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Yeats Valves and Controls Inc.

On May 2, 2000, W. B. "Bill" Yeats, chairman, CEO, and founder of Yeats Valves and
Controls Inc. (YVC), met with Kate Porter, his long-time adviser, investment banker,
and a member of the Yeats Valves board of directors. The pair met to prepare for the
final negotiations about the proposed acquisition of Yeats Valves by TSE International
Corporation. Serious negotiations for combining the two companies had started in
March, following casual conversations, which dated back to late 1999. Those initial talks
focused on broad motives for each side to reach an agreement, and on the social
issues, such as management and compensation in the new firm. The final term sheet
on which the definitive agreement would be drafted and signed was still open for
negotiation.
Porter and Yeats had worked together to craft the outline of the agreement. So far,
the social terms of the merger had been broached, although the specific details
remained to be settled. YVC would become a subsidiary of TSE. Bill Yeats would
remain as YVC's CEO.
Yeats had never thought seriously about a possible sellout before last November,
when he had his 62nd birthday. "I began to wonder what would happen to the company
after I retired or died," he reminded Kate Porter. "I've got a good top-management
team here, but they are all specialists. I don't think any one of them could step in and
run the show alone. It's a tough business to learn, and I don't think I could find a
successor very easily—nor train him quickly. There's stability in the TSE International
combination that's worth something personally to me."
"In your eagerness to sell, just don't leave too much value on the table," Kate
Porter said. "YVC's prospects are brighter than ever. You have technology to die for.
With our intellectual property and new products coming along, there is a lot of hidden
value in this company that's not reflected on the balance sheet. Be a realist about the
value."
Bill Yeats agreed. "There are lots of reasons for me to want to see the acquisition
take place. However, I want to make sure it's also going to be good for our sharehold-
ers. They've put a lot of faith in me at very critical times in the company's history, and
I wouldn't want to let them down."
Yeats Valves and Controls Inc.
Yeats Valves and Controls Inc., headquartered in Innisfree, California, was principally
engaged in the manufacture of specialty valves and heat exchangers. The firm had
many standard items, but nearly 40 percent of its volume and more than 50 percent
of its profits derived from special applications for the defense and aerospace indus-
tries. Such products required extensive engineering work of the kind only a few firms
were capable of matching. Yeats had a reputation for engineering excellence in the
most complex phases of the business and, as a result, often did prime contract work
on highly technical devices for the government.
Yeats was an outgrowth of a small company organized in 1930 for engineering
and developmental work on an experimental heat exchanger product. In 1987, as
soon as the product was brought to the commercial stage, the company was
organized to acquire the patents and properties, both owned and leased, of the
engineering corporation. Bill Yeats, who founded the engineering firm, founded Yeats
Valves and continued as its CEO.
The raw materials used by the company were obtainable in ample supply from a
number of competitive suppliers. Marketing arrangements presented no problems;
sales to machinery manufacturers were made directly by a staff of skilled sales engi-
neers. Auden Company, a large concern in a related field, was an important foreign
channel of distribution under a nonexclusive distributor arrangement. About 15 percent
of Yeats Valves' sales came from Auden. Foreign sales through Auden and direct
through Yeats Valves' own staff accounted for 30 percent of sales. Half of the foreign
sales originated in emerging economies, mainly Brazil, Korea, and Mexico. The other
half originated in the United Kingdom, Italy, and Germany.
Although the foreign-currency crises in the mid-1990s had temporarily interrupted
sales growth for the company, better economic conditions in the markets of developed
countries, together with its recent introduction of new products for the aerospace and
defense industries offered the company excellent prospects for improved
performance. As such, sales in the first quarter of 2000 grew 20-25 percent over the
corresponding period in 1999, whereas many of Yeats Valves' competitors were
experiencing limited growth. Exhibits 1 and 2 show the most recent balance sheet for
Yeats Valves and Controls Inc. and income statements from 1995 forward. Exhibit 3
presents five years of projected sales, earnings, and other data for Yeats Valves.
The Yeats Valves plants, all of modern construction, were organized for efficient
handling of small production orders. The main plant was served by switch tracks in a
15-car dock area of a leading railroad, and additionally served by a truck area for the
company's own fleet of trucks. From 1997 to 1999, net additions to property totaled
$7.6 million. Bill Yeats, outstanding in research in his own right, had always stressed
the research and development of improved products, with patent protection, although
the company's leadership was believed to be based on its head start in the field and
its practical experience.
The success of Yeats Valves and Controls Inc. had brought numerous overtures
from companies looking for diversification, plant capacity, management efficiency,
financial resources, or an offset to cyclical business. For instance, when Yeats Valves
went public in 1986, Auden Company, which later held 20 percent of Yeats Valves'
common stock, advanced a merger proposal. Word of the proposal reached the
financial commentators, who reported possible action by the U.S. Department of
Justice in antitrust proceedings. Although lawyers for Yeats Valves were confident
that they had a ready defense in an antitrust suit, the practical question was one of
whether such a legal victory on principle would offset perhaps two or more years of
litigation, possibly to the U.S. Supreme Court. Lawsuits did not build a business, as
Yeats noted at the time, and they used up time and energy that management should
devote to the company's operating problems. Hence, the idea was not further
developed.
As Bill Yeats neared retirement, however, the idea of selling the company to a
bigger firm seemed almost necessary. Compelling reasons existed in addition to his
impending retirement1 and the problem of management succession. First, the com-
pany needed a deep-pocketed partner to expand, and to bankroll more research and
development (R&D) projects. Conducting research to continue developing leading-
edge products for aerospace and defense required sizeable investments. Second,
Yeats believed that the company would benefit from gaining access to a large
marketing and distribution network. Yeats Valves was highly successful in its own
niche, but Yeats concluded that more segments could be tapped if Yeats Valves'
products were more aggressively marketed and more widely available. Third, as the
company continued to grow, it would need to gain production know-how for high-
volume manufacturing. Yeats Valves did not have this kind of expertise. Finally, there
had been an increasing trend of consolidation in Yeats Valves' industry over the last
year. Yeats feared that without a well-financed partner, the company would be
swamped by competition. Thus, when the merger opportunity with TSE International
Corporation came along in 1999, Yeats determined to make it work as best as he
could.

