Masonite International

4/21/2020
Corporation: Will KKR Slam
the Door
Financial Management Assignment – 3
Case Study No 3
Batch- GMP Tata Steel (19-20)

Prepared by –
1. Ankul Anand (CGT19007)
2. Mrinal Gautam (CGT19013)
3. Pradeep Kumar (CGT19019)
4. Sandeep Sharma (CGT19025)
Contents

1. Case Background ........................................................................................................................ 2

2. Critical Financial Problems......................................................................................................... 4

2.1. The price of C$40.2 per share offered to the shareholders of Masonite International
Corporation was fair or not? ....................................................................................................... 4
2.2. Why LBO of Masonite International Corporation by KKR ? .............................................. 4
2.3. Is the Compensation package offered to senior managers signaling agency problem or fair?
..................................................................................................................................................... 4
2.4. What is breakup fee and is the breakup fee of C$0.5 per share agreed on is too high? ...... 5
2.5. Was the 10% discount factored in the offer price to reflect the low liquidity on stocks fair?
..................................................................................................................................................... 5

3. Analysis of the Problem and Interpretation ................................................................................ 6

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1. Case Background

This case study deals with the leveraged buyout of door manufacturer and merchandiser
Masonite International Corporation, at a time of uncertainty, marked by the ever-increasing cost
of raw materials, the tightening of monetary policy and the concerning health of the housing
market. It offers the opportunity to discuss leveraged buyouts, to value the company and to
analyze the financing of the transaction.

Masonite was one of the world’s largest manufacturers and merchandisers of doors, door
components and door entry systems, headquartered in Mississauga, Ontario. It operated 75
facilities in 16 countries, sold its products to customers in 50 countries and employed about
14,000 people. Though Masonite was adding on its top line growth and margins on year to year
basis but last year quarterly results were below expectations - the EBITDA margin had dropped
from 13.7% to 13.6%, the EBIT margin from 10.9% to 10.1%, and the net profit margin from
6.4% to 4.8%. The decrease in profitability was the consequence of two major factors. Firstly,
the company had struggled to align its prices with increase in costs. As the cost of raw materials
represented 75% of the sales and these costs had pretty much doubled over the last one year.
Secondly, Masonite had recently undertaken a program of standardizing its entry door product
offering and therefore, it had closed two of its manufacturing facilities in the US. This had led
to the restructuring expenses of US$10.4 million in 2004.

In June 2004, the Federal Reserve (Fed) had started increasing its target rate from 46-year low
of 1.0% to 2.5%. This tightening of monetary policy would have a negative impact on consumer
spending and that would directly affect sales, earnings and cash flows of building product
companies. In addition, there were increasing concerns about the health of housing market. The
large, government sponsored enterprises guaranteeing half the mortgages in the US, were
forecasting a decrease of 8 to 11% of housing starts for 2005. They were also expecting a decline
in home sales up to 12% if mortgage rates will rise due to increase in interest rate.

KKR Approach: Kohlberg Kravis Roberts & Co (KKR) is a New York City-based private
equity firm that focuses primarily on late stage leveraged buyouts. KKR developed and
popularized the acquisition concept known as the leveraged buyout (LBO) by creating a series
of limited partnerships to acquire various corporations, which they deemed to be
underperforming. In most cases, KKR (often with management) financed up to ten percent of
the acquisition price with its own capital and borrowed the remainder through bank loans and
by issuing high-yield bonds. KKR would often ensure that the target company's management
retained an equity interest to create a personal financial incentive for them to approve the
takeover.

The bank loans and bonds used to finance the acquisition were collateralized by the tangible and
intangible assets of the target company. Because the bondholders only received their interest
and principal payments after the banks were repaid, these bonds were deemed riskier than
investment grade bonds in the event of default or bankruptcy, and popularly became known as
"junk bonds." Once the targeted company was acquired, KKR would help restructure the
company, usually selling off certain underperforming assets and implementing a series of cost-

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cutting measures. The new, "leaner and more efficient" company could then be resold, often at
significant return on investment (30-40%).

