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Pacific Wardrobe Acquires Surferdude Apparel
by a Skillful Structuring of the Acquisition Plan
Pacific Wardrobe (Pacific) is a privately owned California corporation that has annual
sales of $20 million and pretax profits of $2 million. Its target market is the
surfwear/sportswear segment of the apparel industry. The surfwear/sportswear market
consists of two segments: cutting-edge and casual brands. The first segment includes
high-margin apparel sold at higher-end retail establishments. The second segment
consists of brands that sell for lower prices at retail stores such as Sears, Target, and
J.C. Penney. Pacific operates primarily as a U.S. importer/distributor of mainly casual
sportswear for young men and boys between 1021 years of age. Pacific's strategic
business objectives are to triple sales and pretax profits during the next 5 years. Pacific
intends to achieve these objectives by moving away from the casual sportswear market
segment and more into the high-growth, high-profit cutting-edge surfer segment.
Because of the rapid rate at which trends change in the apparel industry, Pacific's
management believes that it can take advantage of current trends only through a
well-conceived acquisition strategy.
Pacific's Operations and Competitive Environment
Pacific imports all of its apparel from factories in Hong Kong, Taiwan, Nepal, and
Indonesia. Its customers consist of major chains and specialty stores. Most customers
are lower-end retail stores. Customers include J.C. Penney, Sears, Stein Mart, Kids "R"
Us, and Target. No one customer accounts for more than 20% of Pacific's total revenue.
The customers in the lower-end market are extremely cost sensitive. Customers consist
of those in the 1021 years of age range who want to wear cutting-edge surf and sport
styles but who are not willing or able to pay high prices. Pacific offers an alternative to
the expensive cutting-edge styles.
Pacific has found a niche in the young men's and teenage boy's sportswear market. The
firm offers similar styles as the top brand names in the surf and sport industry, such as
Mossimo, Red Sand, Stussy, Quick Silver, and Gotcha, but at a lower price point.
Pacific indirectly competes with these top brand names by attempting to appeal to the
same customer base. There are few companies that compete with Pacific at their
levellow-cost production of ''almost'' cutting-edge styles.
Pacific's Strengths and Weaknesses
Pacific's core strengths lie in their strong vendor support in terms of quantity, quality,
service, delivery, and price/cost. Pacific's production is also scaleable and has the
potential to produce at high volumes to meet peak demand periods. Additionally, Pacific
also has strong financial support from local banks and a strong management team, with
an excellent track record in successfully acquiring and integrating small acquisitions.
Pacific also has a good reputation for high-quality products and customer service and
on-time delivery. Finally, Pacific has a low cost of goods sold when compared with the
competition. Pacific's major weakness is that it does not possess any
cutting-edge/trendy labels. Furthermore, their management team lacks the ability to
develop trendy brands.
Acquisition Plan
Pacific's management objectives are to grow sales, improve profit margins, and increase
its brand life cycle by acquiring a cutting-edge surfwear retailer with a trendy brand
image. Pacific intends to improve its operating margins by increasing its sales of trendy
clothes under the newly acquired brand name, while obtaining these clothes from its
own low-cost production sources.
Pacific would prefer to use its stock to complete an acquisition, because it is currently
short of cash and wishes to use its borrowing capacity to fund future working capital
requirements. Pacific's target debt-to-equity ratio is 3 to 1. The firm desires a friendly
takeover of an existing surfwear company to facilitate integration and avoid a potential
''bidding war.'' The target will be evaluated on the basis of profitability, target markets,
distribution channels, geographic markets, existing inventory, market brand recognition,
price range, and overall ''fit'' with Pacific. Pacific will locate this surfwear company by
analyzing the surfwear industry; reviewing industry literature; and making discrete
inquiries relative to the availability of various firms to board members, law firms, and
accounting firms. Pacific would prefer an asset purchase because of the potentially
favorable impact on cash flow and because it is concerned about unknown liabilities
that might be assumed if it acquired the stock.
Pacific's screening criteria for identifying potential acquisition candidates include the
following:
1) Industry: Garment industry targeting young men, teens, and boys
2) Product: Cutting-edge, trendy surfwear product line
3)Size: Revenue ranging from $5 million to $10 million
4)Profit: Minimum of break-even on operating earnings for fiscal year 1999
5) Management: Company with management expertise in brand and image building
6) Leverage: Maximum debt-to-equity ratio of 3 to 1
After a review of 14 companies, Pacific's management determined that SurferDude best
satisfied their criteria. SurferDude is a widely recognized brand in the surfer sports
apparel line; it is marginally profitable, with sales of $7 million and a debt-to-equity
ratio of 3 to 1. SurferDude's current lackluster profitability reflects a significant
advertising campaign undertaken during the last several years. Based on financial
information provided by SurferDude, industry averages, and comparable companies,
the estimated purchase price ranges from $1.5 million to $15 million. The maximum
price reflects the full impact of anticipated synergy. The price range was estimated
using several valuation methods.
Valuation
On a standalone basis, sales for both Pacific and SurferDude are projected to increase at
a compound annual average rate of 20% during the next 5 years. SurferDude's sales
growth assumes that its advertising expenditures in 1998 and 1999 have created a
significant brand image, thus increasing future sales and gross profit margins. Pacific's
sales growth rate reflects the recent licensing of several new apparel product lines.
Consolidated sales of the combined companies are expected to grow at an annual
growth rate of 25% as a result of the sales and distribution synergies created between
the two companies.
The discount factor was derived using different methods, such as the buildup method or
the CAPM. Because this was a private company, the buildup method was utilized and
then supported by the CAPM. At 12%, the specific business risk premium is assumed to
be somewhat higher than the 9% historical average difference between the return on
small stocks and the risk-free return as a result of the capricious nature of the highly
style-conscious surfware industry. The marketability discount is assumed to be a
relatively modest, 20% because Pacific is acquiring a controlling interest in
SurferDude. After growing at a compound annual average growth rate of 25% during
the next 5 years, the sustainable long-term growth rate in SurferDude's standalone
revenue is assumed to be 8%.
The buildup calculation included the following factors:
The CAPM method supported the buildup method. One comparable company, Apparel
Tech, had a ß estimated by Yahoo.Marketguide.com to be 74, which results in a keof
32.07 for this comparable company. The weighted average cost of capital using a target
debt-to-equity ratio of 3 to 1 for the combined companies is estimated to be 26%.
The standalone values of SurferDude and Pacific assume that fixed expenses will
decrease as a percentage of sales as a result of economies of scale. Pacific will
outsource production through its parent's overseas facilities, thus significantly reducing
the cost of goods sold. SurferDude's administrative expenses are expected to decrease
from 25% of sales to 18% because only senior managers and the design staff will be
retained. The sustainable growth rate for the terminal period for both the standalone and
the consolidated models is a relatively modest 6%. Pacific believes this growth rate is
reasonable considering the growth potential throughout the world. Although Pacific and
SurferDude's current market concentration resides largely in the United States, it is
forecasted that the combined companies will develop a global presence, with a
particular emphasis in developing markets. The value of the combined companies
including synergies equals $15 million.
Developing an Initial Offer Price
Using price-to-cash flow multiples to develop an initial offer price, the target was
valued on a standalone basis and a multiple of 4.51 for a comparable publicly held
company called Stage II Apparel Corp. The standalone valuation, excluding synergies,
of SurferDude ranges from $621,000 to $2,263,000.
Negotiating Strategy
Pacific expects to initially offer $2.25 million and close at $3.0 million. Pacific's
management believes that SurferDude can be purchased at a modest price when
compared with anticipated synergy, because an all-stock transaction would give
SurferDude's management ownership of between 25% and 30% of the combined
companies.
