Tender offers always consist of an offer to exchange acquirer shares for shares in the
target firm. True or False
Answer:
The extremely high leverage associated with leveraged buyouts significantly increases
the riskiness of the cash flows available to equity investors as a result of the increase in
fixed interest and principal repayments that must be made to lenders. Consequently, the
cost of equity should be adjusted for the increased leverage of the firm. True or False
Answer:
Trend extrapolation, which entails extending present trends into the future using
historical growth rates or multiple regression techniques, is rarely used to forecast cash
flow. True or False
Answer:
Shell corporations may be attractive for investors interested in capitalizing on the
intangible value associated with the existing corporate shell. This could include name
recognition; licenses, patents, and other forms of intellectual properties; and
underutilized assets such as warehouse space and fully depreciated equipment with
some economic life remaining. True or False
Answer:
Market power is a theory that suggests that firms merge to improve their ability to set
product and service selling prices. True or False
Answer:
The Euroequity market reflects equity issues by a foreign firm tapping a larger investor
base than the firm’s home equity market. True or False
Answer:
The LBO that is initiated by the target firm’s incumbent management is called a
management buyout. True or False
Answer:
A newly merged company will often experience at least a 5-10% loss of current
customers during the integration effort. True or False
Answer:
A composition is an agreement in which creditors agree to settle for less than the full
amount they are owed. True or False
Answer:
M&A practitioners utilize nominal cash flows except in circumstances of high rates of
inflation, when real cash flows are preferable. True or False
Answer:
Appreciating foreign currencies relative to the dollar increase the overall cost of
investing in the U.S. True or False
Answer:
Firms with redundant assets and predictable cash flow are often good candidates for
leveraged buyouts. True or False
Answer:
Antitakeover laws do not exist at the state level. True or False
Answer:
Elaborate multimedia presentations made to potential lenders in an effort to ‘shop” for
the best financing are often referred to as the “road show.” True or False
Answer:
Using stock as a form of payment is generally less complicated than using cash from
the buyer’s point of view. True or False
Answer:
Acquisition plan objectives should be directly linked to key business plan objectives.
True or False
Answer:
Acquisitions involving companies of a certain size cannot be completed until certain
information is supplied to the federal government and until a specific waiting period has
elapsed.
True or False
Answer:
Federal law prohibits trading in a bankrupt firm’s securities. True or False
Answer:
Empirical studies show that the desire by parent firms to increase strategic focus is an
important motive for exiting businesses. True or False
Answer:
Co-locating employees from the acquiring and target firms is rarely a good idea early in
the integration period because of the inevitable mistrust that will arise. True or False
Answer:
Equity carve-outs are similar to divestitures and spin-offs in that they provide a cash
infusion to the parent. True or False
Answer:
ESOP structures are rarely used vehicles for transferring the owner’s interest in the
business to the employees in small, privately owned firms. True or False
Answer:
Newly merged firms frequently experience a loss of existing customers as a direct
consequence of the merger. True or False
Answer:
The market or markets in which a firm chooses to compete should reflect the fit
between the firm’s primary strengths and its ability to satisfy customers needs better
than the competition. True or False
Answer:
If the selling price of the failing firm is less than the going concern and liquidation
value, the firm should sell the firm to another party.
Answer:
In choosing how to manage an acquisition in a new country, a manager with an in-depth
knowledge of the acquirer’s priorities, decision-making processes, and operations is
appropriate, especially when the acquirer expects to make very large new investments.
True or False
Answer:
LBO investors will often use the target firm’s cash in excess of normal working capital
requirements to finance the transaction. True or False
Answer:
A joint venture is rarely an independent legal entity such as a corporation or
partnership.
True or False
Answer:
A three-month Treasury bill rate is not free of risk for a five- or ten-year period, since
interest and principal received at maturity must be reinvested at three month intervals.
True or False
Answer:
Business alliances often receive favorable antitrust regulatory treatment. True or False
Answer:
Asset based lenders will usually lend up to 100% if the book value of the LBO target’s
receivables. True or False
Answer:
Rumors of impending acquisition can have a substantial deleterious impact on the target
firm. True or False
Answer:
Borrowers often prefer term loans because they do not have to be concerned that these
loans will have to be renewed. True or False
Answer:
The cost of equity can also be viewed as an opportunity cost. True or False
Answer:
Most M&A transactions in the United States are hostile or unfriendly takeover attempts.
True or False
Answer:
When buyers and sellers cannot reach agreement on price, other mechanisms can be
used to close the gap. These include balance sheet adjustments, earn-outs, rights to
intellectual property, and licensing fees. True or False
Answer:
In a public solicitation, a firm can announce publicly that it is putting itself, a
subsidiary, or a product line up for sale. Either potential buyers contact the seller or the
seller actively solicits bids from potential buyers or both. True or False
Answer:
Relative valuation methods are often described as market-based, as they reflect the
amounts investors are willing to pay for each dollar of earnings, cash flow, sales, or
book value at a moment in time. True or False
Answer:
LBO analyses are similar to DCF valuations in that they require projected cash flows,
present values, and discount rates; however, LBO models do not require the estimation
of terminal values. True or False
Answer:
Both public and private firms always attempt to maximize earnings growth. True or
False
Answer:
Avoiding the Merger Blues: American Airlines Integrates TWA
Trans World Airlines (TWA) had been tottering on the brink of bankruptcy for several
years, jeopardizing a number of jobs and the communities in which they are located.
Despite concerns about increased concentration, regulators approved American’s
proposed buyout of TWA in 2000 largely on the basis of the “failing company doctrine.”
This doctrine suggested that two companies should be allowed to merge despite an
increase in market concentration if one of the firms can be saved from liquidation.
American, now the world’s largest airline, has struggled to assimilate such smaller
acquisitions as AirCal in 1987 and Reno Air in 1998. Now, in trying to meld together
two major carriers with very different and deeply ingrained cultures, a combined
workforce of 113,000 and 900 jets serving 300 cities, American faced even bigger
challenges. For example, because switches and circuit breakers are in different locations
in TWA’s cockpits than in American’s, the combined airlines must spend millions of
dollars to rearrange cockpit gear and to train pilots how to adjust to the differences.
TWA’s planes also are on different maintenance schedules than American’s jets. For
American to see any savings from combining maintenance operations, it gradually had
to synchronize those schedules. Moreover, TWA’s workers had to be educated in
American’s business methods, and the carrier’s reservations had to be transferred to
American’s computer systems. Planes had to be repainted, and seats had to be
rearranged (McCartney, 2001).
Combining airline operations always has proved to be a huge task. American has
studied the problems that plagued other airline mergers, such as Northwest, which
moved too quickly to integrate Republic Airlines in This integration proved to be one of
the most turbulent in history. The computers failed on the first day of merged
operations. Angry workers vandalized ground equipment. For 6 months, flights were
delayed and crews did not know where to find their planes. Passenger suitcases were
misrouted. Former Republic pilots complained that they were being demoted in favor of
Northwest pilots. Friction between the two groups of pilots continued for years. In
contrast, American adopted a more moderately paced approach as a result of the
enormity and complexity of the tasks involved in putting the two airlines together. The
model they followed was Delta Airline’s acquisition of Western Airlines in 1986. Delta
succeeded by methodically addressing every issue, although the mergers were far less
complex because they involved merging far fewer computerized systems.
Even Delta had its problems, however. In 1991, Delta purchased Pan American World
Airways’ European operations. Pan Am’s international staff had little in common with
Delta’s largely domestic-minded workforce, creating a tremendous cultural divide in
terms of how the combined operations should be managed. In response to the 19911992
recession, Delta scaled back some routes, cut thousands of jobs, and reduced pay and
benefits for workers who remained..
Before closing, American had set up an integration management team of 12 managers,
six each from American and TWA. An operations czar, who was to become the vice
chair of the board of the new company, directed the team. The group met daily by
phone for as long as 2 hours, coordinating all merger-related initiatives. American set
aside a special server to log the team’s decisions. The team concluded that the two
lynchpins to a successful integration process were successfully resolving labor
problems and meshing the different computer systems. To ease the transition, William
Compton, TWA’s CEO, agreed to stay on with the new company through the transition
period as president of the TWA operations.
The day after closing the team empowered 40 department managers at each airline to
get involved. Their tasks included replacing TWA’s long-term airport leases with
short-term ones, combining some cargo operations, changing over the automatic
deposits of TWA employees’ paychecks, and implementing American’s environmental
response program at TWA in case of fuel spills. Work teams, consisting of both
American and TWA managers, identified more than 10,000 projects that must be
undertaken before the two airlines can be fully integrated.
Some immediate cost savings were realized as American was able to negotiate new
lease rates on TWA jets that are $200 million a year less than what TWA was paying.
These savings were a result of the increased credit rating of the combined companies.
However, other cost savings were expected to be modest during the 12 months
following closing as the two airlines were operated separately. TWA’s union workers,
who would have lost their jobs had TWA shut down, have been largely supportive of the
merger. American has won an agreement from its own pilots’ union on a plan to
integrate the carriers’ cockpit crews. Seniority issues proved to be a major hurdle.
Getting the mechanics’ and flight attendants’ unions on board required substantial effort.
All of TWA’s licenses had to be switched to American. These ranged from the Federal
Aviation Administration operating certificate to TWA’s liquor license in all the states.
Discussion Questions:
1) In your opinion, what are the advantages and disadvantages of moving to integrate
operations quickly? What are the advantages and disadvantages of moving more slowly
and deliberately?
2) Why did American choose to use managers from both airlines to direct the
integration of the two companies? What are the specific benefits in doing so?
3) How did the interests of the various stakeholders to the merger affect the complexity
of the integration process?
Answer:
In determining whether a proposed transaction is anti-competitive, U.S. regulators look
at all of the following except for
a. Market share of the combined businesses
b. Potential for price fixing
c. Ease of new competitors to enter the market
d. Potential for job loss among target firm’s employees
e. The potential for the target firm to fail without the takeover
Answer:
Which of the following is not true about mergers and acquisitions and taxes?
a. Tax considerations and strategies are likely to have an important impact on how a
deal is structured by affecting the amount, timing, and composition of the price offered
to a target firm.
b. Tax factors are likely to affect how the combined firms are organized following
closing, as the tax ramifications of a corporate structure are quite different from those of
a limited liability company or partnership.
c. Potential tax savings are often the primary motivation for an acquisition or merger.
d. Transactions may be either partly or entirely taxable to the target firm’s shareholders
or tax-free.
b. None of the above
Answer:
The form of acquisition refers to which of the following:
a. Tax status of the transaction
b. Acquisition vehicle
c. What is being acquired, i.e., stock or assets
d. Form of payment
e. How the transaction will be displayed for financial reporting purposes
Answer:
Developing staffing plans requires which of the following?
a. Identifying personnel requirements
b. Determining the availability of skilled employees to fill these requirements
c. Developing compensation plans
d. A and B only
e. A, B, and C
Answer:
Institutional investors in private companies often have considerable influence approving
or disapproving
proposed mergers. Which of the following are generally not considered institutional
investors?
a. Pension funds
b. Insurance companies
c. Bank trust departments
d. United States Treasury Department
e. Mutual funds
Answer:
Why would creditors be willing to give a portion of what they are owed by the debtor
firm for equity in the reorganized firm?
a. They are legally obligated to do so under U.S. bankruptcy law.
b. Ownership in a firm is inherently more valuable than being a creditor.
c. The value of the stock may in the long run far exceed the amount of debt the
creditors were willing to forgive.
d. Creditors understand that they can sue the firm at a later date for what they are owed.
e. None of the above.
Answer:
Which one of the following is not a commonly used method of valuing target firms?
a. Discounted cash flow
b. Comparable companies method
c. Recent transactions method
d. Asset oriented method
e. Share exchange ratio method
Answer:
In civil law countries (which include Western Europe, South America, Japan, and
Korea), the acquisition will generally be in the form of a share company or limited
liability company. True or False
Answer:
All of the following are true about product life cycles except for
a. Strong sales growth and low barriers to entry often characterize the early stages of a
product’s introduction
b. New entrants have substantially poorer cost positions, as a result of their small
market shares when compared to earlier entrants.
c. Later phases are characterized by slower market growth rates
d. During the high growth phases, firms usually experience high positive operating cash
flow
e. The introduction of product enhancements can extend a firm’s product life cycle
Answer:
Which of the following is not true about the constant growth valuation model?
a. The firm’s free cash flow is assumed to be unchanged in perpetuity
b. The firm’s free cash flow is assumed to grow at a constant rate in perpetuity
c. Free cash flow is discounted by the difference between the appropriate discount rate
and the expected growth rate of cash flow.
d. The constant growth model is sometimes referred to as the Gordon Growth Model.
e. If the analyst were using free cash flow to the firm, cash flow would be discounted by
the firm’s cost of capital less the expected growth rate in cash flow.
Answer:
Exxon and Mobil MergerThe Market Share Conundrum
Following a review of the proposed $81 billion merger in late 1998, the FTC decided to
challenge the ExxonMobil transaction on anticompetitive grounds. Options available to
Exxon and Mobil were to challenge the FTC’s rulings in court, negotiate a settlement,
or withdraw the merger plans. Before the merger, Exxon was the largest oil producer in
the United States and Mobil was the next largest firm. The combined companies would
create the world’s biggest oil company in terms of revenues. Top executives from Exxon
Corporation and Mobil Corporation argued that they needed to implement their
proposed merger because of the increasingly competitive world oil market. Falling oil
prices during much of the late 1990s put a squeeze on oil industry profits. Moreover,
giant state-owned oil companies are posing a competitive threat because of their access
to huge amounts of capital. To offset these factors, Exxon and Mobil argued that they
had to combine to achieve substantial cost savings.
After a year-long review, antitrust officials at the FTC approved the ExxonMobil
merger after the companies agreed to the largest divestiture in the history of the FTC.
