BAE Systems' acquisition of Norkom

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BSc. Professional Accounting

ISSUES IN FINANCIAL MANAGEMENT

COURSEWORK

BAE SYSTEMS ACQUISITION OF NORKOM

19TH August 2014

Table of Contents

Question 1

BAE Systems acquisition of Norkom

Question 2

Question 3

PRICE

Valuation 1

Valuation 2

CAPITALISED EARNING VALUATION

Valuation 3

PRICE EARNINGS RATIO VALUATION

Using acquirering Company (BAE) P/E ratio

Sector average price earnings ratio

A company similar to BAE is Cobham

D (Other mergers and Acquisition around Norkom takeover in 2011

Question 4

Cost savings

Legal fees

Price earnings ratios

Synergy

Question 5

Financial risk

Appendix 1

Appendix 2

Question 1

BAE Systems acquisition of Norkom

"A

BAE is widely known for its aircraft carriers and army tanks and at the time of acquisition it was making a number of lesser-known innovations, including a long history of providing radar

In its financial annual report BAE stated that is seeking to diversify its services to cyber Security and intelligence and still maintain its strong presence in the core defence markets. This appears to be a sensensible strategy as first the near term outlook for defence spending in Western Europe is negative,secondly, there is a structural trend in government spending away from defence and towards security, and thirdly the Cyber Security market is expected to experience strong growth.

This strategy appears to be implemented through acquisitions. First the acquisition of Detica, L-1 Identity Solutions, ETI and then Norkom in 2011 for €217m

In 2008 BAE bought Detica a company that specialized in security and resilience data analysis. BAE took on board clients such as the Metropolitan Police, UK and US governments and HMRC in which 2009 helped HMRC to detect £600m in tax fraud

The acquisition of Detica made BAE share price rise from 306.87pence in 2009 to 387.40pence in 2010. To diversify more of its services, BAE decided to acquire Norkom whose clients included HSBC, Santander, and Travelex and this complimented its existing Detica Information Intelligence unit which BAE bought in September 2008.

Governments are increasingly requiring financial institutions to adopt anti-money laundering and counter-fraud solutions, and Countering financial crime and the funding of organised crime and terrorism seemed to be a major element of national security, therefore BAE acquiring Norkom could provide him such a capability as Norkom was so equipped in the area of monitoring transactions

BAE has been already in the market due to acquisition of Detica, combining business could put BAE in a position to address customer needs for more integrated financial crimes and compliance solution and more crucially could provide cross selling opportunities for Detica and Norkom's respective products

As the convergence in anti-money laundering and counter-fraud technology and customer demand for more integrated financial compliance solutions, thus combining Detica and Norkom economies of scale due to shared investments

Norkom had a client base of over 100 customers, which span over 100 countries and this included six of the top ten financial services organizations in the world. As Norkom operated across several continents such as Europe, North America and Asia-Pacific and with over 300 employees, this was an opportunity for BAE to increase revenue as well as market shares.

In 2010 year Norkom reported record revenue of £49.3million, an increase of 2.7% from the previous year, which had revenue of £48million and had EBITDA of £10.2 million compared to 8.4 million in the year 2009. With net assets of £65.7 million, therefore Norkom had shown good financial performance and continuity therefore BAE was attracted to the future prospect of the company.

It can also be pointed out that the defense industry is maturing heading to decline state, especially after the UK government voted against going into another Iraq type war and 8% cut down by the coalition government during defense review, therefore for BAE to stay in the game and compete with other companies such as General Dynamics Corporation Company very well established in the US, BAE had to diversify its operations in the area that is not mature such as money laundering and fraud and continue to extend its wings across the globe.