Integration
A transition team consisting of two Pacific and two SurferDude managers will be given
full responsibility for consolidating the businesses following closing. A senior Pacific
manager will direct the integration team. Once an agreement of purchase and sale has
been signed, the team's initial responsibilities will be to first contact and inform
employees and customers of SurferDude that operations will continue as normal until
the close of the transaction. As an inducement to remain through closing, Pacific
intends to offer severance packages for those SurferDude employees who will be
terminated following the consolidation of the two businesses.
Source: Adapted from Contino, Maria, Domenic Costa, Larui Deyhimy, and Jenny Hu,
Loyola, Marymount University, MBAF 624, Los Angeles, CA, Fall 1999.
Discussion Questions:
1) What were the key assumptions implicit in Pacific Wardrobe's acquisitions plan, with
respect to the market, valuation, and integration? Comment on the realism of these
assumptions.
2) Discuss some of the challenges that Pacific Wardrobe is likely to experience during
due diligence.
3) Identify alternative deal structures Pacific Wardrobe might have employed in order to
complete the transaction. Discuss why these alternatives might have been superior or
inferior to the one actually chosen.
Answer:
Succession issues tend to be easier for small family owned firms than for large publicly
traded firms. True or False
Answer:
In liquidation, bankruptcy professionals, including attorneys, accountants, and trustees,
often end up with the majority of the proceeds generated by selling the assets of the
failing firm. True or False
Answer:
Under federal law, states have the right to sue to block mergers they believe are
anti-competitive, even if the FTC or SEC does not challenge them. True or False
Answer:
The risk associated with an illiquid market for a specific stock is referred to as the
liquidity or marketability risk. True or False
Answer:
Shell corporations may have significant value to acquiring firms. True or False
Answer:
Foreign companies having a minority ownership position in international business
alliances rarely have control over the alliance even though they may possess much of
the expertise required to manage the alliance. True or False
Answer:
LBOs normally involve public companies going private. True or False
Answer:
The tax-free structure is generally not suitable for the acquisition of a division within a
corporation. True or False.
Answer:
A letter of intent formally stipulates the reason for the agreement, major terms and
conditions, the responsibilities of both parties while the agreement is in force, a
reasonable expiration date, and how all fees associated with the transaction will be paid.
True or False
Answer:
Integration planning involves addressing human resource, customer, and supplier issues
that overlap the change of ownership. True or False
Answer:
Although public companies still are required to file their financial statements with the
Securities and Exchange Commission in accordance with GAAP, companies
increasingly are using pro forma statements to portray their financial performance in
what they argue is a more realistic (and usually more favorable) manner. True or False
Answer:
Competitive dynamics simply refer to the factors within the industry that determine
industry profitability and cash flow. True or False
Answer:
Large investment banks invariably provide higher quality service and advice than
smaller, so-called boutique investment banks. True or False
Answer:
Under a prepackaged bankruptcy, the debtor negotiates with creditors well in advance
of filing for a Chapter 7 bankruptcy. True or False
Answer:
Dissident shareholders always undertake a tender offer to change the composition of a
firm's board of directors. True or False
Answer:
As in the U.S., any representations and warranties in an acquisition agreement are
intended to cause the seller to disclose significant information. However, because of
local custom, they are often more extensive in foreign countries than in the U.S. True or
False
Answer:
Acquiring companies often find themselves with certain assets and operations of the
acquired company that do not fit their primary strategy. Such assets may be divested to
fund future investments. True of False
Answer:
Empirical studies generally show that the tax shelter resulting from the ability of the
acquiring firm to increase the value of acquired assets to their FMV is a highly
important motivating factor for a takeover. True or False
Answer:
A price or cost leader in an industry is usually the firm with the largest market share.
True or False
Answer:
Reforms in creditor rights tend to increase the availability and reduce the cost of credit
in countries where court enforcement is quick and fair. True or False
Answer:
Whenever possible, integration planning should begin before closing. True or False
Answer:
A spin-off is a transaction involving a separate legal entity whose shares are sold to the
parent firm's shareholders. True or False
Answer:
An astute bidder should always analyze the target firm's possible defenses such as
golden parachutes for key employees and poison pills before making a bid. True or
False
Answer:
Antitrust regulators rarely consider the impact of a proposed takeover on product and
technical innovation. True or False
Answer:
The comparable companies' transactions valuation method is generally considered the
most accurate of all the valuation methods. True or False
Answer:
Although the parent often retains control in an equity carve-out, the shareholder base of
the subsidiary may be different that that of the parent. True or False
Answer:
A successful proxy fight may represent a far less expensive means of gaining control
over a target than a
tender offer. True or False
Answer:
In normalizing historical data, monthly revenue may be aggregated into quarterly or
even annual data to minimize possible distortions in earnings or cash flow due to
inappropriate accounting practices. True or False
Answer:
Employee health care or disability claims tend to escalate just before a transaction
closes, thereby adding to the total cost of the transaction. Who will pay such claims
should be determined in the agreement of purchase and sale. True or False
Answer:
It is generally easier to sell a minority interest than a majority interest in a business
without loss of the value of the original investment. True or False
Answer:
When corporate cultures are substantially different, it may be appropriate to
a. Integrate the businesses as rapidly as possible
b. Leave the businesses separate indefinitely
c. Initially leave the businesses separate but integrate at a later time
d. A or B
e. B or C
Answer:
Which of the following is not true about junk bonds?
a. Junk bonds are either unrated or rated below investment grade by the credit rating
agencies
b. Typically yield about 1-2 percentage points below yields on U.S. Treasury debt of
comparable maturities.
c. Junk bonds are commonly used source of "permanent" financing in LBO transactions
d. During recessions, junk bond default rates often exceed 10%
e. Junk bond default risk on non-investment grade bonds tends to increase the longer
the elapsed time since the original issue date of the bonds
Answer:
Customers of newly acquired firms are usually slow to switch to other suppliers even if
product quality deteriorates due to inertia. True or False
Answer:
Revenue Ruling 59-60 describes the general factors that the IRS and tax courts consider
relevant in valuing private businesses. Of the following valuation methods, which do
the IRS and tax courts view as the most important?
a. Discounted cash flow
b. Comparable company methods
c. Tangible book value
d. Replacement cost method
e. All of the above
Answer:
The Securities Act of 1933 requires the registration of all securities issued to the public.
Such
registration requires which of the following disclosures:
a. Description of the firm's properties and business
b. Description of the securities
c. Information about management
d. Financial statements audited by public accountants
e. All of the above.
Answer:
Which of the following are components of an acquisition plan?
a. Timetable
b. Resource/capability evaluation
c. Management preferences
d. Objectives
e. All of the above
Answer:
Rapid integration is usually important for all of the following reasons except for
a. Minimizes employee turnover
b. Improves the morale and productivity of current employees of both the acquiring and
acquired firms
c. Builds confidence in current employees in the competence of management
d. Dispenses with the need for pre-integration planning
e. Reduces customer turnover
Answer:
Refining the target valuation based on new information uncovered during due diligence
is most likely to affect which of the following
a. Total consideration
b. The search process
c. The business plan
d. The acquisition plan
e. The target's business plan
Answer:
Which of the following is true about the variable growth model?
a. Present value equals the discounted sum of the annual forecasts of cash flow
b. Present value equals the discounted sum of the annual forecasts of cash flow plus the
discounted value of the terminal value
c. Present value equals the discounted value of the next year's cash flow grown at a
constant rate in perpetuity
d. Present value equals the current year's free cash flow discounted in perpetuity
e. None of the above
Answer:
Which of the following is not true about the cost of capital method of valuation?
a. It does not adjust the discount rate for risk as debt is repaid.
b. It requires the projection of future cash flows
c. It requires the projection of future debt-to-equity ratios.
