A Handy Cheat-Sheet For KKR and Blackstone Group

July 31, 2006 Administrator 278 Comments

Almost every month the private equity industry raises a new record fund and completes a record sized deal. Just last week, KKR, Bain Capital and Merrill Lynch agreed to the largest ever private equity buyout when they bought HCA in a transaction valued at $33 billion.

And these mega deals will likely continue. Last month, the Blackstone Group closed on a $15 billion world wide private equity fund. Not to be outdone, KKR recently announced it is raising a $10 billion world wide private equity fund. To put the size of these funds in perspective, I’ve pulled a paragraph from the "New Kings of Capitalism" article from the Economist from just a couple of years ago.

…there has been a dramatic growth in the size of private-equity funds, and in the size of the top firms that manage them. Most private-equity firms raise funds as limited partnerships. The firm is the general partner that manages the fund and gets paid an annual fee (a percentage of the money in, or promised to, a fund) and later a large slice of any profits; outside investors (who often lock up their money for up to ten years) become limited partners who share only in the profits.

In 1980, the world’s biggest fund (KKR‘s) was $135m. Today there are scores of funds with over $1 billion each. J.P. Morgan’s latest one is currently the biggest, at $6.5 billion, ahead of Blackstone’s; Permira has Europe’s largest, at around $6 billion at today’s exchange rate. A $10 billion fund can be only a matter of time, if only for the fabulous annual fees.

A billion dollar buy-out fund is now relatively small change in the world of private equity so these mega funds need to look at bigger and bigger deals and bigger and bigger companies. So in the interest of being a good financial citizen, I’ve provided a handy cheat sheet for KKR and Blackstone Group in their search for deals big enough to attract their interest.

I’ve run a screen that looks for public companies that are capable of "taking themselves private." In other words, I’ve attempted to find companies that already generate enough cash flow to pay the interest on the debt required to "buy-out" the company. In essence, this screen looks for companies with steady cash flows, good balance sheets and a low valuation – exactly what value investors and buy out funds are looking for in making investments.

The actual screen searches for companies that generated enough cash from operations to pay an 8% interest rate on the debt needed to buy the company at today’s enterprise value (equity market value plus total debt outstanding minus cash on the balance sheet). As an example, a company with $100 million market cap and $10 million in debt would need to generate $8.8 million in cash from operations ($110 * 8% = $8.8 million interest expense) to take itself private. It’s a simplistic calculation because I’m not assuming a premium needs to be paid for the stock, that no equity needs to be injected into the deal (just straight debt), and I make no tax adjustment for the additional interest expense that the company can write off on their bill to Uncle Sam. Nor do I base my numbers on forward estimates…just on last twelve months numbers.

With that, lets take a look at some of the companies that could sustain an interest payment and debt load required to take themselves private. Those companies should be ripe for a buyout from Blackstone or KKR, and therefore, ripe for the purchase by value oriented equity investors.

Nike (NKE)

It’s amazing how much money you can make selling $200 sneakers made by Vietnamese kids earning $0.50 an hour. Now if they could just cut Tiger Wood’s and Michelle Wie’s endorsements down to the same size, the company’s profits would truly be stunning. Given the size of their endorsement contracts, Tiger Woods and Michelle Wie might actually want to make a play for Nike themselves.

Nike generated $1.5 billion in cash from operations in 2005 and is on track to generate about the same amount this year. The company’s equity market cap is $20 billion, with a net cash balance (total debt minus total cash) of about $1.3 billion. So Woods and Wie would only need to find about $18.7 billion to buy the company – a sum they could probably pull together in a long weekend playing golf.

At an 8% interest rate, the interest payments on $18.7 billion would equal about $1.5 billion, which is right in line with what the company has consistently generated over the last 3 years. Since Nike only needs about $200 million in maintenance capital expenditures, it’s a perfect buy out candidate. With some cost cuts and less endorsement expenses, the company could easily generate enough cash to continue operating smoothly.

In fact, Woods and Wie could take the company private today if Phil Knight wouldn’t mind working for one of his current employees.

Sherwin-Williams (SHW)

Sherwin-Williams has been under a cloud because of lead paint and asbestos litigation concerns. In addition, the company could be hurt if the housing bubble implodes and everyone stops trying to "Flip This House" by slapping a new coat of paint over the hot pink wallpaper in the bathroom.

But if the housing bubble doesn’t burst, then Sherwin-Williams is prime for a takeout by KKR and Blackstone.

Last year, Sherwin-Williams generated about $716 million in cash from operations. The three years prior, the company generated about $550 million in each year. That’s pretty steady cash flow. SHW trades at an equity market cap of $6.7 billion and has net debt of about $700 million. KKR or Blackstone would need to find about $7.5 billion in debt to buy the company at today’s price. At an 8% interest rate, the company would need to generate about $600 million in cash to pay its interest payments. It certainly generated enough last year to cover that, and then some.

So if you’re an optimist on the housing market, SHW could be a great target for a buy out. Even if you assume a return to a steady state market, SHW might not be such a bad buy since it’s cash flows have been fairly steady for long periods of time.

WW Grainger (GWW)

WW Grainger distributes over 800,000 maintenance and industrial products through its massive 1,000 page catalog. The company is somewhat cyclical, but not so cyclical that it goes from making to losing money in a heartbeat. The items that Grainger sells are all typically needed to keep an industrial company running smoothly. GWW’s customers can delay purchases, but they usually can’t put them off forever.

With that said, GWW’s financial performance has been very steady. Last year the company generated $430 million in cash from operations. That’s in the middle of the $312 to $510 million range of cash from operations over the past five years. The company has a $5.5 billion market cap, $500 million of cash and virtually no debt.

KKR or Blackstone would therefore have to pony up about $5 billion in debt to buy the company. At an 8% rate, the interest expense would be $400 million. The company easily covered that the last two years but might come in a bit under that this year. GWW just pre-announced it’s first earnings miss in several years. However, over time GWW generates enough cash from operations to support a high interest payment. But if you assume that the economic slowdown stays away from recession territory, the GWW makes a very attractive buy-out candidate.

Exxon Mobil (XOM)

So Nike, WW Grainger and Sherwin-Williams aren’t big enough for you? How about the largest company in the world. XOM makes a perfect take out target if you assume that oil will stay remotely around the current level.

Last year, XOM generated $48 billion in operating cash flow. Since XOM constantly needs to drill for new oil to maintain it’s production, it is a very capital intensive business. We therefore have to assume that you need a fairly high amount of capital expenditures to maintain the value of the business. XOM spent $14 billion last year finding oil and natural gas. After deducting the cap ex from cash from operations, XOM is left with $34billion in cash flow to make interest payments.

The company’s enterprise value was $375 billion – and XOM actually has a net cash balance on the balance sheet which is amazing for a company this capital intensive. At an 8% interest rate, the company would need to generate $30 billion in cash to pay its interest expense. XOM generated that and $4 billion extra last year. That’s amazing. And XOM is on track to generate over $40 billion in cash this year.

Forget about KKR and and Blackstone…if you or I could raise $375 billion in debt, we could make a bid for XOM today. I’m going to call MasterCard this afternoon to see if I can get an increase in my credit line – they raise my limit every other week, so why not just let me just take it to $375 billion.

If XOM is a bit much for you to chew off, Chevron (CVX), ConnocoPhilips(COP), Valero (VLO) and Sunnoco (SUN) also pass the screen.

Take your pick or buy ’em all.