BLAINE KITCHENWARE CAPITAL

STRUCTURE
Executive Summary:
Blaine Kitchenware, a medium sized producer of residential kitchenware and
appliances is trying to unleash the value inherent in its strong operational cash
flows and balance sheet to enhance value for majority shareholders. The company
though publicly traded is majorly owned by CEO Dubinski family members. Over the
past couple of years, the company has accumulated significant amount of cash
through operations. While the company dont foresee a significant amount of capital
expenditure as it has outsourced majority of manufacturing operations, it is
interested in pursuing inorganic growth activity through acquisition of other players
in the kitchenware space. From a growth perspective the company is trying to
expand its presence in beverage making appliances and overseas markets. While
the growth plans are on track, the company seems to not have found enough
lucrative opportunities, as it has been significantly increasing the dividend payout
ratio.
The companys $209 Million cash equivalents, zero debt and steady operational
cash flows makes it an ideal candidate for takeover candidate by private equity
firm. CEO Dubinski is worried about maintaining status quo and let someone
takeover Blaine. He is contemplating to emulate the same strategy in-house to
unleash value through recapitalization of Blaines balance sheet, but he is
concerned about the conservative nature of family members who are inherently
averse to debt. Dubinski is in dilemma as to what is the optimal amount of debt to
be taken, whether to go for a repurchase/special dividends. He is also worried about
the further consequences of this transaction on familys ownership, share price,
EPS, dividend payout, cost of capital and growth capital for future.
A detailed analysis of the companys current external, internal environment and
financial condition has led to the conclusion that repurchase of the shares with
existing cash, marketable securities and additional debt will enhance value for the
shareholders, increases the ownership of family and decreases the attractiveness of
Blaine to external investors.

Company analysis:
Blaine Kitchenware is a medium player in kitchen appliance industry with 10% of
market share. In recent years, the company made some very important steps to
reduce its production costs by shifting business model towards outsourcing along
with using Mexico manufacturing opportunities. These changes allowed the
company to sustain price pressure and utilize NAFTA advantages. However, Blaine
hasnt achieved the level of economies of scale as its competitors and hence the
company has shunned away from cost leadership generic strategy and focused on
high-end product lines, niche segments using focused differentiation strategy. The
companys revenue mix is concentrated with more than 85% coming from mid-tier
products, similarly 65% of its sales are from US alone. Recent acquisitions have
helped the company to grow, diversify these revenue streams and were aimed at
different niche markets where the biggest gain in the future margins were believed

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STRUCTURE
to be. The company is a closely controlled family owned entity with trusts together
owning more than 62%. The family is very conservative in nature and owing to this
behavior the company is very receptive to taking debt and in more than 60 years
since its founding the company has only borrowed thrice and was repaid
immediately. The companys business is cyclical in nature with peak sales during
October, November, May and June.

Industry Analysis:
To understand business risks that exist in the industry, Porters five forces
framework has been used.

Bargain power of Suppliers - Low: Since the company outsources most of

its production to countries such as China, Vietnam and Mexico, where labor
costs are much cheaper than in the U.S., manufacturing companies are eager
to work with Blaine, hence power of suppliers is relatively low. Moreover,
there are no significant switching cost from one manufacturer to another, and
move production of any new or existing model of appliance to a new factory.
Additionally, as manufacturing is becoming more and more global, there are
lots of available suppliers.

Bargain power of Buyers - High: Small kitchen appliances are not a

unique product and there are lot of options to choose from. There is no
particular loyalty boundaries for customer to use only one producer. Even
there are many wholesalers, who passing the product towards mass
merchandisers and department stores, they can easily switch brands and
lines to whatever the end-user is looking for. Moreover, having large amount
of appliances suppliers buyers can easily play them against each other to get
the cheapest price and the best conditions. Despite of special kitchen
retailers pretend loyalty, many brands also have their top or professional
product lines that could be switched interchangeably. Furthermore, shifting
shopping pattern preferences of appliances end-users towards big-boxes
malls are diminishing the latter factor.