The divestiture involved the sale of 15% of their service station network, amounting to
2400 stations. This included about 1220 Mobil stations from Virginia to New Jersey and
about 300 in Texas. In addition, about 520 Exxon stations from New York to Maine and
about 360 in California were divested. Exxon also agreed to the divestiture of an Exxon
refinery in Benecia, California. In entering into the consent decree, the FTC noted that
there is considerably greater competition worldwide. This is particularly true in the
market for exploration of new reserves. The greatest threat to competition seems to be
in the refining and distribution of gasoline.
Discussion Questions:
1) How does the FTC define market share?
2) Why might it be important to distinguish between a global and a regional oil and gas
market?
3) Why are the Exxon and Mobil executives emphasizing efficiencies as a justification
for this
merger?
4) Should the size of the combined companies be an important consideration in the
regulators’
analysis of the proposed merger?
5) How do the divestitures address perceived anti-competitive problems?
Answer:
JV and alliance agreements often limit how and to whom parties to the agreement can
transfer their interests. These limitations include which of the following mechanisms?
a. Tag-along provisions
b. Drag-along provisions
c. Put provisions
d. A, B, and C
e. A and B only
Answer:
Purchasing the target firm’s stock in the open market is a commonly used tactic to
achieve all of
the following except for
a. Acquiring a controlling interest in the target firm without making such actions public
knowledge.
b. Lowering the average cost of acquiring the target firm’s shares
c. Recovering the cost of an unsuccessful takeover attempt
d. Obtaining additional voting rights in the target firm
e. Strengthening the effectiveness of proxy contests
Answer:
The screening process represents a refinement of the search process and commonly
utilizes which of the following as selection criteria
a. Market share, product line, and profitability
b. Product line, profitability, and growth rate
c. Profitability, leverage, and growth rate
d. Degree of leverage, market share, and growth rate
e. All of the above
Answer:
Which of the following is true of the adjusted present value method of valuation?
a. Calculates the present value of tax benefits separately
b. Calculates the present value of the firm’s cash flow without debt
c. Adds A and B together
d. A, B, and C
e. A and B only
Answer:
Which of the following are not true about ESOPs?
a. An ESOP is a trust
b. Employer contributions to an ESOP are tax deductible
c. ESOPs can never borrow
d. Employees participating in ESOPs are immediately vested
e. C and D
Answer:
Which of the following is not true of exporting as a market entry strategy?
a. Exporting does not require the expense of establishing local operations
b. Exporters do not need to establish some means of marketing and distributing their
products at the local level
c. Exporters incur high transportation costs
d. Exporters may be adversely impacted by exchange rate fluctuations
e. Exporters may be adversely impacted by tariffs placed on imports into the local
country
Answer:
Which of the following represent common law countries?
a. United Kingdom
b. Australia
c. India
d. Pakistan
e. All of the above
Answer:
All of the following are true of antitrust lawsuits except for
a. The FTC files lawsuits in most cases they review.
b. The FTC reviews complaints that have been recommended by its staff and approved
by the FTC
c. FTC guidelines commit the FTC to make a final decision within 13 months of a
complaint
d. As an alternative to litigation, a company may seek to negotiate a voluntary
settlement of its differences with the FTC.
e. FTC decisions can be appealed in the federal circuit courts.
Answer:
Which of the following is not true about goodwill ?
a. Goodwill must be written off over 20 years.
b. Goodwill must be checked for impairment at least annually.
c. The loss of key customers could impair the value of goodwill.
d. Goodwill does not have to be amortized.
e. Goodwill is shown as an asset on the balance sheet.
Answer:
Which of the following represent alternative ways for businesses to reap some or all of
the advantages of M&As?
a. Joint ventures and strategic alliances
b. Strategic alliances, minority investments, and licensing
c. Minority investments, alliances, and licensing
d. Franchises, alliances, joint ventures, and licensing
e. All of the above
Answer:
Which of the following is true of the equity valuation model?
a. Discounts free cash flow to the firm by the weighted average cost of capital
b. Discounts free cash flow to equity by the cost of equity
c. Discounts free cash flow the firm by the cost of equity
d. Discounts free cash flow to equity by the weighted average cost of capital
e. None of the above
Answer:
Which of the following activities are likely to extend beyond what is normally
considered the conclusion of the post-closing integration period?
a. Developing communication plans
b. Cultural integration
c. Integration planning
d. Developing staffing plans
e. None of the above
Answer:
Which of the following are required for an acquisition to be considered tax-free?
a. Continuity of interest
b. A legitimate business purpose other than tax avoidance
c. The use of predominately acquirer shares to buy the target’s shares
d. An all cash acquisition of the target firm’s shares
e. A, B, and C only
Answer:
Termination provisions in alliances commonly include all but which of the following:
a. Buyout provisions enabling one party to purchase another’s ownership interests
b. Predetermined prices at which the buyouts may take place
c. Breakup payments payable to the remaining partners
d. How assets and liabilities will be divided among the partners
e. What will happen to patents and licenses owned by the alliance
Answer:
The enterprise value to EBITDA multiple relates the total book value of the firm from
the perspective of the liability side of the balance sheet (i.e., long-term debt plus
preferred and common equity), excluding cash, to EBITDA. True or False
Answer:
Certain post integration issues are best addressed prior to the closing. These include all
of the following except for
a. Who will pay for employee severance expenses
b. How will employee payroll be managed during ownership transition
c. What will be done with checks from customers that the seller continues to receive
after closing
d. How will the seller be reimbursed for monies owed to suppliers for products sold
prior to closing
e. Who will pay for health care and disability claims that often arise just before a
business is sold?
Answer:
Which of the following are not true about economies of scale?
a. Spreading fixed costs over increasing production levels
b. Improve the overall cost position of the firm
c. Most common in manufacturing businesses
d. Most common in businesses whose costs are primarily variable
e. Are common to such industries as utilities, steel making, pharmaceutical, chemical
and aircraft manufacturing
Answer:
Local country firms may be interested in alliances for which of the following reasons?
a. To gain access to the technology
b. To gain access to a widely recognized brand name
c. To gain access to innovative products
d. A, B, and C
e. A and B only
Answer:
Kraft Sweetens the Offer to Overcome Cadbury’s Resistance
Despite speculation that offers from U.S.-based candy company Hershey and the Italian
confectioner Ferreiro would be forthcoming, Kraft’s bid on January 19, 2010, was
accepted unanimously by Cadbury’s board of directors. Kraft, the world’s second (after
Nestle) largest food manufacturer, raised its offer over its initial September 7, 2009, bid
to $19.5 billion to win over the board of the world’s second largest candy and chocolate
maker. Kraft also assumed responsibility for $9.5 billion of Cadbury’s debt.
Kraft’s initial bid evoked a raucous response from Cadbury’s chairman Roger Carr, who
derided the offer that valued Cadbury at $16.7 billion as showing contempt for his
firm’s well-known brand and dismissed the hostile bidder as a low-growth
conglomerate. Immediately following the Kraft announcement, Cadbury’s share price
rose by 45 percent (7 percentage points more than the 38 percent premium implicit in
the Kraft offer). The share prices of other food manufacturers also rose due to
speculation that they could become takeover targets.
The ensuing four-month struggle between the two firms was reminiscent of the highly
publicized takeover of U.S. icon Anheuser-Busch in 2008 by Belgian brewer InBev.
The Kraft-Cadbury transaction stimulated substantial opposition from senior
government ministers and trade unions over the move by a huge U.S. firm to take over
a British company deemed to be a national treasure. However, like InBev’s takeover of
Anheuser-Busch, what started as a donnybrook ended on friendly terms, with the two
sides reaching final agreement in a single weekend.
Determined to become a global food and candy giant, Kraft decided to bid for Cadbury
after the U.K.-based firm spun off its Schweppes beverages business in the United
States in 2008. The separation of Cadbury’s beverage and confectionery units resulted
in Cadbury becoming the world’s largest pure confectionery firm following the spinoff.
Confectionery companies tend to trade at a higher value, so adding the Cadbury’s
chocolate and gum business could enhance Kraft’s attractiveness to competitors.
However, this status was soon eclipsed by Mars’s acquisition of Wrigley in 2008.
A takeover of Cadbury would help Kraft, the biggest food conglomerate in North
America, to compete with its larger rival, Nestle. Cadbury would strengthen Kraft’s
market share in Britain and would open India, where Cadbury is among the most
popular chocolate brands. It would also expand Kraft’s gum business and give it a
global distribution network. Nestle lacks a gum business and is struggling with
declining sales as recession-plagued consumers turned away from its bottled water and
ice cream products. Cadbury and Kraft fared relatively well during the 20082009 global
recession, with Cadbury’s confectionery business proving resilient despite price
increases in the wake of increasing sugar prices. Kraft had benefited from rising sales of
convenience foods because consumers ate more meals at home during the recession.
The differences in the composition of the initial and final Kraft bids reflected a series of
crosscurrents. Irene Rosenfeld, the Kraft CEO, not only had to contend with
vituperative comments from Cadbury’s board and senior management, but she also was
soundly criticized by major shareholders who feared Kraft would pay too much for
Cadbury. Specifically, the firm’s largest shareholder, Warren Buffett’s Berkshire
Hathaway with a 9.4 percent stake, expressed concern that the amount of new stock that
would have to be issued to acquire Cadbury would dilute the ownership position of
existing Kraft shareholders. In an effort to placate dissident Kraft shareholders while
acceding to Cadbury’s demand for an increase in the offer price, Ms. Rosenfeld
increased the offer by 7 percent by increasing the cash portion of the purchase price.
The new bid consisted of $8.17 of cash and 0.1874 new Kraft shares, compared to
Kraft’s original offer of $4.89 of cash and 0.2589 new Kraft shares for each Cadbury
share outstanding. The change in the composition of the offer price meant that Kraft
would issue 265 million new shares compared with its original plan to issue 370
million. The change in the terms of the deal meant that Kraft would no longer have to
get shareholder approval for the new share issue, since it was able to avoid the NYSE
requirement that firms issuing shares totaling more than 20 percent of the number of
shares currently outstanding must receive shareholder approval to do so.
Discussion Questions:
1) Which firm is the acquirer and which is the target firm?
2) Why did the Cadbury common share price close up 38% on the announcement date,
7% more than the premium built into the offer price?
3) Why did the price of other food manufacturers also increase following the
announcement of the attempted takeover?
4) After four months of bitter and often public disagreement, Cadbury’s and Kraft’s
management reached a final agreement in a weekend. What factors do you believe
might have contributed to this rapid conclusion?
5) Kraft appeared to take action immediately following Cadbury’s spin-off of
Schweppes making Cadbury a pure candy company. Why do you believe that Kraft
chose not to buy Cadbury and later divest such noncore businesses as Schweppes?
Answer:
Hughes Corporation’s Dramatic Transformation
In one of the most dramatic redirections of corporate strategy in U.S. history, Hughes
Corporation transformed itself from a defense industry behemoth into the world’s
largest digital information and communications company. Once California’s largest
manufacturing employer, Hughes Corporation built spacecraft, the world’s first working
laser, communications satellites, radar systems, and military weapons systems.
However, by the late 1990s, the firm had undergone substantial gut-wrenching change
to reposition the firm in what was viewed as a more attractive growth opportunity. This
transformation culminated in the firm being acquired in 2004 by News Corp., a global
media empire.
To accomplish this transformation, Hughes divested its communications satellite
businesses and its auto electronics operation. The corporate overhaul created a firm
focused on direct-to-home satellite broadcasting with its DirecTV service offering.
DirecTV’s introduction to nearly 12 million U.S. homes was a technology made
possible by U.S. military spending during the early 1980s. Although military spending
had fueled much of Hughes’ growth during the decade of the 1980s, it was becoming
increasingly clear by 1988 that the level of defense spending of the Reagan years was
coming to a close with the winding down of the cold war.
For the next several years, Hughes attempted to find profitable niches in the rapidly
consolidating U.S. defense contracting industry. Hughes acquired General Dynamics’
missile business and made 15 smaller defense-related acquisitions. Eventually, Hughes’
parent firm, General Motors, lost enthusiasm for additional investment in
defense-related businesses. GM decided that, if Hughes could not participate in the
shrinking defense industry, there was no reason to retain any interests in the industry at
all. In November 1995, Hughes initiated discussions with Raytheon, and two years
later, it sold its aerospace and defense business to Raytheon for $9.8 billion. The firm
also merged its Delco product line with GM’s Delphi automotive systems. What
remained was the firm’s telecommunications division. Hughes had transformed itself
from a $16 billion defense contractor to a svelte $4 billion telecommunications
business.
Hughes’ telecommunications unit was its smallest operation but, with DirecTV, its
fastest growing. The transformation was to exact a huge cultural toll on Hughes’
employees, most of whom had spent their careers dealing with the U.S. Department of
Defense. Hughes moved to hire people aggressively from the cable and broadcast
businesses. By the late 1990s, former Hughes’ employees constituted only 1520 percent
of DirecTV’s total employees.
Restructuring continued through the end of the 1990s. In 2000, Hughes sold its satellite
manufacturing operations to Boeing for $3.75 billion. This eliminated the last
component of the old Hughes and cut its workforce in half. In December 2000, Hughes
paid about $180 million for Telocity, a firm that provides digital subscriber line service
through phone lines. This acquisition allowed Hughes to provide high-speed Internet
connections through its existing satellite service, mainly in more remote rural areas, as
well as phone lines targeted at city dwellers. Hughes now could market the same
combination of high-speed Internet services and video offered by cable providers,
Hughes’ primary competitor.
In need of cash, GM put Hughes up for sale in late 2000, expressing confidence that
there would be a flood of lucrative offers. However, the faltering economy and stock
market resulted in GM receiving only one serious bid, from media tycoon Rupert
Murdoch of News Corp. in February 2001. But, internal discord within Hughes and GM
over the possible buyer of Hughes Electronics caused GM to backpedal and seek
alternative bidders. In late October 2001, GM agreed to sell its Hughes Electronics
subsidiary and its DirecTV home satellite network to EchoStar Communication for
$25.8 billion. However, regulators concerned about the antitrust implications of the deal
disallowed this transaction. In early 2004, News Corp., General Motors, and Hughes
reached a definitive agreement in which News Corp acquired GM’s 19.9 percent stake
in Hughes and an additional 14.1 percent of Hughes from public shareholders and GM’s
pension and other benefit plans. News Corp. paid about $14 per share, making the deal
worth about $6.6 billion for 34.1 percent of Hughes. The implied value of 100 percent
of Hughes was, at that time, $19.4 billion, about three fourths of EchoStar’s valuation
three years earlier.