d. It requires the calculation of a terminal value
e. None of the above
Answer:
All of the following represent common sources of value in appraising private or
publicly owned businesses except for
a. Intellectual property
b. Customer lists
c. Licenses
d. Contingent liabilities
e. Employment contracts
Answer:
An investor group acquired all of the publicly traded shares of a firm. Once acquired,
such shares would no longer trade publicly. Which of the following terms best describes
this situation?
a. Merger
b. Going private transaction
c. Consolidation
d. Tender offer
e. Joint venture
Answer:
All of the following represent different forms of debt restructuring except for
a. Debt extensions
b. Debt compositions
c. Share exchange ratios
d. Debt for equity swaps
e. A and D
Answer:
The calculation of free cash flow to the firm includes all of the following except for
a. Net income
b. Marginal tax rate
c. Change in working capital
d. Gross plant and equipment spending
e. Depreciation
Answer:
Which of the following are not components of the negotiation phase of the acquisition
process?
a. Refining valuation
b. Identifying potential target firms
c. Conducting due diligence
d. Structuring the deal
e. Developing the financing plan
Answer:
The hubris motive for M&As refers to which of the following?
a. Explains why mergers may happen even if the current market value of the target firm
reflects its true economic value
b. The ratio of the market value of the acquiring firm's stock exceeds the replacement
cost of its assets
c. Agency problems
d. Market power
e. The Q ratio
Answer:
Real Value Autos acquired Automotive Industries in a transaction that produced an NPV
of $3.7 million. This NPV represents
a. Synergy
b. Book value
c. Investment value
d. Diversification
e. None of the above
Answer:
The discount rate may be estimated using all but the one of the following:
a. The capital asset pricing model
b. The share exchange ratio
c. The cost of capital
d. Return on total assets
e. Price-to-earnings ratio
Answer:
Which of the following is true about supervoting stock?
a. Is a commonly used takeover tactic.
b. Is generally encouraged by the SEC
c. May have 10 to 100 times of the voting rights of other classes of stock
d. Is issued to acquiring firms if they agree not to purchase a controlling interest in the
target firm
e. Is a widely used takeover defense
Answer:
Selecting the appropriate financing structure for the combined firms requires
consideration of which of the following:
a. The impact on the combined firm's EPS
b. Potential violation of loan covenants
c. The extent to which the primary needs of both the buyer's and seller's shareholders
are satisfied.
d. A and B only
e. A, B, and C
Answer:
Which of the following is a disadvantage of balance sheet adjustments?
a. Protects buyer from eroding values of receivable before closing
b. Audit expense
c. Protects seller from increasing values of receivables before closing
d. Protects from decreasing values of inventories before closing
e. Protects seller from increasing values of inventories before closing
Answer:
Google Buys YouTube: Valuing a Firm Without Cash Flows
YouTube ranks as one of the most heavily utilized sites on the Internet, with one billion
views per day, 20 hours of new video uploaded every minute, and 300 million users
worldwide. Despite the explosion in usage, Google continues to struggle to "monetize"
the traffic on the site five years after having acquired the video sharing business. 2010
marked the first time the business turned marginally profitable. Whether the transaction
is viewed as successful depends on whether it is evaluated on a stand-alone basis or as
part of a larger strategy designed to steer additional traffic to Google sites and promote
the brand.
This case study illustrates how a value driver approach to valuation could have been
used by Google to estimate the potential value of YouTube by collecting publicly
available data for a comparable business. Note the importance of clearly identifying key
assumptions underlying the valuation. The credibility of the valuation ultimately
depends on the credibility of the assumptions.
Google acquired YouTube in late 2006 for $1.65 billion in stock. At that time, the
business had been in existence only for 14 months, consisted of 65 employees, and had
no significant revenues. However, what it lacked in size it made up in global
recognition and a rapidly escalating number of site visitors. Under pressure to continue
to fuel its own meteoric 77 percent annual revenue growth rate, Google moved
aggressively to acquire YouTube in an attempt to assume center stage in the rapidly
growing online video market. With no debt, $9 billion in cash, and a net profit margin
of about 25 percent, Google was in remarkable financial health for a firm growing so
rapidly. The acquisition was by far the most expensive acquisition by Google in its
relatively short eight-year history. In 2005, Google spent $130.5 million in acquiring 15
small firms. Google seemed to be placing a big bet that YouTube would become a huge
marketing hub as its increasing number of viewers attracts advertisers interested in
moving from television to the Internet.
Started in February 2005 in the garage of one of the founders, YouTube displayed in
2006 more than 100 million videos daily and had an estimated 72 million visitors from
around the world each month, of which 34 million were unique.1 As part of Google,
YouTube retained its name and current headquarters in San Bruno, California. In
addition to receiving funding from Google, YouTube was able to tap into Google's
substantial technological and advertising expertise.
To determine if Google would be likely to earn its cost of equity on its investment in
YouTube, we have to establish a base-year free cash-flow estimate for YouTube. This
may be done by examining the performance of a similar but more mature website, such
as about.com. Acquired by The New York Times in February 2005 for $410 million,
about.com is a website offering consumer information and advice and is believed to be
one of the biggest and most profitable websites on the Internet, with estimated 2006
revenues of almost $100 million. With a monthly average number of unique visitors
worldwide of 42.6 million, about.com's revenue per unique visitor was estimated to be
about $0.15, based on monthly revenues of $6.4 million.2
By assuming these numbers could be duplicated by YouTube within the first full year of
ownership by Google, YouTube could potentially achieve monthly revenue of $5.1
million (i.e., $0.15 per unique visitor × 34 million unique YouTube visitors) by the end
of year. Assuming net profit margins comparable to Google's 25 percent, YouTube
could generate about $1.28 million in after-tax profits on those sales. If that monthly
level of sales and profits could be sustained for the full year, YouTube could achieve
annual sales in the second year of $61.2 million (i.e., $5.1 × 12) and profit of $15.4
million ($1.28 × 12). Assuming optimistically that capital spending and depreciation
grow at the same rate and that the annual change in working capital is minimal,
YouTube's free cash flow would equal after-tax profits.
Recall that a firm earns its cost of equity on an investment whenever the net present
value of the investment is zero. Assuming a risk-free rate of return of 5.5 percent, a beta
of 0.82 (per Yahoo! Finance), and an equity premium of 5.5 percent, Google's cost of
equity would be 10 percent. For Google to earn its cost of equity on its investment in
YouTube, YouTube would have to generate future cash flows whose present value
would be at least $1.65 billion (i.e., equal to its purchase price). To achieve this result,
YouTube's free cash flow to equity would have to grow at a compound annual average
growth rate of 225 percent for the next 15 years, and then 5 percent per year thereafter.
Note that the present value of the cash flows during the initial 15-year period would be
$605 million and the present value of the terminal period cash flows would be $1,005
million. Using a higher revenue per unique visitor assumption would result in a slower
required annual growth rate in cash flows to earn the 10 percent cost of equity.
However, a higher discount rate might be appropriate to reflect YouTube's higher
investment risk. Using a higher discount rate would require revenue growth to be even
faster to achieve an NPV equal to zero.
Google could easily have paid cash, assuming that the YouTube owners would prefer
cash to Google stock. Perhaps Google saw its stock as overvalued and decided to use it
now to minimize the number of new shares that it would have had to issue to acquire
YouTube, or perhaps YouTube shareholders simply viewed Google stock as more
attractive than cash.