Threat of new entrants - High: Since Blaine presented its first cream
separator in 1927, kitchen appliances progressed from state-of-the-art
product to a commodity stage. Most functions are similar between producers.
There are little to no difference in design. Because of pre-maturity industry
stage, companies, chasing cost reduction, changed business model from full
cycle of design and production to outsourcing in countries with cheap labor
cost. This shift allowed new players to enter the industry relatively easily.
There are no heavy initial investments in production and distribution needed,
and, if things wont go well, liquidation costs are fairly small. Moreover,
processes of design and production of kitchen appliances are well learned
and there is no any patents protection left. Along with customers little brand

BLAINE KITCHENWARE CAPITAL

STRUCTURE
loyalty, there is a big threat of new entrants. Globalization also made it
possible for other kitchen appliance producers from Asia to penetrate western
markets with their products who compete fiercely on price.

Threat of substitutes - Medium: Small kitchen appliances are satisfy

needs for cooked meals for its end-users. In developed countries like the US,
where competition in a food and restaurant industries so high that prices for
dining out are always under the pressure. In addition, government and
society quality control along with wide availability make restaurant industry
more affordable and acceptable even for very strict customers. Fulfilling the
same basic needs with no switching costs, that industry is imposing
undeniable threat to the small kitchen appliances.

Rivalry among competitors - High: The industry has seen a lot of

consolidation processes in recent years. Big national chains, mass
merchandizers, feeling pressure from cheap Asian import, started to use price
wars techniques to secure market share. Even in fast recovering and growing
economy, there is an inadequate slow growth in new unit consumption. As
stated earlier, kitchen appliance has become more like a commodity,
homogenous product and switching cost are very low.

Based on the analysis, we can conclude that small kitchen appliances industry is not
attractive. Very high level of competition, high bargain power of buyers, and
substantial threat of new entrants along with possible threats of substitutes from
restaurant industry can negatively influence the future of company. Low suppliers
power helps the industry players be more flexible in their production and fixed-cost
decisions. Furthermore, slow growth and consolidation trend are forcing companies
to cut price and erode margins.
Since the industry leader, Auto Tech Appliances, whose revenue is larger by more
than four times than that of the second player, XQL Corporation, the Rule of Three
and Four is not applicable to the kitchenware industry that highlighted instability of
the industry and room for growth to all the players.

Industry/Compa
ny
High
Medium
Low

High

Medium

Low

Blaine

Using GE/McKinsey matrix above, we can conclude that Blaine Kitchenware is

located in an unattractive industry and its strength as a business is medium with its
differentiation strategy. There is enough room for growth as the industry is not

BLAINE KITCHENWARE CAPITAL

STRUCTURE
stable and the company only has 10% growth market share, but the company and
industrys growth is dependent on broad economic and housing growth.
Despite the cyclical nature of the business, a regression analysis of companys
Sales, EBITDA and Dividends against time gave a high positive correlation indicating
that the Business risk is relatively low-moderate as the industry has been instable
and the company has been able to constantly expand its operations. The low
correlation amongst EBITDA, EPS can be attributed to the integration costs during
the time period. This low-moderate business risk profile of the company suggests
that there is room for taking some financial risk, still keeping the overall risk profile
medium.
2004-2006
Correlation

Revenue
0.979

EBITDA
0.819

EPS
0.432

DPS
0.998

Financial Analysis:
From 2003-2006, despite being positioned in an industry with modest dollar sales
volume growth of 3.5%, Blaine was able to grow at a CAGR of 6.6%. The topline
growth is mostly attributed to the increase in volume of shipments as most of the
industry players are constrained in pricing owing to competition from inexpensive
imports and aggressive pricing by mass merchandisers. Even though the industry is
expected to consolidate the same pattern can be observed for pricing and even
Blaine expects the growth to be modest at roughly 3.5% going forward. The
company can pursue further organic growth through penetration into other markets
(Currently 65% of revenue comes from US) and increasing its share in beverage
market appliances (Currently 2%).

Blaines EBIT margins have reduced from 21.4% to 18.7% largely due to integration
costs. Despite this reduction the companys margins are the highest in the industry
(14.9%), partly due to the companys product mix that is dominated by mid-tier
products (85% of sales and 80% of EBIT). A significant portion (17.4%) of net
income is derived from other income through marketable securities. The companys
effective tax rate is expected to increase to 40% which will negatively affect
companys cash flows and net margins. The dividend payout ratio has significantly
increased in the recent years with 53% in 2006 which highlights the fact that there
are not enough lucrative growth opportunities for the management to invest in. This
dividend payout ratio might be tough to retain in the future years, if the company
has to pursue any inorganic growth, capital expenditures or service debt.

