Dollar Tree (DLTR): A Company Valuation

(Disclaimer: Excel file attached below the post) 

Dollar Tree is one of the stores that my wife and I frequent, and it is not due to competitive prices but because of the wide variety of assortments that the stores carry, and being that I am a loyal patron, I wanted to delve deeper into the company's financials and see if it meets my criterion for holding it in my portfolio. I will be looking at the company's financials for the past 5 years and, with my understanding of its business and the retail sector overall, I will try to value the company based on its intrinsic characteristics and compare that to its current market price. 

Dollar Tree

DLTR 10-K

DLTR is one of the leading retail discount stores operator in the US and Canada and functions under the Dollar Tree, Family Dollar, and Dollar Tree Canada banners. As of the end of FY '23, the company operates 16,774 stores across 48 states in the US and five Canadian provinces. The company reports revenues and numbers for two segments: Dollar Tree and Family Dollar. 

Dollar Tree Segment

The Dollar Tree segment includes 8,415 stores operating under the Dollar Tree and Dollar Tree Canada banners, and has 15 distribution centers in the United States and two in Canada. Dollar Tree stores generally range anywhere from 8,000-10,000 selling square feet. Company primarily carried $1 items in its locations up until the recent past, and then made the pivot towards an increase where now the lowest end of the range is $1.25 whereas the upper range is in the $5 vicinity; the change was, of course, driven by the unquenchable desire to increase shareholder value as well as other number of factors that we will get into in the sections below. 

The Dollar Tree brand carries approximately 8,000 items and as of the end of FY '23, roughly 27% of the items were automatically replenished while the remaining items were either allocated to the stores or managed by direct store delivery vendors. The merchandise mix in the Dollar Tree stores consists of:

• Consumable merchandise, which includes everyday consumables such as household paper and chemicals, food, candy, health and personal care products, and in most stores, frozen and refrigerated food. 
• Discretionary merchandise includes:
• Variety merchandise, which includes toys, durable housewares, gifts, stationery, party goods, greeting cards, softliners, arts and crafts supplies and other items.
• Seasonal goods, which include, among others, Christmas, Easter, Halloween and Valentine's Day merchandise. 

Dollar Tree has historically been the largest part of the company's top line; the segment has consistently contributed more 50% of the company's total sales. As for the segment itself, net sales for this segment increased 8.9%, or $1,365MM, and this increase was mainly due to an increase in comparable store net sales of 5.8%. Gross profit margin for the segment decreased to 35.8% from 37.5% on a YOY basis even though the overall revenues increased. This decrease in gross profit margins could be attributed to an increase in merchandise costs, distribution costs, shrink costs (theft, etc.) decrease in markdowns and occupancy costs. 

Operating margin for the Dollar Tree segment also decreased  from 16.5% in FY '22 to 13.6% in FY '23. The reduction in operating margins was due to wage investments, minimum wage increases and other general liability claims. 

Family Dollar Segment

Family Dollar is the second largest part of the company's total revenues and accounted for anywhere from 45% to 48% of total sales over the last 5 years. The Family Dollar segment includes 8,359 stores operating under the Family Dollar brand and has 10 distribution centers as of the FYE '23. Merchandise at Family Dollar locations range from $1 to $10 and locations have historically ranged from 6,000- 8,000 selling square feet. 

Family Dollar stores generally carry around 11,800 items, and as of FYE '23, ~75% of the items were automatically replenished. The merchandise mix in the company's Family Dollar locations includes:

• Consumable merchandise, which includes food, beverages, tobacco, health and personal care products, household chemicals, paper, and automotive supplies. 
• Discretionary merchandise, which includes:
• Home products, which include housewares, home decor, giftware, and domestics, including comforters, sheets and towels;
• Apparel and accessories merchandise, which includes clothing, fashion accessories and shoes. 

Net sales for Family Dollar segment increased 7% on a YOY basis to $13.8B; the increase was due to an improvement in comparable and noncomparable store net sales. Gross profit margin for the Family Dollar Segment decreased from 24.4% in FY '22 to 23.9% by the end of FY '23; this decrease was due to an increase in shrink costs, increased markdowns, and increase in distribution and decrease in occupancy and merchandise costs. 

Operating margin for this particular segment decreased to (19.3)% resulting from the gross profit margin decrease, and increase in SG&A expense rate which includes the impairment charges reported for FY '23. 

Historicals

With an understanding of the company's segments, lets now look at the company's financials for the last five years starting with the income statement.

Historical Income Statement

As you can see, the company reported total net sales of $30.6BB for FY '23, which was an increase of 8% on a YOY basis and this increase was due to the increase in the Dollar Tree and Family Dollar segments we discussed in the section above. One of the things that stands out is the fact that company's COGS as a % of its total net sales have consistently been hovering around the 70% mark, and it could be due to micro reasons such as higher costs, increased in inventory as well as macro factors such increase in inflation and freight costs, or it could just be because retail industry has historically been a low margin business. Although gross margins decreased on a segment basis, the company reported positive gross margins, around 30%, for the last 5 historical years. 

Company's total operating expense as a % of net sales have also consistently been in the 22%-25% range, with the exception in FY '23 when the company reported the impairment of its Family Dollar brand that the company purchased back in 2015. Dollar Tree has also reported subpar operating margins over the last 5 years, in the 5%-8% range; I am excluding FY '23 when the operating margins were (2.9)% due to the impairment charge the company included in its yearly operating expenses. Lastly, net margins have also been consistently low; around 5% from FY '20 to FY '22, and (3)% for FY '23, again due to the impairment charge of over $1BB. Let's now move onto the company's historical balance sheet. 

The balance-sheet is pretty self-explanatory, but there are a couple of things that I think I would like to bring to your attention: the first one is the company's healthy cash and cash equivalents balance, which as you can see, was $757.2MM as of the end of the FY '23; second would be the reduction in goodwill and its related impairment for FY '23; and lastly, although the company has no short-term debt, it does have a healthy amount of long-term debt and operating lease liabilities which for analytical purposes are treated as debt. 

Industry and Competition

I think that after reviewing the segments, their performance, and the historical numbers, and before we can talk about the company's valuation, it is prudent for me to briefly discuss the retail industry and its future as well as Dollar Tree's competition. 

Retail Industry

My overall outlook of the retail industry is positive, I believe that after navigating the tumultuous COVID times, companies are well positioned to handle future headwinds. I believe that companies have acclimated to the fact that rates will be higher for a little while longer, even given the recent reductions, and are taking appropriate actions such as healthy inventory sizes, price increases, and managing their supply, occupancy, and freight costs. I also believe that companies have begun to seriously consider diversifying their offerings, take DLTR for instance, the company reports revenues in a third segment which primarily comprises of advertising revenue. With solid numbers reported in the latest employment numbers, the economy added more than 250,000 new jobs, I believe that consumers will continue to spend in the future, even going either as high as the pre-pandemic levels or maybe even higher.    

Although my outlook is positive, there are a few underlying issues that I believe will make it hard for the companies in this industry to grow their top line and margins, at least in the near future, and I would like to briefly discuss these issues.  

