Esco Electronics An Exercise in Securities Valuation

Let me offer a specific example of the security valuation process. Esco Electronics Corporation is a defense company that was spun off8 from Emerson Electric Company in October 1990; the shares were distributed free to shareholders of Emerson. Esco competes in a variety of defense-related businesses, including electronics, armaments, test equipment, and mobile tactical systems. Holders of Emerson received Esco shares on a one-for-twenty basis; that is, a holder of one thousand Emerson shares received fifty shares of Esco. Esco first traded at around $5 per share and quickly declined to $3; the spinoff valued at market prices was worth only fifteen cents per Emerson share (which itself traded around $40). Needless to say, many holders of Emerson quickly sold their trivial Esco holdings.

What was Esco worth at the time of spinoff? Was it undervalued in the marketplace, and if so, why? Was it an attractive value-investment opportunity? The way to answer these questions is to evaluate Esco using each of the methods that value investors employ.

To begin with, Esco is a substantial company, having approximately $500 million in annual sales and six thousand employees, who occupy 3.2 million square feet of space, 1.7 million of which are owned by the company. Esco's only recent growth has come from its acquisition of Hazeltine Corporation in late 1986 for $190 million (over $15 per Esco share). A major consideration leading to the spinoff was that Esco's after-tax profits had declined from $36.3 million in 1985 (actual) to $6.7 million (pro form a, to reflect adjustments related to the spinoff) in 1989 after $8.2 million of nonrecurring charges and to a loss of $5.2 million (pro forma) in 1990 after $13.8 million of nonrecurring charges. The company was spun off with a conservative capitalization, having only $45 million in debt compared with almost $500 million in equity. Tangible book value exceeded $25 per share, and net-net working capital, current assets less all liabilities, exceeded $15 per share.

Two questions regarding Esco's future worried investors. One was whether the sharp recent drop in profitability, related to money-losing defense contracts the company had taken on, would reverse. The second concerned the outcome of two pending contract disputes between Esco and the U.S. government; an adverse outcome could have cost Esco tens of millions of dollars in cash and forced it to report sizable losses. These uncertainties caused Emerson to spin off, not shares of common stock, but common stock trust receipts held in escrow in order to ensure that Esco would meet its obligation to indemnify Emerson for certain customer-contract guarantees.

The first step in valuing Esco in October 1990 was to try to understand its business results: earnings and cash flow. Esco's future earnings were particularly difficult to forecast, especially because in each of the preceding two years the company had taken significant nonrecurring charges. An analyst at Bear Stearns estimated break-even earnings for fiscal year 1991. This estimate was after the deduction of a newly instituted charge of $7.4 million, payable by Esco to Emerson each year from 1991 to 1995, for guaranteeing outstanding defense contracts. Although this charge would have the effect of reducing reported earnings for five years, it was not a true business expense but rather more of an extraordinary item.9

Another ongoing depressant to earnings was Esco's approximately $5 million per year charge for nondeductible goodwill amortization resulting from the Hazeltine acquisition. Since goodwill is a noncash expense, free cash flow from this source alone was $5 million, or forty-five cents per share.

In order to value Esco using NPV analysis, investors would need to forecast Esco's likely future cash flows. Goodwill amortization of forty-five cents a year, as stated, was free cash. Beginning in 1996 there would be an additional forty-five cents of after-tax earnings per year as the $7.4 million guaranty fee ended. Investors would have to make some assumptions regarding future earnings. One reasonable assumption, perhaps the most likely case, was that earnings, currently zero, would gradually increase over time. Unprofitable contracts would eventually be completed, and interest would be earned on accumulated cash flow. An alternative possibility was that results would remain at current depressed levels indefinitely.

In addition to predicting future earnings, investors would also need to estimate Esco's future cash investment or disinvestment in its business in order to assess its cash flow. Depreciation in recent years had approximated capital spending, for example, and assuming it would do so in the future seemed a conservative assumption. Also, working capital tied up in currently unprofitable contracts would eventually be freed for other corporate uses, but the timing of this was uncertain. Were Esco's working capital-to-sales ratio, currently bloated, to move into line with that of comparable defense elec tronics firms, roughly $80 million in additional cash would become available. To ensure conservatism, however, I chose to project no free cash flow from this source.