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STRUCTURE
The companys asset base has grown at 9.1% from 2004-06, a major portion of
growth is attributed to the growth of fixed assets which have grown at a staggering
rate of 32.4% during the same period, while cash & marketable securities have
reduced at 10.1% during the same period. Despite this rapid decrease in cash
&marketable securities, they still constitute a significant portion (39%) to overall
asset base. Non-cash current assets have increased at 9.6%, while current liabilities
have increased at 10.3%, this narrow increase is not expected to cause any material
difficulties in working capital management (Quick ratio of 1.42). Total liabilities
have increased at a faster pace (14.1%), compared to shareholders equity (8.2%)
during the same period. The significant portion of cash and faster growth of
liabilities compared to equity is a concern for investors.
Market Balance Sheet 2006 ($ Millions)
Assets
Operating Assets:

Liabilities & Equity

799.7

Debt:

-230.9

Tax Shield:

-71.0

Equity:

959.6

Total:

728.7

Total:

728.7

Cash Conversion Cycle (Days)

100
80

84

82

89

80
51

60

51

52

47

47

86

86

47

40
20
-

Inventory

A/R
2004

A/P
2005

Cash Conversion

2006

The companys net working capital/sales at 9.4% is marginally higher than

industrys average of 8.9%, but compared to the industry average of 17% D/E,
Blaine has a negative D/E ratio of -24%.

BLAINE KITCHENWARE CAPITAL

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Blaine Returns (%)
15%
13%
11%
9%
7%
5%
2004

2005
ROA

2006
ROE

The companys inefficiency in churning out maximum output of its assets is visible
in the poor return on asset and equity numbers (ROA of 9%, compared to peers
12%, ROE of 11%, compared to peers 26%) compared to the industrys average.
This can be largely attributable to high cash & marketable securities which
constitute a significant portion of assets but give relatively modest returns at 6%.
EVA ($ Million)
EBIT
Tax %)
NOPAT
Equity
Mkt Equity
Net Debt
Capital
Book Capital
Asset Beta
Equity Beta
Cost of Debt
Cost of Equity
WACC
EVA

2004
62
32%
42
417
777
(286)
491
132
0.67
0.50
6.75%
7.87%
9.78%
30

2005
61
32%
41
459
864
(268)
596
191
0.67
0.53
6.75%
8.01%
9.54%
23

2006
64
31%
44
488
960
(231)
729
257
0.67
0.56
6.75%
8.18%
9.29%
20

Even though the company has created positive EVA from 2004-06, the absolute
value of EVA dropped overtime due to increase in fixed assets. Owing to the
expected increase in tax rates, insufficient growth opportunities, EVA, ROA and ROE
might drop down significantly in the years to come.

LTM
Multiples
EV/Revenue

Blaine
2.1

EasyLiv
ing
1.9

Average
1.5

Min
1.0

Max
1.9

BLAINE KITCHENWARE CAPITAL

STRUCTURE
18.1
EV/EBIT

11.4

10.4

7.4

18.1

9.1

6.0

15.2

3.5

1.6

4.9

16.2

9.9

31.8

15.2
EV/EBITDA

9.9
4.4

Market/Book

2.0
31.8

P/E

17.9

Except for Market/Book value, Blaine is marginally trading above the industry
multiples mostly due to the negative debt, which decreased the EV and increased
the multiples (A trend that is visible even in Easyliving stock which is trading
significantly at higher multiples compared to its peers). Despite this premium in
trading multiples, the stock has underperformed compared to its peers and barely
over performed compared to the broad market at only 11% per year from 2004-06.

If Blaine maintains status quo without any significant changes to its

operations/investing/financing activities, it might create negative EVA/destroy value
to shareholders. The company doesnt have not much near term scope in increasing
the value through operations/investing activities (Organic/Inorganic). It should
possibly explore creating value through financing activities as there is lot of room
for improvement considering its healthy cash flows, over liquidity and negatively
levered balance sheet. We will study the capital structure of Blaine in detail for this.

Blains Capital Structure and Payout Policies Analysis:

Blaines current capital structure is very conservative with no debt and large
amounts of cash and marketable securities. A rational capital structure should
consider the tradeoff among the following major features: (1) corporate ownership
and control; (2) cost efficiency of capital by utilizing leverage; and (3) profitability
and real economic value added based on companys long-term strategic plan.

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STRUCTURE
However, at the end of 2006, Blaine held $231 million in cash and securities and
also it was the only debt free public company among the selected public
kitchenware producers. By carrying so much of negative debt, the company is
potentially destroying value to the tune of $71 Million, earning negative tax shield
benefit. Specifically, BKI maintained stable operation performance in the past years
and has significantly improved its dividend payout ratio.

