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Thermo Electron Corporation

Thermo Electron Corporation. Cash Distribution Analysis. Thermo Electron Corporation. Craig Billings Tony Curry David Rice Zach Strobel Assisted by Ashok Vishnubhakta Doug Wilson. Team Members:. Our Recommendation. Initiate regular dividend combined with open market repurchase

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Thermo Electron Corporation

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  1. Thermo Electron Corporation Cash Distribution Analysis

  2. Thermo Electron Corporation Craig Billings Tony Curry David Rice Zach Strobel Assisted by Ashok Vishnubhakta Doug Wilson Team Members:

  3. Our Recommendation Initiate regular dividend combined with open market repurchase • Annual dividend of $50MM • $0.30 per share (based on 162MM sh OS) • $500MM 3 year open market repurchase • At or below $25.50 per share (3Q 2003 valuation) • Represents 3 years of projected FCF net of the recommended annual dividend

  4. Agenda • Framework for deciding on the best method of cash distribution • Cash distribution recommendation • Additional considerations

  5. I. Framework for Deciding on the Best Method of Cash Distribution • Recent trends in cash distribution • Financial policy framework • Company characteristics • Types of cash distribution methods • Tax implications for investors

  6. Recent Trends in Cash Distribution 17 S&P 500 companies have initiated dividends in 2003 • vs. 4 in 2002 • 16 are growth stocks According to Morningstarmetrics Average Results • Average market cap prior to initiation: $15B • Annual dividend size: $147MM - $0.38 per share • Announcement effect on share price: 0.6% • Company S&P adjusted return to date: 21.3% Source: S&P Addl. Info in appendix slides 44-50

  7. Recent Trends in Cash Distribution 13 S&P 500 companies have initiated or resumed share repurchases in 2003 to date • All open market repurchases • 10 are growth stocks According to Morningstarmetrics Average Results • Average market cap prior to initiation: $12.6B • Announced size $500MM • Completed size to date: $71MM • Announcement effect on share price: (0.2%) • Company S&P adjusted return to date: 11.1% Source: Compustat Addl. Info in appendix slides 44-51

  8. Recent Trends in Cash Distribution 5 S&P 500 companies have initiated dividends combined with a share repurchase in 2003 • 4 are growth stocks According to Morningstarmetrics Average Results • Annual dividend size $99MM - $0.40 per share • Announced repurchase size $600MM • Announcement effect on share price: (1.3%) • Company S&P adjusted return to date: 26.3% Source: S&P, Compustat Addl. Info in appendix slides 44-51

  9. I. Framework for Deciding on the Best Method of Cash Distribution • Recent trends in cash distribution • Financial policy framework • Company characteristics • Types of cash distribution methods • Tax implications for investors

  10. Financial Policy Framework Cash Generation WACC - Organic Investment = Free Cash Flow M&A Investment Debt Financing ( + / - ) Equity Financing ( + / - ) Dividend Decision

  11. Cash Generation Cash flow from operations expected to be positive for the foreseeable future Source: ACFIN model

  12. Cost of Capital Considerations Current WACC Credit Rating: BBB • Increase leverage- • Move towards minimal WACC • BBB credit rating Source: ACFIN model based on 3Q 2003

  13. Organic Investment • Difficult to evaluate incremental investment opportunities externally • Company is struggling to earn cost of capital – ROIC less than WACC • Projected single-digit revenue growth • Trend in M/B ratio declining Limited internal reinvestment opportunities Source: analyst reports, ACFIN model

  14. Free Cash Flow • Free cash flow expected to be positive for the foreseeable future Free cash flow is either used for M&A, debt reduction, share repurchase, dividends OR accumulates on the balance sheet Source: ACFIN model

  15. M&A Investment Uncertain Economic Benefit • Unknown availability of future targets at attractive prices • In general, most M&A transactions do not add value to the acquirer • Thermo Electron’s M&A track record has been mixed

  16. M&A Investment Analysis of Thermo Electron’s M&A activity 1998-2003 * Pre and Post Announcement Date Addl. info in appendix slides 52-53

  17. Debt Financing (+/-) Increase debt (+ cash) Preferable to debt reduction, but raises other issues • Some room to increase leverage ($485MM) and maintain investment-grade credit rating • Moves towards minimum WACC • Contributes additional cash for distribution to shareholders • Reduction of debt (- cash) • Not desirable • Moves company farther away from minimal WACC • Leasing strategy makes it difficult to reduce debt beyond a certain level Source: ACFIN model

  18. Equity Financing (-) • Share repurchase (- cash) • Desirable effects • Cash distributions discipline investment decisions • Reduces WACC by increasing leverage Source: ACFIN model

  19. I. Framework for Deciding on the Best Method of Cash Distribution • Recent actions in cash distribution • Financial policy framework • Company characteristics • Types of cash distribution methods • Tax implications for investors

