KTM — VENTURE CAPITALIST EXIT
INTRODUCTION
In early January 2003, Dr. Rudolf Knünz, chief financial officer of KTM,
was considering the company’s future financing needs. KTM designed and
manufactured motocross, rally and cross-country racing motorcycles for adults
and children and had ambitious growth plans due to the rapid growth being
experienced in this area. At the time, a holding company that KTM management
had a large stake in, Cross-Holding, owned 51
per cent of the firm. The other 49 per
cent was owned by BC European Capital (BC), a venture capitalist firm.
Since most venture capitalists made investments that had the potential to grow
exponentially (earning their returns when their stakes in the business were
sold), BC had been pushing for high growth at KTM ever
since they purchased their equity stake in
1999, and would soon be looking for an exit strategy. To facilitate
this, Knünz had to develop a financing strategy that would raise enough money
to purchase BC’s equity and enable future growth plans.
Management had developed a set of objectives to help choose the best
means for BC to sell its stake in KTM. First,
the option should maximize the proceeds to KTM. Not only would this
allow KTM to buy out BC by giving them a fair return on their investment, but
it would also provide capital for the company’s expansion plans. Second, it was
important to choose an option that would allow present management to continue
to play a central role in directing the company. Both Knünz and Stephan Pierer,
chief executive officer of KTM, saw significant growth potential in the company
and wanted to see this growth through.
The two were partners in Cross-Holding, and they were not anxious to
divest themselves of KTM. Furthermore, the value and reputation KTM had
developed was a testament to investors’
confidence in Knünz and Pierer’s
management. Third, it was vital for KTM to remain financially stable and
flexible in order to capitalize on potential opportunities for future growth.
The strength of KTM’s financial position is highlighted in Exhibits 1 to 4,
which show KTM’s recent financial performance, consolidated balance sheets,
statement of cash flows and financial ratios.
KTM
KTM began when Hans Trunkenpolz
opened a motorcycle repair shop in Mattighofen, Austria, in 1934. Over the
years the company had become a household name with off-road motorcycle
enthusiasts because of its sponsorship
of cross-country racing events and riders. KTM, with its bold orange logo and
renowned Austrian engineering, had a reputation for producing reliable,
high-quality motorcycles. The company had also gained expertise in
manufacturing core parts such as the engine, radiator and exhaust system.
KTM focused its marketing on building
the brand’s image of technological leadership, high quality and a legacy of
championship titles. KTM’s customers were young, edgy and liked racing. Knünz
explained, “You could take our standard
production KTM bike and get to a 10th place on it in any world championship
race without doing anything. The proof is in the 23 world championships KTM
riders have won in the past three years.”
KTM distributed 80 percent of its
motorcycles through its own sales subsidiaries (which contracted with dealers),
and 20 percent through general importers. KTM had a strong dealer relations
system that enabled the company to respond quickly to market trends, to
effectively predict sales, and to reduce inventory costs. General importers
were used in smaller markets such as South America, Africa, Australia and
smaller countries in Asia.
KTM’s product mix was largely focused
around off-road motorcycles and related accessories, which made up over 80
percent of the revenue generated over the past few years. The remainder of
sales came from the sport- mini cycles, which were motorcycles designed for
youth, and “naked bikes,” which were on- and off-road hybrids. Approximately 60
percent of KTM’s 2002 revenue came from Europe, with Austria and Germany
comprising a large share of the sales. The remainder of the sales came from the
United States, which made up about 30 percent, with smaller markets around the
world rounding out the rest.
Strategy
KTM’s strategy focused on two avenues
of growth: geographic expansion and product line expansion. Geographically, KTM
could expand its dealer network and brand into new European Union countries and
in North America.
As of the end of 2002, more than
two-thirds of the company’s dealer network was centralized in Western Europe.
However, growth for motorcycles was projected to be highest in the United
States, South America, and Asia. On the other hand, most of Western Europe was
becoming saturated, and growth was expected to slow. Knünz wanted to ensure
that KTM was poised to deal with and benefit from these geographic trends.
KTM could also expand its product
line to offer on-road motorcycles, ATVs or other products. For example, almost 80 percent of motorcycle
sales were of on-road motorcycles, and this segment was growing. To do this,
Knünz knew that it would cost €10 million in research and development (R&D)
and another €10 million to develop the tooling necessary to start producing
on-road motorcycles.
Financial Performance
KTM’s financial performance over the
previous few years was very impressive. The company has been able to leverage
its strong supplier relationships, improved inventory management, and the
rationalization.
