Thiel Machinery: the case of the disappearing LIFO.

Jesswein, Kurt R.

THIEL MACHINERY

Despite the recent economic downturn, Thiel Machinery has continued to be a turn-of-the-century bright spot in the economy. From humble beginnings only a short ten years ago, the company has seen continual growth. John Minnie, the founder and president, is excited about how far he has come and is looking forward to expand his operations in the near future.

The company to date has been extremely profitable. Despite the company's successes, John has found it necessary to borrow a significant amount of long-term and short- term funds from his local bank, First Security, to meet his growing financing needs.

First Security has been an avid provider of funds given the long-term relationship that John Minnie and his family has had with the bank over many decades, and because of the growth potential of the company itself. For example, Thiel Machinery has consistently and easily met all of the loan covenants that First Security has had in place.

However, John's vision is even greater. Although he is appreciative of the financing he has received in the past from First Security, he does not believe the bank can provide the extensive amount of financing that he believes will be necessary to expand the company's operations and meet the growing demand for his high quality and high value product line. So besides maintaining the relationship with First Security, John is also examining the possibility of going public and issuing common stock to fund his expansion plans.

Potential Fly in the Ointment

Despite his current successes, John has become aware of a potential problem that might affect both his current financing arrangement and the possibility of raising new funds through the issuance of common stock. John' nephew, Leonard Minnie, has been studying accounting and finance at State University, and has learned that there is a move to shift U.S. Generally Accepted Accounting Principles (GAAP) to the more globally-accepted International Financial Reporting Standards (IFRS).

Among the multitude of potential changes to the company' financial statements that might be expected from a switch to IFRS, the one that John is most concerned about is the abolition of using the LIFO (last-in, first-out) inventory costing system that his company has been using. The use of LIFO is common among small- to medium-sized machinery companies. For example, Leonard Minnie, while working with Compustat data on a research paper at school, discovered that of the 102 companies in the same industry sector as Thiel Machinery, 44 used LIFO inventory valuation. This was an extremely high percentage given that only around 300 of the 8,000 companies in the Compustat database used LIFO.

Wen using LIFO, companies assign the most recent costs of acquiring inventory to the inventory sold during the period, with the remaining older costs assigned to the valution of the remaining unsold inventory. In periods of rising prices this usually has the effect of reducing profits. Thiel Machinery has used LIFO because, among other things, the reduced amount of profits meant the company paid significantly less in taxes, which has allowed it to reinvest a higher proportion of cash back into the business. This tradeoff, reporting lower accounting profits in exchange for paying lower taxes, is due to a tax regulation commonly referred to as the LIFO conformity rule. Unlike other aspects of accounting such as fixed-asset depreciation, the tax code states that companies using LIFO must use it for both financial reporting and tax reporting. This differs, for example, with depreciation, in which many companies employ straight-line depreciation in their financial reporting and hence disclose higher profit margins, but then use accelerated depreciation for tax reporting and hence pay lower amounts of tax.

If the switch to IFRS caused LIFO to be abolished, Thiel Machinery could potentially face a variety of distinct yet interrelated problems. First, the company is required by First Security to maintain adequate financial ratios, most notably an Altman Z-score of greater than 3.0, and the loss of LIFO might negatively affect the calculation of this measure. Second, the company would be required to make tax payments to cover the amounts previously deferred by using LIFO, reducing the amount of free cash available for its operations. Third, the reduction in cash flows from paying more in taxes could potentially reduce the value of the company's equity and the price of any new common stock that the company was considering to issue. This would provide the company with less cash than it had anticipated from the stock issue.

The Altman Z-score is calculated as a weighted sum of five individual ratios: working capital to total assets (X1); retained earnings to total assets (X2); EBIT, or earnings before interest and taxes, to total assets (X3); market value of equity to book value of liabilities (X4); and sales to total assets (X5), using the following formula: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5. Z-scores above 3.0 are typically associated with companies that are not expected to suffer significant financial difficulties and bankruptcy and Thiel Machinery has consistently maintained a Z- score above this threshold, per the loan covenant with First Security.

Oe complication with the Z-score calculation for Thiel Machinery is that it is a privately-held company and therefore does not have a readily determinable market price for its common equity. Because of this, John Minnie, working with his lenders at First Security, has been estimating the market value of its equity using a variation of the free cash flow valuation model. This model first estimates the present value of the company's future expected free cash flows through the use of a constant-growth perpetuity formula. It then subtracts the amounts owed to its debt holders with the remaining amount assumed to be the market value of the equity. To demonstrate, John Minnie estimated that in 2008, Thiel's free cash flows (that is, the amount of cash available for future investments after paying for required investments in fixed assets and working capital) was $25.0 million. Assuming a constant growth rate of three percent per year, and discounting the future cash flows at ten percent (based on an estimate of the required rate of return of similar publicly-traded companies), the present value of the company's free cash flows was estimated to be $367.9 million. Note that the constantly-growing perpetuity formula is written as [(FCF x (1 + g)) + (r - g)] with FCF being the free cash flow of $25.0 million, g representing the growth rate of three percent, and r representing the discount rate of ten percent. Subtracting te $125. million of outstanding short-term and long-term debt leaves $242.8 million as the estimated market value of the company's equity. This amount would then be used to calculate the X4 variable in the Z-score model.

