Prime Micro Inc.

8 Pages   |   1,790 Words
This case is basically, about the decision which South Bank (SB) needs to make. South Bank was trying to become Prime Micro Inc. agent since many years, but was unable to succeed. Now the ball is in the court of South Bank, but conditions have changed significantly. Debt to equity of Prime Micro Inc. has changed and has gone to the highest level.
Despite this fact, Prime Micro Inc. wants an overdraft limit of around USD 120 million. Risk of South Bank will reduce, as it will earn fee income and will arrange a syndicate of around 10-12 banks, providing funds amounting to USD 10 million to USD 20 million. SB has to provide USD 50 million as the initial outlay as mentioned in the deal.
After knowing the outline of the deal, we need to do a thorough financial analysis of the firm. At the beginning of the analysis, we need to estimate returns through projected free cash flows. After commenting on return, we will discuss risks of the firm which include technological risk, credit risk etc. Cash flow projections attached in Exhibit 2 of the case shows sales growth is assumed to be increasing at 15% each year.

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It is very hard to be optimistic for future four years, after seeing the dot com bubble burst. Secondly in a rapidly changing technological environment, it is very much difficult to achieve double digit growth figures. Historically, Prime Micro Inc. is growing at good growth rate and its recent acquisitions are a good sign for growth. It is not wrong to say that the technology Industry is highly unpredictable. However, it is evident from the data, that intrinsic value of firm is $65 per share, but it has currently market value of around $6.  This fact show, that currently Prime Micro Inc. is understated and has huge potential for growth, in years coming ahead.
The Fair value analysis clearly shows that, currently Prime Micro Inc. is largely, undervalued. For the calculations, equity growth rate is assumed to be 12%. This 12% is an average of the past growth, in book value of equity. Furthermore, it is expected that industry will grow at the same level due to research and development by the company. Before we get into risk discussion, we must see that residual is very large, which results in higher value of stock.
Price to earnings is low at the moment. We cannot calculate definite figure, because data is approximate. Trend can clearly be seen from the historical price chart of stock. This represents decrease in quality of earnings, greatly. If we analyze this decrease from another school of thought, we will find that stock is greatly undervalued. Second school of thought can be supported because of the fact, that market crashed recently.
Credit Risk
Prime Micro Inc. is highly leveraged firm and its capital structure consists of 88% debt. In this situation, further leverage will increase credit risk and risk of owners will decrease. As adapted from Modigliani-Miller theorem rise in debt will increase cost of debt (kd) and hence will increase cost of capital (kc). This will not allow South Bank to provide funds at lower costs as prescribed in the agreement by Prime Micro Inc...
If we dig into expected capital expenditure, it is expected to increase. Cash flow from investing activities is currently negative, suggesting that Prime Micro Inc. is a growing company. This investment is also expected to bear fruits, as soon as dual core processors are launched in the market. All of these prospective quantitative facts will result in higher returns; obviously higher risks are also attached. Past products have been successful, and cost leadership is the strategy followed by Prime Micro Inc.
Copying the past product launch, we will see that future launches have a higher probability of success. We should note here, that during past launches; product of Intel was actually reversed engineered. At the moment, Prime Micro Inc. is launching an entirely new “dual core processors” series, which has more risk of failure attached.
 
2004E
2005E
2006E
2007E
Long term debt/ equity
          0.88
          0.82
          0.85
          0.76
 
 
Analyzing the situation further we come to know, that in projected financials actually gearing ratio is decreasing sharply to 0.76. Interest coverage ratio is expected to increase slightly to 2.5 times. These projections are indicating that the current position of Prime Micro Inc. is very strong. Risk attached to the differentiation strategy are expected to decrease in the near future, and capital structure will change drastically, lowering gearing ratio to more than 10%, leading it to be around 76%.
Market Risk
Price of Prime Micro Inc. is currently undervalued. Analysis provided in the case suggests that price of Prime Micro Inc. was expected to be around USD 20 per share, but after the bust, it was trading at USD 4.05. Decline in prices is also considered to be reflecting investor sentiment. After this bust, shares of Prime Micro Inc. have been delisted.
As an agent bank will not be exposed to Market risk, because it will only provide leverage through overdraft lending. However, it can be counter argued, that how will more equity be generated, or how will Prime Micro Inc. reduce its gearing ratio. These questions are critical, because loan pay off exposes stock holder to increased level of risks.
Technology Risks
Technology itself is a very risky business, as argued before; new technology has a lot of risks attached to it. This phenomenon can be further explained by recalling the failed products. These failed products have heavy cost of research and development attached to it. Everyday hundreds of mobile phones are launched; only few of them succeed.
Similarly, operating system, Windows XP succeeded in generating more revenues than Windows Vista; Symbian technology is now obsolete. Similarly, Prime Micro Inc. spider processor can face such issues. Furthermore, if Prime Micro Inc. is not successful in attaining product patent, its new series will easily be imitated. The success of processor also will make Prime Micro Inc. attractive for acquisition by competitors like Intel.
This risk can be mitigated by continuous innovation and remain private limited. Pre testing of chipsets is expected to increase the probability of success. However, Prime Micro Inc. needs to bundle it processors with other products like, Windows, DOS, office etc. They should also target global market as developing nations are more concerned with price, rather than quality.
Liquidity Risk
It is very important to comment on liquidity risk, while commenting on net working capital. The table below shows the decline in the current ratio and expected increase next year. It is also observed that this ratio is expected to remain almost alike throughout next four years.
 