Case Study Discussion Questions:
1) How did changes in Hughes’ external environment contribute to its dramatic 20-year
restructuring effort? Cite specific influences in answering this question. (Hint: Consider
some of the motivations discussed in this chapter for engaging in restructuring
activities.). Cite examples of how Hughes took advantage of their core competencies in
pursuing other alternatives?
2) Why did Hughes’ board and management seem to rely heavily on divestitures rather
than other restructuring
strategies discussed in this chapter to achieve the radical transformation of the firm? Be
specific.
3) What risks did Hughes face in moving completely away from its core defense
business and into a high-technology commercial business? In your judgment, did
Hughes move too quickly or too slowly? Explain your answer.
4) Why did Hughes move so aggressively to hire employees from the cable TV and
broadcast industry?
5) Speculate as to why News Corp, a major entertainment industry content provider,
might have been interested in acquiring Hughes. Be specific.
Answer:
Coca-Cola and Procter & Gamble’s Aborted Effort to Create a Global Joint
Venture Company
Coca-Cola (Coke), arguably the world’s best-known brand, manufactures and
distributes Coca-Cola as well as 230 other products in 200 countries through the world’s
largest distribution system. Procter & Gamble (P&G) sells 300 brands to nearly 5
billion consumers in 140 countries and holds more food patents than the three largest
U.S. food companies combined. Moreover, P&G has a substantial number of new food
and beverage products under development. Both firms have been competing in the
health and wellness segment of the food market for years. P&G spends about 5 percent
of its annual sales, about $1.9 billion, on R&D and holds more than 27,000 patents. The
firm employs about 6,000 scientists, including about 1,200 people with PhDs.
Both firms have extensive distribution systems. P&G uses a centralized selling and
warehouse distribution system for servicing high-volume outlets, such as grocery store
chains. With a warehouse distribution system, the retailer is responsible for in-store
presentations of the brands, including shelving, display, and merchandising. The
primary disadvantage of this type of distribution system is that it does not reach many
smaller outlets cost effectively, resulting in many lost opportunities. In contrast, Coke
uses three distinct systems. Direct store delivery consists of a network of independently
operated bottlers, which bottle and deliver the product directly to the outlet. The bottler
also is responsible for in-store merchandising. Coke’s warehouse distribution is similar
to P&G’s and is used primarily to distribute Minute Maid products. Coke also sells
beverage concentrates to distributors and food service outlets.
On February 21, 2001, Coca-Cola and Procter & Gamble announced, amid great
fanfare, plans to create a stand-alone joint venture corporation focused on developing
and marketing new juice and juice-based beverages as well as snacks on a global basis.
The new company expected to benefit from Coca-Cola’s worldwide distribution,
merchandising, and customer marketing skills and P&G’s R&D capabilities and wide
range of popular brands. The new company would focus on the health and wellness
segment of the food market. Less than nine months later, Coke and P&G released a
one-sentence joint statement on September 21, 2001, that they could achieve better
returns for their respective shareholders if they pursued this opportunity independently.
Although it is unclear what may have derailed what initially had seemed to the potential
partners like such a good idea, it is instructive to examine the initial rationale for the
proposed joint effort.
Each parent would own 50 percent of the new company. Because of the businesses each
partner was to contribute to the JV, the firm would have annual sales of $4 billion. The
new firm would be an LLC, having its own board of directors consisting of two
directors each from Coke and P&G. Moreover, the new firm would have its own
management and dedicated staff providing administrative and R&D services. Coke was
contributing a number of well-known brands including Minute Maid, Hi-C, Five Alive,
Cappy, Kapo, Sonfil, and Qoo; P&G contributed Pringles, Sunny Delight, and Punica
beverages. The new company would have had 15 manufacturing facilities and about
6,000 employees.
Although the new firm was to have access to all distribution systems of the parents, it
would have been free to choose the best route to market for each product. Although
Minute Maid was to continue to use Coke’s distribution channels, it also was to take
advantage of existing refrigerated distribution systems built for Sunny Delight. Pringles
was to use a variety of distribution systems, including the existing warehouse system.
The Pringles brand was expected to take full advantage of Coke’s global distribution
and merchandising capabilities. Minute Maid was to gain access to new outlets through
Coke’s fountain and direct store distribution system.
The new company’s sales were expected to grow from $4 billion during the first 12
months of operation to more than $5 billion within two years. The combination of
increasing revenue and cost savings was expected to contribute about $200 million in
pretax earnings annually by 2005. Specifically, Pringles’s revenue growth as a result of
enhanced distribution was expected to contribute about $120 million of this projected
improvement in pretax earnings. The importance of improved distribution is illustrated
by noting that Coke has access to 16 million outlets globally. In the United States alone,
that represents a 10-fold increase for Pringles, from its current 150,000 points of outlet.
Similarly, improved merchandising and distribution of Sunny Delight was expected to
contribute an additional $30 million in pretax income. The remaining $50 million in
pretax earnings was to come from lower manufacturing, distribution, and administrative
expenses and through discounts received on bulk purchases of foodstuffs and
ingredients. P&G and Coke were hoping to stimulate innovation by combining global
brands and distribution with talent from both firms in what was hoped would be a
highly entrepreneurial corporate culture. The parents also hoped that the stand-alone
firm would be able to achieve focus and economies of scale that could not have been
achieved by either firm separately.
The results of the LLC were not to be consolidated with those of the parents but rather
shown using the equity method of accounting. Under this method of accounting, each
parent’s proportionate share of earnings (or losses) is shown on its income statement,
and its equity interest in the LLC is displayed on its balance sheets. The new company
was expected to be nondilutive of the earnings of the parents during its first full year of
operations and contribute to earnings per share in subsequent years. The incremental
earnings were expected to improve the market value of the parents by at least $1.52.0
billion (Bachman, 2001).
Some observers suggested that P&G would stand to benefit the most from the JV. It
would have gained substantially by obtaining access to the growing vending machine
market. Historically, P&G’s penetration in this market had been miniscule. This
perceived disproportionate benefit accruing to P&G may have contributed to the
eventual demise of the joint venture effort. Coke may have sought additional benefits
from the JV that P&G was simply not willing to cede. Once again, we see that, no
matter how attractive the concept may seem to be on the surface, the devil is indeed in
the details when comes to making it happen.
Discussion Questions:
1) In your opinion, what were the motivating factors for the Coke and P&G business
alliance?
2) Why do you think the parents selected a limited liability company structure for the
new company? What are the advantages and disadvantages of this structure over
alternative legal structures?
3) The parents estimate that the new company will add at least $1.5-$2.0 billion to their
market values. How do you think this estimated incremental value was determined?
4) Why do you think the parents opted to form a 50/50 distribution of ownership? What
are some of the possible challenges of operating the new company with this type of an
ownership arrangement? What can the parents do to overcome these challenges?
5) Do you think it is likely that the new company will become highly entrepreneurial
and innovative? Why? / Why not? What can the parents do to stimulate the
development of this type of an environment within the new company?
6) What factors may have contributed to the decision to discontinue efforts to
implement the joint venture? Consider control, scope, financial, and resource
contribution issues.
Answer:
Answer:
Answer:
Additional Problems/Case Studies
The Importance of Distinguishing Between Operating and Nonoperating Assets
In 2006, Verizon Communications and MCI Inc. executives completed a deal in which
MCI shareholders received $6.7 billion for 100% of MCI stock. Verizon’s management
argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI
having agreed to pay its shareholders a special dividend of $1.4 billion contingent on
their approval of the transaction. The $1.4 billion special dividend reduced MCI’s cash
in excess of what was required to meet its normal operating cash requirements.
To understand the actual purchase price, it is necessary to distinguish between operating
and nonoperating assets. Without the special dividend, the $1.4 billion in cash would
have transferred automatically to Verizon as a result of the purchase of MCI’s stock.
Verizon would have had to increase its purchase price by an equivalent amount to
reflect the face value of this nonoperating cash asset. Consequently, the purchase price
would have been $6.7 billion. With the special dividend, the excess cash transferred to
Verizon was reduced by $1.4 billion, and the purchase price was $5.3 billion.
In fact, the alleged price reduction was no price reduction at all. It simply reflected
Verizon’s shareholders receiving $1.4 billion less in net acquired assets. Moreover, since
the $1.4 billion represents excess cash that would have been reinvested in MCI or paid
out to shareholders anyway, the MCI shareholders were simply getting the cash earlier
than they may have otherwise.
The Hunt for Elusive Synergy@Home Acquires Excite
Background Information
Prior to @Home Network’s merger with Excite for $6.7 billion, Excite’s market value
was about $3.5 billion. The new company combined the search engine capabilities of
one of the best-known brands (at that time) on the Internet, Excite, with @Home’s
agreements with 21 cable companies worldwide. @Home gains access to the nearly 17
million households that are regular users of Excite. At the time, this transaction
constituted the largest merger of Internet companies ever. At the time of the transaction,
the combined firms, called Excite @Home, displayed a P/E ratio in excess of 260 based
on the consensus earnings estimate of $0.21 per share. The firm’s market value was
$18.8 billion, 270 times sales. Investors had great expectations for the future
performance of the combined firms, despite their lackluster profit performance since
their inception. @Home provided interactive services to home and business users over
its proprietary network, telephone company circuits, and through the cable companies’
infrastructure. Subscribers paid $39.95 per month for the service.
Assumptions
Excite is properly valued immediately prior to announcement of the transaction.
Annual customer service costs equal $50 per customer.
Annual customer revenue in the form of @Home access charges and ancillary services
equals $500 per customer. This assumes that declining access charges in this highly
competitive environment will be offset by increases in revenue from the sale of
ancillary services.
None of the current Excite user households are current @Home customers.
New @Home customers acquired through Excite remain @Home customers in
perpetuity.
@Home converts immediately 2 percent or 340,000 of the current 17 million Excite
user households.
@Home’s cost of capital is 20 percent during the growth period and drops to 10
percent during the slower, sustainable growth period; its combined federal and state tax
rate is 40 percent.
Capital spending equals depreciation; current assets equal current liabilities.
FCFF from synergy increases by 15 percent annually for the next 10 years and 5
percent thereafter. Its cost of capital after the high-growth period drops to 10 percent.
The maximum purchase price @Home should pay for Excite equals Excite’s current
market price plus the synergy that results from the merger of the two businesses.
Discussion Questions
1) Use discounted cash flow (DCF) methods to determine if @Home overpaid for
Excite.
2) What other assumptions might you consider in addition to those identified in the case
study?
3) What are the limitations of the discounted cash flow method employed in this case?
Answers to Case Study Questions:
1) Did @Home overpay for Excite?
2) What other assumptions might you consider?
3) What are the limitations of the valuation methodology employed in this case?
Answer:
Daimler Acquires ChryslerAnatomy of a Cross-Border Transaction
The combination of Chrysler and Daimler created the third largest auto manufacturer in
the world, with more than 428,000 employees worldwide. Conceptually, the strategic fit
seemed obvious. German engineering in the automotive industry was highly regarded
and could be used to help Chrysler upgrade both its product quality and production
process. In contrast, Chrysler had a much better track record than Daimler in getting
products to market rapidly. Daimler’s distribution network in Europe would give
Chrysler products better access to European markets; Chrysler could provide parts and
service support for Mercedes-Benz in the United States. With greater financial strength,
the combined companies would be better able to make inroads into Asian and South
American markets.
Daimler’s product markets were viewed as mature, and Chrysler was under pressure
from escalating R&D costs and retooling demands in the wake of rapidly changing
technology. Both companies watched with concern the growing excess capacity of the
worldwide automotive manufacturing industry. Daimler and Chrysler had been in
discussions about doing something together for some time. They initiated discussions
about creating a joint venture to expand into Asian and South American markets, where
both companies had a limited presence. Despite the termination of these discussions as
a result of disagreement over responsibilities, talks were renewed in February Both
companies shared the same sense of urgency about their vulnerability to companies
such as Toyota and Volkswagen. The transaction was completed in April 1998 for $36
billion.
Enjoying a robust auto market, starry-eyed executives were touting how the two firms
were going to save billions by using common parts in future cars and trucks and by
sharing research and technology. In a press conference to announce the merger, Jurgen
Schrempp, CEO of DaimlerChrysler, described the merger as highly complementary in
terms of product offerings and the geographic location of many of the firms’
manufacturing operations. It also was described to the press as a merger of equals
(Tierney, 2000). On the surface, it all looked so easy.
The limitations of cultural differences became apparent during efforts to integrate the
two companies. Daimler had been run as a conglomerate, in contrast to Chrysler’s
highly centralized operations. Daimler managers were accustomed to lengthy reports
and meetings to review the reports. Under Schrempp’s direction, many top management
positions in Chrysler went to Germans. Only a few former Chrysler executives reported
directly to Schrempp. Made rich by the merger, the potential for a loss of American
managers within Chrysler was high. Chrysler managers were accustomed to a higher
degree of independence than their German counterparts. Mercedes dealers in the United
States balked at the thought of Chrysler’s trucks still sporting the old Mopar logo
delivering parts to their dealerships. All the trucks had to be repainted.
Charged with the task of finding cost savings, the integration team identified a list of
hundreds of opportunities, offering billions of dollars in savings. For example,
Mercedes dropped its plans to develop a battery-powered car in favor of Chrysler’s
electric minivan. The finance and purchasing departments were combined worldwide.
This would enable the combined company to take advantage of savings on bulk
purchases of commodity products such as steel, aluminum, and glass. In addition,
inventories could be managed more efficiently, because surplus components purchased
in one area could be shipped to other facilities in need of such parts. Long-term supply
contracts and the dispersal of much of the purchasing operations to the plant level
meant that it could take as long as 5 years to fully integrate the purchasing department.