Masonite’s Leveraged Buyout

KKR, through its wholly-owned subsidiary Stile Consolidated Corporation (Stile), was offering
C$40.20 (or US$32.66) per share to take control of Masonite. The offer represented an implied
premium of 13.2% based on the stock price at the close of the previous trading day and 21.3%
premium based on the average stock price over the previous 60 trading days. Though
management and the Board of Directors (BoD) had unanimously approved the deal, it had taken
15 months to organize.
By December 2003, KKR and Masonite had dropped the idea of involving another building
products company, and they had signed a confidentiality and standstill agreement to start
working on a deal. KKR presented a tentative transaction, which was reviewed by Masonite’s
directors on March 16 and 23, 2004. The BoD terminated the talks because the offer price was
far too low. KKR did not give up and approached Masonite again. In July 2004, Philip Orsino
(Masonite CEO) accepted to re-open the negotiations on the basis of C$40 to C$42 per share
and at a BoD meeting on August 30, 2004, Philip Orsino convinced the directors to give KKR
a second chance. Masonite’s BoD appointed a Special Committee to consider KKR’s proposal,
review the alternatives available to the company and conduct negotiations in the best interest of
Masonite’s shareholders. Special committee team engaged a financial advisor Merrill Lynch
(Edgar and team) upon a transaction fee of C$2.9m for doing the valuation and expressing a
fairness option.
Based on initial analysis, Edgar had put Masonite’s value per share in the range of C$37 to C$46.
KKR made its formal offer to acquire Masonite at US$32.25 per share (C$39.44 per share) with
a breakup fee of US$0.82 per share (C$1.00 per share). But later after few round of negotiation,
KKR bettered its offer to C$40.20 per share with a breakup fee of C$0.50 per share

Concerns:
1. Several investors and analysts were arguing that KKR was trying to buy Masonite on
the cheap. In particular, they were highly critical of the 10% discount factored in the
offer price to reflect the low liquidity on the stock. The offer also didn’t take into account
Masonite’s strong growth rate and recent acquisitions abroad.
2. The investment community was shocked at the size of the breakup fee, C$0.50 per share
or C$28.7 million, including all shares and options. Masonite was prevented from
seeking another bidder and if one emerged, it would face a penalty of close to a quarter
of annual net income to break the deal with KKR.
3. Conflict of Interest: Senior managers were facing a substantial conflict of interest. First
of all, their job description was to act in the best interest of shareholders, but by accepting
to team up with KKR to take over the company, they were no longer in a position to do
so. Second, by being able to roll their common and phantom shares into the new
company, they were offered a tax-efficient deal, when all other shareholders would have
to pay capital gains.
4. BoD at Masonite was sketchy: BoD had remained secretive about the deal until its
announcement. Why had they accepted to put the company for sale, in particular, when
Masonite was in reportedly good financial health?

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2. Critical Financial Problems

2.1. The price of C$40.2 ($32.66) per share offered to the shareholders of
Masonite International Corporation was fair or not?

In the LBO of Masonite by KKR the deal was finalized at a price of C$40.2 per share for the
54796531 shares of common stock outstanding. Initially there was a price gap between the buyer
and the seller. Masonite was asking for a price of C$43.5 per share to shares of common stock
holders while KKR was ready to pay a price of C$39.44. Suddenly the deal was finalized at a price
of C$ 40.2 per share based on the opinion of Edgar’s oral opinion. This price as per the minority
shareholders was not justified and quite low. The question here is that if the price is justified as
per valuations of the firm. Because of this price issue the minority shareholders(Greystone
Managed Investments, Eminent Capital, Mawar Investment Management, Ontario Teacher’s
Pension Plan and Directors and officers ) colluded together and asked for a justification , If not
correct they wanted to go for law suit which would turn the deal down.

2.2 What will be the return on Equity post LBO?

As LBO leads to high debt and low equity, if a company does well post acquisition, RoE is
significantly high which any PE firm wants. We’ll evaluate RoE of the firm.

