O.M. Scott and Company Case

O.M. Scott and Company Case Study

The O.M. Scott leveraged buyout case was an example of 1980s creative financing, in which a large corporation in deep debt was able to not only be bought out by a company it then took over, but gained momentum and credit credibility.

Background of company

O.M. Scott manufactures, markets and sells lawn care and garden products; and provides garden maintenance services.

O.M. Scott & Sons was founded in 1868 by Orlando McLean Scott. Scott worked at a seed elevator for several years before buying his own hardware shop in 1870.

Scott's hatred of weeds led him to start sorting weed seeds from crop seeds for local farmers and selling on his 99.71% weed-free farm seed at a premium. In 1870 Scott added grass seed, but this segment didn't become a part of the business until the early 1900s.

Scott's sons Dwight and Hubert became partners in 1902 and Dwight launched the O.M. Scott & Sons mail-order grass seed business in 1906. The mail-order business spread business throughout Pennsylvania, Virginia, Kentucky and West Virginia. By 1921, O.M. Scott & Sons was responsible for seeding one fifth of America's golf courses.

In 1928 the company launched Turf Builder, and in 1945, the company launched 4-XD broadleaf herbicide, followed by Scutl, Clout and Halts in the 1950s. In 1956 O.M Scott & Sons used new chemical products and processes to create a new 'improved' Turf Builder formulation. The company also developed the first patented Kentucky Bluegrass, the first lawn spreader, and various other innovations for home and commercial lawns (Pederson 45).

Analysis of Case

O.M. Scott & Sons was sold and became a closely held company following the war, when, in 1971, it was bought out by ITT. O.M. Scott & Sons remained within the conglomerate until 1986.

Sales had increased from about $10 million to $43 million between 1955 and 1961.To provide for possible adjustments and allowances in the liquidation of dealer accounts receivable, the company provided an increase in reserve by a charge to net earnings of $150,00 and a charge to retained earnings of $530,000.

Major problems

At the end of fiscal 1961, Scott and its subsidiaries had $16.2 million of long-term debt outstanding, $12 million in renewable five-year subordinated notes of the parent company held by four insurance companies and a trustee, and $4.2 million in publicly held bonds owed by Scotts Chemical Plant, Inc., a wholly-owned subsidiary.

The governing loan indenture limited the company's maximum outstanding debt to an amount not greater than three times the company's "equity working capital" as of the preceding March 31. The note indenture restricted outstanding subordinated notes to only 60% of maximum allowed debt. The agreement also required that Scott be free of bank debt for 60 consecutive days each year and that the company earn before taxes one and a half times its fixed financial charges, including interest on funded and unfunded debt, amortization of debt discount, and rentals on leased properties.

In addition to this debt, Scott also had a $12.5 million line of credit at the end of fiscal 1961 with seven commercial banks. The maximum line had been used at some point during each year. Scott agreed to maintain average compensating balances of 15% of the line of credit with the banks involved.

As far as accounts payable were concerned, Scott negotiated an arrangement with its principal chemical suppliers whereby the company settled with these suppliers only once or twice a year. The suppliers were persuaded that it was in their best interest to help Scott develop and expand the market. No interest or other charges were levied on these amounts.

In 1986, the company's president and CEO, Tadd C. Seitz led a highly leveraged buyout of O.M. Scott & Sons. In order to buy it, Scotts' managers borrowed $190 million of the $211 million from the investment banking firm of Clayton Dubilier Inc. And O.M. Scott & Sons became the primary subsidiary of CDS Holding Corp. Many of Scotts' senior executives took out second mortgages and personal loans in order to buy into the deal. In order to buy the company, about 90% came from the investment banking firm of Clayton Dubilier Inc. CDS Holding Corp. is a private company 61% owned by Clayton Dublier.

All holders of the notes at September 30, 1961, except for $1 million, surrendered the notes then held in exchange for new notes having exactly the same terms but maturing October 28, 1966, at an interest rate of 6% per annum to October 10, 1962. Subsequent to September 30, 1961, arrangements were made for the note for $1 million not exchanged to mature September 1, 1962, and to issue a note for $1 million to another lender maturing October 28, 1966. The LBO is criticized for being a means for Wall Street to earn paper profits by arbitraging the valuation differences between public and private markets.

Alternative Course of Action

An alternative to a leveraged buyout is innovative financing achieved through a variety of financial intermediaries. In the 1980s commercial banks were generally the main source of senior debt, with blind pools, or institutional investors providing mezzanine financing, equity financing, and pools of capital, with or without specified uses.

Analysis of Alternatives

Capital for a leveraged buyout generally consists of the following: senior debt, senior subordinated debt, subordinated debt, mezzanine financing, bridge financing, and equity layers. The equity layers in the 80's were usually thin, contributing less than twenty percent of the total capitalization of the new entity.

Heavy debt may be risky as financial calamity risk increases with leverage ratio. A firm is said to be in financial distress if the firm's earnings before interest, taxes, depreciation and amortization (EBITDA) is less than its interest expense, if it attempts to restructure its debt, or if it defaults on its debt. In the early 80's, however, most LBO targeted companies were mature, stable, asset-rich companies with low capital needs. Financing structure was relatively conservative for LBOs and hence appropriate for the underlying business risk. Therefore, the combined benefits of debt outweighed its disadvantages, bringing significant success to this LBO transaction.

Conclusion

Management-owned stock or stock-related compensation was rare prior to LBOs. But with LBOs, the buyout firms typically owned 80-90% of the target, and operating management owned about 10%. This was an ownership structure clearly aligned with the interests of the management and owners, reducing agency costs in managing the firm. As the manager's ownership significantly increased, it gave them strong incentive to work harder. Secondly, managerial discipline was tightened through high debt service requirements.

Scotts saw a marked jump in profits under Seitz's leadership, as expansion came through strategic acquisitions and new product introductions. Environmentalism spurred development of new organic fertilizers. In 1990, the company began to research and develop supposedly environmentally friendly biological pesticides using insect viruses, bacteria, protozoa and plant extracts.

By 1988, the company had reduced its debt to $125 million, and in 1992 Scotts decided to go public as the Scotts Company. The company's sales increased dramatically, from $413.6 million in 1992 to over $750 million in 1996. Some of this growth came from acquisitions.

The organizational changes that took place at O.M. Scott & Sons Co. In response to their leveraged buyout demonstrates the effects of high leverage on management decision making, and the differences between operating as a small subsidiary of a large conglomerate and as a free-standing company. The LBO sponsor manages the company, has restrictive debt covenants, and changes in the compensation system. Debt was not really necessary to force OM Scott to make the operating changes, but the alternatives for companies that do not want to take on so much debt are few.