Leveraged Buyout of Seagate Technology

Background

Hard disk drives make up the largest sector of the information storage industry in 1999. The hard disk drive market can be classified into three separate categories, desktop, enterprise, and mobile. The mobile and desktop markets are expected to converge in the long run. While the desktop market represents approximately 58% of the $25 billion total hard disk drive market, enterprise margins were nearly double the margins in the desktop sector (10-15%). Since 1997, the number of disk drive units sold has grown while prices have dropped dramatically, causing overall revenues to decline. This situation is expected to continue, with revenue growth lagging far behind unit growth due to the vigorous competition between disk drive manufacturers.

Growth Opportunities

One identified growth opportunity within the disk drive industry is storage networking, which provides disk drive manufacturers the ability to differentiate their products. The other identified growth opportunity is within the consumer electronics market. While only projected to have sales of $0.5 billion in 2000, the consumer electronics market is expected to grow over 50% annually over the next three years.

Seagate's Undervaluation

Background

Founded in 1979, Seagate Technology, Inc. is the market leading manufacturer of computer hard drives, owning 21.1% of the total disk drive market in 1999, an industry where six companies account for 95% of sales. Seagate also had the largest market share of the Enterprise (41%) and Desktop (21.1%) disk drive market sectors in 1999.

In May 1999, Seagate sold its Network & Storage Management Group to VERITAS Software Corporation, an independent manufacturer of storage management systems, for approximately 155 million shares of VERITAS stock. With an ownership stake of over 40%, Seagate became VERITAS' largest stockholder. From June 1999 through November 1999, Seagate's stock price increased by 25%, while VERITAS' stock price increased by over 200%. This resulted in occurrences of Seagate's stake in VERITAS exceeding the entire market value of Seagate's equity, essentially assigning a negative value to Seagate's large and market-leading disk drive business.

Market Valuation

In March 2000, Seagate's stake in VERITAS was valued at $21.6 billion, with an after-tax value of $14.3 billion. Based upon Seagate's financial data from June 1999 and projected future cash flows generated by their disk drive assets, the value of Seagate's non-VERITAS component of equity is approximately $1.8 billion. This is based on the Weighted Average Cost of Capital valuation method. In reality, Seagate's total market equity is worth approximately $14.6 billion as of March 3^rd, 2000, which equates to a market valuation of $0.3 billion for the disk drive component of Seagate's equity. This is a potential undervaluation of $1.5 billion, based on the NPV-calculated value of Seagate's disk drive assets.

The undervaluation of Seagate's component of equity was due primarily to two factors: tax liability of the VERITAS stake and the maturation of the disk drive industry. First, if Seagate tried to sell VERITAS shares, or distributed the shares to Seagate shareholders, a potential large tax liability would be created. Not only would Seagate itself be taxed 34% on the capital gains from selling the VERITAS shares, but shareholders would also be double taxed on their capital gains as well. Second, Seagate's core business of disk drives had fallen victim to the market frenzy surrounding the emergence and growth of internet businesses, and the gravitation of investors to favor this new industry over the more mature disk drive industry. This would limit Seagate's ability to obtain long-term projects from public markets for future business expansion.

Proposed Solution

Background

Due to the large tax liabilities, the potential arbitrage opportunity represented with this undervaluation market inefficiency of Seagate's disk drive operations of -$1.5 billion is difficult to execute. Seagate's management and shareholders felt they needed to reestablish the value associated with their core disk drive business, without incurring taxes, and that this value re-creation should happen through restructuring Seagate via leveraged buyout involving a private equity firm (Silver Lake Partners L.P.).

There are four challenges facing Seagate in the restructuring transaction. First, they needed to decide how much Silver Lake Partners should pay to acquire Seagate's disk drive operations. Second, they needed to answer how the transaction should be financed. Third, the team had to consider the needs of VERITAS, since Seagate held a large stake in the corporation. Finally, the team needed to consider how the transaction would affect Seagate's stock price. The proposed transaction must be structured to maximize value for Seagate's shareholders. The team felt that this could be done by distributing the VERITAS shares tax free, sell the Seagate's core disk drive business at a fair market value, and adsorb the remaining Seagate assets into VERITAS. It is important to note the necessity of distributing the VERITAS shares in a tax free manner; simply selling the shares would result in a huge tax burden to the shareholders realized through capital gains due to the dramatic increase in stock price.

The initial step of the proposed transaction would entail Seagate selling all operating assets, essentially their disk drive operations and including approximately $765 million in cash, to an investor group controlled by Silver Lake Partners for cash, at an agreed-upon buyout purchase price. The second step of the transaction is that the remaining Seagate shell corporation would exchange the existing 128 million share equity stake in VERITAS for 109 million new VERITAS shares through a tax-free stock swap. The remaining Seagate assets, including the 109 million VERITAS shares, the cash proceeds from the buyout, and any cash in excess of $765 million, approximately $515 million, would then be distributed to Seagate shareholders. Provided the merger qualified as a reorganization under Section 368(a) of the Internal Revenue Code, no corporate or personal tax liability would be created by the deal.