However, with the probable loss of the use of LIFO, the company' financial statements could be significantly altered, in which case the Z-scre might also change. To estimate the impact on the Z-score, pro forma estimates of the key variables used in the model must be made. Companies using LIFO are required to report an estimate of how much their inventory is undervalued relative to the FIFO (first-in, first-out) method. This figure is known as the LIFO reserve account. The LIFO reserve (Thiel reported a value of $42.8 million in 2008) would then be added to the inventory value reported on the balance sheet, consequently increasing the value of the company's inventory, total current assets, and total assets.

Te company would similarly need to estimate a liability for the taxes that had been deferred through the use of LIFO but which would now need to be paid. Given the company' current tax rate of 35 percent, this would be approximately $15 million, although this amount would likely not need to be repaid all at once. For example, the U.S. Treasury Department's 2010 Green Book summarizing the current government budget proposals explains that companies like Thiel would be allowed eight years to repay these taxes. Thus, assuming equal amounts paid per year, one-eighth of the tax liability would be considered a current liability with the remaining amount a long-term liability. Lastly, to complete the balance sheet adjustments, the remaining amount of the LIFO reserve not accounted for as tax liabilities would be considered net after-tax profits with that amount added to retained earnings.

Besides the balance sheet adjustments, it would be necessary to make adjustments t the company' income statement. For example, increases in the LIFO reserve account during a reporting period can be interpreted as the amount by which the company's cost of goods sold was overstated, and consequently the operating profits were understated, during the period. Hence, the operating profits (earnings before interest and taxes, or EBIT) for the period would need to be adjusted upward by the growth in the LIFO reserve for the year (or adjusted downward by any reduction in the LIFO reserve). Adjusting for the change in LIFO reserve would also affect the reported net profits and associated increase in retained earnings after reducing the amount of change by the change in taxes to be paid on the increase (at a 35 percent tax rate in this situation). Thiel Machinery reported that its LIFO reserve was valued at $42.8 million at the end of 2008, up from $34.2 million the year before. Consequently, the cost of goods sold for the company would need to be adjusted downward, and the EBIT upward by $8.6 million. In addition, the net income for the company would be adjusted upward by approximately $5.6 million after accounting for the tax rate of 35 percent.

Your task

You have recently been hired by John Minnie to help him assess the financial implications of having to abandon his use of LIFO. He has asked you for a review of his Altman z-score calculation. This assessment should first be based on the company' current financial statement data, including the assumptions necessary for estimating the value of the company' equity. The financial statements wuld then need to be adjusted to reflect the pro forma situation of not having LIFO available (that is, incorporating the value of the LIFO reserve and the change in the value during the most recent period) with the Altman Z-score recalculated to reflect those adjustments. Note that because of the increased amount of taxes to be paid, the company' free cash flows would fall by an amount equal to the LIFO reserve amount multiplied by the tax rate (35 percent) and then divided by eight to reflect the expected implementation of this rule as outlined in the U.S. Treasury Department' Green Book. This reduction in free cash flows would subsequently reduce the value of the firm as estimated by the free cash flow valuation model, which, in turn, would reduce the market value of the company' equity, further affecting the Altman Z-score calculation. This potential reduction in the market value of the equity also has possible implications for the company's expected public offering of stock, a significant issue given the company's belief in needing this new source of financing to fund future growth.

You should write a short report or memorandum to Mr. Minnie in which you describ your calculations and analysis and provide a summary of the potential implications. This should include an analysis of the company' current Altman Z-score, a summary of the free cash flow model for estimating the value of the company' equity, an explanation of the necessary adjustments to the financial statements should LIFO no longer be allowed, an analysis of the recalculated Altman Z-score based on the adjusted financial statement figures, and a discussion of the potential problems for the proposed stock offering given the possibility of lower valuations being made for the company because of the reduction in free cash flows from having to make larger tax payments.

Kurt R. Jesswein, Sam Houston State University

Exhibit 1 Financial Statements ($ millions)

                                2008       2007

Cash                           $ 7.7      $ 6.9
Receivables                     25.1       23.8
Inventory                      116.8      103.9
Other current assets            11.5
Total current assets           161.1      144.2
Fixed assets, net              218.5      188.2
Intangibles & other assets      21.0       19.5
Total assets                  $400.6     $351.9

Memo: LIFO Reserve             $42.8      $34.2

Sales                         $486.4
Less: Cost of sales            318.4
Gross profit (loss)            168.0
Less: Operating expenses       102.4
Operating profit (loss)         65.6
Less: Interest expense          35.6
Earnings before tax             30.0
Less: Income tax expense        10.5
Net earnings after tax         $19.5

                                2008       2007

Short-term debt                $ 6.5      $ 5.7
Accounts payable                45.6       40.3
Other current liabilities       22.5       18.2
Total current liabilities       74.6       64.2
Long-term debt                 118.6      112.3
Other long-term liabilities     51.3       38.8
Total liabilities              244.5      215.3
Equity                          31.0       31.0
Retained earnings              125.1      105.6
Total equity                   156.1      136.6
Total liabilities and equity  $400.6     $351.9