With YouTube having achieved marginal profitability in 2010, it would appear that the
valuation assumptions implicit in Google's initial valuation of YouTube may, indeed,
have been highly optimistic. While YouTube continues to be wildly successful in terms
of the number of site visits, with unique monthly visits having increased almost six fold
from their 2006 level, it appears to be disappointing at this juncture in terms of
profitability and cash flow. The traffic continues to grow as a result of integration with
social networks such as Facebook and initiatives such as the ability to send clips to
friends as well as to rate and comment on videos. Moreover, YouTube is showing some
progress in improving profitability by continuing to expand its index of professionally
produced premium content. Nevertheless, on a stand-alone basis, it is problematic that
YouTube will earn Google's cost of equity. However, as part of a broader Google
strategy involving multiple acquisitions to attract additional traffic to Google and to
promote the brand, the purchase may indeed make sense.
.
Discussion Questions:
1) What alternative valuation methods could Google have used to justify the purchase
price it paid for YouTube? Discuss the
advantages and disadvantages of each.
2) The purchase price paid for YouTube represented more than one percent of Google's
then market value. If you were a Google
shareholder, how might you have evaluated the wisdom of the acquisition?
3) To what extent might the use of stock by Google have influenced the amount they
were willing to pay for YouTube? How might
the use of "overvalued" shares impact future appreciation of Google stock?
4) What is the appropriate cost of equity for discounting future cash flows? Should it be
Google's or YouTube's? Explain your
answer.
5) What are the key valuation assumptions implicit in the valuation method discussed in
this case study?
Answer:
Market profiling requires an analysis of all of the following factors except for:
a. Customers
b. Suppliers
c. Core competencies
d. Current and potential competitors
e. Product or service substitutes
Answer:
As the LBO's extremely high debt level is reduced, the cost of equity needs to be
adjusted to reflect the decline in risk, as measured by the firm's unlevered beta. True or
False
Answer:
A "floating or flexible share exchange ratio is used primarily to
a. Protect the value of the transaction for the acquirer's shareholders
b. Protect the value of the transaction for the target's shareholders
c. Minimize the number of new acquirer shares that must be issued
d. Increase the value for the acquiring firm
e. Increase the value for the target firm
Answer:
As part of its restructuring plan, a holding company plans to undertake an IPO for 35
percent of the shares it owns in a subsidiary. The sale of these shares would be called a
a. Divestiture
b. Split-off
c. Split-up
d. Equity carveout
e. Breakup
Answer:
Which of the following are often true about the challenges of valuing private firms?
a. There is a lack of analyses generated by sources outside of the company.
b. Financial reporting systems are often inadequate.
c. Management depth and experience is often limited.
d. Reported earnings are often understated to minimize taxes.
e. All of the above.
Answer:
Which of the following is true of the cost of capital method of valuation?
a. It is generally more tedious to calculate than alternative methodologies
b. It requires the separate estimation of the present value of future tax savings
c. It adds the present value of the firm without debt to the present value of tax savings
d. It does not adjust the discount rate as debt is repaid
e. All of the above
Answer:
The incremental cash flows of a merger can relate to which of the following:
a. Working capital
b. Profits
c. Capital spending
d. Income taxes
e. All of the above
Answer:
In a conducting a self-assessment, a firm should consider all of the following except for
a. The degree on government regulation in its targeted markets
b. The effectiveness of its R&D activities
c. Product quality
d. Responsiveness to changing customer needs
e. Brand name recognition
Answer:
Blackstone Outmaneuvers Vornado to Buy Equity Office Properties
Reflecting the wave of capital flooding into commercial real estate and the growing
power of private equity investors, the Blackstone Group (Blackstone) succeeded in
acquiring Equity Office Properties (EOP) following a bidding war with Vornado Realty
Trust (Vornado). On February 8, 2007, Blackstone Group closed the purchase of EOP
for $39 billion, consisting of about $23 billion in cash and $16 billion in assumed debt.
EOP was established in 1976 by Sam Zell, a veteran property investor known for his
ability to acquire distressed properties. Blackstone, one of the nation's largest private
equity buyout firms, entered the commercial real estate market for the first time in
2005. In contrast, Vornado, a publicly traded real estate investment trust, had a
long-standing reputation for savvy investing in the commercial real estate market.
EOP's management had been under fire from investors for failing to sell properties fast
enough and distribute the proceeds to shareholders.
EOP signed a definitive agreement to be acquired by Blackstone for $48.50 per share in
cash in November 2006, subject to approval by EOP's shareholders. Reflecting the view
that EOP's breakup value exceeded $48.50 per share, Vornado bid $52 per share, 60
percent in cash and the remainder in Vornado stock. Blackstone countered with a bid of
$54 per share, if EOP would raise the breakup fee to $500 million from $200 million.
Ostensibly designed to compensate Blackstone for expenses incurred in its takeover
attempt, the breakup fee also raised the cost of acquiring EOP by another bidder, which
as the new owner would actually pay the fee. Within a week, Vornado responded with a
bid valued at $56 per share. While higher, EOP continued to favor Blackstone's offer
since the value was more certain than Vornado's bid. It could take as long as three to
four months for Vornado to get shareholder approval. The risks were that the value of
Vornado's stock could decline and shareholders could nix the deal. Reluctant to raise its
offer price, Vornado agreed to increase the cash portion of the purchase price and pay
shareholders the cash more quickly than had been envisioned in its initial offer.
However, Vornado did not offer to pay EOP shareholders a fee if Vornado's
shareholders did not approve the deal. The next day, Blackstone increased its bid to
$55.25 and eventually to $55.50 at Zell's behest in exchange for an increase in the
breakup fee to $720 million. Vornado's failure to counter gave Blackstone the win. On
the news that Blackstone had won, Vornado's stock jumped by 5.8 percent and EOP's
fell by 1 percent to just below Blackstone's final offer price.
Discussion Questions:
1) Describe Blackstone's negotiating strategy with EOP in its effort to counter Vornado's
bids. Be specific.
2) What could Vornado have done to assuage EOP's concerns about the certainty of the
value of the stock portion of its offer?
3) Explain the reaction of EOP's and Vornado's share prices to the news that Blackstone
was the winning bidder. What does the movement in Vornado's share price tell you
about the likelihood that the firm's shareholders would have approved the takeover of
EOP?
Answer:
HCA's LBO Represents a High-Risk Bet on Growth
While most LBOs are predicated on improving operating performance through a
combination of aggressive cost cutting and revenue growth, HCA laid out an
unconventional approach in its effort to take the firm private. On July 24, 2006,
management again announced that it would "go private" in a deal valued at $33 billion
including the assumption of $11.7 billion in existing debt.
The approximate $21.3 billion purchase price for HCA's stock was financed by a
combination of $12.8 billion in senior secured term loans of varying maturities and an
estimated $8.5 billion in cash provided by Bain Capital, Merrill Lynch Global Private
Equity, and Kohlberg Kravis Roberts & Company. HCA also would take out a $4
billion revolving credit line to satisfy immediate working capital requirements. The firm
publicly announced a strategy of improving performance through growth rather than
through cost cutting. HCA's network of 182 hospitals and 94 surgery centers is
expected to benefit from an aging U.S. population and the resulting increase in
health-care spending. The deal also seems to be partly contingent on the government
assuming a larger share of health-care costs in the future. Finally, with many nonprofit
hospitals faltering financially, HCA may be able to acquire them inexpensively.
While the longer-term trends in the health-care industry are unmistakable, shorter-term
developments appear troublesome, including sluggish hospital admissions, more
uninsured patients, and higher bad debt expenses. Moreover, with Medicare and
Medicaid financially insolvent, it is unclear if future increases in government
health-care spending would be sufficient to enable HCA investors to achieve their
expected financial returns. With the highest operating profit margins in the industry, it is
uncertain if HCA's cash flows could be significantly improved by cost cutting, if the
revenue growth assumptions fail to materialize. HCA's management and equity
investors have put themselves in a position in which they seem to have relatively little
influence over the factors that directly affect the firm's future cash flows.
Discussion Questions:
1) Does a hospital or hospital system represent a good or bad LBO candidate? Explain
your answer.