The time required to integrate the manufacturing operations could be significantly
longer, because both Daimler and Chrysler had designed their operations differently and
are subject to different union work rules. Changing manufacturing processes required
renegotiating union agreements as the multiyear contracts expired. All of that had to
take place without causing product quality to suffer. To facilitate this process, Mercedes
issued very specific guidelines for each car brand pertaining to R&D, purchasing,
manufacturing, and marketing.
Although certainly not all of DaimlerChrysler’s woes can be blamed on the merger, it
clearly accentuated problems associated with the cyclical economic slowdown during
2001 and the stiffened competition from Japanese automakers. The firm’s top
management has reacted, perhaps somewhat belatedly to the downturn, by slashing
production and eliminating unsuccessful models. Moreover, the firm has pared its
product development budget from $48 billion to $36 billion and eliminated more than
26,000 jobs, or 20% of the firm’s workforce, by early 2002. Six plants in Detroit,
Mexico, Argentina, and Brazil were closed by the end of 2002. The firm also cut
sharply the number of Chrysler. car dealerships. Despite the aggressive cost cutting,
Chrysler reported a $2 billion operating loss in 2003 and a $400 million loss in 2004.
While Schrempp had promised a swift integration and a world-spanning company that
would dominate the industry, five years later new products have failed to pull Chrysler
out of a tailspin. Moreover, DaimlerChrysler’s domination has not extended beyond the
luxury car market, a market they dominated before the acquisition. The market
capitalization of DaimlerChrysler, at $38 billion at the end of 2004, was well below the
German auto maker’s $47 billion market cap before the transaction.
With the benefit of hindsight, it is possible to note a number of missteps
DaimlerChrysler has made that are likely to haunt the firm for years to come. These
include paying too much for some parts, not updating some vehicle models sooner,
falling to offer more high-margin vehicles that could help ease current financial strains,
not developing enough interesting vehicles for future production, and failing to be
completely honest with Chrysler employees. Although Daimler managed to take costs
out, it also managed to alienate the workforce.
Discussion Questions:
1) Identify ways in which the merger combined companies with complementary skills
and resources?
2) What are the major cultural differences between Daimler and Chrysler?
3) What were the principal risks to the merger?
4) Why might it take so long to integrate manufacturing operations and certain
functions such as purchasing?
5) How might Daimler have better managed the postmerger integration?
Answer:
FTC Prevents Staples from Acquiring Office Depot
As the leading competitor in the office supplies superstore market, Staples’ proposed
$3.3 billion acquisition of Office Depot received close scrutiny from the FTC
immediately after its announcement in September The acquisition would create a huge
company with annual sales of $10.7 billion. Following the acquisition, only one
competitor, OfficeMax with sales of $3.3 billion, would remain. Staples pointed out that
the combined companies would comprise only about 5% of the total office supply
market. However, the FTC considered the superstore market as a separate segment
within the total office supply market. Using the narrow definition of “market,” the FTC
concluded that the combination of Staples and Office Depot would control more than
three-quarters of the market and would substantially increase the pricing power of the
combined firms. Despite Staples’ willingness to divest 63 stores to Office Max in
markets in which its concentration would be the greatest following the merger, the FTC
could not be persuaded to approve the merger.
Staples continued its insistence that there would be no harmful competitive effects from
the proposed merger, because office supply prices would continue their long-term
decline. Both Staples and Office Depot had a history of lowering prices for their
customers because of the efficiencies associated with their ‘superstores.” The companies
argued that the merger would result in more than $4 billion in cost savings over 5 years
that would be passed on to their customers. However, the FTC argued and the federal
court concurred that the product prices offered by the combined firms still would be
higher, as a result of reduced competition, than they would have been had the merger
not taken place. The FTC relied on a study showing that Staples tended to charge higher
prices in markets in which it did not have another superstore as a competitor. In early
1997, Staples withdrew its offer for Office Depot.
Discussion Questions:
1) How important is properly defining the market segment in which the acquirer and
target
companies compete to determining the potential increased market power if the two are
permitted to combine? Explain your answer.
2) Do you believe the FTC was being reasonable in not approving the merger even
though?
Staples agreed to divest 63 stores in markets where market concentration would be the
greatest
following the merger? Explain your answer.
Answer:
Delta Airlines Rises from the Ashes
Key Points:
Once in Chapter 11, a firm may be able to negotiate significant contract concessions
with unions as well as its creditors.
A restructured firm emerging from Chapter 11 often is a much smaller but more
efficient operation than prior to its entry into bankruptcy.
______________________________________________________________________
________________
On April 30, 2007, Delta Airlines emerged from bankruptcy leaner but still an
independent carrier after a 19-month reorganization during which it successfully fought
off a $10 billion hostile takeover attempt by US Airways. The challenge facing Delta’s
management was to convince creditors that it would become more valuable as an
independent carrier than it would be as part of US Airways.
Ravaged by escalating jet fuel prices and intensified competition from low-fare,
low-cost carriers, Delta had lost $6.1 billion since the September 11, 2001, terrorist
attack on the World Trade Center. The final crisis occurred in early August 2005 when
the bank that was processing the airline’s Visa and MasterCard ticket purchases started
holding back money until passengers had completed their trips as protection in case of a
bankruptcy filing. The bank was concerned that it would have to refund the passengers’
ticket prices if the airline curtailed flights and the bank had to be reimbursed by the
airline. This move by the bank cost the airline $650 million, further straining the
carrier’s already limited cash reserves. Delta’s creditors were becoming increasingly
concerned about the airline’s ability to meet its financial obligations. Running out of
cash and unable to borrow to satisfy current working capital requirements, the airline
felt compelled to seek the protection of the bankruptcy court in late August 2005.
Delta’s decision to declare bankruptcy occurred about the same time as a similar
decision by Northwest Airlines. United Airlines and US Airways were already in
bankruptcy. United had been in bankruptcy almost three years at the time Delta entered
Chapter 11, and US Airways had been in bankruptcy court twice since the 9/11 terrorist
attacks shook the airline industry. At the time Delta declared bankruptcy, about one-half
of the domestic carrier capacity was operating under bankruptcy court oversight.
Delta underwent substantial restructuring of its operations. An important component of
the restructuring effort involved turning over its underfunded pilot’s pension plans to
the Pension Benefit Guaranty Corporation (PBGC), a federal pension insurance agency,
while winning concessions on wages and work rules from its pilots. The agreement with
the pilot’s union would save the airline $280 million annually, and the pilots would be
paid 14 percent less than they were before the airline declared bankruptcy. To achieve
an agreement with its pilots to transfer control of their pension plan to the PBGC, Delta
agreed to give the union a $650 million interest-bearing note upon terminating and
transferring the pension plans to the PBGC. The union would then use the airline’s
payments on the note to provide supplemental payments to members who would lose
retirement benefits due to the PBGC limits on the amount of Delta’s pension obligations
it would be willing to pay. The pact covers more than 6,000 pilots.
The overhaul of Delta, the nation’s third largest airline, left it a much smaller carrier
than the one that sought protection of the bankruptcy court. Delta shed about one jet in
six used by its mainline operations at the time of the bankruptcy filing, and it cut more
than 20 percent of the 60,000 employees it had just prior to entering Chapter 11. Delta’s
domestic carrying capacity fell by about 10 percent since it petitioned for Chapter 11
reorganization, allowing it to fill about 84 percent of its seats on U.S. routes. This
compared to only 72 percent when it filed for bankruptcy. The much higher utilization
of its planes boosted revenue per mile flown by 15 percent since it entered bankruptcy,
enabling the airline to better cover its fixed expenses. Delta also sold one of its “feeder”
airlines, Atlantic Southeast Airlines, for $425 million.
Delta would have $2.5 billion in exit financing to fund operations and a cost structure
of about $3 billion a year less than when it went into bankruptcy. The purpose of the
exit financing facility is to repay the company’s $2.1 billion debtor-in-possession credit
facilities provided by GE Capital and American Express, make other payments required
on exiting bankruptcy, and increase its liquidity position. With ten financial institutions
providing the loans, the exit facility consisted of a $1.6 billion first-lien revolving credit
line, secured by virtually all of the airline’s unencumbered assets, and a $900 million
second-lien term loan.
As required by the Plan of Reorganization approved by the Bankruptcy Court, Delta
cancelled its preplan common stock on April 30, 2007. Holders of preplan common
stock did not receive a distribution of any kind under the Plan of Reorganization. The
company issued new shares of Delta common stock as payment of bankruptcy claims
and as part of a postbankruptcy compensation program for Delta employees. Issued in
May 2007, the new shares were listed on the New York Stock Exchange.
Discussion Questions:
1) To what extent do you believe the factors contributing to the airline’s bankruptcy
were beyond the control of management? To what extent do you believe past airline
mismanagement may have contributed to the bankruptcy?
2) Comment on the fairness of the bankruptcy process to shareholders, lenders,
employees, communities, government, etc. Be specific.
3) Why would lenders be willing to lend to a firm emerging from Chapter 11? How did
the lenders attempt to manage their risks? Be specific.
4) In view of the substantial loss of jobs, as well as wage and benefit reductions, do you
believe that firms should be allowed to reorganize in bankruptcy? Explain your answer.
5) How does Chapter 11 potentially affect adversely competitors of those firms
emerging from bankruptcy? Explain your answer.
Answer:
Pepsi Buys Quaker Oats in a Highly Publicized Food Fight
On June 26, 2000, Phillip Morris, which owned Kraft Foods, announced its planned
$15.9 billion purchase of Nabisco, ranked seventh in the United States in terms of sales
at that time. By combining Nabisco with its Kraft operations, ranked number one in the
United States, Phillip Morris created an industry behemoth. Not to be outdone,
Unilever, the jointly owned BritishDutch giant, which ranked fourth in sales, purchased
Bestfoods in a $20.3 billion deal. Midsized companies such as Campbell’s could no
longer compete with the likes of Nestle, which ranked number three; Proctor &
Gamble, which ranked number two; or Phillip Morris. Consequently, these midsized
firms started looking for partners. Other companies were cutting back. The U.K.’s
Diageo, one of Europe’s largest food and beverage companies, announced the
restructuring of its Pillsbury unit by cutting 750 jobs10% of its workforce. PepsiCo,
ranked sixth in U.S. sales, spun off in 1997 its Pizza Hut, KFC, and Taco Bell restaurant
holdings. Also, eighth-ranked General Mills spun off its Red Lobster, Olive Garden,
and other brand-name stores in 1995. In 2001, Coca-Cola announced a reduction of
6000 in its worldwide workforce.
As one of the smaller firms in the industry, Quaker Oats faced a serious problem: it was
too small to acquire other firms in the industry. As a result, they were unable to realize
the cost reductions through economies of scale in production and purchasing that their
competitors enjoyed. Moreover, they did not have the wherewithal to introduce rapidly
new products and to compete for supermarket shelf space. Consequently, their revenue
and profit growth prospects appeared to be limited.
Despite its modest position in the mature and slow-growing food and cereal business,
Quaker Oats had a dominant position in the sports drink marketplace. As the owner of
Gatorade, it controlled 85% of the U.S. market for sports drinks. However, its
penetration abroad was minimal. Gatorade was the company’s cash cow. Gatorade’s
sales in 1999 totaled $1.83 billion, about 40% of Quaker’s total revenue. Cash flow
generated from this product line was being used to fund its food and cereal operations.
Gatorade’s management recognized that it was too small to buy other food companies
and therefore could not realize the benefits of consolidation.
After a review of its options, Quaker’s board decided that the sale of the company
would be the best way to maximize shareholder value. This alternative presented a
serious challenge for management. Most of Quaker’s value was in its Gatorade product
line. It quickly found that most firms wanted to buy only this product line and leave the
food and cereal businesses behind. Quaker’s management reasoned that it would be in
the best interests of its shareholders if it sold the total company rather than to split it
into pieces. That way they could extract the greatest value and then let the buyer decide
what to do with the non-Gatorade businesses. In addition, if the business remained
intact, management would not have to find some way to make up for the loss of
Gatorade’s substantial cash flow. Therefore, Quaker announced that it was for sale for
$15 billion. Potential suitors viewed the price as very steep for a firm whose businesses,
with the exception of Gatorade, had very weak competitive positions. Pepsi was the
first to make a formal bid for the firm, quickly followed by Coca-Cola and Danone.
By November 21, 2000, Coca-Cola and PepsiCo were battling to acquire Quaker. Their
interest stemmed from the slowing sales of carbonated beverages. They could not help
noticing the explosive growth in sports drinks. Not only would either benefit from the
addition of this rapidly growing product, but they also could prevent the other from
improving its position in the sports drink market. Both Coke and PepsiCo could boost
Gatorade sales by putting the sports drink in vending machines across the country and
selling it through their worldwide distribution network.
PepsiCo’s $14.3 billion fixed exchange stock bid consisting of 2.3 shares of its stock for
each Quaker share in early November was the first formal bid Quaker received.
However, Robert Morrison, Quaker’s CEO, dismissed the offer as inadequate. Quaker
wanted to wait, since it was expecting to get a higher bid from Coke. At that time, Coke
seemed to be in a better financial position than PepsiCo to pay a higher purchase price.
Investors were expressing concerns about rumors that Coke would pay more than $15
billion for Quaker and seemed to be relieved that PepsiCo’s offer had been rejected.
Coke’s share price was falling and PepsiCo’s was rising as the drama unfolded. In the
days that followed, talks between Coke and Quaker broke off, with Coke’s board
unwilling to support a $15.75 billion offer price.
After failing to strike deals with the world’s two largest soft drink makers, Quaker
turned to Danone, the manufacturer of Evian water and Dannon yogurt. Much smaller
than Coca-Cola or PepsiCo, Danone was hoping to hype growth in its healthy nutrition
and beverage business. Gatorade would complement Danone’s bottled-water brands.
