Case Study 2: PPP Acquisition of Anderson’s

Late one afternoon in November 1987, Tom Robertson, sole owner and CEO of California Plant Protection (PPP), sat in his office
staring at the financing plan. Tom was trying to decide whether or not he should increase his $85 million bid to purchase Anderson’s
- the legendary security guard firm—from its current owner, American Brands. On the previous day, Tom had been told by Morgan
Stanley, American Brands’ investment banker that his bid of $85 million had been rejected and that nothing less than $100 million
would be accepted. While Tom was elated at still being in the deal, he had a problem. PPP’s board of directors had reluctantly
approved the earlier $85 million bid and were sure to balk at a $100 million bid. Tom desperately wanted to buy Anderson’s but was
not sure how much it was worth or how to finance it. Tom knew he had to act now or miss this unprecedented growth opportunity and
probably his last chance to be one of the industry’s biggest players.

The Security Guard Industry

The security guard industry had two segments: (1) proprietary guards and (2) contract guards. While both types of guards performed
similar services, a proprietary guard was an employee on the payroll of a non-security firm. Contract guards were “rented” from
specialist suppliers like Anderson’s, PPP, Wackenhut, and Baker Industries. The historical growth of the contract guard segment of
the industry was due in part to companies concluding that they gained operating flexibility by contracting out their security needs as
opposed to managing their own security operations. By late 1987, security guard services were a $10 billion industry growing at 6%
a year. But the industry was also mature, fragmented and price competitive. As a result, there was an ongoing trend toward
consolidation at the expense of smaller local guard companies whose employees were often imperfectly screened and poorly trained.

Anderson’s
The security guard industry began in 1850 when Allan Anderson founded Anderson’s. The firm gained fame in the nineteenth century
with its pursuit of such outlaws as Butch Cassidy and the Sundance Kid. Anderson ran his firm until he died in 1884. The company
was then headed by Anderson family until 1967 when the family reign ended with the death of Robert Anderson. American Brands,
the $5 billion consumer goods company purchased Anderson’s for $162 million in 1982. American Brands made the acquisition in
order to expand the service side of its business and because it saw the Anderson’s brand name as a great addition to “a company of
great brand names.” The Anderson family sold the company because they felt the industry was becoming extremely price-competitive
and therefore the company needed a strong parent to compete and grow. In 1987 Anderson’s was among the largest security guard
firms in the United States, with sales over $400 million, 150 offices in the US, Canada, and the UK, and a particular strength in the
eastern United States. Exhibit 1 gives selected financial data for Anderson’s.

California Plant Protection

When Tom bought PPP in 1963, the firm had 18 employees and revenues of $163,000. By 1987, Tom had built PPP into a $250 million
security guard company with 20,000 employees and 125 offices in 38 states and Canada. Exhibit 2 gives selected financial data for
PPP. Tom built PPP with his consummate marketing skills and the strategy of differentiating the firm with employee screening and
continual training. PPP’s expansion was aided by the explosive growth of California’s economy and because the bigger, more
established East Coast security guard firms had ignored the West Coast. While Tom was the sole owner of PPP, he had a board of
directors that he used as advisors. The board had three members: Albert Berger, James Hall, and Gerald Murphy.

PPP’s Acquisition of Anderson’s

Tom wanted to buy Anderson’s for several reasons. First, he had always had the goal of creating the largest firm in the security guard
industry, and the acquisition of Anderson’s would put him in a virtual tie with Baker Industries - the largest provider of contract guard
services. Secondly, Tom had been convinced for some time that American Brands was mismanaging Anderson’s and destroying a great
brand name with its pricing strategy. In October 1987, American Brands announced it had decided to sell Anderson’s because the
security guard firm no longer fit into their business strategy. Morgan Stanley, an investment bank, was to represent American Brands
in the sale and the bidding promised to be hotly contested. A task force of senior managers was quickly formed to prepare PPP’s bid.
The task force believed there were three ways PPP could create value by acquiring Anderson’s. The most obvious source of value
would come from consolidating the operations of PPP and Anderson’s by eliminating common overhead expenses such as corporate
headquarters, support staff, and redundant offices. Second, significant improvements could be made in the management of Anderson’s
net working capital. The third source of value, and possibly a unique insight by the task force was the Anderson’s name. They believed
that, while the industry was highly price-competitive, the services of both Anderson’s and PPP could be successfully marketed under
the Anderson’s brand name at a premium price.