2) Having pledged not to engage in aggressive cost cutting, how do you think HCA and
its financial sponsor group planned on paying off the loans?
Answer:
Xerox Buys ACS to Satisfy Shifting Customer Requirements
In anticipation of a shift from hardware and software spending to technical services by
their corporate customers, IBM announced an aggressive move away from its
traditional hardware business and into services in the mid-1990s. Having sold its
commodity personal computer business to Chinese manufacturer Lenovo in mid-2005,
IBM became widely recognized as a largely "hardware neutral" systems integration,
technical services, and outsourcing company.
Because information technology (IT) services have tended to be less cyclical than
hardware and software sales, the move into services by IBM enabled the firm to tap a
steady stream of revenue at a time when customers were keeping computers and
peripheral equipment longer to save money. The 20082009 recession exacerbated this
trend as corporations spent a smaller percentage of their IT budgets on hardware and
software.
These developments were not lost on other IT companies. Hewlett-Packard (HP) bought
tech services company EDS in 2008 for $13.9 billion. On September 21, 2009, Dell
announced its intention to purchase another IT services company, Perot Systems, for
$3.9 billion. One week later, Xerox, traditionally an office equipment manufacturer
announced a cash and stock bid for Affiliated Computer Systems (ACS) totaling $6.4
billion.
Each firm was moving to position itself as a total solution provider for its customers,
achieving differentiation from its competitors by offering a broader range of both
hardware and business services. While each firm focused on a somewhat different set of
markets, they all shared an increasing focus on the government and healthcare
segments. However, by retaining a large proprietary hardware business, each firm faced
challenges in convincing customers that they could provide objectively enterprise-wide
solutions that reflected the best option for their customers.
Previous Xerox efforts to move beyond selling printers, copiers, and supplies and into
services achieved limited success due largely to poor management execution. While
some progress in shifting away from the firm's dependence on printers and copier sales
was evident, the pace was far too slow. Xerox was looking for a way to accelerate
transitioning from a product-driven company to one whose revenues were more
dependent on the delivery of business services.
With annual sales of about $6.5 billion, ACS handles paper-based tasks such as billing
and claims processing for governments and private companies. With about one-fourth
of ACS's revenue derived from the healthcare and government sectors through
long-term contracts, the acquisition gives Xerox a greater penetration into markets
which should benefit from the 2009 government stimulus spending and 2010 healthcare
legislation. More than two-thirds of ACS's revenue comes from the operation of client
back office operations such as accounting, human resources, claims management, and
other business management outsourcing services, with the rest coming from providing
technology consulting services. ACS would also triple Xerox's service revenues to $10
billion.
Xerox hopes to increases its overall revenue by bundling its document management
services with ACS's client back office operations. Only 20 percent of the two firms'
customers overlap. This allows for significant cross-selling of each firm's products and
services to the other firm's customers. Xerox is also betting that it can apply its globally
recognized brand and worldwide sales presence to expand ACS internationally.
A perceived lack of synergies between the two firms, Xerox's rising debt levels, and the
firm's struggling printer business fueled concerns about the long-term viability of the
merger, sending Xerox's share price tumbling by almost 10 percent on the news of the
transaction. With about $1 billion in cash at closing in early 2010, Xerox needed to
borrow about $3 billion. Standard & Poor's credit rating agency downgraded Xerox's
credit rating to triple-B-minus, one notch above junk.
Integration is Xerox's major challenge. The two firms' revenue mixes are very different,
as are their customer bases, with government customers often requiring substantially
greater effort to close sales than Xerox's traditional commercial customers. Xerox
intends to operate ACS as a standalone business, which will postpone the integration of
its operations consisting of 54,000 employees with ACS's 74,000. If Xerox intends to
realize significant incremental revenues by selling ACS services to current Xerox
customers, some degree of integration of the sales and marketing organizations would
seem to be necessary.
It is hardly a foregone conclusion that customers will buy ACS services simply because
ACS sales representatives gain access to current Xerox customers. Presumably,
additional incentives are needed, such as some packaging of Xerox hardware with
ACS's IT services. However, this may require significant price discounting at a time
when printer and copier profit margins already are under substantial pressure.
Customers are likely to continue, at least in the near term, to view Xerox, Dell, and HP
more as product than service companies. The sale of services will require significant
spending to rebrand these companies so that they will be increasingly viewed as service
vendors. The continued dependence of all three firms on the sale of hardware may
retard their ability to sell packages of hardware and IT services to customers. With
hardware prices under continued pressure, customers may be more inclined to continue
to buy hardware and IT services from separate vendors to pit one vendor against
another. Moreover, with all three firms targeting the healthcare and government
markets, pressure on profit margins could increase for all three firms. The success of
IBM's services strategy could suggest that pure IT service companies are likely to
perform better in the long run than those that continue to have a significant presence in
both the production and sale of hardware as well as IT services.
Discussion Questions:
1) Discuss the advantages and disadvantages of Xerox's intention to operate ACS as a
standalone business. As an investment banker supporting Xerox, would you have
argued in support of integrating ACS immediately, at a later date, or to keep the two
businesses separate indefinitely? Explain your answer.
2) How are Xerox and ACS similar and how are they different? In what way will their
similarities and differences help or hurt the long-term success of the merger?
3) Based on your answers to questions 1 and 2, do you believe that investors reacted
correctly or incorrectly to the announcement of the transaction?
Answer:
Microsoft Partners with Yahoo!An Alternative to Takeover?
Business alliances sometimes represent a less expensive alternative to mergers and
acquisitions. This notion may have motivated Microsoft when the firm first approached
Yahoo! about a potential partnership in November 2006 and again in mid-2007.
Frustrated with their inability to partner with Yahoo!, Microsoft initiated a hostile
takeover bid in 2008 valued at almost $48 billion or $33 per share, only to be spurned
by Yahoo!. Following the withdrawal of Microsoft's offer, Yahoo!'s share price fell into
the low to mid-teens and remained in that range throughout 2010.
Reflecting the slumping share price and a failed effort to create a search partnership
with Google, Yahoo!'s cofounder, Jerry Yang, was replaced by Carol Bartz in early
2009. The U.S. Justice Department had threatened to sue to block the proposed
partnership between Yahoo! and Google on antitrust grounds.
Microsoft again approached Yahoo! with a partnering proposal in mid-2009, which
resulted in an announcement on February 18, 2010, of an Internet search agreement
between the two firms. As a result of the agreement, Yahoo! transferred control of its
Internet search technology to Microsoft. Microsoft is relying on a ten-year arrangement
with Yahoo! to help counter the dominance of Google in the Internet search market. By
gaining access to each other's Internet users, both firms hope to be able to attract more
advertising dollars from companies willing to pay for links on Microsoft's and Yahoo!'s
websites. With Microsoft's search technology believed to be superior to Yahoo!'s, users
requesting searches through Yahoo!'s site will be implemented using Microsoft's search
software.
Regulatory agencies in both the United States and the European Union had no trouble
approving the proposal because the combined Yahoo! and Microsoft Internet search
market share is dwarfed by Google's. Google is estimated to have about two-thirds of
the search market, followed by Yahoo! at 7% and Microsoft with about 3%.
Yahoo! could profit handsomely from the deal, since it will retain 88% of the revenue
from search ads on its website during the first five years of the ten-year contract.
Microsoft will pay for most of the costs of implementing the partnership by giving
Yahoo! $150 million to defray its expenses. Microsoft also agreed to absorb about 400
of Yahoo!'s nearly 14,000 employees. Ironically, Microsoft may get much of what it
wanted (namely Yahoo!'s user base) at a fraction of the cost it would have paid to
acquire the entire company.