1
For Yeats' estate-planning purposes, selling his shares in Yeats Valves would also
work to his advantage.
Bill Yeats believed that YVC had alternatives to this deal. Rockheed-Marlin
Corporation, a large defense contractor (or any of a number of others), might be
induced to make an offer for Yeats Valves, though Yeats preferred TSE International
Corporation as a merger partner. YVC and TSE might establish a joint venture of
some sort, though Bill Yeats suspected that joint ventures faced the same kinds of
integration problems as did acquisitions; as a result, he thought joint ventures were
an inferior alternative. YVC could move forward alone, but that would require raising
large sums of new debt and equity to finance the rapid expansion of the firm's
"widening gyre" program. Yeats was concerned that he might lose voting control of
the firm regardless. It seemed to him that doing a deal with a known and friendly
partner today would prepare the way for an orderly transition for himself and the firm.

Bill Yeats and Tom Eliot had known each other for four years, having been introduced
at an industry conference where they were both speakers. As founders and significant
stockholders of their firms, they liked and respected each other. Talks of a possible
combination seemed to gain momentum following the announcement by Yeats Valves
of a U.S. government contract to develop an advanced hydraulic-controls system
code-named Widening Gyre for use in a wide array of commercial and military
applications in aerospace, automotive, and transportation industries. The Widening
Gyre program had already generated valuable patents, numerous options for ongoing
R&D. Bill Yeats and his team were most interested in the R&D aspects of the program,
and hoped that TSE or some other partner would assume the work on commercializa-
tion, and numerous possible product extensions. Yeats insisted that the financial fore-
casts for his firm were conservative, and included only the most predictable benefits of
the Widening Gyre. He told Kate Porter, "I hope TSE will recognize the intellectual
capital we have built up for the Widening Gyre program. We're all very excited about
it; it could be really big. We have one high-profile government contract. But right now
the forecasts don't show its promise. And the stock price doesn't reflect our growth
prospects. How should we build it into our negotiations?"

TSE International Corporation


TSE International Corporation was incorporated in 1970. By 2000, the company man-
ufactured products ranging from advanced industrial components to chains, cables,
nuts and bolts, castings and forgings, and other similar products, and they sold them,
for the most part indirectly, to various industrial users. One division produced parts for
aerospace propulsion and control systems with a broad line of intermediate products.
A second division produced a wide range of nautical navigation assemblies and allied
products. The third division manufactured a line of components for missile and fire-
control systems. Those products were all well regarded by TSE's customers, and
each was a significant factor in its natural market. Financial statements for TSE
International are provided in Exhibits 4 and 5—the firm's debt was currently rated Baa.
Porter had obtained an analysts' consensus forecast of TSE's earnings, dividends,
and cash flow items as shown in Exhibit 6.
The company's raw material supply, in the form of sheets, plates, and coils— of
various metals—came from various producers. The TSE International plants were
modern, ample, equipped with substantially new machinery, and adequately served
by railroad sidings. The firm was considered a low-cost producer, made possible by
unusual production knowledge. TSE International was also known as a tough
competitor.