Of its administrative costs to
improve profitability year after year. The company’s efficiency and liquidity
positions were in line with industry averages; however, Knünz was slightly
concerned about KTM’s capital structure (see Exhibit 4). Although the company
had adequate interest coverage, KTM was highly leveraged with debt-to-equity
ratios that were much higher than its closest competitors.
Knünz projected earnings before
interest and taxes (EBIT) to grow between six to eight percent for the next
three years before leveling off to around four to six percent for the following
two years. Capital expenditures were expected to be concentrated largely in the
next couple of years as shown in Exhibit 5. Depreciation was projected to be
similar to last year’s percentage of sales. Knünz believed that growth in EBIT
beyond year five would be similar to projected inflation in the European Union,
which analysts expected to be around one to two percent. He wondered how the
financial markets (Exhibit 6) would affect KTM’s financial outlook. Using the
forecasted values for EBIT, depreciation, amortization and capital expenditures
over the next several years, Knünz could forecast the free cash flows necessary
to estimate a value for KTM. This value could be compared to the values
obtained by comparison to similar firms (Exhibit 7). Knünz recognized the
importance of these values since they would be what BC would be used to
determine the value it would require to sell its equity stake in KTM. Though it
was not clear that BC required the
entire sum at once, this amount would form the basis for the ultimate value
required for BC’s stake.
THE MOTORCYCLE INDUSTRY
The motorcycle industry was comprised
of the on-road and off-road segments. Both segments had seen steady growth over
the last several years. Global demand for motorcycles was projected to grow at
5.3 percent for the next four years as they gained broader acceptance. On-road
riders rode for many different reasons. Some young, mostly urban males chose
motorcycles as their chief means of transportation. Younger riders preferred performance bikes
such as Ninjas and other Japanese racer-replicas. A significant portion of
on-road riders was older and desired a sense of “lifestyle” and community from
their motorcycle-riding experience. This was particularly true for riders of
the large, cruising type of motorcycle exemplified by brands such as
Harley-Davidson and Victory. This aspect of an on-road motorcycle’s brand was
particularly important for attracting new customers.
Off-road riders, on the other hand,
tended to be young and edgy and were into racing and adventure. Trends were an important part of producing
off-road motorcycles that sold successfully because off-road riders were quick
to adapt to these changes. Thus, one of the keys to winning in the off-road
segment was flexibility in product mix. The technology was also extremely
important in the off-road segment. Racing represented the best opportunity for
manufacturers to showcase their products and technology since motorcycles with
superior performance usually won races.
Competition
Harley Davidson manufactured on-road
motorcycles in the cruiser segment that appealed to riders in the 30-plus age
range. Harley had a brand that was globally recognized, one that embodied
all-American values. Other motorcycle manufacturers admired Harley’s marketing
and after-sales methodologies, which had built the world’s largest motorcycle
community, creating a lifestyle and heritage around the brand that commanded
high premiums for its bikes. Harley bikes were not known to be technological
forefront. Many of its bike designs had changed very little, if at all, since release.
In contrast, the “Big Four” Japanese
motorcycle manufacturers, which included Honda, Yamaha, Suzuki, and Kawasaki,
were responsible for many of the major developments in the second half of the
twentieth century. These motorcycle manufacturers were highly diversified,
producing everything from musical keyboards to power generators. Honda was
known for successfully adapting Harley’s successful after-sales strategies to
consumers outside of the cruiser segment through value-added services and products.
For example, Honda customers were able to custom-build their bikes and take
part in training courses and exhibitions. Yamaha focused on its core
competencies in design and racing technology, outsourcing many of its
non-value-added activities to take advantage of cost efficiencies. All Yamaha
employees embraced the company motto of “Kando,” which refers to the excitement
and satisfaction people feel when they experience something of exceptional
value. Seeking Kando drove the company to develop bikes to surpass customer
expectations on all dimensions. Suzuki and Kawasaki were similar in that they
both competed to produce state-of-the-art bikes that incorporated leading-edge
technology. Both focused on street bikes that were geared toward younger
riders.
Outside of the Japanese “Big Four”
and Harley, KTM also competed with Polaris and Ducati. Polaris was a U.S.
motorcycle manufacturer that offered a line of bikes under the Victory brand.
These motorcycles were in direct competition to Harley’s cruiser offerings.
Polaris tried to differentiate itself from Harley by incorporating
technological innovations into its bikes by leveraging its R&D expertise in
ATVs and snowmobiles. In contrast, Ducati was the only “pure play” company,
focusing only on motorcycles. It was a European on-road bike manufacturer that
had dominated the World Superbike Championship in recent years, helping it to
gain global credibility amongst serious riders. Ducati had a wide range of
bikes, from dual-sport to sport-touring to super-sport, and combined
leading-edge technology with Italian style. Recent years had seen the company
experience steady top-line growth backed by a strong U.S. dealer network.
