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Appraisal Rights Litigation Blog

PetSmart Merger-Price Ruling: The Breakdown

Posted in Discounted Cash Flow Analysis, Fair Value, Merger Price

Further to our prior post on the recent PetSmart decision, we wanted to highlight some key factors that led the court to peg its fair value determination at the merger price.  In PetSmart, the Delaware chancery court found that the sales process, while not perfect, was good enough to produce a reliable indicator of PetSmart’s fair value.  The court recognized that its statutory obligation to consider “all relevant factors” did not end with its finding that the merger price was a reliable indicator of fair value; on the contrary, it needed to consider the reliability of a DCF or any other valuation method it could use to reach its final determination of fair value.  In looking at the viability of other valuation methodologies, including mainly a DCF analysis, the court found that a DCF valuation would not be reliable since management had not historically created long-term projections and the projections that were created for the sales process, apparently at the Board’s insistence, were too aggressive to be reasonable.  And none of the other projections prepared outside of PetSmart (e.g., by the buyer) reflected PetSmart’s “operative reality” for purposes of appraisal.

The pet specialty retailer had announced in August 2014 that it was pursuing strategic alternatives, including a sale, and received final bids in December 2014.  A private equity firm, BC Partners, paid $83 per share in cash for PetSmart stock, and the merger closed on March 11, 2015.  Among the factors cited in the court’s decision, based on the record at trial, were the following:

Management’s projections were flawed.

  1. Management had never before prepared long-term projections;
  2. When the Board tasked management with preparing long-term projections, the process was vastly different than the process previously employed to prepare short-term (one-year) budgets following PetSmart’s so-called Summer Strategy meetings;
  3. Even the short-term projections historically created were not reliable, and the company routinely underperformed relative to those projections;
  4. On top of these factors, the projections were prepared under time pressure, as the board rushed management to prepare them (the Base Case was prepared in the span of a few days, and the Base-Plus Case prepared “extremely quickly”);
  5. The final set of projections presented to the board — the Management Projections — were aggressive to the point of “bordering on being too aggressive,” and approaching “insanity;” and
  6. This was an outgrowth of the fact that the Board had pressured (inexperienced) management to prepare increasingly aggressive and unrealistic long-term projections.

The sales process was robust.

  1. The company’s financial advisor, JP Morgan, spoke with 27 potential bidders, 15 of which signed NDAs and five of which bid by October 31, 2014; four of these bids were $80/share or higher;
  2. Parties that chose not to bid saw “significant execution risk” in PetSmart’s business and “inadequate potential for upside growth”; and
  3. The court found Petitioners’ criticism of JP Morgan’s fairness opinion unsupported by the evidence, as JP Morgan had no preconceptions or pre-designed result and worked up its WACC or other component analyses thoroughly and objectively.

Post-announcement, PetSmart’s business was still sagging but “ripe” for a turnaround.

  1. BC Partners found that PetSmart had been “undermanaged” and could be revived by a new management team;
  2. Management projections were “not achievable,” at least not with current management in place; and
  3. BC Partners’ equity syndication memo sent to potential investors included a more conservative “BCP Case” with lower total revenues and year-over-year sales growth and fewer new store openings for the five-year projection period.

In sum, the court’s apparent takeaway was that the deal was fairly shopped and the PE buyer was able to add value through its post-closing strategy, including replacing management and making other changes in plans.  In contrast, any DCF that was based on the management projections — which the court found to be unreliable, unrealistic, and not prepared in the ordinary course — would likewise be tainted, and the court was unwilling to rely on a “garbage in, garbage out” valuation methodology.  The court thus chose to “defer” to the merger price based on the evidence before it.