With huge operational cash flow, $231 million cash equivalents, free debt and weak
enterprise value, BKI would be an available and vulnerable target company of the
hostile takeover due to this capital structure. The acquirer can effectively take
advantage of the characteristics of BKIs capital structure, zero D/E ratios and great
cash flow, to initiate the hostile takeover with minimum acquisition cost, for
example, by pursuing the LBO. Based on industry and BKIs competitive advantage
analysis, it is clear that BKI didnt have outstanding competitive advantage.
Therefore, BKI should improve its D/E ratios to create rather than destroy value
through tax shield, optimize its capital structure, which would be helpful in
defending against the potential hostile takeover. No matter what strategy BKI finally
employs, stock buyback or special dividend, both of them will enhance shareholder
value. In particular buyback strategy might also bring management a higher
percentage of share ownership and control.

More important, BKI took on additional debt with the purpose of either paying a
large dividend or repurchasing shares. The result is a far more utilization of financial
leverage. After the debt increased in fourth time in BKIs history, it would initiate the
serious strategy consideration about (1) how to redesign the payout policies and
finance budgeting process of BKI; (2) how to enhance the profitability through
sustainable improvement in operation performance, product innovation, and
economies of scale; (3) how to select its strategic direction, cost leadership or
differentiation business strategy or integration strategy based on different market
segment; and (4) Whether the pretty conservative management style is suitable for
the fast changing environment and more intense competition? The reduced idle
cash and debt capacity would push BKIs management to dedicate to its target,
continuously generating more cash flows to lower its D/E ratio in long-term.

BKIs payout policy sounds rational. Even though it signifies the managements
inability to find sufficient growth opportunities through organic or inorganic routes,
the intent of management to distribute the excess cash to shareholders rather than
investing in negative NPV projects is plausible. Over the years the payout ratio has
increased significantly and to maintain the same payout ratio in the future would be
an uphill task, especially if the management require significant amount of growth
capital. As on 2006, BKI held $231 million in cash and marketable securities. The
annual average return on these liquid assets over the last three years at 5.78% is
much lower than the companys cost of equity i.e. 8.18%. So rather than further

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accumulating this cash and destroying value the aggressive upward revision in the
payout policy is a good move by the management. However, from a long term
perspective shareholders tend to expect the same payout ratio to continue in
future. The reduced or discrete dividend payout is generally viewed as a negative
signal for a companys performance. It was possible that the management of BKI
didnt want the market to discover its embarrassed situation in the capability to
create value for shareholders in long term. So the company would have been better
off if it would have declared special dividend/bought back shares rather than
horrendously increasing payout ratios in a short frame of time.

Basically, management of BKI should redesign its capital structure and payout
policy based on its long-term strategy, which should focus on business innovation
and continuous cash flow creation capability, not just simply better financial and
dividend payout ratio in short-term.

Stock Buyback Strategy Analysis

The major targets for BKIs management are defense against hostile takeover and
maximize return for shareholders. To achieve the targets, it seems that optimizing
the capital structure of BKI through stock buyback is a plausible strategy at this
special time. BKI, despite being public company, was controlled by family members
descendent from the firms founders. From this aspect, buybacks would increase in
management/family ownership, control over cash usage and decision authority. The
family stakeholders of BKI would applaud this strategy. Similarly, the market
generally regards stock buyback as a positive signal, if the company maintains a
stable operation. BKIs stock buyback would bring positive signal effect, such as
enhancing the confidence of investors and stakeholders, and would become a driver
forces for BKIs management back to optimal track to make its business plan and
market strategy in long-run.

Whether is repurchasing stock really good strategy for BKI at this moment? Dubinski
should consider the following downsides of stock buyback strategy. Blaines stock
price was not far off its all-time high, yet its performance clearly lagged that of its
peers. Per this reality, we assume that the stock price of BKI in 2006 was
overvalued. If so, it could lead the proportional loss of shareholders value. On the
other hand, it is possible release misleading signal to market and drive the stock
price higher, deviating from its real value. Thus, Dubinski should consider whether it
is a good timing to pursue stock buyback and whether buyback truly represents the
best possible financial leverage strategy for BKI compared other possible strategy
like special dividend and etc.