What was Esco worth if it never did better than its current depressed level of results? Cash flow would equal forty-five cents per share for five years and ninety cents thereafter when the guaranty payments to Emerson had ceased. The present value of these cash flows is $5.87 and $4.70 per share, calculated at 12 percent and 15 percent discount rates, respectively, which themselves reflect considerable uncertainty. If cash flow proved to be higher, the value would, of course, be greater.

What if Esco managed to increase its free cash flow by just $2.2 million a year, or twenty cents per share, for the next ten years, after which it leveled off? The present value of these flows at 12 percent and 15 percent discount rates is $14.76 and $10.83, respectively. Depending on the assumptions, then, the net present value per share of Esco is conservatively calculated at $4.70 and less pessimistically at $14.76 per share, clearly a wide range but in either case well above the $3 stock price and in no case making highly optimistic assumptions.

Investors in Esco would certainly want to consider alternative scenarios for future operating results. Obviously there was some chance that the company would lose one or more of its contract disputes with the U.S. government. There was some possibility that a widely anticipated reduction in national defense spending would cause the company to lose profitable contracts or fail to receive new ones. There was a chance that the newly independent company, smaller than most of its competitors, would face difficulties in trying to operate apart from Emerson.

Alternatively, there was some prospect that Esco would either win both of its contract disputes outright or settle with the government on acceptable terms. Indeed, the new top management would likely wish to start afresh, putting past difficulties behind them. (The disputes were, in fact, tentatively settled within months of the spinoff on terms favorable to Esco.) Further, new management expressed its intention to maximize cash flow rather than sales; new contracts would be accepted on the basis of low-risk profitability rather than prestige or the desire to achieve revenue growth. Thus it was not unreasonable to think that earnings would grow over time as unprofitable contracts were concluded and profitable contracts added.

Investors would want to consider other valuation methods in addition to NPV. The private-market value method, however, was not applicable in the case of Esco because there had been few recent business transactions involving sizable defense companies. Even if there had been, Esco's pending contract disputes would put a damper on anyone's enthusiasm to buy all of Esco except at an extreme bargain price. Indeed Esco had been put up for sale prior to spinoff, and no buyers emerged at prices acceptable to Emerson.

Conversely Emerson had only four years earlier paid $190 million for Hazeltine, which comprised only a fraction of Esco's business at the time of spinoff. At a takeover multiple even close to that of the Hazeltine transaction, all of Esco would be worth many times its prevailing stock market price, with Hazeltine alone worth $15 per Esco share.

A liquidation analysis was also not particularly applicable; defense companies cannot be easily liquidated. The assets have few alternate uses, and inventory and receivable valuations are realizable only for an ongoing defense concern. Esco could be valued, however, on the basis of a gradual liquidation, whereby existing contracts would be allowed to run to completion and no new business would be sought. The value in such a scenario is uncertain, but it is hard to imagine the proceeds realized over time being less than the net-net working capital of $15 per share.

Stock market value is another useful yardstick, especially for gauging where a spinoff new to the market might reasonably be expected to trade. This method would not determine over- or undervaluation, but simply relative valuation compared with other defense-electronics companies. In this case Esco seemed to trade as if its business were located on a different planet. At $3 per share, the stock sold for only 12 percent of tangible book value, a staggeringly low level for a viable company with positive cash flow and little debt. Indeed, the shares could rise 400 percent from that level and still be below half of tangible book value. Of course, other defense company shares were also depressed at the time, with most of them trading at only four to six times earnings; another recent defense spinoff, Alliant Techsystems, traded at only two times estimated earnings. However, most comparable firms were trading at between 60 and 100 percent of book value and had historically traded considerably above that. Although Esco was less profitable than most other defense companies, it was selling for only three times earnings if both goodwill amortization and the $7.4 million special charge were ignored. The extremely low valuation seemed to more than fully discount Esco's current shortcomings as a business.