Moreover, Quaker’s cereals would fit into Danone’s increasing focus on breakfast
cereals. However, few investors believed that the diminutive firm could finance a
purchase of Quaker. Danone proposed using its stock to pay for the acquisition, but the
firm noted that the purchase would sharply reduce earnings per share through 2003.
Danone backed out of the talks only 24 hours after expressing interest, when its stock
got pummeled on the news.
Nearly 1 month after breaking off talks to acquire Quaker Oats because of
disagreements over price, PepsiCo once again approached Quaker’s management. Its
second proposal was the same as its first. PepsiCo was now in a much stronger position
this time, especially because Quaker had run out of suitors. Under the terms of the
agreement, Quaker Oats would be liable for a $420 million breakup fee if the deal was
terminated, either because its shareholders didn’t approve the deal or the company
entered into a definitive merger agreement with an alternative bidder. Quaker also
granted PepsiCo an option to purchase 19.9% of Quaker’s stock, exercisable only if
Quaker is sold to another bidder. Such a tactic sometimes is used in conjunction with a
breakup fee to discourage other suitors from making a bid for the target firm.
With the purchase of Quaker Oats, PepsiCo became the leader of the sports drink
market by gaining the market’s dominant share. With more than four-fifths of the
market, PepsiCo dwarfs Coke’s 11% market penetration. This leadership position is
widely viewed as giving PepsiCo, whose share of the U.S. carbonated soft drink market
is 31.4% as compared with Coke’s 44.1%, a psychological boost in its quest to
accumulate a portfolio of leading brands.
Discussion Questions:
1) What factors drove consolidation within the food manufacturing industry? Name
other industries that are currently undergoing consolidation?
2) Why did food industry consolidation prompt Quaker to announce that it was for sale?
3) Why do you think Quaker wanted to sell its consolidated operations rather than to
divide the company into the food/cereal and Gatorade businesses?
4) Under what circumstances might the Quaker shareholder have benefited more if
Quaker had sold itself in pieces (i.e., food/cereal and Gatorade) rather than in total?
5) Do you think PepsiCo may have been willing to pay such a high price for Quaker for
reasons other than economics? Do you think these reasons make sense? Explain your
answer.
Answer:
Boston Scientific Overcomes Johnson & Johnson to Acquire GuidantA Lesson in
Bidding Strategy
Johnson & Johnson, the behemoth American pharmaceutical company, announced an
agreement in December 2004 to acquire Guidant for $76 per share for a combination of
cash and stock. Guidant is a leading manufacturer of implantable heart defibrillators
and other products used in angioplasty procedures. The defibrillator market has been
growing at 20 percent annually, and J&J desired to reenergize its slowing growth rate
by diversifying into this rapidly growing market. Soon after the agreement was signed,
Guidant’s defibrillators became embroiled in a regulatory scandal over failure to inform
doctors about rare malfunctions. Guidant suffered a serious erosion of market share
when it recalled five models of its defibrillators.
The subsequent erosion in the market value of Guidant prompted J&J to renegotiate the
deal under a material adverse change clause common in most M&A agreements. J&J
was able to get Guidant to accept a lower price of $63 a share in mid-November.
However, this new agreement was not without risk.
The renegotiated agreement gave Boston Scientific an opportunity to intervene with a
more attractive informal offer on December 5, 2005, of $72 per share. The offer price
consisted of 50 percent stock and 50 percent cash. Boston Scientific, a leading supplier
of heart stents, saw the proposed acquisition as a vital step in the company’s strategy of
diversifying into the high-growth implantable defibrillator market.
Despite the more favorable offer, Guidant’s board decided to reject Boston Scientific’s
offer in favor of an upwardly revised offer of $71 per share made by J&J on January 11,
2005. The board continued to support J&J’s lower bid, despite the furor it caused among
big Guidant shareholders. With a market capitalization nine times the size of Boston
Scientific, the Guidant board continued to be enamored with J&J’s size and industry
position relative to Boston Scientific.
Boston Scientific realized that it would be able to acquire Guidant only if it made an
offer that Guidant could not refuse without risking major shareholder lawsuits. Boston
Scientific reasoned that if J&J hoped to match an improved bid, it would have to be at
least $77, slightly higher than the $76 J&J had initially offered Guidant in December
2004. With its greater borrowing capacity, Boston Scientific knew that J&J also had the
option of converting its combination stock and cash bid to an all-cash offer. Such an
offer could be made a few dollars lower than Boston Scientific’s bid, since Guidant
investors might view such an offer more favorably than one consisting of both stock
and cash, whose value could fluctuate between the signing of the agreement and the
actual closing. This was indeed a possibility, since the J&J offer did not include a collar
arrangement.
Boston Scientific decided to boost the new bid to $80 per share, which it believed
would deter any further bidding from J&J. J&J had been saying publicly that Guidant
was already “fully valued.” Boston Scientific reasoned that J&J had created a public
relations nightmare for itself. If J&J raised its bid, it would upset J&J shareholders and
make it look like an undisciplined buyer. J&J refused to up its offer, saying that such an
action would not be in the best interests of its shareholders. Table 1 summarizes the key
events timeline.
A side deal with Abbott Labs made the lofty Boston Scientific offer possible. The firm
entered into an agreement with Abbott Laboratories in which Boston Scientific would
divest Guidant’s stent business while retaining the rights to Guidant’s stent technology.
In return, Boston Scientific received $6.4 billion in cash on the closing date, consisting
of $4.1 billion for the divested assets, a loan of $900 million, and Abbott’s purchase of
$1.4 billion of Boston Scientific stock. The additional cash helped fund the purchase
price. This deal also helped Boston Scientific gain regulatory approval by enabling
Abbott Labs to become a competitor in the stent business. Merrill Lynch and Bank of
America each would lend $7 billion to fund a portion of the purchase price and provide
the combined firms with additional working capital.
To complete the transaction, Boston Scientific paid $27 billion, consisting of cash and
stock, to Guidant shareholders and another $800 million as a breakup fee to J&J. In
addition, the firm is burdened with $14.9 billion in new debt. Within days of Boston
Scientific’s winning bid, the firm received a warning from the U.S. Food and Drug
Administration to delay the introduction of new products until the firm’s safety
procedures improved.
Between December 2004, the date of Guidant’s original agreement with J&J, and
January 25, 2006, the date of its agreement with Boston Scientific, Guidant’s stock rose
by 16 percent, reflecting the bidding process. During the same period, J&J’s stock
dropped by a modest 3 percent, while Boston Scientific’s shares plummeted by 32
percent.
As a result of product recalls and safety warnings on more than 50,000 Guidant cardiac
devices, the firm’s sales and profits plummeted. Between the announcement date of its
purchase of Guidant in December 2005 and year-end 2006, Boston Scientific lost more
than $18 billion in shareholder value. In acquiring Guidant, Boston Scientific increased
its total shares outstanding by more than 80 percent and assumed responsibility for $6.5
billion in debt, with no proportionate increase in earnings. In early 2010, Boston
Scientific underwent major senior management changes and spun off several business
units in an effort to improve profitability. Ongoing defibrillator recalls could shave the
firm’s revenue by $0.5 billion during the next two years.1 In 2010, continuing
product-related problems forced the firm to write off $1.8 billion in impaired goodwill
associated with the Guidant acquisition. At less than $8 per share throughout most of
2010, Boston Scientific’s share price is about one-fifth of its peak of $35.55 on
December 5, 2005, the day the firm announced its bid for Guidant.
Discussion Questions
1) What were the key differences between J&J’s and Boston Scientific’s bidding
strategy? Be specific.
2) What might J&J have done differently to avoid igniting a bidding war?
3) What evidence is given that J&J may not have taken Boston Scientific as a serious
bidder?
4) Explain how differing assumptions about market growth, potential synergies, and the
size of the potential liability related to product recalls affected the bidding?
Answer:
America Online Acquires Time Warner:
The Rise and Fall of an Internet and Media Giant
Time Warner, itself the product of the world’s largest media merger in a $14.1 billion
deal a decade ago, celebrated its 10th birthday by announcing on January 10, 2000, that
it had agreed to be taken over by America Online (AOL) at a 71% premium to its share
price on the announcement date. AOL had proposed the acquisition in October 1999. In
less than 3 months, the deal, valued at $160 billion as of the announcement date ($178
billion including Time Warner debt assumed by AOL), became the largest on record up
to that time. AOL had less than one-fifth of the revenue and workforce of Time Warner,
but AOL had almost twice the market value. As if to confirm the move to the new
electronic revolution in media and entertainment, the ticker symbol of the new company
was changed to AOL. However, the meteoric rise of AOL and its wunderkind CEO,
Steve Case, to stardom was to be short-lived.
Time Warner is the world’s largest media and entertainment company, and it views its
primary business as the creation and distribution of branded content throughout the
world. Its major business segments include cable networks, magazine publishing, book
publishing and direct marketing, recorded music and music publishing, and filmed
entertainment consisting of TV production and broadcasting as well as interests in other
film companies. The 1990 merger between Time and Warner Communications was
supposed to create a seamless marriage of magazine publishing and film production, but
the company never was able to put that vision into place. Time Warner’s stock
underperformed the market through much of the 1990s until the company bought the
Turner Broadcasting System in 1996.
Founded in 1985, AOL viewed itself as the world leader in providing interactive
services, Web brands, Internet technologies, and electronic commerce services. AOL
operates two subscription-based Internet services and, at the time of the announcement,
had 20 million subscribers plus another 2 million through CompuServe.
Strategic Fit (A 1999 Perspective)
On the surface, the two companies looked quite different. Time Warner was a media and
entertainment content company dealing in movies, music, and magazines, whereas AOL
was largely an Internet Service Provider offering access to content and commerce.
There was very little overlap between the two businesses. AOL said it was buying
access to rich and varied branded content, to a huge potential subscriber base, and to
broadband technology to create the world’s largest vertically integrated media and
entertainment company. At the time, Time Warner cable systems served 20% of the
country, giving AOL a more direct path into broadband transmission than it had with its
ongoing efforts to gain access to DSL technology and satellite TV. The cable connection
would facilitate the introduction of AOL TV, a service introduced in 2000 and designed
to deliver access to the Internet through TV transmission. Together, the two companies
had relationships with almost 100 million consumers. At the time of the announcement,
AOL had 23 million subscribers and Time Warner had 28 million magazine subscribers,
13 million cable subscribers, and 35 million HBO subscribers. The combined
companies expected to profit from its huge customer database to assist in the cross
promotion of each other’s products.
Market Confusion Following the Announcement
AOL’s stock was immediately hammered following the announcement, losing about
19% of its market value in 2 days. Despite a greater than 20% jump in Time Warner’s
stock during the same period, the market value of the combined companies was actually
$10 billion lower 2 days after the announcement than it had been immediately before
making the deal public. Investors appeared to be confused about how to value the new
company. The two companies’ shareholders represented investors with different
motivations, risk tolerances, and expectations. AOL shareholders bought their company
as a pure play in the Internet, whereas investors in Time Warner were interested in a
media company. Before the announcement, AOL’s shares traded at 55 times earnings
before interest, taxes, depreciation, and amortization have been deducted. Reflecting its
much lower growth rate, Time Warner traded at 14 times the same measure of its
earnings. Could the new company achieve growth rates comparable to the 70% annual
growth that AOL had achieved before the announcement? In contrast, Time Warner had
been growing at less than one-third of this rate.
Integration Challenges
Integrating two vastly different organizations is a daunting task. Internet company AOL
tended to make decisions quickly and without a lot of bureaucracy. Media and
entertainment giant Time Warner is a collection of separate fiefdoms, from magazine
publishing to cable systems, each with its own subculture. During the 1990s, Time
Warner executives did not demonstrate a sterling record in achieving their vision of
leveraging the complementary elements of their vast empire of media properties. The
diverse set of businesses never seemed to reach agreement on how to handle online
strategies among the various businesses.
Top management of the combined companies included icons such as Steve Case and
Robert Pittman of the digital world and Gerald Levin and Ted Turner of the media and
entertainment industry. Steve Case, former chair and CEO of AOL, was appointed chair
of the new company, and Gerald Levin, former chair and CEO of Time Warner,
remained as chair. Under the terms of the agreement, Levin could not be removed until
at least 2003, unless at least three-quarters of the new board consisting of eight directors
from each company agreed. Ted Turner was appointed as vice chair. The presidents of
the two companies, Bob Pittman of AOL and Richard Parsons of Time Warner, were
named co-chief operating officers (COOs) of the new company. Managers from AOL
were put into many of the top management positions of the new company in order to
‘shake up” the bureaucratic Time Warner culture.
None of the Time Warner division heads were in favor of the merger. They resented
having been left out of the initial negotiations and the conspicuous wealth of Pittman
and his subordinates. More profoundly, they did not share Levin’s and Case’s view of
the digital future of the combined firms. To align the goals of each Time Warner
division with the overarching goals of the new firm, cash bonuses based on the
performance of the individual business unit were eliminated and replaced with stock
options. The more the Time Warner division heads worked with the AOL managers to
develop potential synergies, the less confident they were in the ability of the new
company to achieve its financial projections (Munk: 2004, pp. 198-199).
The speed with which the merger took place suggested to some insiders that neither
party had spent much assessing the implications of the vastly different corporate
cultures of the two organizations and the huge egos of key individual managers. Once
Steve Case and Jerry Levin reached agreement on purchase price and who would fill
key management positions, their subordinates were given one weekend to work out the
“details.” These included drafting a merger agreement and accompanying documents
such as employment agreements, deal termination contracts, breakup fees, share
exchange processes, accounting methods, pension plans, press releases, capital
structures, charters and bylaws, appraisal rights, etc. Investment bankers for both firms
worked feverishly on their respective fairness opinions. While never a science, the
opinions had to be sufficiently compelling to convince the boards and the shareholders
of the two firms to vote for the merger and to minimize postmerger lawsuits against
individual directors. The merger would ultimately generate $180 million in fees for the
investment banks hired to support the transaction. (Munk: 2004, pp. 164-166).