2.3. Why LBO of Masonite International Corporation by KKR ?

Masonite’s financial performance was very good in the past. Its gross margin had declined for a
short term recently because of different macro-economic factors. Why Masonite wanted to go for
a Leveraged Buyout by KKR. What benefits is Masonite going to get from this deal in terms of
operational efficiency, Finance structure, tax benefits etc. In leverage buy outs, capital structure of
the firm bought becomes highly leveraged which in turn provides tax benefits to the firm. Also
since the aim of the LBO firms remains to increase the value of firms that they are acquiring by
measures like increasing operational efficiency etc. so that they earn money after 4-5 years by
making the firm public through IPO or by selling the firm to competitors at a higher value.

2.4 Is the Compensation package offered to senior managers signaling agency

problem or fair?

The deal offer extended to the 281018 stock options, 299433 restricted share units (RSUs), and
167443 deferred share units (DSUs). RSUs and DSUs were phantom shares, part of the

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compensation package awarded to senior managers if they reached performance targets. These
shares had the same price as the shares of common stock, but they could not be cashed
immediately. Managers had to wait 3 years to cash their RSUs, and could not cash their DSUs
until they either retired or left the company. Was the compensation justified? Generally, in LBOs
such phantom stocks are offered to the top management because the objective of the LBO firm
remains to increase the firm valuation in short term and harness the profit out of it. They don’t
change the management rather link their compensation to performance in order to achieve their
goals and targets.

2.5 What is breakup fee and is the breakup fee of C$0.5 per share agreed on is
too high?

A breakup fee is used in takeover agreements as leverage on the seller against backing out of
the deal to sell to the purchaser. A breakup fee, or termination fee, is required to compensate the
prospective purchaser for the time and resources used to facilitate the deal. The initial offer made
by KKR was for a breakup fee of C$1 per share which was further reduced to C$0.5 per share and
was agreed on. The Investment community was shocked at the size of the breakup fee – C$ 0.5
per share or C$28.7 million, including all shares and options It was always in best interest of
target’s shareholders if a bidding war was to follow the announcement of an acquisition. But
Masonite was prevented from seeking another bidder and, if one emerged it would face a penalty
of close to a quarter of annual income to break the deal with KKR. The range of breakup fee
remains to be 1 to 3 percent of deal value. In this case it seems to be below 1% and hence fair and
good.

2.6 Was the 10% discount factored in the offer price to reflect the low liquidity
on stocks fair?

One issue that Masonite had been facing for years was the low liquidity on its stock, with average
trade volumes of only 3 million shares a month on the Toronto Stock Exchange, and fewer than
250000 shares a month on the New York Stock Exchange. As a consequence, Masonite’s stock was
trading at a discount compared to its peers, and KKR had reflected this discount in its offering price
by lowering its bid by 10%. Was this 10% discount justified or a trick to lower the price.

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3. Analysis of the Problem and Interpretation

Financial reports of FY’04 reflects a healthy financial and operational condition of the firm.
Between 2003 and 2004, sales had soared by 23.8% to US$2.2 billion, a balance of organic growth
and acquisitions. Earnings before interest tax depreciation and amortization (EBITDA) and
earnings before interest and tax (EBIT) were up by 23.0% and 20.8%, respectively. Net income
had increased by 18.8% to US$128.0 million. However, results of Q4 were not in line with
previous results. EBITDA margin had dropped from 13.7% to 13.6%, the EBIT margin from
10.9% to 10.1%, and the net profit margin from 6.4% to 4.8%. Earnings per share (EPS) had
decreased by 4 cents, from US$0.54 to US$0.50, breaking a trend of 18 consecutive quarters of
profit growth. But this can be treated as short term effect due to increased cost and decrease in
demand due to increased housing interest rate. Financial Structure of the company was as follows:

Equity (Balance Sheet FY'04) 0.44

Debt (In Mn$) 637.274
Total Shares Outstanding 57544425

The firm had debt of around $ 637 Mn. Considering the interest paid in FY’04, cost of debt comes
around 7.34 %. Over all WACC comes around 9.36%. Details can be found in excel sheet.