• Interest Rates: The Federal Funds Rate, the rate at which financial institutions lend capital to other financial institutions, usually overnight, at the time of this post is 4.25%-4.50%. If you remember, we have had rate cuts but nearly not as much as investors were expecting which is why treasury yields have recently been rising; the yield on a 10-year treasury note was 4.8% a couple of days ago but has since come down to 4.58% as of the timing of this post. The reduction in this rate is not nearly as rapid as investors or consumers were expecting and that is partly because of the strong employment numbers as well as inflation which I believe is still around 3%. Remember, the basic premise behind rate hikes is to reduce inflation and bring employment within the FED's goals and expectations, and since that is not happening, I believe we might end the year with 3.75%-4.00% of Federal Funds Rate, and since high rates impact both the companies and the consumers, I believe Dollar Tree will not only have to earn a higher return on its investments, but will also have to compete aggressively with other players in the market for consumers and their limited budgets which will hinder the company's top line and margins, at least in the near future.  
• Consumer Expectations: As of the writing of this post, consumer expectations have also risen in terms of what they think will happen with food prices and other everyday necessities. I believe that this increased sentiment will only be propelled by the new government's policies as well as healthy labor market and inflation. I believe that this will lead to consumers further tightening their wallets and limiting their spendings for the near future which will make it harder for companies like Dollar Tree to grow their top-line and improve their margins in the near term. 
• Political: Dollar Tree has around 25 distribution centers which means that about 90% of Dollar Tree's locations and 70% of Family Dollar locations get their inventory from the company's own distribution centers, with remaining inventory coming from third party vendors and independent distributors. But the issue that I see here is the fact that those 25 distribution centers get their inventory from other countries such as China, and given the US's on-going quarrels with China, it should not only make it hard for the company to restock its shelves, but it might also increase the costs. 
• Governmental Policies: Donald Trump was inaugurated as the US president on Jan 19th, and I believe his policies in terms of tariffs and trade that he has proclaimed throughout his campaign and also in his inaugural address will make it costly for Dollar Tree to do business in the country. This would mean that not only will the company need to pass the costs through to customers, which could back-fire, but it could also compel the management to spend heavily in the US in order to lessen the company's dependency on foreign distributors and business partners.  

Competition

Dollar Tree operates in not only a low-margin business but also in a industry that is highly saturated with players such Walmart, Target, Costco, Aldi, Lidl and Dollar General; not to mention your corner delicatessens and other local and regional brick and mortar brands. Dollar Tree's competitors, especially the major ones, have an immense buying and purchasing power and some have even gone so far as to create separate sections with highly competitive prices. I believe that the heightened nature of the market and its players should make it difficult for Dollar Tree to not only grow its revenues and expand its business but also make it difficult for the company to improve its margins and profitability. 

Valuation

Before we move onto the valuation, I think it might be beneficial for us to break down my assumptions (base case) for the future.

• Revenues
• Dollar Tree: I expect Dollar Tree segment to continue to be a huge part of the company's top-line in the future (staying relatively flat for the next 10 years with slight fluctuations on year over year basis); I believe that this will be due to Dollar Tree's strong brand name and customer loyalty. I expect revenues for this segment to increase from $16.7BB in FY '23 to $21.6BB by the end of FY '34.
• Family Dollar: I expect family dollar's revenues as a % of the company's net sales to reduce from 45% in FY '23 to about 44% by the end of FY '34. I believe this reduction will be due to Family Dollar's weaker brand as well as the issues I mentioned in the section above. I expect Family Dollar's revenues to increase from $13.8BB in FY '23 to $17.3BB by the end of FY '34.
• Cost of Sales: I expect cost of sales to continue to be a huge pull-down for the company's margins and profitability. I expect cost of sales to increase for the next 5 years due to the issues that I mentioned and then finally begin to decrease in year 6th and end the projection period on a high note. I expect cost of sales as a % of total sales to increase from 69.5% ($21.2BB) in FY '23 to 70% ($24BB) by the end of FY '29, and then decrease to about 65% or $24.4BB by the end of FY '34.
• Operating Expenses: Company reported operating expenses of $9.1BB or 29.9% of total net sales, and I do not see a reason for reduction in the near future. On the contrary, I expect operating expenses to continue to rise for the next 5 years to 30% or $10.4BB for FYE '29 due to increase not only in wage and minimum wage but also to stay competitive and retain employees and talent. I expect as the company gets a better hold of its business, operating expenses should decrease to $9BB or 23% by the end of FY '34.
• Operating Margins: As a result of my expectations surrounding company's revenues, COGS, and SG&A, I expect relatively non-existent operating margins for the next 5 years, and starting FY '30, the margins should begin to improve and end at about 12% by the end of FY '34.
• Capex: Dollar Tree reported capex margins of 6.9% for FY '23  and given my expectations in revenue growth, I expect the company to continue to invest in capex until the end of the projection period with capex margins of 5% for FYE '34.
• WACC: The risk free rate as of this analysis was 4.80%, DLTR's beta is 0.92, and the market risk premium is 4.00%, giving us a cost of equity of 8.48%. I could not find the yield on the latest debt the company raised and so I am making an executive decision and using 5% as my pre-tax cost of debt, and assuming a marginal tax rate of 25%, I get an after-tax cost of debt of 3.75%. Why 5%? I looked at the company's debt and the cost of debt that the company disclosed in its footnotes, and they were all a few years old, meaning the cost of debt that the company disclosed is not in line with the current market conditions, and having done these sorts of analyses before, I believe that 5% is in line with the current macro conditions. With the company's 61.08% weight of equity and 38.9% weight of debt, I get a WACC of 6.64%.
• EBITDA Multiple: As I have said at ad nauseam at this point, I do not believe in EBITDA multiple being a part of an intrinsic valuation, but it seems to be an enticing term that everyone on the street seems to think is of paramount importance, as such, I have only recently started utilizing it in my own work. I do not know the multiple Dollar Tree is trading at due to my limited resources, but I can finesse my way into deriving one with the information I do have; my implied EBITDA multiple given my growth in perpetuity of 0.5% and WACC of 6.64% is 9.10x, and for conservatism's sake, I will assume an exit EBITDA multiple of 8x. 

With my assumptions in place, here is what the future income state looks like:

As you can see, in my base case, I am not expecting much growth in the company's future for the next 10 years and the reasons are an amalgam of what I have hinted at in the sections above. I feel like with the risks and the nature of the market, the revenue growth that I have assumed is pretty solid, of course things change if I switch to best case or deteriorate if we move into the weak case. As mentioned above, I am assuming COGS and operating expenses to slightly reduce over the next years with slight fluctuations throughout the years. Here is a look at the company future balance sheet:

As is evident from the projected balance sheet, I expect the company to raise further debt for the next 8-9 operating years and as a result have a minimum cash balance of $500MM throughout the next 9 years with ending the projection period with $1.67BB in FY '34. Let's now look at the company's cash flow statement to better understand the company's liquidity for the next 10 projected years.

As expected, I am expecting moderate growth in the company's operating cash flows and increase in its capex activities which yields negative free cash flows for the next 5 years, and as the company enters the second phase, I expect the company to turn positive and end the projection period with $3.7BB in free cash flows to the company. With all of the financial statements in our rearview, let's now look at the crux of this whole analysis: DCF derived price per share. 

Based on my base case assumptions, I get a price per share of $115.54, the stock is currently trading at $73.48, giving us an upside potential of ~50%. It goes without saying that one of the inherent flaws with a DCF is that it is based on what I think about factors such as growth, risk and the company's cash flows, and so to offset some of that risk, I have created scenarios around the price; my base case price per share, as mentioned before, is $115.54, and in my best case, I get a price per share of $214.09, and $63.54 in my weak case. I think in order to better manage the risk around my assumptions, it would also be beneficial to look at a few data tables and see how the price changes due to alterations in some of the variables. 

