As we previously posted, the Chancery Court appraised the fair value of Clearwire Corp. to be $2.13 per share, substantially below the $5 per share merger price paid by Sprint Nextel Corp in July 2013.  This post will provide a more detailed breakdown of the ruling and the bases for Vice Chancellor Laster’s opinion.

I. The M&A Transaction(s)

The court examined not only the underlying acquisition of Clearwire by Sprint, but also the related transaction by which Softbank Corp. — Japan’s largest telecom company — planned to acquire Sprint, immediately upon Sprint’s acquisition of Clearwire.  The sale process in effect proceeded in two stages, the first leg of which culminated in December 2012, with Sprint agreeing to pay $2.97 per share for Clearwire.  But shareholder reaction to that initial deal was extremely negative and drew active opposition.  At the same time, DISH, Sprint’s competitor, proposed a tender offer at $3.30 per share, along with other financing terms as well as demands regarding board appointments and other governance rights.  This intervention by DISH disrupted the sale process, which thus entered into a new phase that ultimately culminated in Sprint paying $5 per share in June 2013.  In particular, DISH and Sprint engaged in a bidding war starting in April that involved Sprint raising its $2.97 offer to $3.40, DISH topping that offer at $4.40 per share, and Sprint again increasing its bid to $5 per share in June 2013.

II. The Court Found the Clearwire-Sprint Transaction to Be Entirely Fair

Before reaching the appraisal issue, the court analyzed whether a breach of fiduciary duty had occurred and whether the transaction was entirely fair to overcome any claim of breach.  Because the transaction involved self-dealing by a controlling shareholder — Sprint owned just over 50 percent of Clearwire heading into the negotiations — the applicable standard of judicial review was entire fairness, with Clearwire bearing the burden of persuasion of proving that the transaction was entirely fair.

The court was persuaded that Sprint and Softbank actually did engage in a series of acts that constituted unfair dealing.  However, the court was not persuaded that any of that unfair dealing had any impact on the ultimate $5 merger price that was reached in June 2013.  Indeed, once DISH intervened in the process, the court found that the landscape had changed “so substantially as to render immaterial the instances of unfair dealing that took place during the first phase” of the sale process.  Opinion, at 50.  The court thus found that despite Sprint and Softbank’s unfair dealing during the first phase of the transaction, the eventual $5 merger price and the process that culminated in it were entirely fair.

Given this distinction between the two phases of the sale process, the court reviewed a series of missteps that would otherwise have rendered the transaction unfair, but because the deal price ultimately did not remain at $2.97 and increased to the revised $5 price, that any incidents that would have tainted the first phase of the transaction ultimately lost their relevance once Sprint increased the merger consideration to $5.

As the court summarized:

In a hypothetical world in which the Clearwire-Sprint merger closed at $2.97 per share, Sprint and Softbank’s interference with the stockholder vote on the Clearwire-Sprint merger would have warranted a finding of unfairness and an award of a fairer price.  Under those circumstances, the resulting award would not have approached $5.00 per share.  It likely would have anchored off of the Special Committee’s consistent demand of $3.15 per share, thereby giving credit to the contemporaneous judgment of Clearwire’s informed, independent fiduciaries. . . .  At $5.00 per share, the consideration received by the minority stockholders exceeded anything this court would have awarded as a remedy for unfair dealing.

Opinion, at 65.

III. The Court Disregarded the Merger Price That Followed a Bidding War and Included Massive Synergies

A. The Court Was Within Its Discretion to Select One Party’s Valuation Work

Having found the transaction to be entirely fair, the court then examined what the stock’s fair value should be to resolve the appraisal case.  The court relied on Delaware precedent providing a judge with discretion to select one of the party’s valuation models as its general framework, citing MG Bancorporation, Inc. v. LeBeau, 737 A.2d 513, 525-26 (Del. 1999).

The court found that with neither party having argued in favor of deal price, and with the record containing other reliable evidence of fair value, it did not consider at all the deal price but relied exclusively instead on a DCF analysis.  In doing its DCF analysis, the court found that the heart of the dispute — i.e., 90% of the difference in valuations as between the two sides — arose from the difference in the projections that each side’s valuation expert used.

