1995 DLJ [VALUATION & CASE ANALYSIS] This paper contains the details of the valuation & analysis of the operating investment bank ‘Donaldson, Lufkin & Jenrette (DLJ)’. DLJ is planning for a repeat public offering for raising capital & that’s why 4 of the renowned investment banks are appointed as issue manager who are ought to set a offering price of the to be floated shares.
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
1995
DLJ
[VALUATION & CASE ANALYSIS] This paper contains the details of the valuation & analysis of the operating investment bank ‘Donaldson, Lufkin & Jenrette (DLJ)’. DLJ is planning for a repeat public offering for raising capital & that’s why 4 of the renowned investment banks are appointed as issue manager who are ought to set a offering price of the to be floated shares.
It’s a matter of great contentment to be able to complete this study project in due time. Our endeavor will be considered successful if the report is of any help to anybody. At the very outset, we would like to express my heartiest gratitude to Almighty Allah for giving me the capacity to complete this task. Then I would like to place my humble gratitude to our respected course teacher Prof. Dr. M. Sadiqul Islam, Department of Finance, Dhaka University for his valuable time commitment, guidance, patience and stimulation made along throughout the total course duration.
We have put our best effort to make this report to serve its purpose; that is, to analyze & valuate the upcoming IPO offering of Donaldson, Lufkin & Jenrette (DLJ). We had to surf around the case for different issues at times & had to gather some information for the analysis from the internet as well.
The ‘Investment Banking & Managing Assets’ course gives a detailed overview on the total investment banking activity in the capital market & money market zone as well as about the different types of securities, derivatives & other financial assets of the capital & money market. We get the opportunity to work on a case problem at the end of the course for portraying our idea & knowledge of the total course that we have learnt throughout the duration of the course. At this continuation, we got “Donaldson, Lufkin & Jenrette (1995) abridged” as our case problem & we have worked on the analysis & valuation of this firm for their upcoming IPO floatation.
1.2 Objectives
The objective of this report is to –
Analyze the Case at the most detailed level
Relate the case proposition with that of our course content
Make an industry Analysis of the Investment Banking Industry in 1995.
Outline the company’s operational activities & discuss about its different business units.
Analyze its financial statements & comment about the company performance through ratio analysis.
Make valuation of the total enterprise & state the proposed stock price for the floatation of IPOs of DLJ.
The information availability of our analysis was solely limited to our presented case of DLJ. In this regard, many of the required information crucial to the analysis & valuation was absent within the case. So, we had to forecast some parameters on a realistic assumption basis for preparation of the solution report. So, some of the valuation outcomes may not fully representative or coherent with the company’s information representation. We have also tried to remain as close to the context of the case as possible which we hope reflects at the outcome of the case.
1.4 Methodology
At the outset, we all started to gather a detailed knowledge about the case as well as the company “Donaldson, Lufkin & Jenrette (DLJ)” for the preparation of this report. Then, we exchanged our views & ideas about the case and came to a consensus point for working with the case. We started data mining from the case & later compiled the data in the form helpful for the analysis & valuation of the case. After that, we used Microsoft Excel 2007 to calculate the different ratios as well make the enterprise valuation of DLJ. After making all the valuations, we interpreted the results through our available knowledge & recommended some points to be taken into consideration.
In 1959, when brokerage houses primarily created to individual investors, seeing that institutional investors were not adequately served, the three Harvard Business School graduates William Donaldson, Dan Lufkin, and Richard Jenrette set out with $100,000 to create an equity –research firm that would serve Institutional shareholders. Their firm prospered, offering sophisticated equity analysis to institutional investors in the hope of receiving their lucrative fixed-commission trading business. The firm decided to go public in 1970 for generating more capital, became member of New York Stock Exchange. However, NYSE prohibited members from having public shareholders> No NYSE members had ever offered shares to the public. The Business Week reported on the controversial transaction as follows:
Wall Street is, rather proudly, the home of the Big Risk and the Big Stake. Last week, three young men
staked their 10-year old, $14-milliom firm in one of the most remarkable wages in recent financial
history. If they lose, they forfeit their membership in the nation’s wealthiest club, the New York Stock
Exchange. If they win, they can increase the value of their firm tenfold, literally overnight. Win or lose,
they have already set in motion forces that in the coming decade will wrench the sinews of power in
every quarter of the U.S. securities industry.
DLJ kept in NYSE membership, and in April of 1970, DLJ offered shares of itself to the public. At the time, DLJ had just over 400 employees with revenues of $21.9 million. The market valued the company at approximately $115 million. To continuing its strategy of diversification DLJ sold itself to Equitable in 1985 for $465 million. Equitable was then a mutual life insurance company, owned by policyholders. Richard Jenrette, head of DLJ, joined Equitable as chief investment officer shortly after the merger. He became chairman in 1990. Jenrette initiated a restructuring of Equitable in response to serious problems.