Sensitivity

The tables in the images above are pretty self-explanatory, and without going into too much detail, image 1 shows the changes in price per share given changes in the long-term growth rate and WACC; whereas image 2 shows us the impact on price per share given the changes in our EBITDA multiple and the company's WACC. Let's look at another set of tables that shows us the price per share given changes in revenues, EBITDA multiple, and margins by the end of FY '34.

As you can see, if I assume changes in my final year revenues and operating margins, my price per share could end up being dramatically different than what I have gotten in any of my scenarios; the same impact goes for changes in EBITDA and WACC for the final year of the projection period. 

Conclusion

Every time I do an analysis of this kind, my goal is always to understand all of the micro and macro factors that I possibly can so that my value ends up in a range that makes sense to me, but all of this is based on my inherent thinking of the company, its business, the industry, and the larger economic picture, and I can of course be wrong. So, if you end up disagreeing with my analysis, I have attached the file below for your review, please, feel free to go ahead and make the changes and convert the numbers into what you might think make more sense. Of course, DCF is an intrinsic valuation, and so if you try to compare this to what Dollar Tree's peers are trading at, well, that becomes a pricing game, and that comes with its own pros and cons. But, I have lately been thinking of conducting not only a DCF analysis but also couple it with a comparable analysis; but as can be expected, it becomes an arduous and time consuming journey, and so I'll just roll with the punches and see what I end up doing in the future. 

Links:

Dollar Tree Valuation- 01/22/2024

02/02/2024 10-K

 

Intel (INTC): Too Big To Acquire?

(Disclaimer: Excel file attached below the post) 

I recently got done reading "Dethroning the King" by Julie Macintosh and have been grossly contemplating how companies rise to power, are considered the paragons of their industry, and then just as quickly, lose touch with reality, their consumers, and just altogether, loose the will or the appetite to maintain their market share or brand. I initially wanted to talk about the unholy relation between corporate governance and corporate cycle and company valuations, but I opted to shelve that thought and write about something that is directly relevant to what I read: the rise and potential fall of yet another American corporate icon, Intel. 

Up until the recent past, Intel was a part of my investment portfolio, but I decided to severe ties with the company right after its earnings call for FY 2023. It had completely vanished from my thoughts until a couple of weeks ago when news about a potential takeover of the company by Qualcomm (QCOM) started circulating the various news outlets and I rendered it serendipitous that this was all occurring when I was reading a book about the rise and fall of A-B. Given my piqued interest and curiosity, I decided to look at the company's financial statements, its current valuations, and of course, what a deal between Qualcomm and Intel could look like. Without any further ado, lets dive right in. 

Intel

Ghosts of Intel's Past

Intel- 2023 10K

Founded in 1968 by Gordon Moore, Bob Noyce, and Andy Grove, Intel has long been one of the leaders of the technological advancement over the last few decades as well as being the pinnacle of designing and manufacturing chips, processors and various other products and services that were pivotal to the convenience of the end consumers. The company's rise and long standing leadership during the 80s, 90s, and to some extent in the 2000s, is something that should be studied and applied to companies in their early growth stages, but the company seems to have lost its touch over the last decade, especially the last few years, and before we delve deeper into some of the reasons for its decline and potential demise, I think we should take a few minutes to mull over its performance over the last few years and see if we can see the decline in the numbers.

Over the last 10 years, Intel's revenues have gradually been declining for reasons that we will address later in the post, while at the same time, its Capex (as a % of its total net revenues) has risen over the same time period. Company's capex for FY 2014 was $10BB (18% of total net revenues), and in FY 2023, the company reported capex of almost $25BB (46% of total net revenues). Although the company's capex have risen over the last decade, its revenues have actually declined and margins, both gross and operating, have contracted. Speaking of its margins, Intel had fairly consistent and decent operating margins (anywhere from 25%-30%) for most part of the last decade, right up until FY 2021, and after that things have gotten sour to say the least. Intel reported operating margins of 3.7% on total net revenues of $63BB for FY '22, which resoundingly means that the company's competitive edge, its economic moat, and unit economics have worsened; the company had to spend so much on COGS, R&D and MG&A that even revenues of $63BB- a topline number that I might add, companies would kill for- yielded meager operating margins of 3.7% and gross margins of 42%, where the company posted gross margins in excess of 50% for the preceding three fiscal years in '19, '20, and '21. 

In order to get a clear picture of the company's performance and its gradual fall from grace, I think that we should look at its historical financial statements and try and assess if we can spot the usual suspects in the numbers. As such, here is a look at the company's income statement for the last five years from FY '19- FY '23:

Intel reports revenues in various different segments, and as we can see, the company has been witnessing a gradual and perpetual decline in most its segments. In FY '19, the company reported total net revenues of $72BB and that number has plummeted down to $54BB at the end of FY '23. Moving on to the cost of sales, or more colloquially known as COGS, have actually risen; company reported cost of sales of $30BB (41% of total net revenues) for FY '19, and during the next five years, even though its revenues have gone down, its cost of sales have actually grown to $32.5BB (60% of total net revenues), signifying that at sometime over the last five years, Intel has lost its economic moat and, consequently, its unit economics have all but drowned. This decline in revenues and the proportional increase in cost of sales has yielded worsening gross margins over the last five years; company reported gross margins (considered by many to be the proxy for a company's unit economics and economies of scale) of 58.6% for FY '19, and fast forward to FY '23, company reported ailing gross margins of 40%, further highlighting its incremental decline in the markets and the industry.

Moving over to operating expenses (R&D, MG&A, and occasional Restructuring Charges), Intel's operating expenses have skyrocketed similar to its cost of sales. For FY '19, the company reported operating expenses as a percentage of total net revenues of 28%, and in its latest fiscal year FY '23, the company had operating expenses margins of whopping 40%. Lastly, its NI tells a similar story; Intel's net margins have decreased from 29% in FY '19 to mediocre 3% for FY '23. The company's decreasing revenue growth, increasing cost of sales and humongous increase in its operating expenses tell a tale of company that is very much at the end of its proverbial life cycle. Before moving onto the next section of my analysis, I would like to take a few seconds and talk about the company's cash flow statement for the last three years, only because I believe it will give a real inside view of the cash inflows and outflows of the company, and we might even see positive cash flow despite the poor margins and profitability. 

As we can see, company's cash from operations (which starts with NI and adjusts for non-cash expenses and the changes in working capital items) have seen commensurate decline along with its revenues and margins, and that is not a surprise because the starting line in cash from operations is the NI from income statement. Additionally, Intel had positive free cash flows (cash from operations minus capex) in FY '21, but given its massive restructuring and expansion efforts under Pat Gelsinger, the company's free cash flows have been negative for the last two years. Other honorable mentions here would be the fact that Intel repurchased shares back in FY '21 and then suspended their decision to repurchase any shares for the next two years as well as scaling back their dividends; these two could either be perceived as a good thing because it means that the company is reinvesting in order to regain it leadership role in the industry or it could also mean that the company is not profitable enough to generate cash flows that can sustain share repurchases and future dividends.  

Ghosts of Intel's Present

Before we move onto some of the reasons, according to my research and understanding, for Intel's decline in revenues, margins and profitability, I think that in order to set a baseline, it is imperative that we discuss its latest operating year in more detail, as I suspect it will divulge more information that will come in handy for my analysis down the road.

