Thermo Electron Corporation

1
Thermo Electron Corporation

• Cash Distribution Analysis

2
Thermo Electron Corporation
Team Members

• Craig Billings
• Tony Curry
• David Rice
• Zach Strobel
• Assisted by
• Ashok Vishnubhakta
• Doug Wilson

3
Our Recommendation

• Initiate regular dividend combined with open
  market repurchase
• Annual dividend of 50MM
• 0.30 per share (based on 162MM sh OS)
• 500MM 3 year open market repurchase
• At or below 25.50 per share (3Q 2003 valuation)
• Represents 3 years of projected FCF net of the
  recommended annual dividend

4
Agenda

• Framework for deciding on the best method of cash
  distribution
• Cash distribution recommendation
• Additional considerations

5
I. Framework for Deciding on the Best Method of
Cash Distribution

• Recent trends in cash distribution
• Financial policy framework
• Company characteristics
• Types of cash distribution methods
• Tax implications for investors

6
Recent Trends in Cash Distribution

• 17 SP 500 companies have initiated dividends in
  2003
• vs. 4 in 2002
• 16 are growth stocks
• According to Morningstar metrics
• Average Results
• Average market cap prior to initiation 15B
• Annual dividend size 147MM - 0.38 per share
• Announcement effect on share price 0.6
• Company SP adjusted return to date 21.3

Source SP Addl. Info in appendix slides 44-50
7
Recent Trends in Cash Distribution

• 13 SP 500 companies have initiated or resumed
  share repurchases in 2003 to date
• All open market repurchases
• 10 are growth stocks
• According to Morningstar metrics
• Average Results
• Average market cap prior to initiation 12.6B
• Announced size 500MM
• Completed size to date 71MM
• Announcement effect on share price (0.2)
• Company SP adjusted return to date 11.1

Source Compustat Addl. Info in appendix slides
44-51
8
Recent Trends in Cash Distribution

• 5 SP 500 companies have initiated dividends
  combined with a share repurchase in 2003
• 4 are growth stocks
• According to Morningstar metrics
• Average Results
• Annual dividend size 99MM - 0.40 per share
• Announced repurchase size 600MM
• Announcement effect on share price (1.3)
• Company SP adjusted return to date 26.3

Source SP, Compustat Addl. Info in appendix
slides 44-51
9
I. Framework for Deciding on the Best Method of
Cash Distribution

• Recent trends in cash distribution
• Financial policy framework
• Company characteristics
• Types of cash distribution methods
• Tax implications for investors

10
Financial Policy Framework
WACC
Cash Generation
- Organic Investment
Free Cash Flow
MA Investment
Debt Financing ( / - )
Equity Financing ( / - )
Dividend Decision
11
Cash Generation

• Cash flow from operations expected to be positive
  for the foreseeable future

Source ACFIN model
12
Cost of Capital Considerations
Source ACFIN model based on 3Q 2003
13
Organic Investment
Limited internal reinvestment opportunities

• Difficult to evaluate incremental investment
  opportunities externally
• Company is struggling to earn cost of capital
  ROIC less than WACC
• Projected single-digit revenue growth
• Trend in M/B ratio declining

Source analyst reports, ACFIN model
14
Free Cash Flow

• Free cash flow expected to be positive for the
  foreseeable future

Free cash flow is either used for MA, debt
reduction, share repurchase, dividends OR
accumulates on the balance sheet
Source ACFIN model
15
MA Investment

• Uncertain Economic Benefit
• Unknown availability of future targets at
  attractive prices
• In general, most MA transactions do not add
  value to the acquirer
• Thermo Electrons MA track record has been mixed

16
MA Investment
Analysis of Thermo Electrons MA activity
1998-2003
Pre and Post Announcement Date
Addl. info in appendix slides 52-53
17
Debt Financing (/-)

• Reduction of debt (- cash)
• Not desirable
• Moves company farther away from minimal WACC
• Leasing strategy makes it difficult to reduce
  debt beyond a certain level