BLAINE KITCHENWARE CAPITAL

STRUCTURE
It would definitely be a big problem with BKI that if repurchasing the number of
shares is not complemented on behalf of creating more value for shareholders and
increasing cash flow generation capability but rather making financial data look
better, as the higher debt ratio means requiring higher ability to generate cash flow
to reduce the D/E ratio effectively. Therefore, Dubinski should consider this
transformation in conjunction with all of BKIs strategy planning, which should
include organization structure optimization (e.g. incentive policy, leadership,
culture, and target of BKI), ownership structure adjustment, redesigning financial
budgeting process, marketing strategy (e.g. pricing, positioning, and acquisition
plan), and supply chain management (e.g. sourcing strategy, back integration or
forward integration, and operation efficiency) etc. In a nutshell, pursuing stock
buyback to optimize BKIs financial ratios should not become the core of this
transformation, BKI should plan it from strategic perspective and focus on EVA.

Stock Buyback Impact on BKI:

Blaine will use $209 million of cash from its balance sheet and $50 million
in new debt bearing interest at the rate of 6.75% to repurchase 14.0
million shares at a price of $18.50 per share.
The company currently has 59.05 million shares outstanding at $16.25/share. After
repurchasing 14.00 million shares at $18.50/share, there will be 45.05 million shares
outstanding at $18.50/share. The announcement of buyback by liquidation of cash
and additional debt taken will create an immediate tax shield benefit.
Tax shield benefit = $259 Million * 30.8% = $79.8 Million (Assuming that the
company holds on to this debt indefinitely and keeps very minimal cash required for
operations)
Tax benefit/Share = $79.8 Million / 59.05 Million shares = $1.35/share. So the share
price immediately jumps to $17.60/share. If we assume the tax rate to 40%, then it
will jump to $18.00/share. It is very realistic to assume that the buyback happens at
$18.50/share and the share price remains at $18.50/share as now the stock is
relatively illiquid and not susceptible to volatility in stock markets.

WACC (%)

Cost of
Equity
Cost of Debt

Old

New

8.18%
6.75%

8.88%
6.75%

Comments
Assuming Rf: 5.10% and Rm-Rf: 5.50%
18.50/Share * 45.05 Million Shares

Equity ($ Mn)

960

833

Debt ($ Mn)

(231)

Value ($ Mn)

729

862

E/V

1.3

1.0

28

In new scenario, Net debt includes the $22

Mn cash left

BLAINE KITCHENWARE CAPITAL

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D/V
WACC

(0.3)
9.27%

0.0
8.54%

Asset Beta
New Equity
Beta

0.67

0.67

0.56

0.69

Unlevered beta is calculated

Metric ($ Mn )

Chang
e

EBIT

Other Income

(13.5)

Interest expense

(3.4)

PBT

(16.9)

Tax

5.2

Net Income

(11.7)

New Equity beta is found out using unlevered

beta
Comments
Old

New

At previous level of 30.8%

53.6

41.9

Shares

59.1

45.1

Equity (Book)

488.4

229.4

Equity (Mkt)

959.6

833.5

EBITDA

73.9

73.9

Interest expense
Interest Coverage (with
EBITDA)