Garmin Utilizes Supply Agreement as Alternative to Acquiring Tele Atlas
Following an aggressive bidding process, Garmin Ltd., the largest U.S. maker of
car-navigation devices, withdrew its bid for the Netherlands-based Tele Atlas NV on
November 16, 2007. Tele Atlas provides maps of 12 million miles of roads in 200
countries. The move cleared the way for TomTom NV to buy the mapmaker for $4.25
billion. Both Garmin and TomTom are leading manufacturers of global positioning
systems (GPSs), which enable users to navigate more easily through unfamiliar
territory. The most critical component of such navigation systems is the map.
In lieu of acquiring Tele Atlas, Garmin entered into a six-year deal with an option to
extend for an additional four years to obtain maps from Tele Atlas's competitor Navteq
Corp. In doing so, Garmin avoided the EPS-dilutive effects of owning money-losing
Tele Atlas. Garmin can focus on building traffic information and business listings into
its products without having to own the underlying maps. An acquisition would have
diluted Garmin's profit until 2010. Building maps comparable to those owned by Tele
Atlas could take up to 10 years and cost $1 billion.
By owning the maps, TomTom is seeking to become more of a service provider than
simply a manufacturer of GPS devices. Such devices are widely used in the automotive
industry, as well as aviation and boating. The biggest growth opportunity is the
increased use of GPS tracking capabilities in the market for mobile phones. This
application is expected to dwarf the transportation and sports markets for GPS devices.
Because it will own the underlying maps, TomTom may be able to more easily combine
the data with navigation devices and add traffic, gas station, and restaurant information.
In contrast, Garmin will have to obtain proprietary data from others. Garmin may also
have to pay more for maps or even lose access after the contract (including the option to
extend) expires.
Discussion Questions:
1) Describe the advantages of the supply agreement to Garmin compared to outright
acquisition of Tele Atlas?
2) Describe the disadvantages of the supply agreement to Garmin?
Answer:
Hewlett-Packard Family Members
Oppose Proposal to Acquire Compaq
On September 4, 2001, Hewlett-Packard ("HP") announced its proposal to acquire
Compaq Computer Corporation for $25 billion in stock. Almost immediately, investors
began to doubt the wisdom of the proposal. The new company would face the
mind-numbing task of integrating overlapping product lines and 150,000 employees in
160 countries. Reflecting these concerns, the value of the proposed merger had sunk to
$16.9 million within 30 days following the announcement, in line with the decline in
the value of HP's stock.
In November 2001, Walter Hewlett and David Packard, sons of the co-founders, and
both the Hewlett and Packard family foundations, came out against the transaction.
These individuals and entities controlled about 18% of HP's total shares outstanding.
Both Carly Fiorina, HP's CEO, and Michael Capellas, Compaq's CEO, moved
aggressively to counter this opposition by taking their case directly to the remaining HP
shareholders. HP management's efforts included a 49-page report written by HP's
advisor Goldman Sachs to rebut one presented by Walter Hewlett's advisors. HP also
began advertising in national newspapers and magazines, trying to convey the idea that
this deal is not about PCs but about giving corporate customers everything from storage
and services to printing and imaging.
After winning a hotly contested 8-month long proxy fight by a narrow 2.8 percentage
point margin, HP finally was able to purchase Compaq on May 7, 2002, for
approximately $19 billion. However, the contentious proxy fight had lingering effects.
The delay in integrating the two firms resulted in the defection of key employees, the
loss of customers and suppliers, the expenditure of millions of dollars, and widespread
angst among shareholder.
Discussion Questions:
1) In view of the dramatic decline in HP's stock following the announcement, why do
you believe Compaq shareholders would still vote to approve the merger?
2) In an effort to combat the proxy contest initiated by the Hewlett and Packard families
against the merger, HP's board and management took their case to the shareholders in a
costly battle paid for by HP funds (i.e., HP shareholders). Do you think it is fair that
HP's management can finance their own proxy contest using company funds while
dissident shareholders must finance their effort using their own funds.
Answer:
Determining Deal Structuring Components
BigCo has decided to acquire Upstart Corporation, a leading supplier of a new
technology believed to be crucial to the successful implementation of BigCo's business
strategy. Upstart is a relatively recent start-up firm, consisting of about 200 employees
averaging about 24 years of age. HiTech has a reputation for developing highly
practical solutions to complex technical problems and getting the resulting products to
market very rapidly. HiTech employees are accustomed to a very informal work
environment with highly flexible hours and compensation schemes. Decision-making
tends to be fast and casual, without the rigorous review process often found in larger
firms. This culture is quite different from BigCo's more highly structured and
disciplined environment. Moreover, BigCo's decision making tends to be highly
centralized.
While Upstart's stock is publicly traded, its six co-founders and senior managers jointly
own about 60 percent of the outstanding stock. In the four years since the firm went
public, Upstart stock has appreciated from $5 per share to its current price of $100 per
share. Although they desire to sell the firm, the co-founders are interested in remaining
with the firm in important management positions after the transaction has closed. They
also expect to continue to have substantial input in both daily operating as well as
strategic decisions.
Upstart competes in an industry that is only tangentially related to BigCo's core
business. Because BigCo's senior management believes they are somewhat unfamiliar
with the competitive dynamics of Upstart's industry, BigCo has decided to create a new
corporation, New Horizons Inc., which is jointly owed by BigCo and HiTech
Corporation, a firm whose core technical competencies are more related to Upstart's
than those of BigCo. Both BigCo and HiTech are interested in preserving Upstart's
highly innovative culture. Therefore, they agreed during negotiations to operate Upstart
as an independent operating unit of New Horizons. During negotiations, both parties
agreed to divest one of Upstart's product lines not considered critical to New Horizon's
long-term strategy immediately following closing.
New Horizons issued stock through an initial public offering. While the co-founders are
interested in exchanging their stock for New Horizon's shares, the remaining Upstart
shareholders are leery about the long-term growth potential of New Horizons and
demand cash in exchange for their shares. Consequently, New Horizons agreed to
exchange its stock for the co-founders' shares and to purchase the remaining shares for
cash. Once the tender offer was completed, New Horizons owned 100 percent of
Upstart's outstanding shares.
Discussion Questions:
1) What is the acquisition vehicle used to acquire the target company, Upstart
Corporation? Why was this legal structure used?
2) How would you characterize the post-closing organization? Why was this
organizational structure used?
3) What is the form of payment? Why was it used?
4) What was the form of acquisition? How does this form of acquisition protect the
acquiring company's rights to HiTech's proprietary technology?
5) How would the use of purchase accounting affect the balance sheets of the combined
companies?
6) Was the transaction non-taxable, partially taxable, or wholly taxable to HiTech
shareholders? Why?
Answer:
Determining Deal Structuring Components
BigCo has decided to acquire Upstart Corporation, a leading supplier of a new
technology believed to be crucial to the successful implementation of BigCo's business
strategy. Upstart is a relatively recent start-up firm, consisting of about 200 employees
averaging about 24 years of age. HiTech has a reputation for developing highly
practical solutions to complex technical problems and getting the resulting products to
market very rapidly. HiTech employees are accustomed to a very informal work
environment with highly flexible hours and compensation schemes. Decision-making
tends to be fast and casual, without the rigorous review process often found in larger
firms. This culture is quite different from BigCo's more highly structured and
disciplined environment. Moreover, BigCo's decision making tends to be highly
centralized.
While Upstart's stock is publicly traded, its six co-founders and senior managers jointly
own about 60 percent of the outstanding stock. In the four years since the firm went
public, Upstart stock has appreciated from $5 per share to its current price of $100 per
share. Although they desire to sell the firm, the co-founders are interested in remaining
with the firm in important management positions after the transaction has closed. They
also expect to continue to have substantial input in both daily operating as well as
strategic decisions.