• Increase debt ( cash)
• Preferable to debt reduction, but raises other
  issues
• Some room to increase leverage (485MM) and
  maintain investment-grade credit rating
• Moves towards minimum WACC
• Contributes additional cash for distribution to
  shareholders

Source ACFIN model
18
Equity Financing (-)

• Share repurchase (- cash)
• Desirable effects
• Cash distributions discipline investment
  decisions
• Reduces WACC by increasing leverage

Source ACFIN model
19
I. Framework for Deciding on the Best Method of
Cash Distribution

• Recent actions in cash distribution
• Financial policy framework
• Company characteristics
• Types of cash distribution methods
• Tax implications for investors

20
Distribution Policy Company Characteristics

• 3 Objectives of distribution policy
• Distribute cash generated by the company
• Maintain financial stability access to capital
  markets
• Maintain flexibility insure against downturns

21
I. Framework for Deciding on the Best Method of
Cash Distribution

• Recent actions in cash distribution
• Financial policy framework
• Company characteristics
• Types of cash distribution methods
• Tax implications for investors

22
Equity Financing - Repurchase
Source JP Morgan
23
Dividend Decision
Source JP Morgan
24
I. Framework for Deciding on the Best Method of
Cash Distribution

• Recent actions in cash distribution
• Financial policy framework
• Company characteristics
• Types of distribution
• Tax implications for investors

25
Tax Implications for Investors
For Institutions Tax exempt indifferent between
methods
For Corporations Strong dividend preference

• Dividend
• Due to the dividend received deduction,
  corporations generally only pay tax on 30 of the
  dividend received.
• Effective tax rate of 10.5

• Stock Repurchase
• Capital gains for corporations are taxed at
  marginal rates 35.
• Capital loss treatment available
• Flexibility in timing of cash receipt

For Individuals Slight preference for repurchase

• Dividend
• Taxed at max 15
• Forced cash receipt

• Stock Repurchase
• Taxed at max 15
• Capital loss treatment available
• Flexibility in timing of cash receipt

Effects of 2003 dividend tax cuts already priced
into the market
26
Agenda

• Framework for deciding on the best method of cash
  distribution
• Cash distribution recommendation
• Dividend
• Share repurchase
• Additional considerations

27
Value in Dividend Policy

• In light of the cut in taxation and the greater
  visibility security of the dividend, companies
  should distribute as much sustainable FCF as a
  dividend as possible
• Growth in dividends should track growth in FCF
  (permanent sustainable)
• Share repurchase linked to potentially
  non-sustainable cash flows
• Policy on future dividend prospects adds value to
  current dividends

28
Dividend Recommendation

• Free cash flow is the main driver of dividends
• Recommended annual dividend size 50MM
• 0.30 per share, based on 162MM shares
  outstanding
• Based on 2003 projections, payout ratio 27.3,
  yield 1.4, percent of FCF 30

Source ACFIN Model Addl. Info in appendix slides
54-55
29
Dividend Rationale

• 50MM annual dividend is below 10 year historic
  low in free cash flows
• Reduces risk of having to lower dividends in the
  future
• Leaves FCF for share repurchase or MA activity
  in most years

Projected 1.4 dividend yield in-line with median
SP 500 dividend yield Annual dividend size of
0.30 in line with 2003 initiations (average
0.38)
Source Historic F/S, ACFIN model, SP
30
Share Repurchase Recommendation

• Given annual dividend commitment of 50MM,
  residual FCF should be used for 500MM open
  market share repurchase up to 25.50 per share
• Represents 3 years of projected FCF
• Distributes cash in a flexible way
• May be EPS accretive
• Lowers cost of capital
• Neutralizes dilution from exercise of management
  stock options
• Result At 25.50, a purchase of 20MM shares, 12
  of market float