Restructuring:
In the restructuring, Jenrette cut $150 million in annual cost, and sold 49 percent of Equitable to AXA, a French holding company for a group of international insurance and financial service companies. He also demutualized Equitable, raising $450 million in an initial public offering (IPO). Equitable separated DLJ’s original asset-management operations, Alliance Capital Management (“Alliance”), from DLJ. Later, Equitable sold part of Alliance to the public. In June of 1995, Alliance’s market capitalization stood at approximately $2 billion. By 1995, AXA owned approximately 60 percent of Equitable. Under Equitable, DLJ built industry and product groups as opportunity itself. DLJ’s strategy was one of the patience, keeping lean in the good times and taking chances when others saw gloom. For example, when many securities firms fired employees following Black Monday-the October 17, 1987 crash-DLJ actively hired select professionals. Similarly, after the junk-bond market collapsed
in 1990, DLJ sought out and hired a core group of junk-bond specialists from fallen market leader Drexel Burnham Lambert. DLJ’s careful strategy excelled, pushing DLJ up the industry league tables. Together, DLJ and Equitable sought a solution.
DLJ Business Groups:
The company was a leading investment and merchant bank that served institutional, corporate, government, and individual client. In terms of capital, DLJ ranked as the 11th largest securities firm. DLJ’s business included: Securities Underwriting Sales and Trading Merchant Banking Venture Capital Financial Advisory Services Investment Research Correspondent Brokerage Services & Asset Management DLJ operated through three principal Groups: the Banking Group, the Capital Market Group, and the Financial Services Group.
In 1995, DLJ employed 4,676 people, including 431 professionals in the Banking Group, 821 professionals in the Capital Market Group, and 998 professionals in the Financial Services Group.
The professionals in the Banking Group assisted clients in raising capital through the issuance of debt and equity securities in the public and private markets. The Investment Banking Group also provided its clients with financial advice concerning mergers and acquisitions, restructurings, and other transactions. Since 1990, the Investment Banking Group had Assisted its clients in raising over $150 billion in capital and completed over 300 M & A transactions, worth approximately &65 billion. The firm also maintained successful groups in private placements, private fund-raising (i.e. raising money for LBO fund), structured finance, and restructuring. The Merchant Banking Group invested capital directly into companies. DLJ utilized two investment funds with combined capital of $2.25 billion:
DLJ Merchant Banking Partners L.P. and DLJ Bridge Fund
In 1985, the group had invested in 46 companies with an aggregate purchase price over $18 billion. Since 1992, DLJ had placed $580 million in 20 companies and realized $610 million from seven partial or whole realizations. DLJ earned one of the highest returns among principal investors, with
annual return thought to exceed 90 percent. The bridge fund had completed 74 transactions totaling $12 billion of commitments to clients. The fund had $230 million of bridge loans outstanding as of June 30, 1995. The merchant banking activities earned money by charging a small fixed percentage for asset under management and keeping approximately 20 percent of the profits realized through the investments. The bridge operations earned money for committing to lend money and on the interest on money it lent out. DLJ then planned to form four new funds in the near future:
Mergers & Acquisitions
Restructuring and other
transaction
Private Placement, Private Fund Raising
Structured Finance &
Restructuring
DLJ Real State Fund DLJ Senior Debt Fund
DLJ investment Partners Global Retail Partners L.P.
The Emerging Markets Group was founded by DLJ in February 1995 to provide a broad array of investment banking, merchant banking, sale, and trading services to clients in Latin America and Asia. Additionally, the company agreed to invest $7 million in Pleiade Investments, a South African merchant bank. The Banking Group produced high margins with lower levels of risk in favorable environments. Most of its costs were personnel related. These costs were tied to the group’s performance through year-end bonuses; if performance fell, bonuses and cost fell. Merchant Banking offered more risk as DLJ put in its own capital with its limited partners in purchasing securities in companies.