I think that the image above, taken from Intel's 2023 10K best summarizes the company's performance over the last year, and as you can see, it is shouting all sorts of troubles. Over the latest fiscal year, company's revenues have declined due to lower revenues from CCG (Consumer Client Group), DCAI (Data Center and AI), and NEX (Network and Edge) segments; we will discuss the segments in more detail down the road. Company's both GAAP and non-GAAP gross margins declined YOY due to increased unit costs, lower revenues, and higher excess capacity charges, the reduction was somewhat offset by the sale of its existing inventory, lower inventory purchases and lower product ramp costs. Moreover, both GAAP and non-GAAP EPS were down YOY due to lower gross profits driven by lower revenues and higher costs and partially offset by relatively lower operating expenses and a higher tax benefit (tax benefit without which the company would have reported negative NI). Lets now discuss the segments in more a little more detail; the company reports revenues in the following segments: CCG (Client Computing Group), DCAI (Data Center and AI), NEX (Network and Edge), Mobileye, and Intel Foundry Services.

CCG (Client Computing Group)

CCG or Client Computing Group is by far the biggest source of revenues for Intel. For instance, for all of the last five observed years, CCG has constituted for more than 50% of Intel's total net revenues. Intel's CCG group engages in products and developments that are mainly utilized in PCs through companies such as DELL (19% of Intel's total revenues), HP (10% of Intel's total revenues), and Lenovo (11% of Intel's total revenues). Under the auspices of this group, Intel has launched the industry's first AI PC Acceleration Program to help enable AI on more than 100 million PCs through 2025 as well as launching 13th Gen Intel Core mobile and select desktop processors, Intel Core 14th Gen Processors, and Intel Core Ultra Processors. 

Intel's 10K

Revenue within the CCG group is further divided into Notebook, Desktop, and Other categories, and as you can see, overall revenues for the group have declined due to a decrease in demand for notebooks and desktops as well as lower demand for wireless and connectivity products. 

DCAI (Data Center and AI)

Data Center and AI (DCAI) is the second biggest source of revenues for Intel; the company reported DCAI revenues of $26BB (32.7% of total net revenues), $19BB (30% of total net revenues) and $15.5BB (28.6% of total net revenues) for FYs '21, '22, and '23, respectively. This group delivers cutting edge work-load optimized solutions for cloud service providers and enterprises along with silicon devices for communication service providers. The group has sold more than 2 million 4th Generation Intel Xeon Scalable processors as of the end of FY '23, and 5th Gen Intel Xeon processors in the fourth quarter of FY '23. Furthermore, the 4th Gen Intel Xeon processor was recognized by MLCommons which stated that the processor is a compelling invention that competes on performance, price and availability with its competition in the AI markets. 

Intel's 10K

Revenues for the segment decreased YOY by $3.9BB due to a decrease in demand in the CPU data center market; this decrease could be attributed to increased competition from NVidia (through its GPUs that are powering the artificial intelligence services) and AMD (through its encroachment of the PCs and data centers' processors and CPUs). 

NEX (Network and Edge)

NEX is the third largest source of revenue for Intel; the company reported $4BB (5% of total revenues), $9BB (14% of total revenues), and $6BB (11% of total revenues) for FYs '21, '22, and '23, respectively. This group provides and delivers products and services that helps Intel's consumers improve their operations and protect their data on the Edge through AI driven automation. The company launched 4th Gen Intel Xeon processor with Intel vRAN Boost, and announced the Intel Xeon D-1800 series and the Intel Xeon D-2800 series processors that are optimized for cloud, edge, and 5G networks. 

Intel's 10K

Revenues for the segment were down by almost $6BB on YOY basis due to lower demand driven by the macro events of the last year. 

Mobileye

Mobileye is Intel's autonomous vehicle and related technologies division, and develops products and services for autonomous driving and related solutions. The company reported $1.3BB (1.8% of total net revenues), $1.9BB (3% of total net revenues), and $2BB (3.8% of total revenues) for FYs '21, '22, and '23, respectively. Mobileye launched EyeQ based systems into approximately 300 different vehicle models and built significant traction with other products in the company's portfolio. Mobileye SuperVision is continually being delivered on the air in order to improve highway driving and navigate-on-pilot capabilities. 

Intel's 10K

Even though Intel has been working on delivering autonomous driving related products and services for over 20 years now, it only recently started reporting for this segment after it acquired Mobileye back in 2017 and its subsequent IPO in 2022. Revenues for this segment increased by $210MM due to the increased demand for EyeQ products and Mobileye SuperVision. 

Intel Foundry Services

Intel's foundry services works with other companies and firms in order to manufacture chips that are designed by its business partners and are specifically tailored for their needs. One of the things that management realized over the years is TSMC's monumental growth given its manufacturing of products that are designed by its clients, instead of designing and manufacturing chips and other products in house and selling them to clients, and in order to compete, Intel started its own foundry business in the last few years and it is very much still in its nascent years, as evidenced by the revenues and consistently negative operating income below.

Intel's 10K

This segment reported revenues of $952MM, an increase from $895 it reported last year. Due its infancy, this segment has gargantuan future growth potential given what other foundry businesses have been able to do as well as the increasing costs and investments that come with growth.   

The Dog Ate My Homework

With an understanding of the company's financials for the last decade, and the last year in more detail, I think that I am ready to move onto some of the reasons why I think the company has been putting sub-par numbers, to put it mildly, in the recent years.

Complacency Driven by Magnanimity:

 

One of the many reasons why empires (i.e., Roman, Carthage, Persian, Greeks, and Ottoman to name a few) failed is their complacency and it is no different for companies and corporations after they reach a certain point. There is a valid reason as to why corporations are legally treated as citizens because they behave in much the same way, and I believe that Intel suffered from the same ailment. The company was quite literally on top of the technological world and its processors were synonymous with the Windows operating system; I remember when discussing new computers and laptops, the first question that was asked was "what Intel processor does it have?" The version of the processor was how consumers used to determine if it was a newer model or an old relic, and that has since changed, for many reasons, complacency being one of them. When companies reach the pinnacle of their cycle, they tend to enjoy the high instead of looking at the future. 

There have been so many examples in the corporate world that have suffered the fate that many might think seems like an eventuality for Intel; think IBM, Blockbuster, and Toy's 'R' Us, and is there something that the management at Intel could have done to better position themselves? Yes. The company's R&D and capex have inversely ballooned in relation to its revenues and that should make one wonder where all that capital was being deployed. Intel for the most part of its tenure has been a designer and a manufacturer and so the R&D expense, in many ways, fueled the management's lack of foresight. Their myopia, in hindsight, is quite vivid because it seems like the capital they deployed has been for new iterations of their existing repertoire of products and services rather than ground-breaking new technologies. I say this because given its place in the industry, I believe Intel should have been the one at the forefront of artificial intelligence and the mania surrounding it rather than an underdog like NVidia, which at the time of this post, is the second most valuable company with market cap slightly below that of Apple's. 

Lack of Risk Taking

I mentioned at the beginning of the post that one of the reasons why I decided to do this is due to the fact that I just finished reading "Dethroning the King", and the book goes in excruciating elucidation into A-B's lack of risk taking and how that contributed to it being taken over by a company that stemmed from Brazil and that A-B, at one point in time, had the opportunity to acquire. Lack of risk taking would be the second reason why I think Intel is in the place that it is in; management was, I suspect, quite comfortable enjoying the position that the company was in and, I suspect, did not see the point in taking risks and exploring new ways of expansion and relevance. I will mention two examples here: one that of autonomous driving and the second of the foundry business. 

