A not so solid concrete plant dealIn this post, we provide another example of a valuation of lost profits in a business case. This case involves a joint production deal that fell thru. In the deal two U.S. companies, Divisor Inc. and Palladium Inc. had entered into a written and oral agreement to jointly obtain bank and venture capital financing to build 4 new maximum capacity concrete, cement and aggregate products in central China. For reasons that are in dispute in the case, the financing deal unraveled and the strategic alliance between the two companies did not occur.
Divisor, Inc, sued Palladium for breach of contract. In the lawsuit Divisor alleges that Palladium did not perform the agreed upon due diligence and pre-funding activities and actions that the funding agency required and was therefore responsible for the failed business venture. Divisor is asking the court for the lost profits that they would have earned from building the 6 new concrete product plants in China.
We were asked by Divisor to calculate the economic value of the lost profits in this matter. In this post, we will provide an overview of the failed business deal and provide a discussion of the methodology that we used to calculate the economic value of the lost profits in this case. The names of the individuals and companies have of course been changed.
Case set-upIn 1999, Sloan Thompson the CEO of Divisor and William Cole of Palladium entered an agreement to obtain bank and venture capital financing to build 6 new concrete plants in Central China. Divisor is a company that owns a number of concrete product production plants throughout North America. Palladium is a company that owns and operates concrete product distributorships and resale shops.
Under the initial agreement the two companies would create a 50-50 partnership that would build, operate and distribute concrete thru out China. Each plant installation will require the physical manufacturing site, land, computer systems and vehicles and other equipment.
Each plant cost about $12 million (USD) to produce in China. The Divisor-Palladium partnership projects that the Cost of Sales will be equal to about 61.7% of gross sales. The plants would have come on line in a staggered fashion, with two plants per year becoming active.
In the partnerships pro forma business plan the cost of sales (COS) includes the labor, vehicles and other costs associated with making a concrete product sale. As conventional economic wisdom would predict the labor expenses are much lower, and constitute a much smaller percentage of expenses, in China than in the U.S. The partnership accounts for administrative, marketing and selling costs as expenses.
The financing deal
The initial financing deal was structured as follows. The financing would come in the form of a $175 million (USD) 10 year loan to the 50-50 partnership. The partnership would make draws on the funds in increments. One fourth of the funds would be drawn the first year, one-fourth of the funds would be drawn the second year and the remaining one-half will be drawn the third year.
The partnership will only make interest payments, based on LIBOR rates at the time (about 7.5%) on the loan the first three years. Principal payments on the loan begin in year 4.
The British Bankers Association (BBA) LIBOR is a widely used benchmark rate for short term interest rates. LIBOR stands for the London Interbank Offered Rate. The LIBOR rate is the rate of interest at which banks could borrow funds from other banks in the London interbank market.
Valuing the total lost revenue from the projectAs with any asset the value of the lost revenue associated with the breached agreement is equal to the present value of the profits that it will generate over the lifetime of the project. The unique issue in this case is that there is no earnings history for the partnership because the funding did not occur and the investment was never actually made.
That in essence makes this essentially an economic calculation and not an accounting exercise. In business interruption lawsuits it is sometimes the case that the interpretation of the accounting data will tell the valuation analyst the most about the pre- and post-incident investment earnings potential. For example, a company may have special one-time charges, expenses, or special depreciation allowances that can potentially yield two radically different pictures of the intrinsic value. In the current lost profits lawsuit, the projection of the economic values is the key.
With that issue in mind, how do you go about estimating the lost revenue in this case? The first steps in the analysis is to study the economic viability of the building the concrete plants in China. Studies of the economic viability began by reviewing the overall Chinese economy and the concrete sector. It is not uncommon for some of this information to be found in a pro-forma business plan.
In this case, the partnership prepared a detailed business plan that included discussion about the labor sector, concrete market, taxes and the overall economy. While the business plan is useful, it is also critical to review information from outside sources.
After reviewing a number of different data sources concerning the Chinese concrete market, we determined that the demand for concrete was indeed very strong. Assuming that the partnership could indeed obtain the facilities, licenses and other elements that are needed to get the plants in place, the project seemed quite viable.
In addition to the overall economy the next step in a valuation of lost profits is to study the revenue and cost that the concrete plants could have been expected to generate. In this case, as in many detailed pro forma business plans, the partnership prepared very detailed projections of year by year revenue and expected operating cost.
In the business plan and our analysis, it is assumed that the plant would be able to sell all the concrete products that they produced. Our study of the concrete market clearly showed that the Chinese concrete market was operating at a near capacity. Moreover the growth that was projected (and was experienced) by China’s economy suggests that the demand for the concrete products would be high.
Also, while the additional high capacity plants that the partnership were planning to put in place would have added to the capacity in the Chinese concrete market, the additional capacity added by the plants would add less than 1% to the overall capacity. The added capacity would more than likely be absorbed without many effects on price or overall inventory levels in the industry.
In terms of cost, while the business plan was very useful as a guide, we relied on industry level cost data to determine the operating cost for the pro forma concrete plants. EBIITDA (earnings before interest, taxes, depreciation, and amortization) data from leading Chinese concrete manufacturers was used to determine the ratio of gross earnings that would have spent on expenses.
The industry data suggested that operating cost would be higher than estimated in the partnerships plan. While the special expertise of the partnership and the other advantages that they reported to possess, could have no doubt put them in a better market position than other potential entrants into the concrete market, the use of the higher cost numbers produces a more conservative estimate of the lost profits.
After determining the cash flow that the concrete plants would have generated, the last stage is to determine the discount interest rate factor by which to determine value of the lost cash revenues and the terminal value of the partnership assets. The terminal value of the asset (the agreement/plants) is the value of the remaining profits that exists at the end of the contract.
Since a financing agreement was in place that tells us the interest rate at which the partnership was actually able to borrow money at the time the contract began, the discount factor is based on the build up method. The build up method in this case includes the cost of capital (the stated loan interest rate), the industry risk premium, and the country specific risk premium. The industry and country risk premiums represents the added interest that investors in similar projects require.
Using this methodology we estimated that Divisor, Inc. lost over $560 million in lost profits.
Mitigation or no mitigation?Should the calculation include any offsetting income? For example, now that the investment did not take place was Divisor able to earn money in a different way that should offset the lost earnings?
In this type of case, the answer from an economic standpoint is no. There is no mitigating income to consider because there were no pre-breach assets in place that could have generated income in the post-contract breach period. In this case the partnership did not receive the funding so the assets were never purchased.
Mitigation arguments do make sense in some business valuations but not in this one. For instance in cases where the agreement breach involves a different use of existing assets then mitigation may be relevant. For instance if the two companies were agreeing to re-tool existing plants to produce a different type of product then a breach of contract analysis should take into account the revenue that is earned from the current (non-retooled) use of the plant. In this case there are not assets to ‘re-tool’.