Capital Market Group:
The Capital Market Group offered trading, research, and sales services in fixed-income and equity securities. In these markets, DLJ focused on serving its clients and had not undertaken a large amount of proprietary trading. The Institutional Equities division covered major U.S. institutions with 100 traders and salespeople. For listed equities, the company acted as principal and agent, often taking long and short positions to help clients quickly gain liquidity. Most trades were made in blocks of 10,000 shares or more. DLJ also made markets in approximately 350 securities traded on the National Association of Securities Automated Quotation System (NASDAQ). The division primarily made markets for stocks of companies that had been underwritten by Investment Banking or covered by the research department. The Taxable Fixed Income division concentrated on serving institutional investors in high-yield corporate, investment-grade corporate, U.S.-government (as a primary dealer), and mortgage backed securities. The division employed 450 professionals-including 72 traders, 137 institutional salespeople, and 52 fixed income research analysts. By the Equity Derivatives divisions, the company provided a limited number of derivative products, mostly equity and index options. Most of its products were tailored to meet a client’s specific needs, in contrast to taking on trading risk or generating large volumes of generic derivatives. The Equity Derivatives division also participated in trading and distributing convertible securities. Sprout, one of the oldest and largest venture-capital operations, resided in the Capital Markets group. Sprout managed over $1 billion in capital, focusing on investments in business services, computer graphics and peripherals, health care, leveraged transactions, office automation, retailing, and telecommunications. The professionals in Sprout worked closely with those in research and Investment Banking.
DLJ earned the moniker The House that Research Built, referring to DLJ’s founding as a research firm and continued strength in providing high quality research. To serve clients, the Capital Markets Group held large inventories of stocks and bonds. While these positions were hedged to varying extents, their values changed with changes in the overall market. Under U.S. generally accepted accounting principles (GAAP), DLJ had to continuously mark its positions to market, creating losses and gains that appeared on the income statement. It financed much of its inventory through repurchase agreements with other financial institutions. These lenders would carefully watch DLJ and its financial condition in determining the rate they charged DLJ, which in turn would impact DLJ’s overall profitability.
Financial Services Group:
The Financial Services Group (FSG) provided a broad array of services targeted to individual investors and the financial intermediaries who represented them. Approximately 1,000 professionals worked in FSG. The Pershing Division offered correspondent brokerage services, clearing transactions for over 500 U.S. brokerage firms and lending clients money for margin trades. Pershing’s clients collectively managed over 1 million accounts with assets of $100 billion. In clearing trades for others, Pershing accounted for approximately 10 percent of the daily volume on the New York Stock Exchange. Pershing’s Financial Network was the largest on-line discount broker in the United States, providing trading through several on -line services, like American On-Line (AOL), PRODIGY, and Reuters Money Network. Between 1990 and 1994, the average daily volume traded through this service soared at an annual rate of 128 percent. The Investment Services Group (ISG) served high-net-worth investors and smaller institutions. ISG gave its clients access to DLJ’s research and sales and trading capabilities. DLJ purchased Wood, Struthers & Winthrop in 1977 to provide investment management and trust services to its clients. Wood, Struthers & Winthrop managed $205 billion, and operated three U.S. equity funds and two fixed-income funds. DLJ earned interest income by lending to customers to purchase securities and by holding higher yielding inventory funded with lower cost capital. In this capacity, DLJ made money much like a
bank did, on the spread between the rates at which in lent or invested money and the rate at which it borrowed money. In 1994, DLJ made $288.1 million in net interest income. Separated to the above three group, DLJ owned Autranet, a distributor of independent research. Approximately 450 independent research firms, who had no affiliation with underwriters, supplied Autranet with research. Autranet distributed the research to over 400 institutions.
On the strength and opportunity side of DLJ, there are several issues to be considered, which are listed
below:
Firm's growth has outpaced most of the industry over the last five years It has a successful strategy of competing in several higher margin businesses like IPO, high-
yield underwriting and trading, and merchant banking The revenue and profits have grown consistently with the increased market share From 1990 to 1994 revenues have increased at a compound average rate of 21.9 percent During this period net income has also increased at 75.4 percent generating an average
annual pretax return on common equity of 33.6 percent The three operating groups have expanded roughly at equal rates The investors will have opportunity to share in DLJ's success with the new public offering Many securities-industry specialists called DLJ one of the most desirable franchise in Wall
Street DLJ has not committed its large amount of resources to the lower margin businesses of
underwriting and trading of investment grade debt and municipal bond
On the other side of weaknesses and threats, DLJ has the following issues to face:
It would have to increasingly compete with firms like Goldman Sachs, Merrill Lynch and Morgan Stanley to continue gaining market share
DLJ does not have sufficient operations overseas or large recurring-fee operations Its profits were tied to trading activity by its client It does not have sources of steady revenue stream from asset management activity Critics were not sure whether DLJ would find new business lines that would maintain its
growth rates and profit margins Increasingly competitive high yield market and lack of diversification may hinder post-IPO
profit Employee retention by DLJ may face public scrutiny The stock offering by DLJ may that be perceived as the owners' decision of thinking it as a
good time to sell the firm and thus become unattractive to the investors
0
0.1
0.2
0.3
0.4
Average 1991 Average 1992 Average 1993 Average 1994
Certainly, investors would count on receiving dividends from DLJ. During the past five years
investors in other brokerage stocks had fared well, as dividends from these firms had grown
considerably and stock prices had increased. Beginning in the first quarter of 1996, DLJ's board of
directors planned on instituting a $0.l25 quarterly dividend per share, or $0.50 at an annual rate.