3.4

EPS
ROE
ROA

0.91
0.93
11.0%
18.3%
9.1%
11.6%
24.1%
3.38%
12.27
47.3%
%

D/E (Mkt)
D/E (Book)
Family
Ownership (%)
P/E
Enterprise
Value

Assuming the share price at

$18.50/share

EBITDA/Interest expense
NM

21.9

62.0%
17.9

81.3%
19.9

728.7

861.6

Includes the $22 Mn cash

leftover
Includes the $22 Mn cash
leftover

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First of all, share buyback reduces the number of shares outstanding, thus then
increasing the control and ownership of BKI. Moreover, as BKI should input cash to
repurchase its outstanding shares, it leads to reduction of the assets on the balance
sheet, and then, as a result, the ROA goes up. In terms of ROE, it is obvious that
repurchasing stock is equal to reducing the outstanding shares in stock market, so
there is less outstanding equity of BKI and it conversely results in increased ROE.
Besides, it will also improve the P/E ratio, as the stock price of BKI might increase
after its buyback announcement and retiring its stock.
The share buyback significantly increases the family ownership to 81.3%, increases
ROE drastically and marginally increases ROA and EPS. The buyback marginally
increases the equity cost of capital but with reduction in cash and additional debt it
reduces the weighted average cost of capital of Blaine. The buyback also increased
the enterprise value of the company to $861.6 Million and P/E to 19.9.
Shareholders response:
The buyback significantly increases the ownership of family members, though the
family members are traditionally reluctant to debt, the increase in ownership,
influence, increased returns, reduction in taxable income and decreased risk of
takeover by an external investor outweighs the traditional reluctance to debt. With
the increased ownership the family can freely pursue their own organic or inorganic
growth plans, declare dividends at their will. As a member of family I would
welcome the buyback offer.
The buyback reduces the external shareholders ownership as a group, though
technically if an external shareholder that remains with the company increases his
ownership, the external shareholders as a group loses their influence in companys
operational activities, deciding dividend distribution etc. The buyback also reduces
the chances of takeover by an external investor who might typically pay premium of
more than 30-40%, compared to ~ 14% premium (at $18.50 average buyback) the
shareholders get in a buyback offer. It is also not clear when will the buyback
program start and typically buybacks arent announced at a particular share price
and if market situation deteriorates, the company might buyback the stock at lesser
price than envisaged. So even though it improves ROE and ownership if an external
shareholder continues to remain a shareholder or offers a slight premium for those
who are willing to offload their shares, buyback is not a very attractive alternative.
As an external shareholder, thought it marginally benefits me, I wouldnt be very
enthusiastic about this proposal and look for an alternative if available.
Special Dividend Impact on BKI:
Blaine will use $209 million of cash from its balance sheet and $50 million
in new debt bearing interest at the rate of 6.75% to issue special dividend
at $4.39 per share.
The company currently has 59.05 million shares outstanding at $16.25/share. The
announcement of special dividend by liquidation of cash and additional debt taken
will create an immediate tax shield benefit.

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Tax shield benefit = $259 Million* 30.8% = $79.8 Million (Assuming that the
company holds on to this debt indefinitely and keeps very minimal cash required for
operations)
Tax benefit/Share = $79.8 Million / 59.05 Million shares = $1.35/share. So the share
price immediately jumps to $17.60/share. If we assume the tax rate to 40%, then it
will jump to $18.00/share. Assuming that the positive mood surrounding the stock
due to announcement of dividend and tax shield effect further push the stock price
to $18.50/share. After ex-dividend date, the share price will drop by $4.39 to
$14.11/share and remain at that level.

WACC (%)
Cost of
Equity
Cost of Debt

Old

New

8.18%
6.75%

8.88%
6.75%

Comments
Assuming Rf: 5.10% and Rm-Rf: 5.50%
14.11/Share * 59.05 Million Shares

Equity ($ Mn)

960

833

Debt ($ Mn)

(231)

Value ($ Mn)

729

862

E/V

1.3

1.0

D/V
WACC

(0.3)
9.27%

0.0
8.54%

Asset Beta
New Equity
Beta

0.67

0.67

28

In new scenario, Net debt includes the $22

Mn cash left

Unlevered beta is calculated

0.56

New Equity beta is found out using unlevered

beta

0.69

Metric ($ Mn )

Chang
e

EBIT

Other Income

(13.5)

Interest expense

(3.4)

PBT

(16.9)

Tax

5.2

Net Income

(11.7)

Comments
Old

New

At previous level of 30.8%

Shares
Equity (Book)

53.6

41.9

59.1

59.1

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488.4

229.4

Equity (Mkt)

959.6

833.5

EBITDA

73.9

73.9

Interest expense
Interest Coverage (with
EBITDA)