  20. Distribution Policy & Company Characteristics • 3 Objectives of distribution policy: • Distribute cash generated by the company • Maintain financial stability & access to capital markets • Maintain flexibility & insure against downturns

  21. I. Framework for Deciding on the Best Method of Cash Distribution • Recent actions in cash distribution • Financial policy framework • Company characteristics • Types of cash distribution methods • Tax implications for investors

  22. Equity Financing - Repurchase Source: JP Morgan

  23. Dividend Decision Source: JP Morgan

  24. I. Framework for Deciding on the Best Method of Cash Distribution • Recent actions in cash distribution • Financial policy framework • Company characteristics • Types of distribution • Tax implications for investors

  25. Tax Implications for Investors For Institutions: Tax exempt; indifferent between methods For Corporations: Strong dividend preference • Dividend: • Due to the dividend received deduction, corporations generally only pay tax on 30% of the dividend received. • Effective tax rate of ~10.5% • Stock Repurchase: • Capital gains for corporations are taxed at marginal rates ~35%. • Capital loss treatment available • Flexibility in timing of cash receipt For Individuals: Slight preference for repurchase • Dividend: • Taxed at max 15% • Forced cash receipt • Stock Repurchase: • Taxed at max 15% • Capital loss treatment available • Flexibility in timing of cash receipt Effects of 2003 dividend tax cuts already priced into the market

  26. Agenda • Framework for deciding on the best method of cash distribution • Cash distribution recommendation • Dividend • Share repurchase • Additional considerations

  27. Value in Dividend Policy • In light of the cut in taxation and the greater visibility & security of the dividend, companies should distribute as much sustainable FCF as a dividend as possible • Growth in dividends should track growth in FCF (permanent & sustainable) • Share repurchase linked to potentially non-sustainable cash flows • Policy on future dividend prospects adds value to current dividends

  28. Dividend Recommendation • Free cash flow is the main driver of dividends • Recommended annual dividend size: $50MM • $0.30 per share, based on 162MM shares outstanding • Based on 2003 projections, payout ratio 27.3%, yield 1.4%, percent of FCF 30% Source: ACFIN Model Addl. Info in appendix slides 54-55

  29. Dividend Rationale • $50MM annual dividend is below 10 year historic low in free cash flows • Reduces risk of having to lower dividends in the future • Leaves FCF for share repurchase or M&A activity in most years Projected 1.4% dividend yield in-line with median S&P 500 dividend yield Annual dividend size of $0.30 in line with 2003 initiations (average $0.38) Source: Historic F/S, ACFIN model, S&P

  30. Share Repurchase Recommendation Given annual dividend commitment of $50MM, residual FCF should be used for $500MM open market share repurchase up to $25.50 per share • Represents 3 years of projected FCF • Distributes cash in a flexible way • May be EPS accretive • Lowers cost of capital • Neutralizes dilution from exercise of management stock options Result: At $25.50, a purchase of 20MM shares, 12% of market float

  31. Share Repurchase – Target Price Calculated Enterprise Value $26.60 Basic $25.50 Diluted Repurchasing shares at greater than calculated price is value-destroying to non-tendering shareholders Source: ACFIN Model Addl. Info in appendix slides 56-57

  32. Repurchase – EPS Effects In a debt-financed repurchase, EPS is accretive to the extent that the earnings yield at the repurchase price exceeds the after-tax interest yield 22.8 P/E Source: ACFIN Model

  33. Repurchase - EPS Effects In a cash-financed repurchase, EPS is accretive to the extent that the earnings yield at the repurchase price exceeds the investment yield 25 P/E 50 P/E 16.7 P/E 12.5 P/E Source: ACFIN Model

  34. Agenda • Framework for deciding on the best method of cash distribution • Cash distribution recommendation • Additional considerations

  35. Additional Considerations • Is Thermo Electron a “growth” company? • What are the implications to Thermo Electron’s investor clientele? • What is the effect on management’s stock options?

  36. Value vs. Growth Stocks Benchmark definitions • Value Stock • A company that is considered under-priced relative to the industry. Common characteristics include a low market-to-book ratio and a high dividend yield. • Growth Stock • A company whose earnings are expected to grow at an above average rate relative to the market. Generally have high market-to-book ratios. Source: Investopedia

  37. Investor Clientele Implications Is Thermo Electron a growth company? • LowM/Bratio of 1.7 • Median M/B ratio for mid-cap, growth firms is 4.29 (Source: Morningstar Mid-Growth Index) • Low P/E ratio of 22-23 • Median P/E ratio for mid cap, growth firms is 52.7 (Source: Morningstar Mid-Growth Index) • Low salesgrowth • last 4 years - negative (Source: 10-K filings) • future growth projections – single digits (Source: compilation of analyst reports 10/2003) • Institutional ownership is primarily non-growth oriented funds (Source: Reuters Investor, top 20 investors)

  38. Investor Clientele Implications Effect on Thermo Electron being perceived as a growth or value company • Dividend is usually an indicator of a mature company and has both positive and negative attributes: • Implies reduced corporate risk • Suggests reduced investment opportunities • However, because of tax-law changes, most companies initiating dividends in 2003 were growth companies • A share repurchase could have varying effects on investors’ perceptions: • A “dividend-like” recurring share repurchase plan will have a similar effect as a dividend • A large tender offer may indicate that management believes the stock is undervalued; however, tender offers come at a premium.