Intel touts in its latest 10K that it has been invested in autonomous driving related products and services for over 20 years, and yet they took the step to acquire Mobileye in 2017. If the management had the appetite for risk and the yearning for future growth, they would have taken the initiative well before 2017 and taken advantage of the situation when the markets were putting a premium on companies within the electric and self-driving categories. The second example of the foundry services pretty much paints the same image; Intel was so insulated in designing and manufacturing its own chips that what other firms like TSMC and Samsung were doing seemed to be of no consequence and as a result, Intel lost valuable market share to those companies due to their ability to not only manufacture chips and processors built by their clients but also improve them through testing. Intel started its own foundry services a few years ago in order to compete with companies like TSMC and Samsung, and it might be too little too late because now they have to engage in competition on two fronts: Intel not only has to compete for its foundry business with well established aforementioned companies but it also has to compete with the likes of NVidia (who gets its manufacturing done primarily by TSMC) in terms of designing and building GPUs and accelerators that are required for AI and related products and services. Will Intel's foundry business see the success that TSMC is enjoying? Only time will tell, because they will have to not only outperform TSMC and Samsung but also incentivize companies to engage their services instead of TSMC and Samsung. This begs an even bigger question, will they be able to compete on such a large scale when they are also being pummeled in the AI field by NVidia? 

The Business

Another reason that I can think of is the industry that the company is in; this particular industry witnesses rapid technological, geopolitical, and market developments and it becomes hard for an individual company to stay abreast with the ever changing needs of companies, the clients, and consumers and their unpredictable and capricious spending behavior and habits. lets look at CCG and DCAI in order to understand how rapidly the industry needs change and how, understandably, hard it is to stay on the top. The Client and Computing Group engages in products and services that are catered for laptops and PCs through the company's partners, and this segment has been gradually declining due to consumers veering towards tablets and mobile phones with ginormous screens. Given the change in consumers' behavior, laptop and desktop manufacturers have scaled back their demands in order to not only sell their current inventory but also take lower reserves for the future; this is one of the major reasons for the decline in this particular group. DCAI or Data Center and AI engages in CPUs and other products that are specifically designed for data centers and we can all guess the tectonic shift in that group: data centers are now in need of GPU accelerators that are designed by NVidia and manufactured by TSMC and their need for CPUs that Intel used to deliver is rapidly deteriorating. The sudden changes are unpredictable, yes, but not at all surprising because that is the business the company is in, if they are unable to predict the future demand then perhaps they should focus on buying instead of trying to achieve the impossible, that for intents and purposes, the company seems incapable of doing. Additionally, Given the fact that CCG and DCAI accounted for 54% and ~ 30%, respectively, of the company's total net revenues for FY '23, Intel will have to figure out an avenue to turn things around in these segments if they wish to stay relevant.

Geopolitics

Intel's 10K

 

Majority- almost 73%- of the company's total net revenues are generated outside of the US, and China, without any consternation, is the company's biggest country in terms of billing and revenues. As we can see, US's policy of preventing advanced technologies being delivered to countries that it considers hostile, namely China, is now showing up in the numbers for companies that engage in international affairs. Intel reported revenues of almost $23BB for FY '21 from China, and that number, two years later, is now down to almost $15BB. Another aspect of geopolitics would be that countries, as a result of supply chain bottlenecks and resulting inflation during Covid, are now focused on onshoring a lot of the manufacturing of chips, processors along with other goods and services. US is one of those countries and the current administration put forward a lofty plan to bring chips and processors' manufacturing back to the States, and Intel has been the primary benefactor of this initiative. There are pros and cons to what transpires in the political sphere but an ideal situation would be that the US and China are again on friendly terms which would, without a doubt, yield better numbers for the company. 

Market and Expectations

Another reason that comes to mind when looking at Intel is the market and its expectations. Equity investors inherently are focused on future growth- as opposed to creditors and lenders that are primarily focused on the past- and if the markets suspect that the company has fallen back, it gets punished for it, regardless of how effective the company has been in the past. To put things in perspective, Intel's revenues declined, for reasons mentioned in this section, by 14% on YOY basis and still reported $54BB, a number that majority of the publicly listed companies would quite literally kill to attain, and yet it is trading, for the first time in decades, below its book value (assets minus liabilities). I believe a large reason for this is that investors are now attributing very little market share of the mammoth AI industry to Intel even though its perfectly suited and positioned to attain a sizable chunk of it. 

Side note: I remember when Apple released its first iPhone and it quite literally decimated other companies such as Blackberry, Nokia and Sony Ericson, but it also resulted in new technology coming into the markets that yielded even bigger players such as Samsung, Xiaomi, and Huawei. So, yes, Intel might not have the first mover advantage in terms of the AI and related products and services, but it definitely stands to benefit from the industry's infancy and massive potential growth in the future.   

Valuation

Base case assumptions

• Client Computing Group (CCG)
• The company reported $29BB (54% of total net revenues) for this segment in FY '23, and I expect this segment to remain relatively flat for the next five years where I suspect it would be around $29BB by the end of FY '28 or 52.5% of total net revenues. However, I do see growth in this segment after five years and I expect that the revenues would then increase to around $39BB by the end of FY '33, but as the company grows its other segments, CCG, by the end of FY '33 will reduce to being ~45% of total net revenues. I see the growth in this segment majorly driven by increased demand in the PC industry given that it should rebound in the coming years. PCs are also still majorly prevalent in the corporate world and that stands to increase over the next decade due to a mixture of new orders as well as replacement ones. Furthermore, I believe that AI related activities should also give a boost to PC's demand not just in the USA but also worldwide. I expect the growth in this sector to be offset by competitive products such as the Macs, cell phones, and tablets of the world.  
• Data Center and AI (DCAI)
• The company reported a reduction in revenues for this segment of 19% or $15.5BB for FY '23. I expect the revenues for this segment to go through further contraction over the next five years, and by FY '28 should be around $3BB. I see this reduction due to clients focusing their needs on GPUs and products that Intel does not have a competitive edge or the first move advantage in. But, as the company continues to invest in the coming years, I believe that this segment will then again see good days and start to improve by FY '26 (I wouldn't be surprised if it improves before then). I expect revenues for this segment to be around $21BB (25% of total net revenues) by the end of FY '33.
• Network and Edge (NEX)
• Intel reported revenues of $5.7BB (10.6% of total net revenues) for this segment by the end of FY '23, a reduction of 35% YOY basis. Given the change in cloud to edge, I expect this segment to again turn positive over the course of next five years. Given the saturation in this segment, I am not seeing monumental growth but only decent where revenues in FY '28 should be around $3BB, and as the company develops its products, services, and relations within the industry, revenues should start to pick up and end the decade on a good note; I expect revenues for this segment to be around $4BB (6% of total net revenues) by the end of FY '33. 
• Mobileye
• Intel reported $2BB (3.8% of its total net revenues) in revenues for this segment which was an 11% increase from the previous year's reported number of $1.9BB. Given the demand and interest in autonomous vehicles, I expect revenues for this segment to increase to about 25% by FY '28, or $5BB (9% of total net revenues). As the industry gets more saturated and the company looses its edge and maybe even market share, I expect this segment to be at ~$12BB (14% of total net revenues) by the end of FY '33.
• Intel Foundry Services
• Intel reported revenues of $952MM (1.8% of its total net revenues) for this segment for FYE '23. I expect this segment to grow to 20% to ~$2BB over the course of the next five years, and as it solidifies its place in the industry, I expect revenues for this segment to end at around $4BB (5% of total net revenues) by the end of FY '33. I understand that this is one of the hardest segments that Intel has to strive in in order to improve their market share due to leading competitors such as TSMC and Samsung; and with the understanding that the company has been investing heavily in the last few years in order to improve this segment, my assumptions do not seem implausible. In fact, I believe that this segment has the potential to outperform my assumptions by a long margin, it all depends on how sanely the company invests its capital and how effectively they'll be able to implement their strategies. 
• Cost of Sales
• One the reasons, along with reduction in total revenues, why Intel's margins have contracted over the last few years has been due to their ginormous cost of sales; for instance, the company reported $35BB (45% of total net revenues), $36BB (57% of total net revenues), and $33B (60% of total net revenues) for FYs '21, '22, and '23, respectively. Given that the company is going through a restructuring of its business model and financial strategies, I expect cost of sales to continue to be a significant part of its total revenues. I expect cost of sales to settle around 55% ($30BB) of total net revenues by the end of FY '28. After FY '28, I suspect that the company should begin to see the fruits of its labor, and as a result, cost of sales should gradually reduce to about 45% ($39BB) by the end of FY '33.
• Operating Expenses
• Operating expenses, in conjunction with the reduction in revenues and increase in cost of sales, have also increased at an almost exponential rate over the last 5 years. Intel reported operating expenses margins (operating expenses divided by total net revenues) of 31% ($24BB), 39% ($24.5BB), and 40% ($22BB) for FYs '21, '22, and '23, respectively, and given the condition the company is in, I do not see a reason why they should improve. I suspect, given that the company has all but lost its competitive edge, and is nowhere near its competitors, management will have to continue to invest heavily in R&D and MG&A in order to retain top talent and improve their top line through marketing efforts. I expect operating expenses to increase to about $25BB (45% of total net revenues) by the end of FY '28, and as the company gains its footing again, these costs should begin to come down; I expect operating expenses of $24BB (28% of total net revenues) by the end of FY '33.
• Operating Margins
• Given my assumptions about the revenues, cost of sales, and operating expenses, I expect margins to be non-existent for the next five years (a long cry from 30% margins the company reported in FY '19). But, here is the kicker, as Intel gains a foothold, as markets and investors start to favor the company, and as it gains a share of the AI industry, I expect margins to improve sometime after FY '28. In my base case, I expect operating margins to be around 27% by the end of the projection period. 
• Capex and Reinvestment
• Capex, no surprise here, has also risen over the last five years, company had capex margins of 47.5% for FY '23, which given its current restructuring and reorganization plan is not that astonishing. I expect capex to gradually decrease over the next 10 years to 25% by the end of FY '33.
• WACC
• Given a after-tax cost of debt of 3.90%, risk free rate as of this post of 4.03%, Intel's beta of 1.26, and the market risk premium of 3.96%, I got a WAC of 8.05%.
• Other Factors
• Other factors that might impact the company's future are as follows:
• The company might end up of divesting or carving out some parts of its business which would lead to a different valuation, I have not taken this into account. 
• If the company continues to pay dividends- my model predicts that the company does not have enough cash flows to support it- it will see negative impact on its cash flows. 
• The management might be able to effectively implement its new plan and strategies which would result in a turnaround and might yield a higher valuation given the increased potential of future cash flows. 
• Company might be able to gain a bigger share of the foundry business than what I have assumed. 

With these assumptions in place, here is a look at Intel's three statements, relative projections, and the valuation.

Starting with the income statement, I expect total net revenues to continue to decline for the next five years due to my assumptions above, and after the "investment" period, which is the next 5 years, I expect total net revenues to pick up again and end the projection period, FY '33, with $86BB in total net revenues. I also expect the company's margins to be uninviting for the next five years, but I believe will end the projection period on a good note. 

I have not assumed any capital raises, debt or equity, and so I expect the company to continue operating at its minimum cash balance due to my projections about line items such as capex and working capital. Given the massive reinvestment, I suspect they will need to raise short-term debt over the next 10 years, but they should be able to repay all of it back by the end of FY '33. My model and assumptions also show me promising improvements in company's retained earnings. 

I do expect the company to continue to yield negative free cash flows for the next five years, and as all the variables that I mentioned above improve, the company should generate $22BB in FCFs by the end of FY '33. I think this is as good a time as any to bring the company's valuation in. 

In my base case, I get an implied value per share of $38.84 through perpetuity growth method and $33.13 through EBITDA multiple approach, the stock, at the time of this post, was trading at $22.38. I believe that given the company's storied history, its brand name and other intangible assets as well as its future potential, the markets are undervaluing the company. I believe a huge chuck of this discounting can be attributed to Intel being late at the AI game and therefore the markets not allotting it any benefit of the doubt. Yes, AI gravy train has left the station but there is possibility that Intel might be able to pick up the gravy that fell on the tracks. 

Sensitivity

Of course, I completely understand that I might be incorrect, or I might be to too heavy or low on some of my assumptions, and so given the variables that I know impact a DCF analysis, here is a look at some data tables that show the share price given changes in some of the variables. 

Images 1 and 2 above show the different ranges of share price given modifications in variables such as WACC, implied growth rate, and the terminal year EBITDA multiple. 

Images 3 and 4 look at the impact on price per share given changes in operating margins, EBITDA, and revenues in FY '33, and as you can see, the company only needs to bring in around $60BB and 25% margins (the lowest end of the range) in order to justify its current trading price of $22.38.

Qualcomm and Intel

As mentioned at the start of the post, what prompted this post was the news about Qualcomm making a bid for Intel, how true that is or what the terms are is still a mystery and to see what the deal could look like, I have made a few assumptions.  

Let me preface this accretion/ dilution analysis with the fact that I believe this deal is close to impossible given the sheer size of Intel and its balance sheet. But, since the news is circulating, I wanted to give it a go and see how dilutive the deal could be for Qualcomm. Qualcomm at the time of this analysis is trading at about 22x its earnings on twelve trailing months basis, and Intel is trading at about 95x its earnings on TTM basis, and just by looking at the P/Es you can tell that there is no way this deal would be accretive for Qualcomm, but lets still jump through the hoops and see what we get.  

Qualcomm, at the time of this post, has a market cap based on its fully diluted shares outstanding of about $197BB, and Intel, based on its diluted shares outstanding, has a market cap of just under $100BB. In order to make the deal appealing to the management and the shareholders, Qualcomm will have to make an offer with a premium of about 20%-30% (which is typically the range for control premiums in M&A transactions of this size), and if we assume a premium of 20%, the offer price for Intel would be $27.98, based on its current trading price, and assuming its diluted shares outstanding of 4,382MM, we get an offer value of $123BB, and if we bring in Intel's net debt, we get a transaction value of $145BB. I have assumed that Qualcomm will use 30% stock and 70% cash, and for 70% cash, they will use about 76% of their own cash (~$8.6BB) and raise $77BB in debt, I have assumed that they will refinance Intel's debt, which will increase their borrowings by $49BB. For the sake of argument, I have also assumed asset write-ups for PP&E and Intel's intangible assets, and I got an additional goodwill of $35BB that Qualcomm will have put on its BS. Given my assumptions about the supposed transaction, here is what Qualcomm's balance-sheet could like on closing:

Since I have assumed a massive amount of debt for the deal, the interest expense for Qualcomm going forward could be well around $4BB, and given the amount of cash that I have assumed they will use, Qualcomm will, without a doubt, loose income on that cash. I don't have access to databases such as FactSet and CapIQ and so I have used Intel's NI and shares outstanding using my own standalone model, but for Qualcomm, I had to make a few assumptions in terms of their NI and EPS. I might be off in terms of Qualcomm's NI or future shares outstanding, but I doubt it'll impact the model in any significant way or turn the deal accretive. Here is how dilutive the deal could be for Qualcomm going forward:

As you can, the deal would be about 50% dilutive for Qualcomm for the foreseeable future, and given that it is a publicly listed company and that the management has a fiduciary duty to its shareholders, this deal, under no circumstances, should be entertained. Qualcomm would need to realize total synergies (revenue, capex or cost) in excess of $6BB just to make the deal break-even, a monumental task to say the least. This was assuming a 30% stock and 70% debt, if we assume all cash, the deal would still be massively dilutive given the sheer size of the borrowings and the resulting interest expense. Would making it all stock make any difference you might ask. No, it doesn't, due to the drastic differences in the companies' P/Es.

Conclusion

This analysis was, of course, to satiate my own curiosity, and if you don't agree, the excel file is attached, play with the numbers and see if you can come up with anything different. In conclusion, I would say that Intel is currently being traded far below its true intrinsic value, and there still is plenty of potential for the company in the future, but if you have already made up your mind, then I doubt there is anything about the company or its future that will make you change your thoughts. As for the deal, I do not believe that acquisition of Intel would be a good corporate action for Qualcomm and its investors, but wall street is adept at persuading companies to do stupid shit!

Links:

 Intel Valuation- 10/18/2024

 

 

Bain Capital and Envestnet: LBO Analysis

(Disclaimer: Excel file attached below the post) 

One of my passions is to keep track of the M&A sector and search for transactions that I find intriguing, and keeping up with my usual methods, I came across Bain Capital's take-private acquisition of Envestnet a few weeks ago. I wanted to analyze the transaction and assess the potential returns, but I was preoccupied with work related responsibilities and couldn't conduct the analysis, but better late than never, right? I had never heard of Envestnet prior to the announcement of this transaction, and so I think a good place to start would be to briefly introduce the company and what it does and then move onto the numbers.

Envestnet (ENV)

Envestnet is a leading provider of integrated technology, intelligent data and wealth solutions. As of the transaction, the company manages over $6 trillion in assets, oversees nearly 20 million accounts, and enables more than 109,000 financial advisors to better meet client financial goals with one of the most comprehensive, integrated platforms delivered at scale in a unified, engaging digital experience. The company has had great success enhancing the advisor and investor experience, and currently supports over 800 asset managers on its Wealth Management Platform. Additionally, Envestnet was recently recognized by the 2024 T3/Inside Information Advisor Software Survey as a leader in Financial Planning, Portfolio Management, TAMP and Billing Solutions.   

Envestnet is organized around two business segments based on clients and products and services that it provides. 

• Envestnet Wealth Solutions
• The company is a leading provider of comprehensive and unified wealth management software, services and solutions to empower financial advisors and institutions to enable them to deliver a holistic advice to their clients.
• Envestnet Data & Analytics
• Envestnet is a leading provider of financial data aggregation, analytics and digital experiences to meet the needs of financial institutions, enterprise FinTech firms and investment research firms worldwide.

As for the company's business and revenue model, it has a model that provides consistently recurring revenues and predictable cash flows. The company earns revenues through three different avenues: "Asset-based Recurring Revenue", "Subscription-based Recurring Revenue", and "Professional Services and Other."

• Asset-based Recurring Revenue
• In the company Wealth Solutions segment, asset-based recurring revenue primarily consists of fees for providing customers continuous access to platform services through the company's uniquely customized platforms. These platform services include investment manager research, portfolio diagnostics, proposal generation, investment model management, and rebalancing and trading along with a packet of other services. Asset-based fees that the company earns are generally based upon variable percentages of assets managed or administered on the company's platforms. 
• Subscription-based Recurring Revenue
• In both the Wealth Solutions and Data & Analytics segments, subscription-based recurring revenue primarily consists of fees that the company generates for providing customers with continuous access to the company's technology platforms for wealth management and financial wellness. The fees vary depending on the scope of technology solutions and services being used, and are priced in a variety of constructs based on the size of the business, number of users or accounts, and in many cases can increase over time based on the growth of these and other relevant factors
• Professional Services and Other 
• In both its Wealth Solutions and Data & Analytics segments, the company generates revenues from professional services for client onboarding, technology development and other project related work as well as revenue generated from Annual Advisor Summits. 

Lets Talk Numbers

Before moving onto the LBO analysis, I think that it is prudent for me briefly talk about the company's historic performance and numbers, and as such, here is a look at company's historical income statement going back four years:

As you can see, more than half the total recurring revenue- comprised of assed-based and subscription-based recurring revenue- is made up by asset-based revenue. Asset-based recurring revenues are not only more than half of the company's recurring revenues, but have also seen somewhat mediocre growth over the last four years. Subscription-based revenues on the other hand have been declining over the course of the last four years, and percentage wise, revenues generated from professional services have stayed pretty consistent over the observed period. 

As for the operating expenses, they have either come pretty close to 100% of total revenues or exceeded the total revenues by a pretty hefty margin. Company reported total operating expenses of 116% of total revenues for the FY '23. Operating expenses consist of direct expense (38% of total revenues for FY '23), employee compensation (36% of total revenues for FY '23), general and administrative (17% of total revenues for FY '23), and depreciation and amortization (11% of total revenues for FY '23). Thought that came to my mind was that the company is either investing a lot in its future growth or is not spending well, and when I look at the top-line growth over the last two years, I fear that it may be the latter and not the former. The company did report positive operating margins for FYs '20 and '21, but then ventured back into the negative territory for FYs '22 and '23. Another thing that stands out is the company's consistently high interest expense with the company reporting $25MM for FY '23 and $17MM for FY '22, which considering that this a growth company, might not be a bad thing, depending on how one views it. Finally, it goes without saying that the company reported negative NI for three of the four years that I looked at it its financials, the company reported $13MM in NI for FY '21 mainly driven by 19% growth in total revenues and about 2% reduction in its overall operating expenses. With a look at its income statement, lets move onto the company's balance sheet:

I do have a few thoughts when looking at Envestnet's historical balance sheet. The company did report a healthy amount of cash reserves for FY '21, but then reported dwindling numbers for the following two years with ending the FY '23 with $91MM. Additionally, company has been reporting higher amount of receivables along with other current assets over the last three years, which of course are cash outflows. PP&E, considering the company's business model, is not a huge part of the balance sheet, but internally developed software and other intangible assets make a good chunk of the company's assets. Over the last few years, Envestnet has been engaged with inorganic growth which explains the inflated goodwill numbers, the lower goodwill number for FY '23 was due to an impairment at the end of the year. Final thought on balance sheet would be the high amount of debt the company has which would explain the high interest expense. 