The Disparity Between Projected and Actual Performance Becomes Apparent
Despite all the hype about the emergence of a vertically integrated new media company,
AOL seems to be more like a traditional media company, similar to Bertelsmann in
Germany, Vivendi in France, and Australia’s News Corp. A key part of the AOL Time
Warner strategy was to position AOL as the preeminent provider of high-speed access
in the world, just as it is in the current online dial-up world.
Despite pronouncements to the contrary, AOL Time Warner seems to be backing away
from its attempt to become the premier provider of broadband services. The firm has
had considerable difficulty in convincing other cable companies, who compete directly
with Time Warner Communications, to open up their networks to AOL. Cable
companies are concerned that AOL could deliver video over the Internet and steal their
core television customers. Moreover, cable companies are competing head-on with
AOL’s dial-up and high-speed services by offering a tiered pricing system giving
subscribers more options than AOL.
At $23 billion at the end of 2001, concerns mounted about AOL’s leverage. Under a
contract signed in March 2000, AOL gave German media giant Bertelsmann, an owner
of one-half of AOL Europe, a put option to sell its half of AOL Europe to AOL for
$6.75 billion. In early 2002, Bertelsmann gave notice of its intent to exercise the option.
AOL had to borrow heavily to meet its obligation and was stuck with all of AOL
Europe’s losses, which totaled $600 million in 2001. In late April 2002, AOL Time
Warner rocked Wall Street with a first quarter loss of $54 billion. Although investors
had been expecting bad news, the reported loss simply reinforced anxieties about the
firm’s ability to even come close to its growth targets set immediately following
closing. Rather than growing at a projected double-digit pace, earnings actually
declined by more than 6% from the first quarter of 2001. Most of the sub-par
performance stemmed from the Internet side of the business. What had been billed as
the greatest media company of the twenty-first century appeared to be on the verge of a
meltdown!
Epilogue
The AOL Time Warner story went from a fairy tale to a horror story in less than three
years. On January 7, 2000, the merger announcement date, AOL and Time Warner had
market values of $165 billion and $76 billion, respectively, for a combined value of
$241 billion. By the end of 2004, the combined value of the two firms slumped to about
$78 billion, only slightly more than Time Warner’s value on the merger announcement
date. This dramatic deterioration in value reflected an ill-advised strategy, overpayment,
poor integration planning, slow post-merger integration, and the confluence of a series
of external events that could not have been predicted when the merger was put together.
Who knew when the merger was conceived that the dot-com bubble would burst, that
the longest economic boom in U.S. history would fizzle, and that terrorists would attach
the World Trade Center towers? While these were largely uncontrollable and
unforeseeable events, other factors were within the control of those who engineered the
transaction.
The architects of the deal were largely incompatible, as were their companies. Early on,
Steve Case and Jerry Levin were locked in a power struggle. The companies’ cultural
differences were apparent early on when their management teams battled over
presenting rosy projections to Wall Street. It soon became apparent that the assumptions
underlying the financial projections were unrealistic as new online subscribers and
advertising revenue stalled. By mid 2002, the nearly $7 billion paid to buy out
Bertelsmann’s interest in AOL Europe caused the firm’s total debt to balloon to $28
billion. The total net loss, including the write down of goodwill, for 2002 reached $100
billion, the largest corporate loss in U.S. history. Furthermore, The Washington Post
uncovered accounting improprieties. The strategy of delivering Time Warner’s rich
array of proprietary content online proved to be much more attractive in concept than in
practice. Despite all the talk about culture of cooperation, business at Time Warner was
continuing as it always had. Despite numerous cross-divisional meetings in which
creative proposals were made, nothing happened (Munk: 2004, p. 219). AOL’s limited
broadband capability and archaic email and instant messaging systems encouraged
erosion in its customer base and converting the wealth of Time Warner content to an
electronic format proved to be more daunting than it had appeared. Finally, Both the
Securities and Exchange Commission and the Justice Department investigated AOL
Time Warner due to accounting improprieties. The firm admitted having inflated
revenue by $190 million during the 21 month period ending in fall of 2000. Scores of
lawsuits have been filed against the firm.
The resignation of Steve Case in January 2003 marked the restoration of Time Warner
as the dominant partner in the merger, but with Richard Parsons at the new CEO. On
October 16, 2003 the company was renamed Time Warner. Time Warner seemed
appeared to be on the mend. Parson’s vowed to simplify the company by divesting
non-core businesses, reduce debt, boost sagging morale, and to revitalize AOL. By late
2003, Parsons had reduced debt by more than $6 billion, about $2.6 billion coming
from the sale of Warner Music and another $1.2 billion from the sale of its 50% stake in
the Comedy Central cable network to the network’s other owner, Viacom Music. With
their autonomy largely restored, Time Warner’s businesses were beginning to generate
enviable amounts of cash flow with a resurgence in advertising revenues, but AOL
continued to stumble having lost 2.6 million subscribers during 2003. In mid-2004,
improving cash flow enabled the Time Warner to acquire Advertising.com for $435
million in cash.
Discussion Questions:
1) What were the primary motives for this transaction? How would you categorize them
in terms of the historical motives for mergers and acquisitions discussed in this chapter?
2) Although the AOL-Time Warner deal is referred to as an acquisition in the case, why
is it technically more correct to refer to it as a consolidation? Explain your answer.
3) Would you classify this business combination as a horizontal, vertical, or
conglomerate transaction? Explain your answer.
4) What are some of the reasons AOL Time Warner may fail to satisfy investor
expectations?
5) What would be an appropriate arbitrage strategy for this all-stock transaction?
Answer:
Verizon Acquires MCIThe Anatomy of Alternative Bidding Strategies
While many parties were interested in acquiring MCI, the major players included
Verizon and Qwest. U.S.-based Qwest is an integrated communications company that
provides data, multimedia, and Internet-based communication services on a national
and global basis. The acquisition would ease the firm’s huge debt burden of $17.3
billion because the debt would be supported by the combined company with a much
larger revenue base and give it access to new business customers and opportunities to
cut costs.
Verizon Communications, created through the merger of Bell Atlantic and GTE in 2000,
is the largest telecommunications provider in the United States. The company provides
local exchange, long distance, Internet, and other services to residential, business, and
government customers. In addition, the company provides wireless services to over 42
million customers in the United States through its 55 percentowned joint venture with
Vodafone Group PLC. Verizon stated that the merger would enable it to more efficiently
provide a broader range of services, give the firm access to MCI’s business customer
base, accelerate new product development using MCI’s fiber-optic network
infrastructure, and create substantial cost savings.
By mid-2004, MCI had received several expressions of interest from Verizon and
Qwest regarding potential strategic relationships. By July, Qwest and MCI entered into
a confidentiality agreement and proceeded to perform more detailed due diligence. Ivan
Seidenberg, Verizon’s chairman and CEO, inquired about a potential takeover and was
rebuffed by MCI’s board, which was evaluating its strategic options. These included
Qwest’s proposal regarding a share-for-share merger, following a one-time cash
dividend to MCI shareholders from MCI’s cash in excess of its required operating
balances. In view of Verizon’s interest, MCI’s board of directors directed management
to advise Richard Notebaert, the chairman and CEO of Qwest, that MCI was not
prepared to move forward with a potential transaction. The stage was set for what
would become Qwest’s laboriously long and ultimately unsuccessful pursuit of MCI, in
which the firm would improve its original offer four times, only to be rejected by MCI
in each instance even though the Qwest bids exceeded Verizon’s.
After assessing its strategic alternatives, including the option to remain a stand-alone
company, MCI’s board of directors concluded that the merger with Verizon was in the
best interests of the MCI stockholders. MCI’s board of directors noted that Verizon’s bid
of $26 in cash and stock for each MCI share represented a 41.5 percent premium over
the closing price of MCI’s common stock on January 26, 2005. Furthermore, the stock
portion of the offer included “price protection” in the form of a collar (i.e., the portion
of the purchase price consisting of stock would be fixed within a narrow range if
Verizon’s share price changed between the signing and closing of the transaction).
The merger agreement also provided for the MCI board to declare a special dividend of
$5.60 once the firm’s shareholders approved the deal. MCI’s board of directors also
considered the additional value that its stockholders would realize, since the merger
would be a tax-free reorganization in which MCI shareholders would be able to defer
the payment of taxes until they sold their stock. Only the cash portion of the purchase
price would be taxable immediately. MCI’s board of directors also noted that a large
number of MCI’s most important business customers had indicated that they preferred a
transaction between MCI and Verizon rather than a transaction between MCI and
Qwest.
While it is clearly impossible to know for sure, the sequence of events reveals a great
deal about Verizon’s possible bidding strategy. Any bidding strategy must begin with a
series of management assumptions about how to approach the target firm. It was
certainly in Verizon’s best interests to attempt a friendly rather than a hostile takeover of
MCI, due to the challenges of integrating these two complex businesses. Verizon also
employed an increasingly popular technique in which the merger agreement includes a
special dividend payable by the target firm to its shareholders contingent upon their
approval of the transaction. This special dividend is an inducement to gain shareholder
approval.
Given the modest 3 percent premium over the first Qwest bid, Verizon’s initial bidding
strategy appears to have been based on the low end of the purchase price range it was
willing to offer MCI. Verizon was initially prepared to share relatively little of the
potential synergy with MCI shareholders, believing that a bidding war for MCI would
be unlikely in view of the recent spate of mergers in the telecommunications industry
and the weak financial position of other competitors. SBC and Nextel were busy
integrating AT&T and Sprint, respectively. Moreover, Qwest appeared to be unable to
finance a substantial all-cash offer due to its current excessive debt burden, and its stock
appeared to have little appreciation potential because of ongoing operating losses.
Perhaps stunned by the persistence with which Qwest pursued MCI, Verizon believed
that its combination of cash and stock would ultimately be more attractive to MCI
investors than Qwest’s primarily all-cash offer, due to the partial tax-free nature of the
bid.
Throughout the bidding process, many hedge funds criticized MCI’s board publicly for
accepting the initial Verizon bid. Since its emergence from Chapter 11, hedge funds had
acquired significant positions in MCI’s stock, with the expectation that MCI constituted
an attractive merger candidate. In particular, Carlos Slim Helu, the Mexican
telecommunications magnate and largest MCI shareholder, complained publicly about
the failure of MCI’s board to get full value for the firm’s shares. Pressure from hedge
funds and other dissident MCI shareholders triggered a shareholder lawsuit to void the
February 14, 2005, signed merger agreement with Verizon.
In preparation for a possible proxy fight, Verizon entered into negotiations with Carlos
Slim Helu to acquire his shares. Verizon acquired Mr. Slim’s 13.7 percent stake in MCI
in April 2005. Despite this purchase, Verizon’s total stake in MCI remained below the
15 percent ownership level that would trigger the MCI rights plan.
About 70 percent (i.e., $1.4 billion) of the cash portion of Verizon’s proposed purchase
price consisted of a special MCI dividend payable by MCI when the firm’s shareholders
approved the merger agreement. Verizon’s management argued that the deal would cost
their shareholders only $7.05 billion (i.e., the $8.45 billion purchase price consisting of
cash and stock, less the MCI special dividend). The $1.4 billion special dividend
reduced MCI’s cash in excess of what was required to meet its normal operating cash
requirements.
Qwest consistently attempted to outmaneuver Verizon by establishing a significant
premium between its bid and Verizon’s, often as much as 25 percent. Qwest realized
that its current level of indebtedness would preclude it from significantly increasing the
cash portion of the bid. Consequently, it had to rely on the premium to attract enough
investor interest, particularly among hedge funds, to pressure the MCI board to accept
the higher bid. However, Qwest was unable to convince enough investors that its stock
would not simply lose value once more shares were issued to consummate the stock and
cash transaction.
Qwest could have initiated a tender or exchange offer directly to MCI shareholders,
proposing to purchase or exchange their shares without going through the merger
process. The tender process requires lengthy regulatory approval. However, if Qwest
initiated a tender offer, it could trigger MCI’s poison pill. Alternatively, a proxy contest
might have been preferable because Qwest already had a bid on the table, and the
contest would enable Qwest to lobby MCI shareholders to vote against the Verizon bid.
This strategy would have avoided triggering the poison pill.
Ultimately, Qwest was forced to capitulate simply because it did not have the financial
wherewithal to increase the $9.9 billion bid. It could not borrow anymore because of its
excessive leverage. Additional stock would have contributed to earnings dilution and
caused the firm’s share price to fall.
It is unusual for a board to turn down a higher bid, especially when the competing bid
was 17 percent higher. In accepting the Verizon bid, MCI stated that a number of its
large business customers had expressed a preference for the company to be bought by
Verizon rather than Qwest. MCI noted that these customer concerns posed a significant
risk in being acquired by Qwest. The MCI board’s acceptance of the lower Verizon bid
could serve as a test case of how well MCI directors are conducting their fiduciary
responsibilities. The central issue is how far boards can go in rejecting a higher offer in
favor of one they believe offers more long-term stability for the firm’s stakeholders.
Ron Perlman, the 1980s takeover mogul, saw his higher all-cash bid rejected by the
board of directors of Revlon Corporation, which accepted a lower offer from another
bidder. In a subsequent lawsuit, a court overruled the decision by the Revlon board in
favor of the Perlman bid. Consequently, from a governance perspective, legal precedent
compels boards to accept higher bids from bona fide bidders where the value of the bid
is unambiguous, as in the case of an all-cash offer. However, for transactions in which
the purchase price is composed largely of acquirer stock, the value is less certain.
Consequently, the target’s board may rule that the lower bidder’s shares have higher
appreciation potential or at least are less likely to decline than those shares of other
bidders.
MCI’s president and CEO Michael Capellas and other executives could collect $107
million in severance, payouts of restricted stock, and monies to compensate them for
taxes owed on the payouts. In particular, Capellas stood to receive $39.2 million if his
job is terminated “without cause” or if he leaves the company “for good reason.”
Discussion Questions:
1) Discuss how changing industry conditions have encouraged consolidation within the
telecommunications industry?
2) What alternative strategies could Verizon, Qwest, and MCI have pursued? Was the
decision to acquire MCI the best alternative for Verizon? Explain your answer.