The Current Situation


During the early part of 2000, a series of group meetings had taken place between
Yeats and Eliot and their respective company's counsel. From the very start of the
negotiations for combining the two companies, the merits of alternative methods had
been considered by counsel for both parties. A straight common-for-common
exchange was expected to be the most likely outcome, although Yeats was willing to
consider an assets-for-stock exchange. Both methods would be structured to provide
a deferment of the tax liability. Whatever terms were finally worked out, the agreement
would be subject to the approval of the stockholders of both companies.

YVC had 560 stockholders. Roughly 70 percent of the stock was held within the board
of directors and their families, including 20 percent owned by Auden Company and 40
percent owned by Bill Yeats. Yeats had kept the board of directors fully informed
throughout the discussions with TSE International. The proposed merger was
discussed with the president of Auden Company, whose approval was necessary
because of his company's 20 percent interest. Although the Auden executives were not
convinced that the proposal had strict business merit, they decided not to object but,
instead, gave notice that they would sell their company's holdings of Yeats Valves
stock. Auden Company was about to undertake a new expansion of its own, and its
executives were not disposed to keep minority interests in a company like TSE
International Corporation. However, they saw no reason for not maintaining their
satisfactory relationships with the Yeats Valves enterprise when it should become a
TSE International division.
Social terms of the merger needed to be confirmed. YVC's management team and
employees would remain intact; no layoffs were contemplated. Bill Yeats sought a grant
of five-year options to purchase 80,000 shares of TSE International stock at 90
percent of its market price at the close of the acquisition, and an incentive bonus
between $50,000 and $200,000 per year. Yeats' current salary at YVC was $300,000
per year.
Kate Porter, as a director of Yeats Valves, had been kept fully informed regarding
the merger discussions. She was intrigued with the possibility that Yeats Valves might
be more fully valued if it were part of a larger, more diversified enterprise. Yeats
Valves had recently traded at a price-earnings ratio of 10.3 times, perhaps reflecting
the risks associated with a small, concentrated enterprise, possibly vulnerable to com-
petition from larger firms. The American Stock Exchange listing of TSE International
would be attractive to some shareholders, although Porter's firm had earned
significant commissions specializing in handling Yeats Valves' NASDAQ trading.
Exhibit 7 shows recent market prices of Yeats Valves and TSE International shares. 2
Exhibit 8 provides valuation information on exchange-listed possible peer firms of
Yeats Valves and TSE International. Exhibit 9 presents information on recent
acquisitions within Yeats Valves' industry. Exhibit 10 presents money market and
stock return data for recent years. Porter believed that a 40 percent marginal tax rate
was warranted for both TSE and Yeats.
"Kate, what do you think of the merger?" Yeats asked his friend as they sat down
to analyze the deal. "It looks good to me, yet maybe I've gotten too close to the sit -
uation to uncover all the things I should be seeing. I also worry that our people, who
have gotten used to an independent, entrepreneurial culture here at Yeats Valves,
would have trouble adjusting at a big firm like TSE International. Do you think that the
merger will benefit Yeats Valves? And, if so, what is the minimum price we should ask
to ensure that our stockholders profit from this merger?"
"April, 2000 was pretty cruel to those dot-com companies," Bill Yeats said. "Our
firm is different. We've got a great growth outlook, but our valuation is still low. Is this
merger a move that will help fetch a better multiple? Or, should we wait to see if our
efforts are better rewarded?" With that comment, Yeats passed the following clipping
to Kate Porter:

Modest Valuations—In light of currently modest share prices, we believe that the
number of acquisitions will increase in the future. Some valuations are so low, in fact,
managers are considering leveraged buyouts of their individual companies .... We
advise most investors to delay additional commitments until the stock market settles. 3

2
TSE International's stock had a beta of 0.85; the beta for Yeats Valves and Controls
was 1.50, based on the most recent year's trading prices.

3
Value Line Investment survey, 5 May 2000, 1301