Specifically, the task force felt that even though higher prices could lead to reduced revenue, the resulting improvement in gross profit
margins, due to the marketability of the Anderson’s name, would be sufficient to result in greater gross profits. For example, the task

4
force believed that a premium price strategy would definitely reduce Anderson’s revenues since that firm had acquired a significant
amount of business since 1985 using a low-price/high market-share strategy.

The new premium pricing strategy would result in Anderson’s revenues shrinking gradually from the 1987 (t = 0) figure of $408.3
million to 90%, 80%, and 70% of the revenues in 1987 level in the following three years (1988, 1989, and 1990, respectively). For the
next two years, revenues will grow at an annual rate of 5%. The task force assumed a steady state growth of 3% thereafter. But the
task force was uncertain in its estimate of the impact of the new strategy on profitability. They expected that the new pricing strategy
would improve Anderson’s gross profit margins from 6.52% (last year 1987) to 8.0% in 1988 and 1989, and 9.0% thereafter. The task
force further expected the new strategy to produce higher margins for PPP, increasing the projected operating profit from PPP’s own
business by $1.2 million in 1989, $1.5 million in 1990, $2.0 million in 1991, and $3 million in 1992. This increase in PPP’s projected
operating profit would be over and above that level that would otherwise have been anticipated in those years, and was expected to
grow at 5% a year, in line with sales, beyond 1992. (Exhibit 3 gives a five-year forecast of PPP’s net income and cash flow assuming
Anderson’s is not acquired).

The task force was confident that, as a result of eliminating common overhead, Anderson’s operating expenses, as a percentage of
sales, could be reduced to 6% in 1988, 5.9% in 1989, and 5.8% in 1990 and beyond. The task force was also confident that Anderson’s
Net Property, Plant, and Equipment (NPPE) could be reduced to 4% of sales and maintained at that percentage relationship for the
foreseeable future. NPPE of Anderson last year (1987) was at $17.6 million. The annual depreciation expense was negligible. The task
force expected that Anderson’s net working capital, as a percentage of sales, could be reduced to 8.6% in 1988, 7.4% in 1989, and
6.2% thereafter.

In addition to current financial market conditions, the financial analyst (Jerry) in the task force took special notice of Wackenhut, the
only publicly traded security guard firm which could be used as a proxy (pure play) to estimate Anderson’s cost of capital (WACC).
Anderson and Wackenhut had similarities on multiple counts: same business and business risk; financial risk will also converge with
similar debt level. Hence Jerry suggested since the capital structure of Anderson would be very similar to Wackenhut, we should use
Wackenhut’s market debt and stock data to estimate the weights as well as cost of each component of capital (See Exhibits 4 and 5).
Wackenhut’s interest-bearing debt was mostly in the form of 5-year maturity bonds with a coupon rate of 5% paid semi-annually and
currently trading at $1,022. The bonds maturity value was $1,000. Jerry thought the yield-to-maturity of the Wackenhut’s bonds would
provide a reasonable estimate of cost of debt for Anderson. The bonds were classified in the ‘A’ category by Moody’s.

Tom did not receive a response to his bid of $85 million for two weeks. Tom knew another firm had bid more than PPP and that Morgan
Stanley was negotiating with that firm. When Morgan Stanley finally called and told Tom his $85 million bid was too low, and that
nothing less than $100 million would be accepted, Tom was elated that he had another chance to buy Anderson’s. But he suspected the
reason Morgan Stanley had finally called him was that the other buyer had been unable to finance their higher bid. Tom sat in his office
and prepared to make the biggest decision of his career. As an entrepreneur and an experienced security guard executive, Tom was
sure Anderson’s was a good buy. How could he justify a $100 million bid for Anderson, particularly in light of his earlier bid of $85
million? And how could he convince the board members for a $100 million bid?