3) Who are the winners and losers in the Verizon/MCI merger? Be specific.
4) What takeover tactics were employed or threatened to be employed by Verizon? By
Qwest? Be specific.
5) What specific takeover defenses did MCI employ? Be specific.
6) How did the actions of certain shareholders affect the bidding process? Be specific.
7) In your opinion, did the MCI board act in the best interests of their shareholders? Of
all their stakeholders? Be specific.
8) Do you believe that the potential severance payments that could be paid to Capellas
were excessive? Explain your answer. What are the arguments for and against such
severance plans for senior executives?
9) Should the antitrust regulators approve the Verizon/MCI merger? Explain your
answer.
10) Verizon’s management argued that the final purchase price from the perspective of
Verizon shareholders was not $8.45 billion but rather $7.05. This was so, they argued,
because MCI was paying the difference of $1.4 billion from their excess cash balances
as a special dividend to MCI shareholders. Why is this misleading?
Answer:
Answer:
Ford Acquires Volvo’s Passenger Car Operations
This case illustrates how the dynamically changing worldwide automotive market is
spurring a move toward consolidation among automotive manufacturers. The Volvo
financials used in the valuation are for illustration only they include revenue and costs
for all of the firm’s product lines. For purposes of exposition, we shall assume that
Ford’s acquisition strategy with respect to Volvo was to acquire all of Volvo’s operations
and later to divest all but the passenger car and possibly the truck operations. Note that
synergy in this business case is determined by valuing projected cash flows generated
by combining the Ford and Volvo businesses rather than by subtracting the standalone
values for the Ford and Volvo passenger car operations from their combined value
including the effects of synergy. This was done because of the difficulty in obtaining
sufficient data on the Ford passenger car operations.
Background
By the late 1990s, excess global automotive production capacity totaled 20 million
vehicles, and three-fourths of the auto manufacturers worldwide were losing money.
Consumers continued to demand more technological innovations, while expecting to
pay lower prices. Continuing mandates from regulators for new, cleaner engines and
more safety measures added to manufacturing costs. With the cost of designing a new
car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint
ventures an attractive means to distribute risk and maintain market share in this highly
competitive environment.
By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a
broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its
presence in Europe. Ford saw Volvo as a means of improving its product weaknesses,
expanding distribution channels, entering new markets, reducing development and
vehicle production costs, and capturing premiums from niche markets. Volvo Cars is
now part of Ford’s Premier Automotive Group, which also includes Aston Martin,
Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting
to 3.7% of sales. Excluding the passenger car group, operating margins would have
been 5.3%. To stay competitive, Volvo would have to introduce a variety of new
passenger cars over the next decade. Volvo viewed the capital expenditures required to
develop new cars as overwhelming for a company its size.
Historical and Projected Data
The initial review of Volvo’s historical data suggests that cash flow is highly volatile.
However, by removing nonrecurring events, it is apparent that Volvo’s cash flow is
steadily trending downward from its high in 1997. Table 9-10 displays a common-sized,
normalized income statement, balance sheet, and cash-flow statement for Volvo,
including both the historical period from 1993 through 1999 and a forecast period from
2000 through 2004. Although Volvo has managed to stabilize its cost of goods sold as a
percentage of net sales, operating expenses as a percentage of net revenue have
escalated in recent years. Operating margins have been declining since 1996. To regain
market share in the passenger car market, Volvo would have to increase substantially its
capital outlays. The primary reason valuation cash flow turns negative by 2004 is the
sharp increase in capital outlays during the forecast period. Ford’s acquisition of Volvo
will enable volume discounts from vendors, reduced development costs as a result of
platform sharing, access to wider distribution networks, and increased penetration in
selected market niches because of the Volvo brand name. Savings from synergies are
phased in slowly over time, and they will not be fully realized until There is no attempt
to quantify the increased cash flow that might result from increased market penetration.
Determining the Initial Offer Price
Volvo’s estimated value on a standalone basis is $15 billion. The present value of
anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should
lie within a range of $15 million to about $16 billion. Although potential synergies
appear to be substantial, savings due to synergies will be phased in gradually between
2000 and 2004. The absence of other current bidders for the entire company and Volvo’s
urgent need to fund future capital expenditures in the passenger car business enabled
Ford to set the initial offer price at the lower end of the range. Thus, the initial offer
price could be conservatively set at about $15.25 billion, reflecting only about
one-fourth of the total potential synergy resulting from combining the two businesses.
Other valuation methodologies tended to confirm this purchase price estimate. The
market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling
interest, Ford had to pay a premium to the market value on January 29, 1999. Applying
the 26% premium Ford paid for Jaguar, the estimated purchase price including the
premium is $15 billion, or $34 per share. This compares to $34.50 per share estimated
by dividing the initial offer price of $15.25 billion by Volvo’s total common shares
outstanding of 442 million.
Determining the Appropriate Financing Structure
Ford had $23 billion in cash and marketable securities on hand at the end of 1998
(Naughton, 1999). This amount of cash is well in excess of its normal cash operating
requirements. The opportunity cost associated with this excess cash is equal to Ford’s
cost of capital, which is estimated to be 11.5%about three times the prevailing interest
on short-term marketable securities at that time. By reinvesting some portion of these
excess balances to acquire Volvo, Ford would be adding to shareholder value, because
the expected return, including the effects of synergy, exceeds the cost of capital.
Moreover, by using this excess cash, Ford also is making itself less attractive as a
potential acquisition target. The acquisition is expected to increase Ford’s EPS. The loss
of interest earnings on the excess cash balances would be more than offset by the
addition of Volvo’s pretax earnings.
Epilogue
Seven months after the megamerger between Chrysler and Daimler-Benz in 1998, Ford
Motor Company announced that it was acquiring only Volvo’s passenger-car operations.
Ford acquired Volvo’s passenger car operations on March 29, 1999, for $6.45 billion. At
$16,000 per production unit, Ford’s offer price was considered generous when
compared with the $13,400 per vehicle that Daimler-Benz AG paid for Chrysler
Corporation in 1998. The sale of the passenger car business allows Volvo to concentrate
fully on its truck, bus, construction equipment, marine engine, and aerospace equipment
businesses. (Note that the standalone value of Volvo in the case was estimated to be $15
billion. This included Volvo’s trucking operations.)
Discussion Questions and Answers:
1) What is the purpose of the common-size financial statements developed for Volvo
(see Table 8-8 in the textbook)? What insights does this table provide about the
historical trend in Volvo’s historical performance? Based on past performance, how
realistic do you think the projections are for 2000-2004?
2) Ford anticipates substantial synergies from acquiring Volvo. What are these potential
synergies? As a consultant hired to value Volvo, what additional information would you
need to estimate the value of potential synergy from each of these areas?
3) How was the initial offer price determined according to this case study? Do you find
the logic underlying the initial offer price compelling? Explain your answer.
4) What was the composition of the purchase price? Why was this composition selected
according to this case study?
Answer:
The Travelers and Citicorp Integration Experience
Promoted as a merger of equals, the merger of Travelers and Citicorp to form Citigroup
illustrates many of the problems encountered during postmerger integration. At $73
billion, the merger between Travelers and Citicorp was the second largest merger in
1998 and is an excellent example of how integrating two businesses can be far more
daunting than consummating the transaction. Their experience demonstrates how
everything can be going smoothly in most of the businesses being integrated, except for
one, and how this single business can sop up all of management’s time and attention to
correct its problems. In some respects, it highlights the ultimate challenge of every
major integration effort: getting people to work together. It also spotlights the
complexity of managing large, intricate businesses when authority at the top is divided
among several managers.
The strategic rationale for the merger relied heavily on cross-selling the financial
services products of both corporations to the other’s customers. The combination would
create a financial services giant capable of making loans, accepting deposits, selling
mutual funds, underwriting securities, selling insurance, and dispensing financial
planning advice. Citicorp had relationships with thousands of companies around the
world. In contrast, Travelers’ Salomon Smith Barney unit dealt with relatively few
companies. It was believed that Salomon could expand its underwriting and investment
banking business dramatically by having access to the much larger Citicorp commercial
customer base. Moreover, Citicorp lending officers, who frequently had access only to
midlevel corporate executives at companies within their customer base, would have
access to more senior executives as a result of Salomon’s investment banking
relationships.
Although the characteristics of the two businesses seemed to be complementary,
motivating all parties to cooperate proved a major challenge. Because of the combined
firm’s co-CEO arrangement, the lack of clearly delineated authority exhausted
management time and attention without resolving major integration issues. Some
decisions proved to be relatively easy. Others were not. Citicorp, in stark contrast to
Travelers, was known for being highly bureaucratic with marketing, credit, and finance
departments at the global, North American, and business unit levels. North American
departments were eliminated quickly. Salomon was highly regarded in the fixed income
security area, so Citicorp’s fixed income operations were folded into Salomon. Citicorp
received Salomon’s foreign exchange trading operations because of their pre-merger
reputation in this business. However, both the Salomon and Citicorp derivatives
business tended to overlap and compete for the same customers. Each business unit
within Travelers and Citicorp had a tendency to believe they “owned” the relationship
with their customers and were hesitant to introduce others that might assume control
over this relationship. Pay was also an issue, as investment banker salaries in Salomon
Smith Barney tended to dwarf those of Citicorp middle-level managers. When it came
time to cut costs, issues arose around who would be terminated.
Citicorp was organized along three major product areas: global corporate business,
global consumer business, and asset management. The merged companies’ management
structure consisted of three executives in the global corporate business area and two in
each of the other major product areas. Each area contained senior managers from both
companies. Moreover, each area reported to the co-chairs and CEOs John Reed and
Sanford Weill, former CEOs of Citicorp and Travelers, respectively. Of the three major
product areas, the integration of two was progressing well, reflecting the collegial
atmosphere of the top managers in both areas. However, the global business area was
well behind schedule, beset by major riffs among the three top managers. Travelers’
corporate culture was characterized as strongly focused on the bottom line, with a lean
corporate overhead structure and a strong predisposition to impose its style on the
Citicorp culture. In contrast, Citicorp, under John Reed, tended to be more focused on
the strategic vision of the new company rather than on day-to-day operations.
The organizational structure coupled with personal differences among certain key
managers ultimately resulted in the termination of James Dimon, who had been a star as
president of Travelers before the merger. On July 28, 1999, the co-chair arrangement
was dissolved. Sanford Weill assumed responsibility for the firm’s operating businesses
and financial function, and John Reed became the focal point for the company’s
internet, advanced development, technology, human resources, and legal functions. This
change in organizational structure was intended to help clarify lines of authority and to
overcome some of the obstacles in managing a large and complex set of businesses that
result from split decision-making authority. On February 28, 2000, John Reed formally
retired.
Although the power sharing arrangement may have been necessary to get the deal done,
Reed’s leaving made it easier for Weill to manage the business. The co-CEO
arrangement had contributed to an extended period of indecision, resulting in part to
their widely divergent views. Reed wanted to support Citibank’s Internet efforts with
substantial and sustained investment, whereas the more bottom-line-oriented Weill
wanted to contain costs.
With its $112 billion in annual revenue in 2000, Citigroup ranked sixth on the Fortune
500 list. Its $13.5 billion in profit was second only to Exxon-Mobil’s $17.7 billion. The
combination of Salomon Smith Barney’s investment bankers and Citibank’s commercial
bankers is working very effectively. In a year-end 2000 poll by Fortune magazine of the
Most Admired U.S. companies, Citigroup was the clear winner. Among the 600
companies judged by a poll of executives, directors, and securities analysts, it ranked
first for using its assets wisely and for long-term investment value (Loomis, 2001).
However, this early success has taken its toll on management. Of the 15 people initially
on the management committee, only five remain in addition to Weill. Among those that
have left are all those that were with Citibank when the merger was consummated.
Ironically, in 2004, James Dimon emerged as the head of the JP Morgan Chase
powerhouse in direct competition with his former boss Sandy Weill of Citigroup.
Discussion Questions:
1) Why did Citibank and Travelers resort to a co-CEO arrangement? What are the
advantages and disadvantages of such an arrangement?
2) Describe the management challenges you think may face Citigroup’s management
team due to the increasing global complexity of Citigroup?
3) Identify the key differences between Travelers’ and Citibank’s corporate cultures.
Discuss ways you would resolve such differences.
4) In what sense is the initial divergence in Travelers’ operational orientation and
Citigroup’s marketing and planning orientation an excellent justification for the merger?
Explain your answer.
5) One justification for the merger was the cross-selling opportunities it would provide.
Comment on the challenges that might be involved in making such a marketing strategy
work.
Answer:
Pacific Investors Acquires California Kool in a Leveraged Buyout
Pacific Investors (PI) is a small private equity limited partnership with $3 billion under
management. The objective of the fund is to give investors at least a 30-percent annual
average return on their investment by judiciously investing these funds in highly
leveraged transactions. PI has been able to realize such returns over the last decade
because of its focus on investing in industries that have slow but predictable growth in
cash flow, modest capital investment requirements, and relatively low levels of research
and development spending. In the past, PI made several lucrative investments in the
contract packaging industry, which provides packaging for beverage companies that
produce various types of noncarbonated and carbonated beverages. Because of its
commitments to its investors, PI likes to liquidate its investments within four to six
years of the initial investment through a secondary public offering or sale to a strategic
investor.
Following its past success in the industry, PI currently is negotiating with California
Kool (CK), a privately owned contract beverage packaging company with the
technology required to package many types of noncarbonated drinks. CK’s 2003
revenue and net income are $190.4 million and $5.9 million, respectively. With a
reputation for effective management, CK is a medium-sized contract packaging
company that owns its own plant and equipment and has a history of continually
increasing cash flow. The company also has significant unused excess capacity,
suggesting that production levels can be increased without substantial new capital
spending.