Finance Structure (Pre Deal) As of FY'04

Equity ( Balance Sheet FY'04) 0.44
Debt 0.29
Other liability 0.28
Interest Expense 46807
Debt (In K$) 637274
Cost of Debt 7.34%
Effective Tax Rate (Assumed as per trend) 24.00%
Net Cost of debt 5.58%

Risk Free Rate (20 Yrs. US treasuries) 4.58%

Beta 1.15
Market Risk Premium 5.50%
Cost of Equity 10.91%
WACC (Pre deal) 9.36%

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How much this firm worth?

Valuation of the company has been done through DCF method and different multiples method.
Comparison of per share through different valuation method are as follows:

Per Share Value

50 $46.55
$37.14 $39.4 $39.68
40 $34.30
30
$32.7
20
10
0
DCF Valuation EBITDA Multiple EBIT Multiple Transaction Value
Multiple

Equity Per Share Average Price/Share Offered Price

Average per share value comes around $39.4/share which is much higher than offered price of
$32.7/ share. Details valuation calculation can be found in attached excel (Masonite Analysis).

Deal structure post LBO would have high debt (75.8%) and low equity (22.8%).

Exhibit 4: Structure Of The Deal

Amount (in US$
million) Percentage of Total
Uses of Funds
Purchase of Common Equity 1865 74%
Debt Refinancing 574 23%
Tax Liability on Debt
Refinancing 17 1%
Transaction Fees 8 0%
Financing Fees 56 2%
Total 2520 100%
Sources of Funds
Options Proceeds 30 1.2%
Proceeds from Sale of Land 5 0.2%
Equity 575 22.8%
Debt 1910 75.8%
Total 2520 100.0%

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The firm is highly leveraged so for sustenance it needs to perform well. Debt post LBO can be
arranged from following sources and WACC for the new financial structure would be 6.36%
against 9.36% of previous financial structure.

Sources of Funds (Debt) - Post Transaction

Amount (in US$ Interest
Type million) Ratio Rate
Senior Secured Term Loan 1175 0.62 6.01%
Senior Secured Multi-Currency Revolving
Credit Facility 350 0.18 6.01%
Revolving Credit Facility 300 0.16 9.51%
Senior Unsecured Subordinated Notes 85 0.04 9.51%

1910 1.00
Cost of Debt 6.72%
Effective Tax Rate 24.00%
Net Cost of debt 5.10%
Cost of Equity
Risk Free Rate 4.58%
Beta 1.15
Market Risk Premium 5.50%
Cost Of Equity 10.91%
WACC (Proposed Deal) 6.36%

Change in WACC
10.00% 9.36%
9.00%
8.00%
7.00% 6.36%
6.00% 32%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
WACC (Pre deal) wACC (Post deal)

Cost of capital has reduced by 32% with change in finance structure. This will help the firm in
better yield in terms of RoE.

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Return on Equity as per projection:

RoE
35.0%
29.4%
30.0%
26.0%
25.0% 23.2%

20.0% 18.0% 17.6%

16.7%
14.7%
13.4%
15.0%
10.4%
10.0%

5.0%

0.0%
2001 2002 2003 2004 2005 2006 2007 2008 2009

RoE of the firm has increased to 29.4% in 2009 from existing level of average 15%. Details can
be found in attached excel (Masonite Analysis/RoE). Few assumptions have made for this
interpretation.

Conclusion:

As this deal needs to get approved by 2/3rd of shareholders, offered price $32.62 seems to be low.
Our analysis results in average share price of deal to be around $39.4/share. Institutional investors
(Around 20%) is opposed to this deal, in addition to that press is also regularly publishing negative
stories about the deal. Although masonite management has agreed on this offered price, it signals
agency problem. Offering equity to management in such deal is always vulnerable for such agency
issue. Securities and Exchange Commission (SEC) is also not satisfied with the answers of the
queries. It appears that it will be very difficult for KKR to get this deal at this offered price. In
Case, KKR seals the deal and goes for LBO RoE will be around 29.4% by 2009 with increasing
trend. PE firms generally take benefit of leverage and command good RoE over time. They
increase equity in the years to come and once they feel that there is stable growth they try to exit
the firm via different mode like IPO, selling to competitor or any business house.

Enclosure: Masonite Analysis (Excel Sheet)

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