Discounted Cash Flow Analysis

The Delaware Supreme Court issued its highly-anticipated ruling today in the Dell appraisal case, reversing and remanding the trial court’s 28% premium awarded to the stockholders.  In sum, the court held that where a company is sold in a pristine M&A auction process, the chancery court must give the merger price “heavy weight” in its ruling, leaving it to the trial court to decide just how much weight that should be in this case.   The Supreme Court also ruled on a cross-appeal challenging how the trial court assessed expenses across the appraisal class.

**This firm is a counsel of record in the Dell case.

On Monday, Law360 [$$] reported that the stockholders in the Clearwire appraisal action filed their opening brief in support of their appeal of the Chancery Court’s ruling, which found the fair value of Clearwire Corp. to be $2.13 per share, well below the $5 per share deal price paid by Sprint Nextel Corp.  As reported in the article, on appeal, the stockholders argue that the “staggering discount” awarded by the Chancery Court is “virtually unprecedented.”  We have previously posted on the Chancery decision here.  We will continue to monitor the appeal and post on new developments as they arise.

The Delaware Supreme Court made its ruling this week in the ISN Software appraisal case.  A three-judge panel (not the full bench) affirmed the Chancery Court’s decision awarding a premium that was more than 2.5 times the merger price, as reported in Law360 [$$].  The Supreme Court affirmed without rendering its own opinion, relying instead on the trial court’s reasoning.  ISN Software was a privately held software company, with the appraisal case stemming from the controlling stockholder’s cash-out of some of the minority shares.

We have previously posted on the Chancery decision here, and have posted on the Supreme Court oral argument here.

As reported in Law360 [$$], on October 11, 2017 the Delaware Supreme Court heard argument appealing the Chancery Court’s ruling in the ISN Software appraisal case.  We have previously posted on the trial court’s decision here, in which Vice Chancellor Glasscock awarded a premium to the merger price.  The Supreme Court did not rule and did not indicate when it would do so.  You can see the complete oral argument here (under the October 11, 2017, listing; ISN Software v. Ad-Venture Capital).  Unlike the Dell and DFC Global arguments, the Supreme Court did not convene en banc – that is, with a full five-justice proceeding – and instead conducted argument by a three-justice panel, which did not include the Chief Justice.

We will continue to monitor the docket and post when the ruling is issued.

As reported today in Law360 [$$], the Delaware Supreme Court heard argument yesterday on the chancery court’s ruling in the Dell appraisal case.  The court did not render its decision and did not indicate when it would do so.  We’ll continue to monitor the docket and post when the ruling comes down.

** Note: this law firm is one of the counsel of record in the Dell case.

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.

Continue Reading Breaking Down The Clearwire-Sprint Appraisal Ruling

Today the Delaware Chancery Court issued its ruling in the Clearwire case, which included claims for breach of fiduciary duty as well as appraisal arising from its acquisition by Sprint.  We’ll provide a more comprehensive breakdown of the decision in a later post.

In the meantime, as reported today by Reuters, Hedge fund stung by unusual ruling over Sprint-Clearwire deal, the ruling “stands out for a court that rarely finds fair value below deal price, let alone more than 50 percent below.”

Among other factors, the court found that neither side argued in favor of deal price, and so the court did not even consider it but looked only at the respective valuation analyses put forth by each side’s valuation expert.  Given the considerable synergies in this transaction, the court held that the deal price provided an “exaggerated picture” of Clearwire’s value.  The court also noted that the experts’ choice of projections drove 90% of the difference in their DCF valuations.

Further to our prior post about Delaware’s two new appraisal decisions, SWS Group was a small, struggling bank holding company that merged on January 1, 2015 into one of its own substantial creditors, Hilltop Holdings.  Stockholders of SWS received a mix of cash and Hilltop stock worth $6.92 at closing.  Vice Chancellor Glasscock rejected the sale price as an unreliable indicator of fair value and performed his own DCF analysis, setting the fair value at $6.38, a price 7.8% below the merger price.

At trial, the petitioners persuaded the court that its critiques of the sale process were valid.  However, the stockholders failed to persuade the court that SWS was on the verge of a turnaround, as the court instead determined that SWS consistently underperformed management projections and, given its structural problems, a turnaround was simply unlikely.

Problems with SWS’s Projections and Performance

As was true in PetSmart, SWS had not historically performed long-term projections, but only created annual budgets that aggregated projections from individual business sectors.  Those single-year projections were then extrapolated into three-year “strategic plans” that assumed the annual budgets would be met.  The court found, however, that SWS never met those budgets between 2011 and 2014.  Also, despite straight-line growth assumptions in the management forecasts, SWS failed to hit its targets and continued to lose money on declining revenues.  The various problems facing the company led the court to embrace the respondents’ theory that SWS would continue to face an uphill climb given its relatively small size, which prevented it from scaling its substantial regulatory, technological, and back-office costs.