B. The Court Found Projections Prepared by Clearwire Management in the Ordinary Course to Be the Most (and Only) Reliable Projections

The petitioners’ expert, Professor Gregg Jarrell, used the so-called Full Build Projections that were prepared by Sprint, while the respondent’s expert, Professor Bradford Cornell, used the so-called Single Customer Case projections that had been prepared by Clearwire’s management.  The court expressed a clear preference for the Single Customer Case projections, because they were prepared by the seller’s own management, and were done in the ordinary course of business.  The court found that the Single Customer Case projections accurately reflected Clearwire’s operative reality as of the merger date.  In contrast, the court held that the Full Build Projections were created by Sprint’s management team — not Clearwire’s — in order to convince Softbank to increase its offer and thereby top DISH’s offer price.  Accordingly, not only were the Full Build Projections created by someone other than management of the seller, but they were created by the buyer with the motivation of showing greater value in Clearwire in order to induce Softbank to bid higher.  Moreover, in examining the various assumptions underlying the Full Build Projections, the court found them to be without basis in the record and dependent on aggressive, “herculean” assumptions about future business with, and prices charged by, Clearwater, which were simply not a part of Clearwire’s operative reality.

In contrast, the court found that respondent’s use of Clearwire’s own Single Customer Case, which was prepared by Clearwire management in the ordinary course of business, was the more, and indeed only, reliable set of projections, as Clearwire’s management had significant experience in preparing long-term financial projections, and they regularly updated the Single Customer case, and even did so as recently as May 2013, within a month of the merger agreement.  While those projections did contemplate a significant increase in Sprint’s wholesale payments to Clearwire, the assumptions did not reflect the astronomical increases that the court found petitioners’ projections to rely on.  And in all events, the court found that Clearwire had tried for years to obtain additional customers, without success, and that there was no reason to believe that it would have had greater success in obtaining any additional customers in the years going forward.  Given its finding that the Single Customer Case was the most reliable set of projections reflecting Clearwire’s operative reality as of the merger date, the court adapted wholesale the respondent’s expert’s use of those projections in his DCF.

C. The Court Found Reasonable a Perpetuity Growth Rate Set at the Midpoint of Inflation and GDP

The only other significant differential in the parties’ DCF analysis was the perpetuity growth rate.  The court agreed with the respondent’s expert’s (Cornell’s) use of a perpetuity growth rate at 3.35%, which represented the midpoint of inflation and GDP growth. The petitioners’ expert (Jarrell) used a perpetuity growth rate of 4.5%, which represented expected GDP growth.  To the extent that Jarrell’s justification for his use of GDP growth was based on Clearwire’s expected performance under the Full Build Projections, the court rejected that rationale, having rejected the notion that the Full Build Projections reflected the realistic future performance of Clearwater for the projection period.  Indeed, the court found Cornell’s choice of the midpoint between inflation and GDP to be more realistic — if anything, more generous for Clearwire — given the likelihood that Clearwire would require ongoing financing from Sprint in order to remain solvent under the Single Customer Case.

The court proceeded to discuss minor differences in some of the components of the discount rate, as well as the parties’ dispute over the value that should be added to the DCF based on Clearwire’s unused spectrum.  Once again, the court generally rejected Jarrell’s assumptions in these areas, although none of these issues had a significant impact on the valuation analysis.

IV. Conclusion

Based on these factors, the court adapted Cornell’s DCF valuation in its entirety, and awarded the petitioners fair value at $2.13 per share, the value that Cornell had arrived at.  In so holding, the court repeatedly cited the recent PetSmart decision to underscore the principle that Delaware Chancery prefers that the projections used in a DCF be derived from contemporaneous management projections that are prepared in the ordinary course of business.  Such projections are generally deemed more reliable as they are prepared by management — who has the best first-hand knowledge of the company’s operations — and they are generally not influenced by transactional dynamics or tainted by hindsight-driven litigation considerations.  But unlike PetSmart, here the court did not peg fair value at merger price given that a case could be made that the previously agreed-to price of $2.97 itself reflected fair value, and that the $5 price that followed the bidding war with DISH was loaded with synergies and was not predicated on valuation fundamentals that were materially different from those used to support the initial $2.97 price.