2002
2003
2004E
2005E
2006E
2007E
current ratio
          2.80
          1.61
          2.68
          2.68
          2.68
          2.68
quick ratio
          1.61
          0.89
               -  
               -  
               -  
               -  
 
The sharp decline in both, above calculated ratio it is noted, that inventory has impacted the ratio, by the same amount during both the years. Decrease in cash and bank balances to one half and increase in accounts payable have impacted the ratio negatively. The overdraft limit will increase liquidity of Prime Micro Inc., and will result, to get back to the actual ratio. Furthermore, this decrease in liquidity risk will enable Prime Micro Inc. to meet its net working capital requirements.
After the fact, it is evident liquidity risk of Prime Micro Inc. will reduce. Currently the risk is very high, as the fall in ratio is very large.
Political Risk
Each industry is exposed to political risk, as the political situation leads to other risks. As an example if socialist rule starts, businesses are not expected to flourish. In this case, political risk prevails, as the government can set regulatory requirements for technology based companies. However, probability of risk is very low. The other risk can be heavy taxation on the industry, because it is expected to grow at 15% in future.
Inflation, Interest Rate and Other Risks
Inflation risk, interest rate risks and other risks are not directly impacting Prime Micro Inc. They can just impact in a way, by affecting purchasing power of people. There seems no evidence in a case, which shows Prime Micro Inc. customers will be affected, because it is already following strategy of low cost leadership. However, inflation will cause other users to switch to Prime Micro Inc. processors.
Conclusion
Through the discussion above, we come to know that currently Prime Micro Inc. has high solvency and liquidity risks. If South Bank succeeds in the bid, situation will change, and these risks will reduce. These projected cash flows, financial position will be realized if a new project of Prime Micro Inc. will become successful and net working capital requirements are met.
Reductions in profits are because of increased capital expenditure last year on Research and Development. It is healthy for a technology based company to continuously innovate. South Bank should take advantage of earning high fee income, with lower expected risk. Mr. Omer needs to go for the agency. He should bid at 120 bases above the LIBOR as recommended in the case. Reason for not charging high risk premium is the expectation of reduction in risk. Therefore, he should speculate the current situation.
This will result in a symbiotic relationship between both parties. As a result, South Bank as an agent will make higher profits. Similarly, Prime Micro Inc. will also make higher profits. Here, we also need to focus on the fact, that share of Prime Micro Inc. in the processor industry has doublet, yet it is still insignificant. Currently it is around 2%, but it is expected to increase in the future right after the launch of new dual core processors.
South Bank needs to focus on uses of funds of Prime Micro Inc. It should keep an eye on management and their duties. Furthermore, it should re evaluate the assets of PMI. Once the calculations are certain, PMI should be extended with a new credit line of USD 120 million.
We recommend Prime Micro Inc. to accept the offer of agency, made by South Bank. This agency will provide them with overdraft lending facility, at lower price. This will be beneficial, for both the stake holders.
 
 
2002
2003
2004E
2005E
2006E
2007E
net income
         20,122
   33,324
     28,998
     34,325
     39,987
     46,627
depreciation
         53,293
   39,840
     90,000
     94,500
     99,225
   104,816
 
 
 
 
 
 
 
cash flows
         73,415
   73,164
   118,998
   128,825
   139,212
   151,443
acquisition
                  -  
  -68,037
              -  
              -  
              -  
              -  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
growth in equity
-
 -
   308,219
   342,543
   382,440
   429,068
 
 
 
 
 
 
 
avg. growth
12%
 
 
 
 
 
 
 
 
 
 
 
 
required return (estimated on the basis of lending rate)
                   6%
 
   258,838
 
 
 
 
 
 
 
 
 
 
Residual = CF07/(R-g)
   2,663,070
 
 
 
 
 
 
 
 
 
 
 
 
PVCF= CF/ (1+r)n
 
   73,164
   111,932
   113,979
   115,855
 
 
 
 
 
 
 
 
PV of residual
   54
 
 
 
 
 
Sum of PVCF
10
 
 
 
 
 
Fair Value
65
 
 
 
 
 
 
 

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