3.4

EPS
ROE
ROA

0.91
0.71
11.0%
18.3%
9.1%
11.6%
24.1%
3.38%
12.27
47.3%
%

D/E (Mkt)
D/E (Book)
Family
Ownership (%)
P/E
Enterprise
Value

Assuming the share price at

$14.11/share

EBITDA/Interest expense
NM

21.9

62.0%
17.9

62.0%
19.9

728.7

861.6

Compared to share buyback, special dividend doesnt reduces the number of shares
outstanding, thus the control and ownership of BKI. But, as BKI inputs cash to
repurchase its outstanding shares, it leads to reduction of the assets on the balance
sheet, and then, as a result, the ROA goes up. In terms of ROE, it is obvious that
special dividends is equal to reducing the shareholders equity, so there is less
outstanding equity of BKI and it conversely results in increased ROE. Besides, it will
also improve the P/E ratio, as the stock price of BKI might increase after its dividend
announcement and the reduced share price after ex-dividend will more than
compensate the reduction in EPS due to reduced earnings.
The special dividend increases ROE drastically, marginally increases ROA and
decreases EPS. The dividend marginally increases the equity cost of capital but with
reduction in cash and additional debt it reduces the weighted average cost of
capital of Blaine. It also increased the enterprise value of the company to $861.6
Million and P/E to 19.9.
Shareholders response:
The special dividend doesnt result in any change in the ownership of family
members, though there is an increased returns, reduction in taxable income and
increased EV and P/E. The special dividend doesnt reduce the risk of takeover by an
external party reasonably as the cash flows even after the special dividends are
significant and the debt isnt very significant, the reduced share price makes BKI
more attractive and with no change in the external shareholding it is still
susceptible for a takeover offer. These risks dont outweigh the traditional

BLAINE KITCHENWARE CAPITAL

STRUCTURE
reluctance to debt. With no change in ownership and the risk of takeover still intact,
the family hasnt benefited much as they would be more interested in control rather
than improvements in returns. As a member of family I would be very skeptical to
the special dividend issue.
The special dividend keeps the ownership and hence the influence of external
shareholders as a group intact, thought it decreases EPS, it increases ROE, P/E and
retains the attractiveness of BKI as a potential attractive candidate with not
significant amount of debt, but with reduced share price, hence offering lot of near
term upside potential. The special dividend retains a significant amount of cash to
shareholders. So even though it reduces share price, the benefits clearly outweigh
the shortcomings. As an external shareholder, I would be very enthusiastic about
this proposal and push forward this proposal alternative to the share buyback
program.

Optimal capital structure and share purchase:

As the company increases its debt levels, its credit risk increases and hence the
interest coverage ratio decreases and credit rating decreases. This is evident in the
quotes received from the banker. As per the quotes received from banker, a
detailed analysis is performed to calculate interest rates, debt borrowing, share
repurchase program and cost of capital for the six alternatives. We have assumed
that $209 Million from existing $231 Million cash and cash equivalents will be used
for buyback and $22 million still remains as cash on balance sheet. We have also
assumed that the buyback will happen at a price of 4% premium to the market price
after the tax shield effect of using extra cash and new debt is factored in the price.
Metric
Interest
Coverage
Risk free Rate
Spread
Effective
Interest
Credit Rating
EBITDA
Interest
Expense
Debt
Net Debt

Old
NM

2
1
1.5
5.02%
0.80%
5.82%

5.02%
0%
5.02%

1
1
5.5
5.02%
0.65%
5.67%

9.2
5.02%
0.85%
5.87%

7.0
5.02%
1.83%
6.85%

5.2
5.02%
2.98%
8.00%

4.2
5.02%
4.10%
9.12%

NM
7
3.9

AAA
7
3.9

AA
7
3.9

A
7
3.9

4.8
84.0
6
2.2

6.4
110.4
88.5

8.0
136.8
11
4.9

BBB
7
3.9
1
0.6
154.0
13
2.2

BB
7
3.9
1
4.1
175.9
15
4.0

B
7
3.9
1
7.4
191.0
16
9.1

0
(230
.9)

BLAINE KITCHENWARE CAPITAL

STRUCTURE
Share Price
Realistic
Share Price
Buyback
(Millions)
Equity
Value
E/V
D/V
Asset Beta
New Equity Beta
Cost of Equity
Cost of Debt
WACC