  39. Effect on Management’s Stock Options Dividend • Signaling effect generally boosts stock price & stock option value • Signaling issues aside, a dividend lowers stock price / option value upon issuance of dividend • Most options not dividend protected Share Repurchase • Initial market reaction to announcements of open market programs is generally only about 4% (compared to about 15% for fixed-price offers)* • Relative to dividend, share repurchase will have a more positive effect on share price because it decreases the number of shares • Increase in leverage affects firm volatility; increasing the value of options • Signaling effect boosts stock price by amount depending on type of stock repurchase • Repurchased shares can be put in treasury and reissued upon exercise of management’s options Source: Journal of Applied Corporate Finance Spring 2000

  40. Effect on Management’s Stock Options • Stock repurchases have no direct effect on the value of stock options and appreciation rights • Dividend payments reduce the value of stock options • This variation raises the issue that stock option grants are an important consideration for management in choosing between dividends and stock repurchases • Consequentially, managers who own stock options are more likely to distribute cash through open-market repurchase rather than an increase in cash dividends Source: Journal of Applied Corporate Finance Spring 1998

  41. Summary Effects of a $50MM annual dividend and a $500MM 3 year open market share repurchase funded with projected free cash flows

  42. Thermo Electron Corporation

  43. Appendix

  44. Recent Trends in Cash Distribution Source: JP Morgan, S&P, Compustat

  45. Recent Trends in Cash Distribution • 180 Companies have increased dividend in 2003 • Dividend yield skewed to low end; most under 3% • Distribution yield not as skewed; lower-yield companies tend to augment distributions with share repurchase Source: JP Morgan, S&P, Compustat

  46. Recent Trends in Cash Distribution • Wide range of dividend payout ratios; median 10%-20% • Distribution flattens with share repurchase; approx 30-40 companies in each band from 10% to 80% • 89 Companies distribute over 100% of earnings • Reflects depressed earnings • Use of share repurchase to recapitalize the balance sheet Source: JP Morgan, S&P, Compustat

  47. Recent Trends in Cash Distribution Completed repurchases increased dramatically to 2000 Dropped sharply as earnings and stock prices fell Trend reversed in 2003 In 2002, 10 largest repurchasers accounted for 50% of total completed volume 5 of top 10 were technology companies, repurchasing to offset warrant dilution 2003 to date: $85.3B repurchases completed Source: JP Morgan, Compustat

  48. Morningstar Growth Ratings • Criteria for Growth Grade • Raw Growth: historical sales growth over past 5 years • Consistency: steady YOY sales growth over past 5 years • Trend: reward accelerated sales growth • Ranking is relative to peers within sector • Distribution of grades: equal numbers of As, Bs, Cs, and Ds with bottom 10% getting Fs Source: Morningstar

  49. Open Market Repurchase: SEC Rule 10b-18 Rule 10b-18 applies to share repurchases on the open market under normal market conditions (i.e. not during mergers, tender offers, or distributions). Specifically, the Rule states the following with respect to the conditions that must be satisfied: • Manner of purchase condition: shares must be repurchased by a single broker/dealer in a day so as to not mislead the market by creating the illusion of wide-spread buying[1] • Timing of purchase condition: shares cannot be repurchased at the beginning of trading nor at the end, because trading those periods are considered to be an indication of the direction of trading, strength of demand, and market value of the security • Price condition: the shares may not be repurchased for a price higher than the last independent published bid or transaction price, so as not to mislead the market • Volume condition: an issuer can purchase daily up to 25 percent of the average daily trading volume (ADTV) of its shares, but this does not include block purchases • Block purchases[2] have either a purchase price of $200,000 or more; at least 5,000 shares of the stock of at least $50,000; at least twenty round lots totaling 150 percent or more of trading volume; or twenty round lots totaling at least .1 percent of the outstanding shares of the security, exclusive of those owned by affiliates • Rule 10b-18 provides issuers with safe harbor from liability for manipulation under Section 9(a)(2) and 10(b), and 10b-5 under the Exchange Act. Rule 10b-18 is designed to minimize the market impact of share purchases, allowing the stock price to be “based on independent market forces without undue influence by the issuer.” • [1] The broker/dealer can arrangements with other broker/dealers, so long as the issuer has engaged only one broker dealer • [2] Block purchases are not included in ADTV Source: SEC

  50. 2003 Dividend Initiation Source: S&P, Morningstar

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