital (WAAC), 21.83%, long-term growth rate, 4%, and capitalization multiple, 5.6x.
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