BC EUROPEAN CAPITAL
BC European Capital was one of the
largest venture capital firms in Europe, with over 15 years of experience
involving over 40 acquisitions. Venture capital refers to the financing of
startup and early-stage businesses. The venture capital firm raises money from
private investors to invest in businesses that are not available through the
standard capital markets, and that are generally recognized as offering higher
returns with higher levels of risk. Investors are often larger institutions
such as pension funds, university endowments, insurance companies, pooled
investment vehicles or wealthy individuals who are looking to diversify their
portfolios.
Venture capital firms usually invest
in firms in exchange for equity, making them the part owner of the firm in
which they are investing. Most venture capital firms expect to sell their
investments in a relatively short time span, usually between three and six
years.
BC European Capital became involved
with KTM due to its somewhat rocky financial history over the past 20 years. In
the late 1980s, propelled by the strong financial markets, a financial investor
purchased KTM and took the company private. Unfortunately, the unbridled
enthusiasm that accompanied the run-up in equity prices during this time
hindered the financial investor’s judgment. Though KTM had a good reputation
and quality products, it had too many products and models, inadequate
management, a lack of strategic focus and considerable debt on the books. This
resulted in KTM having to declare bankruptcy in the largest bankruptcy suit in
Austria in 1991.
With KTM on the verge of extinction
in 1991, a few of the general importers convinced a group of venture
capitalists to save KTM. This resulted in the formation of Cross-Holding,
involving Knünz and Pierer. By
Early 1996, Cross-Holding began to
buy out the general importers. The
formation of the European Union led to shared standards and a common currency
prompting Knünz and Pierer to re-evaluate their situation. They felt that
shifting their strategic focus to selling through dealers directly and cutting
out the general importers would be crucial for KTM’s future growth. At this
point, Knünz and Pierer needed to secure supplier and dealer partners who would
be willing to grow with the company. With the support of a couple of domestic
financial institutions, the group decided to go public by doing an initial
public offering (IPO) to raise money
and increase the company’s profile to attract partners. Knünz and Pierer
ensured that Cross- Holding remained the most influential shareholder, with 23
percent of the shares, in order to retain control over KTM’s future direction.
Although the company’s share price
never dipped below its issue price, external pressure for consistent growth
from analysts and investors, along with a potential takeover bid by Harley
Davidson in 1998, convinced Pierer and Knünz to take the company private again.
In 1999, BC European Capital helped
Knünz and Pierer execute a buy-out, investing capital in return for a 49
percent stake in the company. Knünz described the relationship between KTM and
BC European Capital as amicable and mutually beneficial. The venture capitalist
helped management acquire new skills and business contacts when needed but, in
general, BC European Capital was very hands-off, allowing management to carry
out business strategies for the company independent of external pressure. In
return for their trust, BC European Capital had been rewarded with a cumulative
average growth rate at KTM of 31 percent in revenues and 50 percent in profits from 1999 to 2002.
FINANCIAL MARKETS
As shown in Exhibit 8, the
performance of the major stock indices in the United States and Europe had been
struggling since the third quarter of 2000 when the “tech bubble burst” and was
slow to recover because of events like 9/11. Knünz recognized that although
equity prices had rebounded recently, they were still relatively low compared
to the levels they were at a couple of years previously. He wondered what
implications this had on his options.
Knünz also considered the general
state of the economic environment around the world. He remembered a recent CSFB
Global Economics report that said that the analyst consensus was for 2003
global GDP growth to be three percent,
up from 2.6 percent in 2002. Knünz recognized that there seemed to be vast differences
in economic growth between different regions around the world. For example, in
the European Union, GDP growth in 2002 had been a dismal 0.7 percent.
Economists agreed that the European Union was slowing down due to increasing
unemployment, weakness in the financial sector and a strong Euro currency that
was expected to be sustained despite weakening exports. The 10 new countries
joining the European Union in 2004 were expected to spark the economy, but 2003
forecasts for GDP growth were still at a disappointing 1.3 percent. Inflation
in the United States was expected to be around 2.2 percent in 2003, compared to
one percent in the European Union.
On the other hand, the United States
was expected to experience healthy economic growth. Recent demographic trends,
the commercial application of information technologies and the proposal by the
Bush administration to eliminate all tariffs on manufacturing by 2015 was set
to accelerate the manufacturing and services industries. Furthermore, there was
an expected pick-up in consumer spending being driven by the low interest rates
in the United States, which were expected to hold for 2003.