It is difficult, if not impossible, to determine precisely what Esco stock was worth. It is far simpler to determine that it was worth considerably more than the market price. With the shares selling for $3, yet having $25 per share of tangible book value and little debt, investors' margin of safety was high.

Esco appeared to be worth easily twice its $3 market price, a level that was only six times adjusted earnings, 40 percent of net-net working capital, and less than 25 percent of tangible book value. Was it worth $10 per share? Probably, either on the basis of NPV using mildly optimistic assumptions or on a gradual liquidation basis.

The nice thing about Esco at $3 per share is that one didn't have to know exactly what it was worth. The price reflected disaster; any other outcome seemed certain to yield a higher price. A sizable loss on the disputed contracts was the worst-case scenario, but even that was probably already reflected in the low share price. Management certainly believed that these disputes could be favorably resolved. According to public filings, shortly after the spinoff the chairman of Esco's board purchased shares on the open market for his personal account. By early 1991 selling pressure related to the spinoff subsided, defense stocks rallied, and Esco rose to over $8 per share.

Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Earnings and Earnings Growth

We are near the end of a chapter on business valuation, and there has been virtually no mention of earnings, book value, or dividend yield. Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Earnings per share has historically been the valuation yardstick most commonly used by investors. Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries. It does not attempt to measure the cash generated or used by a business. And as with any prediction of the future, earnings are nearly impossible to forecast.

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend. A few particularly unscrupulous managements play accounting games to turn deteriorating results into improving ones, losses into profits, and small profits into large ones.

Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business. Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality. By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business. By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors.10

Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.

Book Value

What something cost in the past is not necessarily a good measure of its value today. Book value is the historical accounting of shareholders' equity, the residual after liabilities are subtracted from assets. Sometimes historical book value (carrying value) provides an accurate measure of current value, but often it is way off the mark. Current assets, such as receivables and inventories, for example, are usually worth clpse to carrying value, although certain types of inventory are subject to rapid obsolescence. Plant and equipment, however, may be outmoded or obsolete and therefore worth considerably less than carrying value. Alternatively, a company with fully depreciated plant and equipment or a history of write-offs may have carrying value considerably below real economic value.

Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. Real estate purchased decades ago, for example, and carried on a company's books at historical cost may be worth considerably more. The cost of building a new oil refinery today may be made prohibitively expensive by environmental legislation, endowing older facilities with a scarcity value. Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built minimills. As a result, their book value may be significantly overstated.

Reported book value can also be affected by management actions. Write-offs of money-losing operations are somewhat arbitrary yet can have a large impact on reported book value. Share issuance and repurchases can also affect book value. Many companies in the 1980s, for example, performed recapitalizations, whereby money was borrowed and distributed to shareholders as an extraordinary dividend. This served to greatly reduce the book value of these companies, sometimes below zero. Even the choice of accounting method for mergers—purchase or pooling of interests—can affect reported book value.

To be useful, an analytical tool must be consistent in its valuations. Yet, as a result of accounting rules and discretionary management actions, two companies with identical tangible assets and liabilities could have very different reported book values. This renders book value not terribly useful as a valuation yardstick. As with earnings, book value provides limited information to investors and should only be considered as one component of a more thorough and complete analysis.

Dividend Yield

Why is my discussion of dividend yield so short? Although at one time a measure of a business's prosperity, it has become a relic: stocks should simply not be bought on the basis of their dividend yield. Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more. Investors buying such stocks for their ostensibly high yields may not be receiving good value. On the contrary, they may be the victims of a pathetic manipulation. The high dividend paid by such companies is not a return on invested capital but rather a return of capital that represents the liquidation of the underlying business. This manipulation was widely used by money-center banks through most of the 1980s and had the (desired) effect of propping up their share prices.

Conclusion

Business valuation is a complex process yielding imprecise and uncertain results. Many businesses are so diverse or difficult to understand that they simply cannot be valued. Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipline required by value investing. Investors must remember that they need not swing at every

pitch to do well over time; indeed, selectivity undoubtedly improves an investor's results. For every business that cannot be valued, there are many others that can. Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.

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