Question 2

BAE bought Norkom’s entire shares and each share was valued at €2.10. On purchasing shares, BAE used its existing financial resources without going to a financial institution to borrow money to acquire Norkom. This was a good method of financing the deal as borrowing could have increased BAE’s gearing and raising a concern to both existing and prospective investors

The offer of €217m represents 36% control premium Norkom’s 103million shares valued at €1.54 share price at close of business on the 13th Jan 2011, a premium of 121% on the Norkom’s €0.95 share price at close of business on the 25th Jan 2011 and a control premium of 82% on the Norkom’s €1.15 up to 6months after the commencement of the acquisition

Question 3

According to Norkom (2010) annual report, the company posted earnings before interest and tax (EBIT) of €7454millions and the interest and tax charge was €455. This means the profit after tax was 6999 and for convenience 7million is the figure that will be used as profit after tax.

The BAE bought Norkom by paying €217m, this means Norkom had a price earning P/E ratio of 31 that can be calculated as follows € 217m/7=31.

BAE systems appear determined and paid 217million to acquire Norkom. The 217 is a result of BAE using a P/E ratio of Norkom which is 31. I.e. 31 (P/E ratio * 7million profit after tax =€217million. However, this does not tell the whole story, but it looks like BAE was not sure of Norkom’s performance level that is expected by money markets and this is why the P/E ratio used was of Norkom and not BAE. To determine how much exactly BAE should have paid if Norkom valued using P/E ratio, the following valuation analysis will be examined.

PRICE

Number of shares that were bought by BAE 103million

The cost of each share € 2.10 Euro

Market capitalization =103million shares ×€1. 54= €159m

There was a control premium of 36%

€216 × (1+36%) =€294

This means the offer was likely to be beyond €217million

Valuation 1

Norkom has a price earnings ratio of 31, therefore the value of the deal should be

31× profit after tax (PAT) €7million=€217m.

This valuation has a gap between the price and the amount that BAE paid (294-217=77m)

Valuation 2

CAPITALISED EARNING VALUATION

In announcing the deal, Ian King, CEO of BAE systems promised to combine the services already offered by Dentica the company that BAE bought in 2008 and Norkom in order to offer enhanced cyber and intelligence services in the world. The combining of two companies will provide increased earnings due to economies of scale. Therefore, using the capitalized earnings valuation method can help BAE to predict the expected future earnings

As the P/E for Norkom is 31, thus the required earning yield would be 1/31 which is 3.23%. This means the capitalized earning is 7m/3.23%, which is €217million. This is considered a best valuation method because it predicts forward looking performance.

Valuation 3

PRICE EARNINGS RATIO VALUATION

Using acquirering Company (BAE) P/E ratio

This can help to find out how much exactly BAE could afford to pay to buy Norkom. From Appendix 1 the profit after tax (PAT) for Norkom is 6.6 and BAE’s p/e ratios is 33

The price per earnings ratio of BAE is 33 profit after tax is 6.6million, this means 33*6.6=217million.

Sector average price earnings ratio

The following companies are in the same sector as Norkom and their respective price earnings ratio

  1. Cobham 18.8
  2. Accenture 17.35
  3. IBM Global services 13.36
  4. Infosys Technologies 30.54
  5. Meggitt 19.5

99.55

The average of the above chosen companies 99.55/5 is 19.19 price earnings ratio. Applying this ratio will value Norkom, at (19.19*6.6m=131m) €131million.

A company similar to BAE is Cobham

A company similar to BAE is Infosys Technologies, which has a price earnings ratio of 30.54. This makes the valuation to be (18.8*6.6m) €124million.

Since using a price earnings ratio as income based valuation method has brought differing figures such as 131m, 183m and 124m.

The best thing to do is to take the average. Therefore, 217+131+124=€472million. 472/3=€157million. However, this still lower than what BAE paid. Though there is no evidence to suggest that BAE faced intense competition, but to pay above the average would point out that there were other companies bidding to buy Norkom

.

D (Other mergers and Acquisition around Norkom takeover in 2011""

The figure above shows other acquisition that have taken place about the same time BAE bought Norkom. Using their respective EBIT Multiples can help to calculate how much they should have afforded to pay should they had thought to compete with BAE to buy Norkom in 2011.