16.
25
16
.25
95
9.6
72
8.7
1.
32
(0.3
2)
0.
67
0.
56
8.18%
6.75%
9.29%

17.
78
18
.49
1
5.9
79
8.7
86
0.8
0.
93
0.
07
0.
67
0.
71
8.99%
5.67%
8.63%

17.
91
18
.63
1
7.1
78
0.8
86
9.3
0.
90
0.
10
0.
67
0.
72
9.09%
5.82%
8.57%

18.
05
18
.77
1
8.4
76
2.8
87
7.7
0.
87
0.
13
0.
67
0.
74
9.18%
5.87%
8.51%

18.
14
18
.87
1
9.2
75
1.1
88
3.2
0.
85
0.
15
0.
67
0.
75
9.25%
6.85%
8.57%

18.
25
18
.98
2
0.3
73
6.2
89
0.2
0.
83
0.
17
0.
67
0.
77
9.33%
8.00%
8.68%

18.
33
19
.07
2
1.0
72
5.9
89
5.1
0.
81
0.
19
0.
67
0.
78
9.39%
9.12%
8.81%

The increase in borrowing decreases interest coverage, increases credit risk and
hence the credit rating goes down and the interest rate of borrowing increases.
Optimal capital structure should try to reduce the weighted average cost of capital.
From the quotes received from the bank, the third alternative with a credit rating of
A at interest coverage ratio of 9.2 gives the minimum WACC, and hence we should
take $136.8 Mn debt and retire stock. The share price after taking debt increases
and announcement of retirement will be $18.05 due to gain in tax shield, but the
realistic assumption of buying back shares would be at an effective price of
$18.77/share (4% appreciation from theoretical share price). So at $18.77/share we
should buyback 18.4 million shares.
Conducting a similar optimal capital structure analysis at various interest coverage
ratios to find out if 9.2 interest coverage i.e $136.8 Mn is the optimal debt has given
interesting results.

BLAINE KITCHENWARE CAPITAL

STRUCTURE
WACC vs Interest Coverage Ratio
9.10%
9.00%

8.90%
8.80%
8.70%

B
B

8.60%

BB
B

8.40%
8.30%
-

AA
A

AA

8.50%

2.0

4.0

6.0

A
8.0

10.0

12.0

14.0

16.0

18.0

20.0

The graph clearly shows that from AAA to A the weighted average cost of capital
decreases with increase in borrowing and later follows a step function for each of
BBB, BB ratings maintaining the decrease in WACC with increase in borrowing in
those respective limits. For credit rating of B, WACC started increasing with increase
in borrowing. An optimal capital structure essentially should try to minimize WACC.
At interest coverage ratio of 7.1 i.e. the bare minimum ratio at which we can get
credit rating of A, the weighted average cost of capital is minimum. So we should
take $177.2 Million shares and retire 20.34 million shares at $18.99/share.
Optimal capital structure Value of levered firm:
For calculating optimal capital structure, we have studied another approach where
the total value of the levered firm is maximized for a given capital structure.
Value of Levered firm = Value of Unlevered firm + Tax rate*Debt Expected
bankruptcy costs, the value of unlevered firm doesnt change with the debt taken,
so hence we studied the profile of Debt tax shield Expected bankruptcy costs vs
Debt to arrive at the maximum value of levered firm.
Bankruptcy costs are assumed to be 40% of unlevered firm value i.e.
Bankruptcy costs = 40% * Unlevered firm
Unlevered firm = Value of operating assets (From Market Balance Sheet) = $799.7
Million
Bankruptcy cost = $319.9 Million
Further the probability of bankruptcy is assumed as follows considering the
historical bankruptcy of various firms according to their credit rating:

BLAINE KITCHENWARE CAPITAL

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Credit Rating
AAA
AA
A
BBB
BB
B

Probability
0.01%
0.28%
0.53%
2.30%
12.20%
26.36%

Tax Shiled - EBC vs Interest Coverage

BB
B

130.00
120.00

A
AA

110.00
100.00

AA
A

BB

90.00
80.00
70.00
60.00

50.00
40.00
30.00

10

12

14

16

18

20

The graph clearly shows that from AAA to B the expected net increase in firm value
(Tax shield Expected bankruptcy costs) increases with increase in borrowing and
follows a step function in borrowing in those respective limits. An optimal capital
structure essentially should try to maximize the increase in firm value. At interest
coverage ratio of 5.1 i.e. the bare minimum ratio at which we can get credit rating
of BBB, we get the maximum value for levered firm i.e. the optimal capital structure
to be maintained. So we should take $211.4 Million debt and retire 21.92 million
shares at $19.18/share.

While the calculation of bankruptcy might not be accurate, it is very reasonable to

assume that the company would lose significant amount of resources and value if it
files for bankruptcy. Hence the resulting optimal structure might be in that range
that we have arrived, but may not be the same. So through two different
approaches we have arrived at $177.2 and $211.4 Million debt as the optimal debt
amounts to be taken. Both approaches give a similar range i.e. the company should
undertake around $200 million dollar in debt, in addition to utilizing $209 million of
existing cash and marketable securities to retire ~20 Million shares. This repurchase
program unleashes the value hidden in balance sheet, increases the ownership of
family to more than 90% and enhances shareholder value. The company can utilize

BLAINE KITCHENWARE CAPITAL

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the remaining cash flows from operations (after interest payments) for pursuing
growth opportunities or retire debt periodically and reissue debt for growth capital.