Upstart competes in an industry that is only tangentially related to BigCo's core
business. Because BigCo's senior management believes they are somewhat unfamiliar
with the competitive dynamics of Upstart's industry, BigCo has decided to create a new
corporation, New Horizons Inc., which is jointly owed by BigCo and HiTech
Corporation, a firm whose core technical competencies are more related to Upstart's
than those of BigCo. Both BigCo and HiTech are interested in preserving Upstart's
highly innovative culture. Therefore, they agreed during negotiations to operate Upstart
as an independent operating unit of New Horizons. During negotiations, both parties
agreed to divest one of Upstart's product lines not considered critical to New Horizon's
long-term strategy immediately following closing.
New Horizons issued stock through an initial public offering. While the co-founders are
interested in exchanging their stock for New Horizon's shares, the remaining Upstart
shareholders are leery about the long-term growth potential of New Horizons and
demand cash in exchange for their shares. Consequently, New Horizons agreed to
exchange its stock for the co-founders' shares and to purchase the remaining shares for
cash. Once the tender offer was completed, New Horizons owned 100 percent of
Upstart's outstanding shares.
Discussion Questions:
1) What is the acquisition vehicle used to acquire the target company, Upstart
Corporation? Why was this legal structure used?
2) How would you characterize the post-closing organization? Why was this
organizational structure used?
3) What is the form of payment? Why was it used?
4) What was the form of acquisition? How does this form of acquisition protect the
acquiring company's rights to HiTech's proprietary technology?
5) How would the use of purchase accounting affect the balance sheets of the combined
companies?
6) Was the transaction non-taxable, partially taxable, or wholly taxable to HiTech
shareholders? Why?
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 ΔTotal 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:
Getting Wired: Wal-MartAmerica Online and Other Internet Marketing Alliances
During the second half of 1999, the number of marketing alliances between major
retailers and Internet companies exploded. Wal-Mart Stores, the world's biggest retailer,
and Circuit City, a large consumer electronics retailer, announced partnerships with
America Online (AOL). Best Buy, the largest U.S. consumer electronics chain,
collaborated with Microsoft, which previously had joined with Tandy Corporation's
RadioShack stores. Signaling its own strategy of bringing its service to anyone,
anywhere, AOL announced in March 2000 partnerships with Sprint PCS and Nokia to
help move AOL's service from the desktop to phones, pagers, organizers, and even TVs.
Wal-Mart and AOL
Wal-Mart and AOL have agreed to create a low-cost Web service for consumers who
lack access and to promote each other's services. Wal-Mart customers will get software
that allows them to set up the service through AOL's CompuServe service. The retailer
also will distribute AOL's software with a link to Wal-Mart's Web site, Wal-Mart.com.
The Internet access service will be geared to Wal-Mart customers in smaller towns that
currently do not have local numbers to dial for online connections. Wal-Mart wants to
funnel as many customers as possible to its revamped Web site, which contains a
pharmacy, a photo center, and travel services in addition to general merchandise. The
alliance gives AOL access to the 90100 million people who shop at Wal-Mart weekly.
Microsoft, Best Buy, and RadioShack
Through its alliance with Best Buy, Microsoft is selling its productsincluding Microsoft
Network (MSN) Internet access services and hand-held devices such as digital
telephones, hand-held organizers, and WebTV that connect to the Webthrough kiosks in
Best Buy's 354 stores nationwide. In exchange, Microsoft has invested $200 million in
Best Buy. Microsoft has a similar arrangement with Tandy Company's RadioShack
stores in which it agreed to invest $100 million in Tandy's online sales site in exchange
for in-store displays promoting Microsoft products and services. Both Best Buy and
RadioShack are major advertisers on MSN and share in the monthly revenue from some
of the Microsoft Internet access services they sell through their stores. Best Buy has
issued 4 million new shares of common stock to Microsoft in exchange for its
investment, giving Microsoft approximately a 2% ownership position in Best Buy. The
multiyear pact is nonexclusive.
Circuit City and America Online
AOL and Circuit City entered a strategic alliance to provide in-store promotion of AOL
products and services to Circuit City shoppers nationwide, to make AOL Circuit City's
preferred Internet online service, and to feature Circuit City as an anchor tenant in
AOL's shopping mall. Under the agreement, AOL products and services are displayed
prominently in dedicated retail space in Circuit City's 615 stores across the nation.
Access to the Internet is available via AOL through dial-up service and developing
broadband technologies, including digital subscriber line and satellite, as well as
wireless interactive devices. Circuit City is promoting AOL and its in-store offerings in
its print and television advertising programs and in other promotional and marketing
campaigns. As an anchor tenant on AOL's shopping mall, Circuit City will have access
to AOL's more than 32 million subscribers.
Discussion Questions
1) What are the elements that each alliance has in common? Of these, which do you
believe are the most important?
2) In what way do these alliances represent a convergence of "bricks and clicks?"
3) In your judgment, do these alliances deliver real value to the consumer? Explain your
answer.
Answer:
Pfizer Acquires Pharmacia to Solidify Its Top Position
In 1990, the European and U.S. markets were about the same size; by 2000, the U.S.
market had grown to twice that of the European market. This rapid growth in the U.S.
market propelled American companies to ever increasing market share positions. In
particular, Pfizer moved from 14th in terms of market share in 1990 to the top spot in
With the acquisition of Pharmacia in 2002, Pfizer's global market share increased by
three percentage points to 11%. The top ten drug firms controlled more than 50 percent
of the global market, up from 22 percent in 1990.
Pfizer is betting that size is what matters in the new millennium. As the market leader,
Pfizer was finding it increasingly difficult to sustain the double-digit earnings growth
demanded by investors. Such growth meant the firm needed to grow revenue by $3-$5
billion annually while maintaining or improving profit margins. This became more
difficult due to the skyrocketing costs of developing and commercializing new drugs.
Expiring patents on a number of so-called blockbuster drugs (i.e., those with potential
annual sales of more than $1 billion) intensified pressure to bring new drugs to market.
Pfizer and Pharmacia knew each other well. They had been in a partnership since 1998
to market the world's leading arthritis medicine and the 7th largest selling drug globally
in terms of annual sales in Celebrex. The companies were continuing the partnership
with 2nd generation drugs such as Bextra launched in the spring of 2002. For
Pharmacia's management, the potential for combining with Pfizer represented a way for
Pharmacia and its shareholders to participate in the biggest and fastest growing
company in the industry, a firm more capable of bringing more products to market than
any other.
The deal offered substantial cost savings, immediate access to new products and
markets, and access to a number of potentially new blockbuster drugs. Projected cost
savings are $1.4 billion in 2003, $2.2 billion in 2004, and $2.5 billion in 2005 and
thereafter. Moreover, Pfizer gained access to four more drug lines with annual revenue
of more than $1 billion each, whose patents extend through That gives Pfizer, a
portfolio, including its own, of 12 blockbuster drugs. The deal also enabled Pfizer to
enter three new markets, cancer treatment, ophthalmology, and endocrinology. Pfizer
expects to spend $5.3 billion on R&D in 2002. Adding Pharmacia's $2.2 billion brings
combined company spending to $7.5 billion annually. With an enlarged research and
development budget Pfizer hopes to discover and develop more new drugs faster than
its competitors.
On July 15, 2002, the two firms jointly announced they had agreed that Pfizer would
exchange 1.4 shares of its stock for each outstanding share of Pharmacia stock or $45 a
share based on the announcement date closing price of Pfizer stock. The total value of
the transaction on the announcement was $60 billion. The offer price represented a 38%
premium over Pharmacia's closing stock price of $32.59 on the announcement date.