The table below shows the summary of EBIT multiples and the respective prices that the named listed company should have offered to pay Norkom in order to finance the acquisition

Company

EBIT Multiple

PAT€ 6.6M(Norkom)

Should have paid €

Checkpoint

20.6

6.6

136m

Sourcefire

51.5

6.6

340m

Fortinet

51.1

6.6

337m

Symantec

14.1

6.6

93m

Websense

25.1

6.6

167m

These merger and acquisitions deals took place at the same time that BAE bought Norkom in 2011. Should each of them proposed to buy Norkom, basing on the EBIT Multiple either Sourcenet or Fortinet could have outbid BAE as the offered put on the table would have been higher than that of BAE as the offer could have been between €337-340m which is above 56% of what BAE paid.

In conclusion, therefore, using a price earnings ratio as a method of valuing Norkom, its worth should have been at 191million. BAE spending 217million as opposed to 191million implies that the price of 217million was over the odd. However, as the cyber and anti-fraud business expanding, BAE could have been facing heavy competition and in order to outbid the competitors BAE had to pay €26million more than the company worthy of and this must have diluted shareholders

Question 4

Basing on the range of valuations calculated in question 3, there are several explanations can be drawn as why the figures calculated differ from one valuations to another

Cost savings

Some other companies would have paid more as they would have calculated how much they can save from the acquisition. As the case of BAE, the company potentially saved money that would be spent on renting space to accommodate ex-Norkom’s employees who were transferred to BAE. As BAE did not relocate the office rather used Norkom’s existing office this helped BAE to save cash that would have been spent on rental or buying the premises

Legal fees

All the above calculated figures do not include acquisition legal fee and which, according to financial transaction cost of merger and acquisition can range from 6% to 8% times basing on the proposed offer. In this way the price calculated will be different to that actual paid.

Price earnings ratios

While few acquisitions have been done using price earnings ratio, the profit after tax (PAT) used as being the sum of Norkom. However, each company has different ratio and have different activities within the organization ultimately this would give a different share price hence the value will be different

Synergy

BAE combined its existing services offered by Dentica and Norkom. The combination of the two would have thought to bring a greater sum of BAE’s performance; therefore BAE could have paid more to purchase Norkom thinking that the future performance will be excellent.

Question 5

BAE systems did not raise new debt to buy Norkom but rather used its already existed resources. The BAE systems 2010 financial statements show cash and cash equivalent of £2813million on the balance sheet and spending £180 to buy Norkom this is only 6.4% of cash and cash equivalent that BAE system posted in the 2010 financial year.

Spending cash to purchase the entire shareholding of the Norkom BAE system made the right decision because this did not affect the number of ordinary shares that BAE had an issue, thus there was no change in BAE ownership structure and this proves BAE continually to dominate defense industry. More significantly using cash and cash equivalent that BAE already had, it was in possession of estimating how much money was offered to Norkom

This was crucially important to use resources already existed within BAE as it avoided raising debt finance in terms of mezzanine finance or even leveraged takeover. The effect of mezzanine finance or leveraged takeover could have resulted more financial risks such as gearings and interest cover.

Financial risk

BAE systems’ gearing in the year 2010 was 28%, but after the acquisition of Norkom the gearing increased by 36% to make it to 38% in year 2011 (See appendix1). However the interest cover remained steady despite of using cash of £180miliion to acquire Norkom. The interest cover in 2010 was 1.03 times and a year later in 2011 it was 1.1 times (see appendix 1). This means 6.4% money spent from the cash that BAE had, it did not shake their both existing and future commitments as it continued to service the existing debt by paying off its interest charges.

Appendix 1

Price paid to acquire Norkom =price earnings ratio for BAE

Profit after Tax (Norkom)

Profit after tax = 7.5-(7.5*12.5/100)

=7.5-0.93

=6.6

217/6.6=33

BAE P/E RATIO

Appendix 2

GEARING

Gearing =Debt/Debt +Equity

Year 2011 year 2010

2682/2682+4299 2133/2133+5403

2682/6981 2133/7536

38% 28%

Change= 10/28=0.3571=36%

INTEREST COVER

Interest cover= PBIT/INTEREST COVER OR FINANCE CHARGE

Year 2011 year 2010

1580/1408 1601/1547

1.1 1.03

1

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