On the basis of our analysis set forth below, we believe that Infinity Carpets was not a viable LBO candidate. We have answered this question analyzing the various criteria typically looked in a possible LBO scenario, where 1 means low risk and 10 means high risk.
Cyclicality/volatility7Strong dependence on housing market even though good record during recession (p. 2, paragraph 4). Volatility due to exposure to a volatile middle eastern market (p. 5, paragraph 5) due to the Gulf War. Capital Intensity4Barriers to entry are relatively low in terms capital. Just to get an idea, we have calculated the total assets/sales ratio for Intel for 2007, which gives a ratio of 1.47. Intel is considered to be in a very capital intensive business. Doing the same exercise for Infinity yields 0.86. This gives the impression that relatively speaking this is not a capital intensive business However, given that Infinity needs extra investment to cut costs and expand cut-to-order distribution, we decided to give this a 4. Technological riskiness3Essentially, this industry is not rocket science. There are some complexities but there is little indication that Infinity´s technology and processes will become obsolete in the following years. Strong, protected margins7Margins are relatively strong (Exhibit 1); however, we believe Infinity will have problems protecting them due to the large number of competitors who compete on prices. Growth rate (mature)7Infinity is in a mature market so growth is not expected to be very high. Our calculation yields a five-year CAGR of 39%. Given that LBO firms are looking for companies in mature markets, this item on the checklist might be a problem. Quality Assets9The equipment has a long useful life. However, the equipment does not seem to have much value for third parties given that these types of assets were sold by other companies for just 10% during liquidation. Cash flow3Since interest cover is a good indication of strong cash flow, we looked at Exhibit 1, last line item. Clearly, according to those figures, Infinity was a viable LBO candidate. Track record3Average EBIT margin of 5% is a good indication of a strong track record. Management4According to the data in the case, the management had a strong track record prior to the LBO. However, the issues that have surfaced since the LBO show that the team was not as strong as initially thought. A thorough due diligence focused on the management team itself (common in the private equity and venture capital industry) may have identified these issues. Exit strategy2Given that the case gives an indication of a consolidating industry, we believe that at the time of the LBO all signs pointed towards very strong exit potential. An exit through trade sale would have seemed very plausible prior to the post-LBO problems.
The list set forth above illustrates that while the position in 1987 was strong with respect to a number of items, there are also four risk factors which should have been taken into account. The combination of cyclicality with unprotected margins means that with the addition of a large amount of debt through LBO, the company’s operating cash flow becomes extremely vulnerable to economic conditions in the first post-LBO years. We also believe that the very large and consistent growth (CAGR of 39%) sounds good but it may conflict with the obligations to service large level of debt in a post-LBO scenario. A CAGR of 39% can certainly not be described as mature and needs to be financed. To all these adds the poor quality of the assets. We, therefore, believe Infinity was not a suitable LBO candidate.
I.QUESTION 2: MARKET AND OPERATING PROBLEMS
•No branding, in an industry where branding has become an important factor; •Image of polyester carpets suffered from past memories; this negative factor is somehow compensated by low...