Two British Companies fighting it out over WZL !!!Wenzel Downhole Tools Ltd. shareholder Perlus Investment Management LLP has released a letter to shareholders.
Dear Sirs/Mesdames:
We are in receipt of your letter dated July 11, 2013, which was disseminated by way of press release on same date. We are pleased that you responded to our letter and we appreciate your feedback. We nonetheless, still retain numerous material concerns with both the manner in which the process has been conducted to date, as well as the valuation and fairness opinion report dated June 17, 2013, provided by Raymond James Ltd. as amended on July 10, 2013, to correct certain technical errors.
Process related issues
The process related to the plan of arrangement whereby a subsidiary of Basin Tools Ltd. would acquire Wenzel Downhole Tools Ltd. was initiated by Basin, which is currently the single largest shareholder of the company with two directors currently sitting on the board of the company. Charles Laurey serves as chairman of the company and is also a founding member of Basin Capital Partners LLP, a United Kingdom affiliate of Basin. Jim Waters is the non-executive chairman of Basin and a member of the company's board. Basin initiated the strategic review and is also responsible for paying the valuator in connection with the delivery of the valuation. Despite the closely related nature of the parties, the company agreed to a non-solicitation clause and a break fee. In response to our claim that such provisions impact the ability of the company to attract other offers, the company responded by saying that such are customary for transactions of this nature. We note that the company does not refute the claim that such provisions have a chilling effect on receiving other offers. Non-solicitation clauses are common in takeovers but typically are found when in the case of a non-related acquisition. Given the intercompany relationship between Basin and Wenzel, we feel that the non-solicitation clause substantively impedes on the process of determining fair value for the company.
On July 8, 2013, we provided a letter to the company outlining certain concerns with the valuation. On July 10, 2013, as we had not heard or received anything from the company in response to our letter dated July 8, 2013, we decided to disseminate the contents of our letter publicly through a news release. Several hours after the dissemination of our news release, the company responded by answering that the valuation had been amended due to certain technical errors contained therein. Although some of the errors in the valuation were corrected, there still appear to be multiple flaws in both valuation methodologies (to be discussed further below).
Given that (i) the company is restricted from seeking competitive offers; the parties are interrelated; Basin initiated the strategic review and is paying for the valuation; and there are various errors in the valuation conducted by Raymond James (as discussed below and as evidenced by the fact that the valuation has already been amended by the valuator), we strongly believe that the best interest of the company and its shareholders would be served if the company were to seek another valuation from a transparently independent third party. This is especially important given the errors in the valuation and the perceived lack of independence of the valuator. Determining fair value through the strategic review process can come from two sources, either soliciting outside buyers or through a fairness opinion provided by an independent third party. As the non-solicit clause was put in place by the controlling shareholder, the importance of the fairness opinion becomes all the more critical. Given the errors in the valuation, the board cannot be seen as acting in the best interests in the company in relying on this valuation, especially after such errors have been made known to the board. Having another valuation prepared would therefore serve the board well in executing its fiduciary duties to act in the best interests of the company.
Valuation issues
Discounted cash flow
The base case discounted cash flow analysis set out in the valuation overstates taxes payable by the company. The company's annual financial statements for the year ended Dec. 31, 2012, indicate that depreciation for the year was approximately $7.9-million. Assuming a similar depreciation amount for 2014 (not including an obvious reduction in interest payments), would reduce the forecasted EBITDA (earnings before interest, taxes, depreciation and amortization) amount from the stated $23.6-million to $15.7-million. We understand that the applicable U.S. tax rates are 39 per cent and the Canadian tax rates are 25 per cent, though the valuator claims the company's effective tax rate is 37 per cent. If we use the revenue of the company used in determining the starting point for the discounted cash flow model, the effective tax rate would be closer to 33 per cent. The overstatement of the tax rate by 4 per cent impacts 2014 earnings in the base case by $1.1-million and throughout the time period by more than $10-million. This has a significant impact on the range of values set out in the valuation.
The change in working capital adjustment in the valuation is also overstated for the year 2014 by approximately $4.3-million. The working capital formula appears to take the change in revenue from the previous year and applies a proportionate investment requirement in working capital. In 2013, the valuation is only using nine months of operations for the period ended March 31 2013, such that the revenue increase in 2013 compared to 2014 looks quite dramatic. In actuality, a 12-month adjusted number would not be that different and would be similar for that shown for the years subsequent to 2014. As a result, the valuator uses $5.8-million in working capital change for 2014 where it should be closer to $1.5[-million] to $1.8-million as it is for the subsequent years. This would also have a significant impact on the range of values set out in the valuation and is further evidence that the valuation is flawed.
Both of these errors have the effect of understating the valuation range used by the valuator in determining fair value. Furthermore, these errors bring into question the validity of the valuation which we believe cannot be relied upon in determining fair value.
Enterprise value
The selected companies used to determine an appropriate multiple seem peculiar and in our opinion do not represent an appropriate sample. Three of the four precedent transactions are for private companies with only one being for a public company. Private companies typically have a lower multiple than a public company transaction due to increased risk inherent in dealing with a private company as well as generally negotiating with a smaller group of sellers. Furthermore, using private transactions as precedents for a public transaction is also problematic due to a lack of available information from these particular transactions. Furthermore, the valuator uses a trailing 12-month EBITDA figure for the company of $18.72-million for the period ended March 31, 2013, to assess the fairness of the arrangement relative to the cited precedent transactions. It is important to note that this EBITDA figure includes significant one-time legal fees associated with the NOV legal suit as well as unusually high severance fees. On a pro forma basis, the company's trailing 12-month EBITDA is in all likelihood closer to $20-million. The precedent transactions are further flawed for other reasons. The most obvious anomaly is the Tryton Tools transaction which uses a multiple to expected cash flow. The relevance of expected cash flow to an EBITDA multiple is minimal, so this transaction should be removed from the sample. This has the effect of increasing the average of the multiples used to 5.6 times. The only transaction that uses trailing EBITDA is the NQL Energy Services transaction. This is also the only public company transaction. We note that this transaction uses a multiple of 6.5 times. Due to the inconsistencies and intrinsic flaws presented above, this methodology cannot be realistically depended upon as a basis for fair value.
Conclusion
The valuation continues to present data which appear to be inherently unreliable at best, despite it having been corrected once already. We urge the board of the company to consider the optimal interests of the company and its non-affiliated shareholders in carrying out its fiduciary obligations. We feel this would best be accomplished by commissioning a second, third party valuation. We are, as always, free to discuss any aspect of the foregoing in the hopes of maximizing shareholder value.
Yours truly,
Perlus Investment Management LLP.