Exhibit 1: Selected Anderson’s Financial Data (in $millions)

1983 1984 1985 1986 1987 (E)

Income from services $296.4 $307.7 $312.4 $367.7 $408.3

Cost of services provided 264.5 275.4 286.3 342.5 381.7
Gross Profit 31.9 32.3 26.1 25.2 26.6
Operating expenses 15.5 17.1 24.9 24.5 27.0
Operating Profit $ 16.4 $ 15.2 $ 1.2 $ 0.7 $ -0.4
Balance Sheet (Selected Data)
Cash $ 3.8 $ 2.7 $ 2.3 $ 0.0 $ 1.1
Accounts receivable, net 48.7 51.0 55.0 62.8 67.3
Other current assets 0.0 0.0 0.6 0.6 1.0
Total Current Assets 52.5 53.7 57.9 $ 63.4 69.4
Net property, plant, and equipment 11.0 11.3 13.1 15.1 17.6
Total Assets $ 63.5 $ 65.0 $ 71.0 $ 78.5 $ 87.0
Accounts payable $ 0.4 $ 1.0 $ 2.4 $ 4.7 $ 3.4
Accruals & other current liabilities 29.3 29.1 25.6 22.6 27.2
Total Current Liabilities $ 29.7 $ 30.1 $ 28.0 $ 27.3 $ 30.6

5
 Exhibit 2: Selected PPP Financial Data (in $millions)
Year Ending Year Ending
12/31/86 12/31/87(E)

Income from services $243.6 $251.5

Cost of services provided 221.9 229.4
Gross Profit 21.7 22.1
Operating expenses 16.1 14.5
Operating Profit 5.6 7.6
Interest expense, net 0.7 0.4
Amortization of goodwill 0.3 0.3
Income Before Tax 4.6 6.9
Taxes 2.4 2.9
Net Income $ 2.2 $ 4.0
Balance Sheet
Cash $ 1.0 $ 1.2
Accounts receivable, net 33.8 34.0
Other current assets 8.3 13.4
Total Current Assets $ 43.1 $ 48.6
Notes receivable $ 2.4 $ 2.4
Goodwill 1.8 1.5
Net property, plant, and equipment 1.8 2.6
Total Assets 49.1 55.1
Notes payable $ 1.0 $ 1.6
Current portion of long-term debt 1.0 1.1
Accounts payable 2.7 2.1
Accrued expenses and other current liabilities 26.5 30.4
Total Current Liabilities $ 31.2 $ 35.2
Long-term debt, less current portion $ 3.1 $ 2.0
Shareholders’ equity 14.7 18.0
Total Liabilities and Equities $ 49.0 $ 55.2

Exhibit 3: Five-year Forecast of PPP Income and Cash Flow (in $ millions)a
1988 1989 1990 1991 1992

Net Income: $4.1 $4.3 $4.6 $4.8 $5.0

Plus amortization of goodwill 0.3 0.3 0.3 0.3 0.3
Less change in net property, plant, and 0.1 0.1 0.1 0.1 0.1
equipment
Less change in net working capital 1.2 0.7 0.7 0.7 0.8
Less amortization of long-term debt 1.1 1.0 1.0 0.0 0.0
Total Cash Flow 2.0 2.8 3.1 4.3 4.4
aUnder the assumption PPP does not acquire Anderson’s.

Exhibit 4: Wackenhut 1987 Financial Data

Wackenhut Corporation (provides guard and investigative services to industry and government)

Sales ($ million) 382.0 Interest Bearing Debt 46.8*

(million)
Earnings ($ million) 5.7 Assets ($ million) 130.4
Earnings per share $1.47 Stock price ($) 18.00
Book equity ($ million) 39.7 Beta 1.45
Shares outstanding (millions) 3.9 Current corp. tax rate 40%
*Book value of debt is approximately equal to its market value.

6
 Exhibit 5: Selected Capital Market Information as of November 1987

Market Interest Rates

US Treasury Bonds Yields_ ` Corporate Bond Yields
Maturity Yield Rating Yield
1 year 0.47% Aaa 3.97%
2 year 0.67% Aa 4.16%
3 year 0.78% A 4.50%
4 year 0.98% Baa 5.46%
5 year 1.16% Ba 6.10%
10 year 2.75% B 6.90%

 Market Risk Premium (MRP) = 7%

 Anderson’s Corporate Tax Rate = 40%
______________________________________________________