While the most evident loser, in terms of stakeholders, in this proposed transaction is the government who will lose the potential tax revenue, Seagate shareholders will be losers in some way as well, as they have little negotiating ability with the leveraged buyout (LBO) firm for the buyout purchase price. Seagate shareholders are also losers because they are unable to realize the full value of their firm, including both their disk drive operations and stake in VERITAS. Seagate shareholders could also be considered winners in that they are able to unlock the value of their disk drive operations and also realize tax savings on their stake in VERITAS. On the other side of the negotiation, the LBO firm is a winner in this transaction as they possess the negotiating power for the buyout purchase price. The biggest winner in the proposed transaction would be VERITAS, who receive 128 million shares in exchange for 109 million shares, creating $3.2 billion in value for VERITAS shareholders with no tax liability until the shareholder's sell their shares and pay capital gains taxes.

Leveraged Buyout

Central to the proposed transaction is the leveraged buyout of Seagate with borrowed funds. Seagate's assets serve as security for the loans taken out by the LBO firm, which repays the loan out of Seagate's cash flows. While the general benefits of buyouts include economies of scale, economies of vertical integration and complementary resources, eliminating inefficiencies, and industry consolidation, leverage buyouts can also create tax shields for acquiring firms.

Technology firms are generally not good candidates for leveraged buyouts by traditional standards because cash flows were extremely hard to predict due to rapid growth, short product cycles and substantial demand uncertainty. By the late 1990s technology buyouts began to emerge in certain segments of the technology sector that had begun to exhibit the maturity and stability typical of traditional LBO candidates, such as Seagate's hard disk drive operations.

Still, the leveraged buyout of Seagate does not fit the typical buyout criteria. Seagate is already completely vertically integrated, with R&D and manufacturing under the same roof and there are not any apparent operating inefficiencies or underperforming assets, as Seagate is the market leading disk drive manufacturer. Also, the existing management team is expected to remain with Seagate's disk drive operations. Thus, this transaction was a foray into new buyout territory, mainly the unlocking and rediscovery of firm value by wrenching it away from a non-core asset that had grown into a tax liability that was limiting the growth Seagate stock price.

The biggest remaining question surrounding the proposed transaction is the valuation of Seagate's disk drive assets. Seagate shareholders are looking for the highest possible valuation, while the LBO firm is looking for a low valuation. In the end, a value needs to be assigned to Seagate's disk drive assets and then split between the LBO firm and Seagate's shareholders.

Optimal Post-buyout Capital Structure - Qualitative Analysis

The buyout team plan to finance the Seagate acquisition using a combination of debt and equity. The following analysis presents a qualitative assessment of the optimal capital structure.

Business life cycle

Seagate and its competitors are making the transition from high growth to mature growth in the business life cycle. This means that they will be taking on greater amounts of debt.

Tax benefits

Disk drives are becoming a commodity in the late 1990's, and firms compete mostly on price. Seagate will not be able to build changes in inflation into their product cost; they are held only to what the market is willing to pay. Tax benefits of carrying debt on the balance sheet will play an increasing role for Seagate.

Added discipline of debt

Seagate will likely benefit from added discipline of debt in terms of keeping its managers in line. Recently, one of the founding managers was removed in favor of a new COO. It is possible the old management team is becoming disinterested in the industry as the excitement of rapid growth wanes and the normalcy of a competitive landscape settles in.

Bankruptcy Costs

There is a certain element of risk in the disk drive industry, driven mainly by the volatility in the market surrounding computer sales. It would be beneficial to Seagate to carry a smaller amount of debt to cover its interest payments in case of a downswing in the market.

Agency Costs

Because Seagate consists of liquid assets and its product is tangible and understandable, agency costs are minimal for debt holders in Seagate. As a result of this, debt holders may not demand higher than normal interest rates on Seagate debt.

Flexibility Needs

Although the disk drive industry is maturing, the threat of product revolution in the drive industry demands that Seagate be flexible in its financing needs. Because of this, Seagate may want to keep a low debt to value ratio.

Market Perception of the Buyout

In general, all equity buyouts are performed when the target firm is considered overvalued. Cash funded buyouts are generally performed when the acquiring firm considers the target firm to be undervalued. If Seagate and Silver Lake want to keep a positive perception in the market, they should use a significant amount of debt to finance the transaction.

Qualitative Structure Based on Historical Interest Coverage

Figure 1 shows Seagate's historical EBIT, EBIT interest coverage, and %change in EBIT from year to year. The data indicate Seagate's earnings are extremely volatile, having drops in year to year earnings in seven of eighteen years. Figure 2 shows market interest rates and S&P key industrial financial ratios by long-term debt rating for March 2000. The data from the two tables indicate that if debt is used to finance the buyout, the management team should be prudent in selecting its debt ratio. Seagate has a historical average EBIT interest coverage of approx 1.35x. This places their debt in the B-BB range. The listed ratios of total debt as a percentage of market cap, however, are out of line with Seagate's industry. They will likely not carry over 50% debt as a result of the transaction. Based on the data in the tables, Silver Lake management should qualitatively finance the buyout with 15-30% debt.