The owners of CK are demanding a purchase price of $70 million. This is denoted on
the balance sheet (see Table 13-15 at the end of the case) as a negative entry in
additional paid-in capital. This price represents a multiple of 11.8 times 2003’s net
income, almost twice the multiple for comparable publicly traded companies. Despite
the “rich” multiple, PI believes that it can finance the transaction through an equity
investment of $25 million and $47 million in debt. The equity investment consists of $3
million in common stock, with PI’s investors and CK’s management each contributing
$1.5 million. Debt consists of a $12 million revolving loan to meet immediate working
capital requirements, $20 million in senior bank debt secured by CK’s fixed assets, and
$15 million in a subordinated loan from a pension fund. The total cost of acquiring CK
is $72 million, $70 million paid to the owners of CK and $2 million in legal and
accounting fees.
As indicated on Table 13-15, the change in total liabilities plus shareholders’ equity
(i.e., total sources of funds or cash inflows) must equal the change in total assets (i.e.,
total uses of funds or cash outflows). Therefore, as shown in the adjustments column,
total liabilities increase by $47 million in total borrowings and shareholders’ equity
declines by $45 million (i.e., $25 million in preferred and common equity provided by
investors less $70 million paid to CK owners). The excess of sources over uses of $2
million is used to finance legal and accounting fees incurred in closing the transaction.
Consequently, total assets increase by $2 million and total liabilities plus shareholders’
equity increase by $2 million between the pre- and postclosing balance sheets as shown
in the adjustments column.hasi1 Delta;Total assets = ΔTotal liabilities +
ΔShareholders’ equity: $2 million = $47 million $45 million = $2 million.
Revenue for CK is projected to grow at 4.5 percent annually through the foreseeable
future. Operating expenses and sales, general, and administrative expenses as a percent
of sales are expected to decline during the first three years of operation due to
aggressive cost cutting and the introduction of new management and engineering
processes. Similarly, improved working capital management results in significant
declines in working capital as a percent of sales during the first year of operation. Gross
fixed assets as percent of sales is held constant at its 2003 level during the forecast
period, reflecting reinvestment requirements to support the projected increase in net
revenue. Equity cash flow adjusted to include cash generated in excess of normal
operating requirements (i.e., denoted by the change in investments available for sale) is
expected to reach $8.5 million annually by Using the cost of capital method, the cost of
equity declines in line with the reduction in the firm’s beta as the debt is repaid from 26
percent in 2004 to 16.5 percent in 2010. In contrast, the adjusted present value method
employs a constant unlevered COE of 17 percent.
The deal would appear to make sense from the standpoint of PI, since the projected
average annual internal rates of return (IRRs) for investors exceed PI’s minimum
desired 30 percent rate of return in all scenarios considered between 2007 and 2009 (see
Table 13-13). This is the period during which investors would like to “cash out.” The
rates of return scenarios are calculated assuming the business can be sold at different
multiples of adjusted equity cash flow in the year in which the business is assumed to
be sold. Consequently, IRRs are calculated using the cash outflow (initial equity
investment in the business) in the first year offset by any positive equity cash flow from
operations generated in the first year, equity cash flows for each subsequent year, and
the sum of equity cash flow in the year in which the business is sold or taken public
plus the estimated sale value (e.g., eight times equity cash flow) in that year. Adjusted
equity cash flow includes free cash flow generated from operations and the increase in
“investments available for sale.” Such investments represent cash generated in excess of
normal operating requirements; and as such, this cash is available to LBO investors.
The actual point at which CK would either be taken public, sold to a strategic investor,
or sold to another LBO fund depends on stock market conditions, CK’s leverage relative
to similar firms in the industry, and cash flow performance as compared to the plan.
Discounted cash flow analysis also suggests that PI should do the deal, since the total
present value of adjusted equity cash flow of $57.2 million using the CC method is
more than twice the magnitude of the initial equity investment. At $56 million, the APV
method results in a slightly lower estimate of total present value. See Tables
13-14,13-15, and 13-16 for the income, balance-sheet, and cash-flow statements,
respectively, associated with this transaction. Exhibits 13-1 and 13-2 illustrate the
calculation of present value of the transaction based on the cost of capital and the
adjusted present value methods, respectively. Note the actual Excel spreadsheets and
formulas used to create these financial tables are available on the CD-ROM
accompanying this book in a worksheet, Excel-Based Leveraged Buyout Valuation and
Structuring Model.
Discussion Questions
1) What criteria did Pacific Investors (PI) use to select California Kool (CK) as a target
for an LBO? Why were these criteria employed?
2) Describe how PI financed the purchase price. Speculate as why each source of
financing was selected? How did CK pay for feels incurred in closing the transaction?
3) What are the advantages and disadvantages of using enterprise cash flow in valuing
CK? In what might EBITDA been a superior (inferior) measure of cash flow for valuing
CK?
4) Compare and contrast the Cost of Capital Method and the Adjusted Present Value
Method of valuation.
Answer:
Oracle’s Efforts to Consolidate the Software Industry
Key Points:
Industry-wide trends, coupled with the recognition of its own limitations, compelled
Oracle to alter radically its business strategy.
A rapid series of acquisitions of varying sizes enabled the firm to respond rapidly to
the dynamically changing business environment.
Increasingly, the major software competitors seem to be pursuing very similar
strategies.
The long-term winner often is the firm most successfully executing its chosen
strategy.
______________________________________________________________________
_______________________
Oracle ‘s completion of its $7.4 billion takeover of Sun Microsystems on January 28,
2010 illustrated how in somewhat more than five years the firm has been able to
dramatically realign its focus. Once viewed as the premier provider of proprietary
database and middleware services (accounting for about three-fourths of the firm’s
revenue), Oracle is now seen as a leader in enterprise resource planning, customer
relationship management, and supply chain management software applications. What
spawned this rapid and dramatic transformation?
The industry in which Oracle competes has undergone profound and lasting changes. In
the past, the corporate computing market was characterized by IBM selling customers
systems that included most of the hardware and software in a single package. Later,
minicomputer manufacturers pursued a similar strategy in which they would build all of
the crucial pieces of a large system, including its chips, main software, and networking
technology. The traditional model was upended by the rise of more powerful and
standardized computers based on readily available chips from Intel and an innovative
software market. Customers could choose the technology they preferred (i.e., “best of
breed”) and assemble those products in their own data centers networks to support
growth in the number of users and the growing complexity of user requirements. Such
enterprise-wide software (e.g., human resource and customer relationship management
systems) became less expensive as prices of hardware and software declined under
intensifying competitive pressure as more and more software firms entered the fray.
Although the enterprise software market grew rapidly in the 1990s, by the early 2000s,
market growth showed signs of slowing. This market consists primarily of large Fortune
500 firms with multiple operations across many countries. Such computing
environments tend to be highly complex and require multiple software applications that
must work together on multiple hardware systems. In recent years, users of information
technology have sought ways to reduce the complexity of getting the disparate software
applications to work together. Although some buyers still prefer to purchase the “best of
breed” software, many are moving to purchase suites of applications that are
compatible.
In response to these industry changes and the maturing of its database product line,
which accounted for three-fourths of its revenue, Oracle moved into enterprise
applications with its 2004 $10.3 billion purchase of PeopleSoft. From there, Oracle
proceeded to acquire 55 firms, with more than one-half focused on strengthening the
firm’s software applications business. Revenues almost doubled by 2009 to $23 billion,
growing through the 20082009 recession.
Oracle, like most successful software firms, generates substantial and sustainable cash
flow as a result of the way in which business software is sold. Customers buy licenses
to obtain the right to utilize a vendor’s software and periodically renew the license in
order to receive upgrades. Healthy cash flow minimized the need for Oracle to borrow.
Consequently, it was able to sustain its acquisitions by borrowing and paying cash for
companies rather than having to issue stock and potentially diluting existing
shareholders.
In helping to satisfy its customers’ challenges, Oracle has had substantial experience in
streamlining other firms’ supply chains and in reducing costs. For most software firms,
the largest single cost is the cost of sales. Consequently, in acquiring other software
firms, Oracle has been able to apply this experience to achieve substantial cost
reduction by pruning unprofitable products and redundant overhead during the
integration of the acquired firms. Oracle’s existing overhead structure would then be
used to support the additional revenue gained through acquisitions. Consequently, most
of the additional revenue would fall to the bottom line.
For example, since acquiring Sun, Oracle has rationalized and consolidated Sun’s
manufacturing operations and substantially reduced the number of products the firm
offers. Fewer products results in less administrative and support overhead. Furthermore,
Oracle has introduced a “build to order” mentality rather than a “build to inventory”
marketing approach. With a focus on “build to order,” hardware is manufactured only
when orders are received rather than for inventory in anticipation of future orders. By
aligning production with actual orders, Oracle is able to reduce substantially the cost of
carrying inventory; however, it does run the risk of lost sales from customers who need
their orders satisfied immediately. Oracle has also pared down the number of suppliers
in order to realize savings from volume purchase discounts. While lowering its cost
position in this manner, Oracle has sought to distinguish itself from its competitors by
being known as a full-service provider of integrated software solutions.
Prior to the Sun acquisition, Oracle’s primary competitor in the enterprise software
market was the German software giant SAP. However, the acquisition of Sun’s vast
hardware business pits Oracle for the first time against Hewlett-Packard, IBM, Dell
Computer, and Cisco Systems, all of which have made acquisitions of software services
companies in recent years, moving well beyond their traditional specialties in
computers or networking equipment. In 2009, Cisco Systems diversified from its
networking roots and began selling computer servers. Traditionally, Cisco had teamed
with hardware vendors HP, Dell, and IBM. HP countered Cisco by investing more in its
existing networking products and by acquiring the networking company 3Com for $2.7
billion in November 2009. HP had purchased EDS in 2008 for $13.8 billion in an effort
to sell more equipment and services to customers often served by IBM. Each firm
seems to be pursuing a “me too” strategy in which they can claim to their customers that
they and they alone have all the capabilities to be an end-to-end service provider. Which
firm is most successful in the long run may well be the one that successfully integrates
their acquisitions the best.
Investors’ concern about Oracle’s strategy is that the frequent acquisitions make it
difficult to measure how well the company is growing. With many of the acquisitions
falling in the $5 million to $100 million range, relatively few of Oracle’s acquisitions
have been viewed as material for financial reporting purposes. Consequently, Oracle is
not obligated to provide pro forma financial data about these acquisitions, and investors
have found it difficult to ascertain the extent to which Oracle has grown organically
(i.e., grown the revenue resulting from prior acquisitions) versus simply by acquiring
new revenue streams. Ironically, in the short run, Oracle’s acquisition binge has resulted
in increased complexity as each new acquisition means more products must be
integrated. The rapid revenue growth from acquisitions may indeed simply be masking
underlying problems brought about by this growing complexity.
Discussion Questions and Answers:
1) How would you characterize the Oracle business strategy (i.e., cost leadership,
differentiation, niche, or some combination of all three)? Explain your answer.
2) Conduct an external and internal analysis of Oracle. Briefly describe those factors
that influenced the development of Oracle’s business strategy. Be specific.
3) In what way do you think the Oracle strategy was targeting key competitors? Be
specific.
4) What other benefits for Oracle, and for the remaining competitors such as SAP, do
you see from further industry consolidation? Be specific.
Answer:
Case Corporation Loses Sight of Customer Needs
in Integrating New Holland Corporation
Farm implement manufacturer Case Corporation acquired New Holland Corporation in
a $4.6 billion transaction in 1999. Overnight, its CEO, Jean-Pierre Rosso, had
engineered a deal that put the combined firms, with $11 billion in annual revenue, in
second place in the agricultural equipment industry just behind industry leader John
Deere. The new firm was named CNH Global (CNH). Although Rosso proved adept at
negotiating and closing a substantial deal for his firm, he was less agile in meeting
customer needs during the protracted integration period. CNH has become a poster
child of what can happen when managers become so preoccupied with the details of
combining two big operations that they neglect external issues such as the economy and
competition. Since the merger in November 1999, CNH began losing market share to
John Deere and other rivals across virtually all of its product lines.
Rosso remained focused on negotiating with antitrust officials about what it would take
to get regulatory approval. Once achieved, CNH was slow to complete the last of its
asset sales as required under the consent decree with the FTC. The last divestiture was
not completed until late January 2001, more than 20 months after the deal had been
announced. This delay forced Rosso to postpone cost cutting and to slow their new
product entries. This spooked farmers and dealers who could not get the firm to commit
to telling them which products would be discontinued and which the firm would
continue to support with parts and service. Fearful that CNH would discontinue
duplicate Case and New Holland products, farmers and equipment dealers switched
brands. The result was that John Deere became more dominant than ever. CNH was
slow to reassure customers with tangible actions and to introduce new products
competitive with Deere. This gave Deere the opportunity to fill the vacuum in the
marketplace.
The integration was deemed to have been completed a full four years after closing. As a
sign of how painful the integration had been, CNH was laying workers off as Deere was
hiring to keep up with the strong demand for its products. Deere also appeared to be
ahead in moving toward common global platforms and parts to take fuller advantage of
economies of scale.
Discussion Questions:
1) Why is rapid integration important? Illustrate with examples from the case study.
2) What could CNH have done differently to slow or reverse its loss of market share?
Answer:
Exxon-Mobil: A Study in Cost Cutting
Having obtained access to more detailed information following consummation of the
merger, Exxon-Mobil announced dramatic revisions in its estimates of cost savings. The
world’s largest publicly owned oil company would cut almost 16,000 jobs by the end of
2002. This was an increase from the 9000 cuts estimated when the merger was first
announced in December 1998. Of the total, 6000 would come from early retirement.
Estimated annual savings reached $3.8 billion by 2003, up by more than $1 billion from
when the merger originally was announced. As time passed, the companies seemed to
have become a highly focused, smooth-running machine remarkably efficient at
discovering, refining, and marketing oil and gas. An indication of this is the fact that the
firm spent less per barrel to find oil and gas in 2003 than at almost any time in history.
With revenues of $210 billion, Exxon-Mobil surged to the top of the Fortune 500 in
2004.
Discussion Question:
1) In your judgment, are acquirers more likely to under- or overestimate anticipated cost
savings? Explain your answer.
Answer: