Duke Fuqua Case Teaching Note: Probil01-456-113
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01-456-113
February 2001
Probil: Maximizing the Exit Strategy
Teaching Note
Synopsis
The case is set in early February 2001. Probil is the largest independent, multi-vendor IT solutions company in Turkey providing network and computer infrastructure installation, configuration and maintenance. The Turkish economy is such that debt can only be acquired for short durations and at high costs. EMEA Technology Investments, a newly launched venture capital fund founded and managed by Kagan Ceran, has just acquired 51% of Probil, infusing the company with US$10 million in cash.
In order to maximize return on investment for the investors and to grow Probil as quickly as possible, the company must decide how best to allocate their current cash and how to raise more funds. They are planning to issue shares through an initial public offering (IPO) on the Istanbul Stock Exchange in order to generate more cash to grow the company. Kagan's time horizon is a return to investors in 5 years. The Turkish stock market's volatility makes the timing of an IPO of critical importance. Ceran is preparing for a board meeting where he must convince the board of the right path to choose.
Pedagogical Objectives
This case serves as an introduction to the topic of IPO valuation and real options in emerging markets. It was written for a course in Emerging Markets Corporate Finance. The case is intended for students who have had a course in corporate finance or valuations. It can be taught to undergraduates, MBA students, or executives.
It can also be used for discussions of strategy in which the alternatives are wide ranging. For example, instead of when to IPO, the discussion could cover the assumptions underlying decisions on internationalization (and what that means and how it impacts investors’ views of risk and assessment of value), vertical (distributor) acquisitions, horizontal (competitor) acquisitions, etc.
With the rapid growth opportunity in emerging markets, investment bankers and even individuals will need an understanding of how emerging market factors change underlying assumptions and can be mitigated in analyzing opportunities.
The case has 5 objectives:
- It illustrates country-related risks in an emerging market and forces students to consider how those risks affect the company and its alternatives and whether there are factors that mitigate the risks for a specific company.
- It provides a vehicle to discuss the IPO process and its challenges in an emerging market.
- It introduces the discussion on how to calculate the cost of capital for an emerging market and provides an opportunity to compare alternative models.
- Students learn to identify and model "real options" (timing, indirect financial impact of internationalization), allowing them to examine how those options affect valuations and decisions. A time-based evaluation of when/if to IPO is critical given the volatility of the Turkish market.
- It illustrates some of the financial analysis tools and terminology used in estimating IPO value. There is an Excel spreadsheet that accompanies the case that allows students to conduct sensitivity analysis on the return estimates. The spreadsheet can be used with Crystal Ball, a Monte Carlo simulation software package.
Substantive Analysis for Hour One
This case will typically be discussed in two one-hour segments. The first hour will focus more on the qualitative analysis of strategies and risks for the company. The second hour will focus quantitatively on the valuation of the company and its real options.
The discussion will typically begin with an overview of the company and its goals. It is important to understand what a system integrator does and where the business risks are in general. In Probil’s case, the investment was made with the intent of using the cash infusion to accelerate growth through acquisitions or other means.
The discussion should continue with Probil's options for the future. Their current growth opportunities include acquiring a local distributor to improve efficiency in delivering product to one-time customers and acquiring a small US Internet consulting firm to provide access to technical know-how, some US revenue and an international image.
It is important to identify country risks, evaluate the impact that country risks have on the company in general and on the alternative paths that they can choose, and determine ways to mitigate those risks. For example, what happens if the Turkish Lira loses 30% of its US dollar value in one day? How at risk is Probil? What does this mean about the alternatives? Might Probil be able to buy competitors?
The next step is to discuss the IPO as a means of accelerating growth. As Kagan saw it, to accelerate growth they could try to acquire a local distributor and/or they could try to acquire an Internet consulting firm in the US or the EU. In either case, they would need more cash to grow the current business, make strategic investments and still retain a cash buffer against potential fluctuations in the Turkish market. He had originally planned for Probil to raise the needed cash through an IPO of shares on the Istanbul Stock Exchange. He still thought this was the best alternative although a private equity investor had recently indicated interest in investing in Probil. The discussion should encompass the specifics of doing an IPO in Turkey (no guarantee on funds, impact of volatility) and it's implications for Probil's strategy.
Risk Identification
Below we look at different types of risks or issues and consider how they might affect Probil's options.
Country Risks
Country risk is, in some senses, the most nebulous or vague aspect of the analysis. There are several common or standard country risks that must be considered in any emerging market. Below we list common country risks and provide an assessment of those risks to Probil in Turkey.
Expropriation Risk:
While expropriation is a very common risk, especially when a business is controlled by international investors and is successful, the Turkish government has not expropriated companies in the 80 year existence of modern Turkey. So we do not believe outright expropriation is a risk. However, Probil could be subjected to creeping expropriation through imposition of ever higher taxes as the company grows and succeeds. We have no reason to believe creeping expropriation will pose a significant risk in this case. Probil is a very small company compared to traditional industry companies, so the benefit of expropriating Probil is very small.
Currency Risk:
Inflation and exchange rate risks are significant considering the inflation differential between Turkey and OECD economies. Turkey has experienced high inflation over the past 20 years and the currency has been devalued accordingly. Probil, which sources its hardware and software from OECD countries, faces a high degree of currency risk if there is a sudden devaluation because they charge their customers in Turkish lira but pay US dollars for the equipment (almost 80% of the business). Although Probil typically collects its revenue before payment to suppliers is due, during sudden devaluation periods the company will face considerable risk in meeting its obligations. To mitigate this risk, Probil has been negotiating with its suppliers to share the currency risk during sudden devaluations. In the future, the economic stabilization package from the IMF and World Bank, and possibly accession to the EU, may induce Turkey to tighten its inflationary policies and possibly reduce this currency risk for Probil.
War or Violence:
The case provides almost no information with respect to war or violence. It indicates that relations with Greece are improving and that the only military interventions have been relatively short-lived and have resulted in an improved economy overall (taking a long-term view).
In reality, although some might think the Kurdish separatist movement is a reason to view this risk high, there is nothing to indicate this is a current threat. After the earthquake in 1999, Turkey’s relations with its neighbor, Greece, improved substantially, and the chance of Greece and Turkey going to a war over Cyprus is diminished.
Political Risk:
Again there is little in the case to indicate much political risk except the indication that governments are typically made of extremely weak coalitions which are unable to make significant changes which require austerity. Again, the fact that the military (strong supporter of the secular government) has stepped in 3 times in the last 40 years in order to restore stability is actually a mitigating factor. In addition, the rule of law is relatively established (not written in the case, but not raised as a risk issue).
Financial Risk:
The country actually has an entrepreneurial culture and the Istanbul Stock Exchange has been functioning for more than 15 years with daily volumes pushing over $1 billion. The banking crises of course suggest financial instability but overall that risk is handled in the case through currency risk because the cost of debt is high and therefore not an issue to Probil (no debt).
Corruption Risk:
Corruption is a risk shared by many emerging economies. The fact that the electoral system produces weak governments suggests that each branch will typically be able to engage in nepotism and bribery. In addition, the domination of holding groups suggests opportunity for corruption.
While we believe that Probil operates without a significant level of corruption (notice the GAAP-style financials as an indication of transparency) it is reasonable to think that this is not a significant issue because the company has operated for 10 years in Turkey and has been successful (if it is paying bribes, etc. they do not seem to hurt business).
We believe corruption is not a significant problem for Probil.
IPO
The IPO market in Turkey displays certain characteristics generally common to IPOs in emerging markets, such as low volumes and few issues on an annual basis (35 companies with $157.5 million in the year 2000), as well as a significant underpricing given the underlying market volatility and information asymmetries between insiders and investors.
Typically, issuing companies belong to a large holding group that has its own financial institution acting as investment bank. This limits the incentives that an independent investment bank would have to go to market with a high price. At the same time it imposes a credibility burden on the issuing company that results in a higher expected premium demanded by investors. Exhibit D in the case shows the high volatility of the main index in the Turkish stock market (ISE National 100) as compared to the S&P500 and the Nasdaq during the year 2000[1].
The following table summarizes the initial and after-market abnormal returns for the Turkish market in the period 1990-1996.
Sector / Firms / Initial mkt. Adj. returns / After-market cumulative returns (4-week)All firms / 163 / 13.1% / 4.7%
Industrials / 104 / 11.7% / 4.8%
Financials / 46 / 15.0% / -2.5%
Other / 13 / 17.6% / 27.9%
Source: Kiymaz
In addition to pricing issues, demand plays an important role in the IPO market. An increasing number of emerging markets are becoming highly dependant on foreign capital. Given the high volatility of these markets, any relevant change in the political or economic conditions in a specific market or in the surrounding region will be followed by a high outflow of foreign capital that will have a strong effect on the demand for new issues. It is worth noting that some countries have imposed restrictions on capital repatriation which may prevent the outflow of capital and yet do not assure that those funds are maintained in variable investments. These types of restrictions are normally imbedded in the premium demanded by foreign investors. There is no indication that this is an acute problem in Turkey
Debt Financing in Chronic High-Inflation Countries
Countries with chronic hyperinflation or significantly high inflation typically have an active money market for short-term transactions in local currency but an extremely expensive medium-term market (180 days – 540 days) given the high implicit inflation rates. Long-term funding is definitively not available in those conditions. Given the lack of depth and tenor in local currency, the hedging market for medium-term positions is expensive and normally does not exceed 360 days. This structural condition means that companies can only rely on short-term bank financing and equity financing when available, given the market conditions and the company’s attractiveness to investors.
EV/EBITDA versus P/E
In order to check the DCF approach of valuation, a sanity check can be made using triangulation with a multiples valuation approach. Since the debt structure of the peer group may differ, it is more appropriate to use the ratio EV/EBITDA since it deducts the effect of debt (interest) from the cash-flow side and also from the balance sheet side (net borrowings are deducted from the Economic Value figure). The following table summarizes the most important ratios of the comparables:
Substantive Analysis for Hour Two
The instructor should begin the second hour of discussion with a summary of the options and risks discussed in the first section. Then he should probe students to identify the most important real options for Probil.
Before discussing the valuation of the company, the instructor should discuss how to calculate the cost of capital. What risks should be included in the discount rate? How do you reconcile the equity discount rates with the higher interest rates presented in the case?
The next step would be to discuss the valuation approach of each one of the real options. What are the main uncertainties? What is the best strategy for each downstream decision? The instructor could present or request some students to present the results of their Monte Carlo simulations to value the real options.
Based on the results, a set of recommendations should be developed by the class in order to maximize the value of the company to investors.
Valuation Approach
The valuation of a company or project in an emerging market is characterized in general by much higher volatility of the cash flows and by higher influence of country risks on the business risks. We focus on how to identify and model these risks when estimating enterprise value. Additionally, Real Options are presented as a way to diminish the negative impact of these fluctuations in the cash flows, and therefore, as a way to increase the value.
Risk Assessment and Modeling
Confronted with analyzing the risks involved in a project, separate country from specific risks, and decide explicitly how you will model each of them.
- The model includes country risks in the discount rate (cost of capital) and project specific risks in the cash flows.
- The model considers project specific risks by defining the key uncertainty variables as random variables and running a Monte Carlo simulation. Crystal Ball was used in this case.
- The company specific risks in this case are modeled by the fluctuation in the revenue growth rate.
- Probil’s exposure to currency risks seems to be higher than average for Turkey because the company imports the hardware it re-sells locally. The company has tried to mitigate this risk by contracting with suppliers in such a way that they share the risks involved. Additionally, the company only pays suppliers after receiving payment from clients (net-30 v. net-60 allows for this timing). Given these mitigating factors we decided that no special currency risk modeling was required.
When modeling the specific risks in the cash flows, the final result to look at is not only the expected value of the different alternatives, but also their standard deviation and skewness.
- The results include both expected values and distribution curves for each alternative (the overlay charts of Crystal Ball are a good tool). It is important to both model and present these results (whether in class or in business) because the company risks are in the cash flows and not just the discount rate.
- Exhibit A summarizes these metrics and presents a ratio of expected value over standard deviation (Sharpe Ratio) and the skewness statistic (positive skewness is actually good despite it increases volatility).
Cost of Capital Calculation
Several models to determine cost of capital in an international context are used by prestigious firms and financial consultants. Each of these models has its strengths and weaknesses. When confronted with any of these, you have to make a qualitative judgment of the applicability of the underlying assumptions of the model. Many times subjective adjustments will have to be made.
The set of models to choose from includes World CAPM (Sharpe-Ross), Segmented/Integrated (Bekaert-Harvey), Bayesian (Ibbotson Associates), Country Risk Rating (Erb-Harvey-Viskanta), CAPM with Skewness (Harvey-Siddique), Goldman integrated sovereign yield spread model, Goldman-segmented, Goldman-EHV hybrid, CSFB volatility ratio model and CSFB-EHV hybrid. After discussion with Professor Cam Harvey, Duke University Fuqua School of Business, we decided that the Goldman Integrated and Country Risk Rating were the two best options to start with.
The typical investment banker model (Goldman Integrated) would suggest applying the CAPM as if Probil were a company working in the US and adding a premium for the country risk. This premium would normally be calculated as the sovereign bond yield spread between the US and Turkey. In this case, though, inflation in Turkey is high, and the current currency devaluation rate at the time of the case is low in comparison. Therefore taking yield on the bonds introduces variables that do not reflect a real country premium. So, we take the country risk premium suggested by a recent Moody’s report (4.5%) instead. The company’s Beta of 1.45 is derived from the ones provided in the case for comparable companies. This beta seems reasonable since companies tend to cut IT investments dramatically as the first signs of an economic downturn appear. On the other hand, when the economy is flourishing, companies tend to embrace large projects. The US risk free rates and premiums are also provided in the case.