Optimal Post-buyout Capital Structure - Quantitative Analysis

This section estimates Seagate's future free cash flows to the firm and recommends a maximum purchase price for the buyout transaction. It also looks at firm value created by tax shields and quantifies the amounts won and lost by each party.

Firm Value and Risk of Default Using the Adjusted Present Value (APV) Approach

Approximate present values of a firm can be determined using the APV method by estimating the likelihood of defaulting on the interest expense accrued with different amounts of acquired debt. The risk of defaulting is statistically linked to the likely rating of Seagate, which is linked to bond rating associated with interest coverage ratio. The final product is the APV of Seagate, shown in Figure 3. Though the optimum level of debt for Seagate is around 5% to 25%, the acquisition of Silver Lake will exceed this range because there is a lack of up-front equity. The leverage buy-out of Seagate will be financed heavily with debt and most likely will range from 25% to 85% of the firm's value. However, Silver Like needs to be careful with acquiring so much debt due to nearly a 50% statistical chance of defaulting to debt holders.

Discounted FCFF Using Weighted Average Cost of Capital (WACC)

Future earnings projections were obtained from Seagate, including upside and downside variations. Using base case sales projections, the amortization, depreciation, net working capital needs, and capital expenditures were estimated based on historical percentages of earnings combined with projected trends for related accounts. Free cash flow to the firm (FCFF) was calculated from 2000-2006 and discounted to present value using the WACC. A growing perpetuity was used to estimate terminal value in 2007, and discounted to present. The growing perpetuity for years 2007 and beyond were calculated using projected 3% growth and the purchased firm WACC.

WACC Determination

The WACC for discounting cash flows was determined from Seagate and industry data. The Seagate equity beta from the Capital Asset Pricing Model (CAPM) is 1.2. Long term debt for Seagate is $704 million. With taxes at 40%, the overall asset beta for the firm is 1.15. To find the beta of the disk drive assets alone, comparables were used. Unlevered betas of Quantum and Maxtor were calculated to be 0.87 on average. Finally, assuming an 80% debt structure upon leveraged buyout, and an 8.6% return on debt, the future WACC for Seagate was determined to 9.6%.

Recommended Purchase Price

From Seagate's FCFF and WACC, the NPV of the disk drive assets is $1.8 billion. This is the status quo valuation of Seagate Disk Drives. In a leveraged buyout, there is potential for increased firm value in the form of tax shields. In order to determine what amount of leverage is optimal, a WACC variation analysis was performed. The results showed that the maximum value is added at 10% debt, considering the tradeoff between debt rating and increased value from tax shields. However, because this transaction is determined to be a leveraged buyout, as much as 70% debt can be used without destroying substantial firm value. Thus, 70% is recommended as a leverage cap.

The income volatility approach was also used to determine what default risk can be expected from an 80% debt level. The analysis showed that a 23% probability of default can be expected if income volatility levels from 1981-1997 are applied to 1997 EBITDA.

Using a best-case scenario for value creation at the 80% debt level used in the initial WACC valuation, the present value of the tax shields gained by Silver Lake in their acquisition are equal to the effective tax rate times the debt. While an effective rate at 80% debt might be as low as 9%, an assumption of 20% was used for this analysis. At this level, and with 80% debt, the tax shields total $0.19 billion. This value can be added to the maximum amount Silver Lake can consider in their bid for Seagate Disk Drives, bringing the total to $1.96 billion. Of course, $0.703 billion of this value is debt that investors will inherit from Seagate. This will be offset by cash being offered by Seagate at the close of the deal. At the $1.96 billion price, Silver Lake would break even, with significant downside risk.

Conclusion

The bottom line is that Silver Lake should not pay more than $1.2 billion for Seagate and maintain a rating of CCC or better in order to minimize the chance of defaulting. The firm should not exceed 80% to 85% debt, however even these amounts should be avoided. In addition, bondholders need to be careful of Silver Lake not to take high risk/high reward projects with the amount of debt this leverage buy out will employ, because management will not be spending their money, but the bondholder's. Multiple exit strategies should be considered between all investing parties before the deal is brokered.

It is recommended that Silver Lake should try to 'low ball' with an asking price between $500 million and $1 billion, because the Seagate stockholders have no other current options and their stake in VERITAS is worth more, before taxes, than their entire company. Seagate is looking for a way to unlock their firm's potential value and Silver Lake is willing to purchase Seagate's brand and operations so that the Seagate stockholders can walk away with cash and a non-double taxation of their stake in VERITAS.

The true winner of the entire deal is VERITAS; for doing relatively nothing, their firm receives 19 million shares, or about 5%, of their own company. On the other hand, the true loser of the Seagate deal is the U.S. government, because they lose out on the potential capital gains from Seagate selling their shares in VERITAS.