Hilltop’s Influence on the Sale Process Rendered Merger Price Unreliable

Even before SWS launched its sale process, Hilltop was interested in buying the company (unbeknownst to SWS).  Also, since Hilltop had observer status on SWS’s board, it had unique access to SWS’s board meetings and management not available to others.  The court found that Hilltop’s acquisition theses were driven by synergies, as it viewed its acquisition of SWS as resulting mainly in cost savings by reduction of overhead.  A Special Committee was formed after Hilltop made its initial offer in January 2014, and the court found that even though the committee engaged legal and financial advisors, the management projections that evolved in the sale process were still overly optimistic and unrealistic about SWS’s projected growth.  Only two other bidders emerged, one of which was found not to be credible and the other continued to bid through March 2014 despite apparent pressure by Hilltop to proceed with its deal.  Finally, in response to Hilltop’s unilateral March 31, 2014 deadline, the board decided to accept its offer, which at that time was valued at $7.75, consisting of 75% Hilltop stock and 25% cash.  As of closing on January 1, 2015, the value dropped to $6.92 per share based on a reduction in Hilltop’s own stock price.

Another factor making the deal price unreliable was that Hilltop was a creditor of SWS pursuant to a Credit Agreement.  That agreement contained a covenant prohibiting SWS from undergoing a “Fundamental Change,” which was defined to include the sale of SWS.  The agreement thus conferred upon Hilltop a veto right over any competing offers, which right Hilltop refused to waive during the sale process.

Valuation Model & DCF Inputs

The court undertook its own DCF analysis, on which it relied exclusively.  The court refused to put any weight on petitioners’ comparable companies analysis, finding that the comp set diverged too much from SWS in terms of size, business lines, and performance to be meaningful.  The court held that SWS’s unique structure, size, and business model – particularly its composition of a broker-dealer business alongside its banking line – rendered the stockholders’ selected peers not truly comparable.

In performing its DCF valuation, the court used the existing three-year projection period in the management projections, rejecting the stockholders’ argument that SWS had not yet reached a “steady state” and that an additional two years was needed to normalize SWS’s financial performance.  The court found that SWS’s declining revenues in the period leading up to the merger deprived it of any basis to assume (unprecedented) straight-line growth beyond the existing three-year projection period.  In addition, the court found that the exercise of warrants three months prior to the merger pursuant to the Credit Agreement, which resulted in a change to SWS’s capital structure by cancelling debt in exchange for new shares, was part of SWS’s “operative reality” for purposes of the fair-value determination.  This ruling differed from other cases, such as BMC Software and Gearreald, where changes to the company’s balance sheet resulting from actions by the company solely in expectation of the merger – like the company paying off its debt – was not considered to be within the company’s operative reality.

As to the other DCF inputs, the court adopted the respondents’ perpetuity growth rate of 3.35%, which was the midpoint between the long-term inflation rate of 2.3%, and the long-term economic growth rate of 4.4%.  In selecting the appropriate equity risk premium, the court observed that whether to use supply-side or historical ERP should be determined on a case-by-case basis. Nevertheless, it found supply-side ERP appropriate as the “default” method in recent Delaware chancery cases, unless a party provided a compelling reason to use historical ERP.  With regard to beta, the court found fault with both side’s approach.  The respondents’ expert looked at two years of SWS weekly stock returns, which measurement period included a “merger froth” and too much volatility to be reliable.  The petitioners’ expert, in contrast, surveyed multiple betas and used a blended median; even though the court found that this approach relied on comparable companies that were not truly comparable, it nevertheless adopted this beta – despite its apparent drawbacks – as the one more closely in line with the record evidence.  Finally, to determine size premium, the court took the midpoint of both side’s decile (which was 3.46%), finding that using market capitalization is generally appropriate for public companies (the respondents’ approach), and yet SWS’s capital structure, including its substantial in-the-money warrants and the outsized influence of its major creditor, made it more like a private company and not susceptible to a market cap approach (the petitioners’ argument).

Conclusion

In reaching its final determination of $6.38, the court said that a sub-merger price award was not surprising here given the synergistic nature of the transaction.  Also, given the award of statutory interest, which runs from the January 1, 2015 consummation date, it appears that the petitioners will ultimately recover more than the merger price after all.

 

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.