Case 42

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Introduction
Sierra Capital Partners is an investment company in Albuquerque, New Mexico. They were organized in 1974 as a hedge fund, and quickly grew over the years with great success in private equity investments. Sierra focused primarily on the life sciences sector. In the early 2000’s, Sierra was burned by many young firms’ new discoveries that failed to work out. Their new motto for evaluating investments became, “NRDO: no research, development only.”

Arcadian Microarray Technologies was founded in 2003 by research scientists, some of whom were previously involved in a very successful project called the Human Genome Project. Those scientists helped find links between variations in a person’s genetic code and their predisposition to disease. This was a major breakthrough in the Human DNA research area. Their business consisted of two segments DNA microarrays and Human Therapeutics. Arcadians’ management group believed that applications for their DNA microarray technology would be very demanding and would pay off quickly. By the year 2013, they believed their revenues would top $1 billion.

Sierra Capital Partners were considering a deal in which they would purchase 60% equity interest in Arcadian for $40 million dollars. Arcadian had drawn up the details regarding the deal, and Sierra’s managing director Rodney Chu had to analyze the deal and conclude what terms would be the most profitable for $1 billion.

Sierra Capital Partners were considering a deal in which they would purchase 60% equity interest in Arcadian for $40 million dollars. Arcadian had drawn up the details regarding the deal, and Sierra’s managing director Rodney Chu had to analyze the deal and conclude what terms would be the most profitable for Sierra. The money Arcadian received from Sierra would be used for further financing of the firm’s growth. Chu’s initial analysis involved financial forecasting of equity cash flows. His final steps would be to estimate the terminal value for the company and to discount the cash flows and terminal values back to the present value. He requested help with his analysis from a new associate with Sierra Capital, Paige Simon.

Rodney Chu wasn’t quite as optimistic about Arcadian’s dramatic growth. He was concerned that the FDA approval process for their DNA microarray’s segment would slow down the commercialization of Arcadian’s new products. He forecasted the free cash flows to be identical to the equity cash flows because he assumed the Arcadian would not be financing itself with debt. In order to assess them better, Chu looked at two publically held companies in the field of molecular diagnostics.

First, He looked at Affymetrix, Inc. This company was the world’s leading provider of gene expression technology. Its product Gene Chip was used for molecular biology. The firm’s stats are listed in a chart below: Beta1.3

P/E ratio50.09
Price/book8.56
Price/sales7.49
Price/FCF97.50
Debt Outstanding$120 mil.
2002 Sales$290 mil.
2003 Sales$301 mil.
2004 Sales$346 mil.
2005 Sales$380 mil.
DividendsNone

The second company Chu looked at was Illumina, Inc. Their BeadArray technology had made them a very successful technology company in the current market. Chu was not able to look at the firm’s price/earnings ratio because of their negative historical and expected earnings, but he was able to analyze their following stats: Trade compared to BV8.46 times

Trade compared to Sales8.82 times
Revenues in 2002$10 mil.
Revenues in 2003$28 mil.
Revenues in 2004$51 mil.
Expected Revenues in 2005$73 mil.

Chu’s main concern was the difficulty in FDA approval, the flooding of the field with entrepreneurial research scientists. Before preparing his amounts for negotiations, Chu began using terminal value for Arcadian as part of his determining data. Terminal Value is the lump sum of cash flow at the end of a stream of cash flows. It represents either the proceeds to the investor from the...
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