31
Share Repurchase Target Price
Calculated Enterprise Value 26.60 Basic 25.50
Diluted Repurchasing shares at greater than
calculated price is value-destroying to
non-tendering shareholders
Source ACFIN Model Addl. Info in appendix slides
56-57
32
Repurchase EPS Effects
In a debt-financed repurchase, EPS is accretive
to the extent that the earnings yield at the
repurchase price exceeds the after-tax interest
yield
22.8 P/E
Source ACFIN Model
33
Repurchase - EPS Effects
In a cash-financed repurchase, EPS is accretive
to the extent that the earnings yield at the
repurchase price exceeds the investment yield
25 P/E
50 P/E
16.7 P/E
12.5 P/E
Source ACFIN Model
34
Agenda

• Framework for deciding on the best method of cash
  distribution
• Cash distribution recommendation
• Additional considerations

35
Additional Considerations

• Is Thermo Electron a growth company?
• What are the implications to Thermo Electrons
  investor clientele?
• What is the effect on managements stock options?

36
Value vs. Growth Stocks

• Benchmark definitions
• Value Stock
• A company that is considered under-priced
  relative to the industry. Common characteristics
  include a low market-to-book ratio and a high
  dividend yield.
• Growth Stock
• A company whose earnings are expected to grow at
  an above average rate relative to the market.
  Generally have high market-to-book ratios.

Source Investopedia
37
Investor Clientele Implications

• Is Thermo Electron a growth company?
• Low M/B ratio of 1.7
• Median M/B ratio for mid-cap, growth firms is
  4.29
• (Source Morningstar Mid-Growth Index)
• Low P/E ratio of 22-23
• Median P/E ratio for mid cap, growth firms is
  52.7
• (Source Morningstar Mid-Growth Index)
• Low sales growth
• last 4 years - negative
• (Source 10-K filings)
• future growth projections single digits
• (Source compilation of analyst reports 10/2003)
• Institutional ownership is
• primarily non-growth oriented funds
• (Source Reuters Investor, top 20 investors)

38
Investor Clientele Implications

• Effect on Thermo Electron being perceived as a
  growth or value company
• Dividend is usually an indicator of a mature
  company and has both positive and negative
  attributes
• Implies reduced corporate risk
• Suggests reduced investment opportunities
• However, because of tax-law changes, most
  companies initiating dividends in 2003 were
  growth companies
• A share repurchase could have varying effects on
  investors perceptions
• A dividend-like recurring share repurchase plan
  will have a similar effect as a dividend
• A large tender offer may indicate that management
  believes the stock is undervalued however,
  tender offers come at a premium.

39
Effect on Managements Stock Options

• Dividend
• Signaling effect generally boosts stock price
  stock option value
• Signaling issues aside, a dividend lowers stock
  price / option value upon issuance of dividend
• Most options not dividend protected
• Share Repurchase
• Initial market reaction to announcements of open
  market programs is generally only about 4
  (compared to about 15 for fixed-price offers)
• Relative to dividend, share repurchase will have
  a more positive effect on share price because it
  decreases the number of shares
• Increase in leverage affects firm volatility
  increasing the value of options
• Signaling effect boosts stock price by amount
  depending on type of stock repurchase
• Repurchased shares can be put in treasury and
  reissued upon exercise of managements options

Source Journal of Applied Corporate Finance
Spring 2000
40
Effect on Managements Stock Options

• Stock repurchases have no direct effect on the
  value of stock options and appreciation rights
• Dividend payments reduce the value of stock
  options
• This variation raises the issue that stock option
  grants are an important consideration for
  management in choosing between dividends and
  stock repurchases
• Consequentially, managers who own stock options
  are more likely to distribute cash through
  open-market repurchase rather than an increase in
  cash dividends

Source Journal of Applied Corporate Finance
Spring 1998
41
Summary
Effects of a 50MM annual dividend and a 500MM 3
year open market share repurchase funded with
projected free cash flows
42
Thermo Electron Corporation
43
Appendix
44
Recent Trends in Cash Distribution
Source JP Morgan, SP, Compustat
45
Recent Trends in Cash Distribution

• 180 Companies have increased dividend in 2003
• Dividend yield skewed to low end most under 3
• Distribution yield not as skewed lower-yield
  companies tend to augment distributions with
  share repurchase