LBO Analysis

I think that I am in a good place now to talk about the LBO transaction, and I must preface the following analysis with the fact that my resources are limited and so I have had to rely on a few assumptions in terms of the debt to equity structure for the transaction as well as what I think about the future. As I mentioned at the start of the post, Bain Capital's acquisition of Envestnet was finalized and approved by the target's board with an overwhelming support last week. Bain Capital and consortium offered $63.15 for every share of the company, which looking at the company's share price from a month before the transaction announcement ($60.62) is a premium of about 4%. 

When looking at take-private LBO transactions, they are usually structured in one of two ways, they are either in the form of an offer price (which is the case for this analysis) or they are done as a multiple of the target's EBITDA, and to better understand the transaction, I think that it is always a good practice to look at both approaches, and as such, in the image above, we can see that with an offer price of $63.15 and Envestnet's fully diluted shares outstanding of 56,325MM, we get an offer value of $3.5BB, and given the target's net debt of $905MM, we get an enterprise value of $4.5BB, which given the target's EBITDA for FY '23 of $250MM, yields an EBITDA multiple of 17.8x. This is why when analyzing these transactions we must look at both approaches, because at initial glance, the premium of 4% might have looked like a bargain, but the EBITDA multiple of 17.8x tells a different story. Moving onto the assumptions that I mentioned at the start of this section, here is a look at the sources and uses of funds along with the possible transaction and financing fees for the deal. 

For the purposes of this analysis, I am assuming 79% debt, 20% equity and the remainder 1% of the company's existing cash being used. I am assuming 2% of transaction fees ($71MM) and $150MM in financing fees. With these assumptions out of the way, lets talk about the future. 

Future

LBO transactions are structured in a specific manner and there are a few levers that the PE firm can pull in order to boost their returns down the road, and knowing how the industry works, here is what I think about the company's future. 

• Growth in revenues
• Asset-based recurring revenues
• In my base case assumption, I expect asset-based revenues to grow from 1% in FY '23 to 31% by the end of FY '28, in line with 31% growth rate that the company witnessed in FY '21. I believe that this growth in revenues will be driven by the company's future ability to leverage their large base of existing customers, expanding their current relationships through new products and services as well as creating new revenue streams, either through organic or inorganic means. 
• Subscription-based recurring revenues
• The company reported subscription-based revenues growth of -2.7%, and I expect their subscription-based revenues to gradually increase to 7%, which again is in line with what the company reported for FY '21. I expect the company to innovate given its new management and strategy teams and leverage their existing position within the industry, which given Bain Capital's brand name and portfolio of companies, seems like an easy uphill battle. 
• Professional services and other revenues
• Professional services and other revenues consist of fees that the company charges for client onboarding, technology development and other project related work as well as revenues generated from Annual Advisor Summits. Given the historical trends, I expect this particular revenue stream to stay somewhat flat over the next five years. 
• Cost reductions
• The company reported 38% margins for direct expense, 36% margins for employee compensation, and 17% for general and administrative for FY '23. I believe that Bain's expertise and strategic vision for the future should allow the firm to run the company in a more lean manner and not be haphazard with growth and reinvestment. As such, going forward, over the next five years, I expect direct expense to gradually decrease from 38% to 37% of total revenues, employee compensation to decrease from 36% to 32%, and finally, general and administrative to decrease from 17% to 16% of total revenues. 
• Deleveraging
• I do expect the company to generate enough cash flows that would allow the company to meet its future debt obligations in the form of interest expense and mandatory amortization that I have assumed for term loans A and B. 
• EBITDA expansion
• EBITDA is by far considered the most pivotal metric when assessing an LBO transaction and the future exit. Given the increase in revenues that I have assumed, and the cost reductions that I expect Bain to be capable of conducting, I expect the company's EBITDA to grow from 14% in FY '23 to 29% in FY '28.

Future Income Statement

With all of my assumptions in place, here is what I think the company's income statement could like in the future:

As you can see, with my assumptions about the company's segments' growth for the next five years, I expect the cumulative revenue to grow from 0.5% in FY '23 to 22% by the end of FY '28. I also expect operating expenses margins to decrease from 116% in FY '23 to 96% by the end of FY '28. My total revenue growth rate and reduction in operating expenses seem plausible and very much in line with how the PE industry and firms work. Moving on to non-operating expenses, given that I have assumed 79% debt for the transaction, we get interest expense of $268MM for the next five years as well as an interest income of $3MM given the minimum cash balance of $50MM. Lets now move onto the pro-forma balance sheet and see what the company's balance sheet could look like on the day the transaction closes:

I will refrain from delving into the adjustments and why they are made as that is a topic for another day, but I would like to show you how the pro-forma balance sheet could look like for the next five years:

You can see the minimum cash balance that I have assumed for working capital and daily operational needs as well the changes to debt and the new equity for the next five years. Lets now look at probably the most important financial statement in an LBO setting: the cash flow statement.

As you can see, the company does not generate enough or healthy cash flows despite the growth in revenues and the reduction in costs that I have assumed. Cash flows from operations is negative for the two projected years and begin to turn positive from the third year. I expect company's investing activities to be in line with historical numbers where capex and additions to capitalized software and intangible assets margins would remain flat for the entire projection period. This is not the typical convention because as the company grows its revenues and reduces its costs, it also expects its reinvestment to decrease in order to yield higher free cash flows, which in our case, are negative for the entire projection period, but I kept the activities from investing flat because I wanted to see what the cash flows might look like if nothing changed, and it doesn't look good. Finally, because the company does not generate healthy free cash flows, I do not believe that the company will be able to make any discretionary payments beyond the mandatory amortization, and also will need to rely on its revolving credit facility for its day to day operations. With all of this in place, lets now look at what the returns could look like.

Returns

A typical convention for the exit analysis is to assume the same exit EBITDA multiple as the entry multiple, and so my exit analysis is based on the fact that Bain Capital will exit their investment at 17.8x EBITDA, and assuming that multiple, we get an enterprise value of $8.4BB, for comparison, the entry enterprise value was $4.5BB, and given the minimum cash balance of $50MM and debt of $4.6BB, we get an equity value of $3.8BB on fully diluted basis. Again, a reminder, I am assuming Bain Capital puts in about $1BB at the close of the transaction, which gives us the following returns:

As you can, given my assumptions about the exit, Bain Capital would be exiting their investment at a 32% IRR and 4x MOIC. The returns, of course, drastically change if we assume a different EBITDA multiple, for instance, if we assume that Bain Capital is able to expand its multiple and get a 19.8x EBITDA multiple, their IRR would be 38% with a MOIC of 5.0x, and a lower multiple would, naturally, yield lower IRR and MOIC. Another purpose of conducting an analysis of this kind is to see the maximum amount that the sponsors can put in in order to make their minimally desired IRR, and here is what the maximum price could be assuming a different range of Bain Capital's minimum required IRR:

Assuming that Bain Capital's minimum required IRR is 25%, my model, based on my assumptions, predicts that the PE firm can afford to put in $3.8BB instead of the $1BB that I have assumed. 

Conclusion

I conduct these analyses not to criticize the teams or the firms that have worked on the transactions, but to purely quench my own intellectual curiosity. Based on what I have assumed, the transaction seems pretty lucrative from an IRR and MOIC perspective, but not so great from the debt and cash flows angle. As always, I am well aware that everyone thinks and strategizes differently, and so I have linked the Excel file right below the post for you to play with and put in your own assumptions and make your own conclusions.

 

Links:

Bain Capital and Envestnet- LBO Analysis