Securities-industry analyst Guy Moszkowski of Sanford C. Bernstein & Company offered a separate
valuation technique. He stated that he had observed a historical relationship between the
current return on equity and the price-to-book ratio for capital markets firms like DLJ.
Moszkowski noted that these firms often possessed a price-to-book ratio of 10 times the current
return on equity in this part of the earnings cycle.
An important part of the IPO process is the estimation of the value of the firm. This, together with the size of the IPO, will determine the value per share for the firm. After the intrinsic value per share is estimated, the issuer and the underwriter will agree on the offering price per share. In most cases, the price will be set below its value so that there is a higher likelihood of successfully selling the shares. Investors prefer to purchase shares in an IPO under the anticipation that there will be a considerable capital gain in the aftermath. A standard approach to firm valuation is the DCF valuation. In this approach, we discount expected free cash flows at a rate that reflects the firm’s risk (typically the firm’s cost of capital). This approach is tedious and numerous issues must be addressed throughout the process. These include the estimation of expected free cash flows, the estimation of the tax rate to be used, the estimation of the firm’s future reinvestment needs, the estimation of the discount rate, the consideration of the value of cash and non-operating assets (such as marketable securities the firm may own), the impact of warrants, management options and convertible bonds on firm value, and the impact of the IPO on the control of the current owners.
In firms like DLJ, it may simply be very difficult to obtain good estimates of expected cash flows due to the fact that these are affected by several factors that are beyond the control of the company (such as the economic cycle, interest rates, etc.). We can think of the free cash flows as including the sum of the cash flows to the firm’s shareholders and bondholders. One approach is to use the firm’s after-tax earnings after having subtracted reinvestment expenses. For example, the free cash flow to the firm can be given by: FCFF = EBIT (1-tax rate) – (capital spending – depreciation) – change in noncash working capital Accounting for the firm’s reinvestment needs is important because these investments will impact the firm’s current and future growth and, thus, its operating cash flows. In any case, after we have derived the value of the firm through the DCF approach, we can obtain the value of the firm’s shares by discounting the expected cash flows to shareholders: FCFE = FCFF – debt payments + new debt issued It is notable that, in addition to subtracting the cash flows to creditors from the free cash flows to
the firm we must also add any cash inflows from new debt that the firm issues. These are also part
of the cash flows to shareholders.
If we have forecasts of free cash flows for a future period of, let’s say, four to five years, we can use
them to perform a DCF valuation. In this case, we would discount these cash flows at the firm’s cost
of capital and add to them the firm’s terminal value. This value is calculated by assuming that free
cash flows beyond our forecasting horizon will continue to grow at a constant rate. This rate (g)
could be equal to the rate of sales growth that was assumed in the forecasting. Note, though, that
the sales growth rate cannot realistically exceed the nominal rate of growth of the economy (GDP)
in the long run. In the US, this has been around 8%. If there is information about both the sales
growth rate during the forecast period and the growth rate of nominal GDP, then we must compare
the two to ensure that we do not use a rate (g) higher than the nominal GDP rate. Thus, we can use a
constant-growth-valuation model and calculate the terminal value as follows:
TV = (FCFF(1+g))/(WACC-g)
More typically, investment banks may obtain an estimate of a firm’s value and the value of its
shares though a relative valuation approach. In this approach a firm’s value or the value of its
shares is obtained by looking at how similar companies and their shares are currently valued in the
market. This approach uses various multiples, such as earnings multiples, book value multiples, and
revenue multiples. For example, commonly used ratios are:
After considering all the IPO valuation techniques, the recommended price of the DLJ IPO should be
$26 per shares.
Employee Options:
In conjunction with the offering, DLJ offered approximately 500 employees the opportunity to exchange $100 millions of their interests in compensation plans for approximately 5.2 million shares of restricted stock. This stock was subject to vesting and forfeiture in certain circumstances. Additionally, these employees could exchange $55.7 millions of future compensation under these plans for options to purchase approximately 7.2 million shares of DLJ stock at the offering price. Employees who opted to not exchange their interests would receive cash instead. The number of shares and options issued would depend on the final offering price. Their average offered price would be $23.
Employees' Options:
Total Value for 500 Employees: 100,000,000
Number of Stocks offered: 5,200,000.00
Average Price Per Stock: 19.23
Additional Value for 500 Employees: 55,700,000.00
Offer Price of Stock: 26.71
Number of Stocks Available: 2,085,477.31
Total Number of Shares to the Employees: 7,285,477.31