Source JP Morgan, SP, Compustat
46
Recent Trends in Cash Distribution

• Wide range of dividend payout ratios median
  10-20
• Distribution flattens with share repurchase
  approx 30-40 companies in each band from 10 to
  80
• 89 Companies distribute over 100 of earnings
• Reflects depressed earnings
• Use of share repurchase to recapitalize the
  balance sheet

Source JP Morgan, SP, Compustat
47
Recent Trends in Cash Distribution
Completed repurchases increased dramatically to
2000 Dropped sharply as earnings and stock prices
fell Trend reversed in 2003
In 2002, 10 largest repurchasers accounted for
50 of total completed volume 5 of top 10 were
technology companies, repurchasing to offset
warrant dilution 2003 to date 85.3B repurchases
completed
Source JP Morgan, Compustat
48
Morningstar Growth Ratings

• Criteria for Growth Grade
• Raw Growth historical sales growth over past 5
  years
• Consistency steady YOY sales growth over past 5
  years
• Trend reward accelerated sales growth
• Ranking is relative to peers within sector
• Distribution of grades equal numbers of As, Bs,
  Cs, and Ds with bottom 10 getting Fs

Source Morningstar
49
Open Market Repurchase SEC Rule 10b-18

• Rule 10b-18 applies to share repurchases on the
  open market under normal market conditions (i.e.
  not during mergers, tender offers, or
  distributions). Specifically, the Rule states
  the following with respect to the conditions that
  must be satisfied
• Manner of purchase condition shares must be
  repurchased by a single broker/dealer in a day so
  as to not mislead the market by creating the
  illusion of wide-spread buying1
• Timing of purchase condition shares cannot be
  repurchased at the beginning of trading nor at
  the end, because trading those periods are
  considered to be an indication of the direction
  of trading, strength of demand, and market value
  of the security
• Price condition the shares may not be
  repurchased for a price higher than the last
  independent published bid or transaction price,
  so as not to mislead the market
• Volume condition an issuer can purchase daily up
  to 25 percent of the average daily trading volume
  (ADTV) of its shares, but this does not include
  block purchases
• Block purchases2 have either a purchase price
  of 200,000 or more at least 5,000 shares of the
  stock of at least 50,000 at least twenty round
  lots totaling 150 percent or more of trading
  volume or twenty round lots totaling at least .1
  percent of the outstanding shares of the
  security, exclusive of those owned by affiliates
• Rule 10b-18 provides issuers with safe harbor
  from liability for manipulation under Section
  9(a)(2) and 10(b), and 10b-5 under the Exchange
  Act. Rule 10b-18 is designed to minimize the
  market impact of share purchases, allowing the
  stock price to be based on independent market
  forces without undue influence by the issuer.
• 1 The broker/dealer can arrangements with
  other broker/dealers, so long as the issuer has
  engaged only one broker dealer
• 2 Block purchases are not included in ADTV

Source SEC
50
2003 Dividend Initiation
Source SP, Morningstar
51
2003 Repurchase Initiation
Source Compustat, Morningstar
52
Thermo Electron 1998-2003 MA
53
Thermo Subsidiary Acquisitions 1998-Present
54
Comparables - Dividends
Source Compustat
55
Thermo Electron Dividend Calculation
Source ACFIN model based on industry data from
Compustat
56
Share Repurchase Target Price Model 1
Source ACFIN Model
57
Share Repurchase Target Price Model 2
Source ACFIN Model
58
Competitors Investor Clienteles
Most competitors perceived as growth companies
Source Morningstar
59
Effect on Managements Stock Options

• Cautionary Statements
• In an efficient market, repurchases to fund
  employee options do not provide the positive
  signal that repurchases for undervaluation do
• Return for repurchasing firms is significantly
  lower for firms with large amounts of employee
  stock options
• Price increases could result in more exercisable
  options, the firm repurchases more

60
Thermo Electron Corporation
www.bus.wisc.edu/acfin