ALTERNATIVES
Initial Public Offering
Doing an IPO could provide a number
of benefits. KTM would build credibility and awareness in the financial markets
so financial markets would be easier to access in the future to raise
additional funds. IPOs were also one
of the most popular methods of exit for venture capitalists. However, Knünz was
concerned about the pressures to meet quarterly projections and the scrutiny
from investors that public companies faced. He was afraid that this might
distract management’s focus from the company’s growth strategy. Furthermore,
the long list of expenses coming from legal, accounting, investment banking,
and accounting fees added up quickly and would make going public a sizable
outlay.
Knünz knew that he could do the IPO
domestically on the Viennese Stock Exchange, called the Wiener Börse. It seemed
like this was the safe play because KTM was recognized as one of the best-run
companies in the Austrian business community and any public offering would
probably see great investor participation. But, going public internationally
could be the bold strategic move that KTM needed to make in order to gain
worldwide publicity. Recent American depositary receipt (ADR) listings on the
New York Stock Exchange (NYSE) saw great investor participation and strong
post-IPO share price performance. More importantly, the success of these
companies in the international markets prompted major financial institutions to
initiate analyst coverage on them. This tended to have a snowball effect.
Greater coverage usually meant a better proportion of a company’s equity being
owned by institutional investors. This resulted in even greater media publicity
and research coverage.
Other Strategic Investors
Another option that Knünz
contemplated was to find investors who could buy out BC European’s stake in the
company. In the past, Harley Davidson had been interested in KTM as a means of
appealing to a younger group of
customers. A firm like Harley would probably want to buy out KTM entirely.
Based on KTM’s equity value, the company represented less than two percent of
Harley’s market value. Becoming part of
a larger firm like Harley would allow KTM to leverage the firm’s dealer
network, marketing advantages, and other resources and capabilities. However,
it would be difficult to retain control over KTM’s strategic direction if a
firm such as Harley acquired KTM.
Knünz knew that finding another
financial investor like BC European Capital was also possible, but he was
concerned about the level of control and involvement they would want in running
the company. Financial investors, such as hedge funds or private equity funds,
were very astute with their private equity investments and expected high
returns in short time periods. This usually meant that they took a hands-on
approach and wanted a certain level of control over the strategic direction of
their investments to ensure that they met their performance criteria.
Debt Offering
There were several means by which
Knünz could raise capital in the debt markets. There were banks and either
domestic or foreign bond issues. The banks would prefer to provide short-term
financing with relatively restrictive covenants given KTM’s current capital
structure. There were issues specific to bonds that Knünz and management had to
consider before issuing bonds to the public. First, they had to determine how much money they
needed. Based on the future growth strategy and the need to buy out BC European
Capital, the estimates had ranged from €80 million to €125 million. Knünz knew
That ultimately the amount they
needed would depend on the agreed-upon valuation of the company between
management and BC European Capital with the amount to finance future growth
being a small portion of the required capital. Nevertheless, for the sake of
planning, Knünz assumed they would need to raise €100 million if they were to
try to buy out BC all at once. If KTM were to buy out BC in phases, Knünz
assumed the quantity would be slightly larger depending on the time horizon of
the pay-out.
Second, Knünz wondered how to
structure the bond in terms of type, the location of issuance and coupon rate.
In order to generate greater interest from investors, Knünz could make the
bonds convertible into equity at some time in the future. The bond could have
either a traditional fixed coupon rate or a floating coupon rate. With a
floating coupon rate, interest payments to bondholders would be tied to an
index like London Inter-Offer Bank Rate (LIBOR), shifting some of the risks of
interest rate variations from investors to KTM. With respect to location, Knünz
had considered issuing the bonds in Austria or doing an international offering.
He believed that he could place up to approximately €150M in debt domestically
at a maximum of five percent but more likely for around four and a half percent
with a five-year maturity, because of KTM’s reputation as a profitable and
growing company. Placing the same bond in the more international Euro bond
market would require a coupon rate of roughly seven percent.
Though the cost of issuing bonds in
the Euro-currency market-based in London would be more expensive, there were distinct
advantages to issuing internationally. The ability to market the bonds to a
larger audience would increase the probability of KTM selling its entire
offering and would help the company gain much-needed visibility worldwide.
However, Knünz knew that an international debt offering would not generate
nearly as much media attention as an IPO.
Knünz’s final concern was how a debt
offering would impact future cash flows. KTM was still in a growth phase and
would need cash to fund capital projects. The requirements to make the annual
interest payments would impact the funds available to finance this growth.
CONCLUSION
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