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Caught in the MiddleDe-risking 2 Contract Terms you

Normally Ignore

Presented by:

Eric Bartsch

Stoel Rives, LLP

June 12, 2014 • Minneapolis, MN

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Why Contract Terms MatterAcme, Inc. QuarterTypical QuarterGrowing Business - Long Term Contracts

Sales 1 mm units x $3/unit 3,000,000 COGS 1 mm units x $2/unit 2,000,000

Gross Margin 1,000,000

SG&A 800,000

EBITDA 200,000

Taxes 30% 60,000

Net Income 140,000

Stock Market Year

Simplified Valuation Analysis

Annualized Net Income 560,000

P/E Ratio 17

Implied Return (1/PE) 5.88%

Market Capitalization 9,520,000

Earnings per Share (EPS) $0.56/sh

Shares Outstanding 1,000,000

Price Per Share $ 9.52

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Problem: 5¢ Unit ChargeAcme, Inc. Quarter$0.05/Unit ChargeGrowing Business - Long Term Contracts

Sales 1 mm units x $3/unit 3,000,000 COGS 1 mm units x $2.05/unit 2,050,000

Gross Margin 950,000

SG&A 800,000

EBITDA 150,000

Taxes 30% 45,000

Net Income 105,000

Stock Market Year

Simplified Valuation Analysis

Annualized Net Income 420,000

P/E Ratio 17

Implied Return (1/PE) 5.88%

Market Capitalization 7,140,000

Earnings per Share (EPS) $0.42/sh

Shares Outstanding 1,000,000

Price Per Share $ 7.14

25% Drop!

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Amplification Effect

Gross Margin w/out Charge: 4,000,000 Gross Margin w/Charge: 3,800,000 Drop in Gross Margin: 200,000 5%Drop in Net Income: 140,000 25%

Stock Price w/out Charge: 9.52 Stock Price w/Charge: 7.14 Drop in Stock Value: $ 2.38 25%

What Causes Amplification?1. Larger SG&A as % of GM amplifies loss translation2. 1:1 Translation if Stable PE3. More amplification if PE changes

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Effect on Value – PE & EPS

Net Income Falls

PE Stable or Declines

EPS Declines

Both Doubles Downward Trend

Net Income Increases

PE Stable or Increases

EPS Increases

Both Doubles Upward Trend

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Example -TGT

27% Drop

Target Corp. Aug-13 May-14

Earnings Guidance

EPS: $3.85 - 4.15/sh $3.60-3.90/sh$4.00/sh Avg. $3.75/sh Avg.

Net Income 2,532,000,000 2,373,750,000

P/E Ratio (ttm/forward tm) 18.8 14.6

Implied Investor ROI 5.32% 6.85%

Market Capitalization 47,550,960,000 34,656,750,000

Shares Outstanding 633,000,000 633,000,000

Price Per Share $ 75.12 $ 55.00

6% Drop

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Double Amplification

Earnings/SH Change in PE13-Aug $ 4.00 18.814-May $ 3.75 14.6

Difference $ 0.25 4.20

Original ROI 5.32%Multiply Change in PE by Share Impact

Value Loss $ 4.70 4.20 $ 4.70 x

Starting Price 75.12 19.74 Impact on Sh ValueEnding Price 55Difference 20.12

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Risk Term #1: Shipping

• UCC 2-503: Tender of Delivery Requires Seller to put and hold conforming goods at the buyer’s disposition and give the buyer any notification reasonably necessary to enable him to take delivery.

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Seller Ships

• UCC 2-504: Where the seller is required or authorized to send the goods to the buyer. . .then, unless otherwise agreed, he must: (a) put the goods in the possession of a carrier and [contract for their transport to buyer].

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FOB: Dock or Destination

• UCC 2-319: FOB is a delivery term. “Shipping Point” means default 2-504. “Destination” means tender at Buyer.

Buyer Seller

Buyer’s

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Economic Consequence

Gasoline CostsJan-98 – Jan-09

“f.o.b Buyer’s Montreal Warehouse”

Margin w/out Charge: 4,000,000 Margin w/Charge: 3,800,000 Drop in Gross Margin: 200,000 5%Drop in Net Income: 140,000 25%

Stock Price b/4 Charge: 9.52 Stock Price w/Charge: 7.14 Drop in Stock Value: $ 2.38 25%

5 cent/case fuel surcharge

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Better Language

• UCC presumes that tender and title change is at place of shipment (2-503, 2-504, 2-401 (Passing of Title))

• De-Risking Language I use:

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Sale of Goods – Trade Credit

• A “sale” consists in the passing of title from the seller to the buyer for a price.

• Title can pass before you get the cash.• When that happens, you have extended a

loan called trade credit.

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Trade Credit

• Time between shipment and payment is the credit period.– “Credit period” is when the seller becomes a

lender to the buyer.– Unsecured trade credit riskiest form of debt.– Credit period = No goods & no cash.– If 33% Gross Margin, risk $66 to earn $33– Or, need 3 sales to recoup loss of one

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Risk #2: Credit LimitQuarter Sales: $3,000,000

Big Customer: 10% Sales

Big Customer: $ 300,000 33% Margin

Credit Policy: $ 100,000 Per MonthStop Shipping Aged Past 60 Days

Current 0 - 30 30 - 60 60 - 90

$ - $ 100,000 $ 100,000 $ 100,000

$300,000 at risk

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Bankruptcy

Big Customer, Inc.

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No Security Interest

• Trade Credit is Unsecured Debt• File a Claim as an Unsecured Creditor• If no likelihood of being paid, write off

COGS, or $200,000.Budget Net Income: $ 560,000

Write-Down: $ (200,000)

Actual Net Income: $ 360,000 -36%

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Financial Consequence

• Bankruptcy by one big customer threatens systemic risk.

• Risk forces down P/E; increases investor’s demand for a higher return

• FASB requires bad debt write-down plus examination of your allowance accrual for bad debt

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PMSI Solution

• Take a Lien in Big Customer’s Inventory• May need to negotiate with Lender• UCC 9-103: “A security interest in goods is

a purchase-money security interest. . .to the extent that the goods are purchase money collateral with respect to the security interest.”

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Purchase Money Collateral

Seller BuyerPromise to Pay & Credit Agr.

Goods

Secretary of StateUCC - 1

LenderPMSI Notice

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UCC-1 Perfection

• A security interest must both attach and be perfected.– Attachment happens with a signed Credit

Application & goods received by Debtor.– Perfection happens with the filing of a UCC-1

and mailing of Pre-Lien Notice before ship

• The UCC-1 must be filed in the state where the corp. debtor is organized.

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PMSI Pre-Lien Notice

Re: Inventory of ___________ (the “Debtor”)Dear Sir or Madam:

We note your financing statement first filed on ____ __, 20____, with the office of the _________________ against the Debtor (the “Financing Statement”). Based upon the contents of the Financing Statement, it appears that you may assert a security interest in the Debtor’s inventory.Please be advised that we have or expect to acquire a purchase-money security interest in the following property: All inventory acquired by Debtor from [Seller] (“Secured Party”), including all proceeds thereof, pursuant to the terms of that certain Credit Application between the Debtor and Secured Party.Sincerely,[Seller Entity]By:___________________________________

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Credit Agreement

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UCC - 1

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Conclusion

eabartsch@stoel.com