Pfizer's shareholders would own 77% of the combined firms and Pharmcia's
shareholders 23%. The market punished Pfizer, sending its shares down $3.42 or 11%
to $28.78 on the announcement date. Meanwhile, Pharmacia's shares climbed $6.66 or
20% to $39.25.
Discussion Questions:
1) In your judgment, what were the primary motivations for Pfizer wanting to acquire
Pharmacia? Categorize these in terms of the primary motivations for mergers and
acquisitions discussed in this chapter.
2) Why do you think Pfizer's stock initially fell and Pharmacia's increased?
3) In your opinion, is this transaction likely to succeed or fail to meet investor
expectations? Explain your answer.
4) Would you anticipate continued consolidation in the global pharmaceutical industry?
Why or why not?
Answer:
Gillette Announces Divestiture Plans
With 1998 sales of $10.1 billion, Gillette is the world leader in the production of razor
blades, razors, and shaving cream. Gillette also has a leading position in the production
of pens and other writing instruments. Gillette's consolidated operating performance
during 1999 depended on its core razor blade and razor, Duracell battery, and oral care
businesses. Reflecting disappointment in the performance of certain operating units,
Gillette's CEO, Michael Hawley, announced in October 1999 his intention to divest
poorly performing businesses unless he could be convinced by early 2000 that they
could be turned around. The businesses under consideration at that time comprised
about 15% of the company's $10 billion in annual sales. Hawley saw the new focus of
the company to be in razor blades, batteries, and oral care. To achieve this new focus,
Hawley intended to prune the firm's product portfolio. The most likely targets for
divestiture at the time included pens (i.e., PaperMate, Parker, and Waterman), with the
prospects for operating performance for these units considered dismal. Other units
under consideration for divestiture included Braun and toiletries. With respect to these
businesses, Hawley apparently intended to be selective. At Braun, where overall
operating profits plunged 43% in the first three quarters of 1999, Hawley has
announced that Gillette will keep electric shavers and electric toothbrushes. However,
the household and personal care appliance units are likely divestiture candidates. The
timing of these sales may be poor. A decision to sell Braun at this time would compete
against Black & Decker's recently announced decision to sell its appliance business.
Although Gillette would be smaller, the firm believes that its margins will improve and
that its earnings growth will be more rapid. Moreover, divesting such problem
businesses as pens and appliances would let management focus on the units whose
prospects are the brightest. These are businesses that Gillette's previous management
was simply not willing to sell because of their perceived high potential.
Discussion Questions:
1)Which of the major restructuring motives discussed in this chapter seem to be a work
in this business case? Explain your answer.
2) Describe the process Gillette's management may have gone through to determine
which business units to sell and which to keep.
3) Comment on the timing of the sale.
Answer:
The Downside of Earnouts
In the mid-1980s, a well-known aerospace conglomerate acquired a high-growth
systems integration company by paying a huge multiple of earnings. The purchase price
ultimately could become much larger if certain earnout objectives, including both sales
and earnings targets, were achieved during the 4 years following closing. However, the
buyer's business plan assumed close cooperation between the two firms, despite holding
the system integrator as a wholly owned but largely autonomous subsidiary. The
dramatic difference in the cultures of the two firms was a major impediment to building
trust and achieving the cooperation necessary to make the acquisition successful. Years
of squabbling over policies and practices tended to delay the development and
implementation of new systems. The absence of new systems made it difficult to gain
market share. Moreover, because the earnout objectives were partially defined in terms
of revenue growth, many of the new customer contracts added substantial amounts of
revenue but could not be completed profitably under the terms of these contracts. The
buyer was slow to introduce new management into its wholly owned subsidiary for fear
of violating the earnout agreement. Finally, market conditions changed, and what had
been the acquired company's unique set of skills became commonplace. Eventually, the
aerospace company wrote off most of the purchase price and merged the remaining
assets of the acquired company into one of its other product lines after the earnout
agreement expired.
Discussion Questions:
1) Describe conditions under which an earnout might be most appropriate.
2) In your opinion, are earnouts more appropriate for firms in certain types of industries
than for others? If so, give examples. Explain your answer.
Answer:
"Grave Dancer" Takes Tribune Corporation Private in an Ill-Fated Transaction
At the closing in late December 2007, well-known real estate investor Sam Zell
described the takeover of the Tribune Company as "the transaction from hell." His
comments were prescient in that what had appeared to be a cleverly crafted, albeit
highly leveraged, deal from a tax standpoint was unable to withstand the credit malaise
of The end came swiftly when the 161-year-old Tribune filed for bankruptcy on
December 8, 2008.
On April 2, 2007, the Tribune Corporation announced that the firm's publicly traded
shares would be acquired in a multistage transaction valued at $8.2 billion. Tribune
owned at that time 9 newspapers, 23 television stations, a 25% stake in Comcast's
SportsNet Chicago, and the Chicago Cubs baseball team. Publishing accounts for 75%
of the firm's total $5.5 billion annual revenue, with the remainder coming from
broadcasting and entertainment. Advertising and circulation revenue had fallen by 9%
at the firm's three largest newspapers (Los Angeles Times, Chicago Tribune, and
Newsday in New York) between 2004 and 2006. Despite aggressive efforts to cut costs,
Tribune's stock had fallen more than 30% since 2005.
The transaction was implemented in a two-stage transaction, in which Sam Zell
acquired a controlling 51% interest in the first stage followed by a backend merger in
the second stage in which the remaining outstanding Tribune shares were acquired. In
the first stage, Tribune initiated a cash tender offer for 126 million shares (51% of total
shares) for $34 per share, totaling $4.2 billion. The tender was financed using $250
million of the $315 million provided by Sam Zell in the form of subordinated debt, plus
additional borrowing to cover the balance. Stage 2 was triggered when the deal received
regulatory approval. During this stage, an employee stock ownership plan (ESOP)
bought the rest of the shares at $34 a share (totaling about $4 billion), with Zell
providing the remaining $65 million of his pledge. Most of the ESOP's 121 million
shares purchased were financed by debt guaranteed by the firm on behalf of the ESOP.
At that point, the ESOP held all of the remaining stock outstanding valued at about $4
billion. In exchange for his commitment of funds, Mr. Zell received a 15-year warrant
to acquire 40% of the common stock (newly issued) at a price set at $500 million.
Following closing in December 2007, all company contributions to employee pension
plans were funneled into the ESOP in the form of Tribune stock. Over time, the ESOP
would hold all the stock. Furthermore, Tribune was converted from a C corporation to a
Subchapter S corporation, allowing the firm to avoid corporate income taxes. However,
it would have to pay taxes on gains resulting from the sale of assets held less than ten
years after the conversion from a C to an S corporation (Figure 1).
Tribune deal structure.
The purchase of Tribune's stock was financed almost entirely with debt, with Zell's
equity contribution amounting to less than 4% of the purchase price. The transaction
resulted in Tribune being burdened with $13 billion in debt (including the approximate
$5 billion currently owed by Tribune). At this level, the firm's debt was ten times
EBITDA, more than two and a half times that of the average media company. Annual
interest and principal repayments reached $800 million (almost three times their
preacquisition level), about 62% of the firm's previous EBITDA cash flow of $1.3
billion. While the ESOP owned the company, it was not be liable for the debt
guaranteed by Tribune.
The conversion of Tribune into a Subchapter S corporation eliminated the firm's current
annual tax liability of $348 million. Such entities pay no corporate income tax but must
pay all profit directly to shareholders, who then pay taxes on these distributions. Since
the ESOP was the sole shareholder, Tribune was expected to be largely tax exempt,
since ESOPs are not taxed.
In an effort to reduce the firm's debt burden, the Tribune Company announced in early
2008 the formation of a partnership in which Cablevision Systems Corporation would
own 97% of Newsday for $650 million, with Tribune owning the remaining 3%.
However, Tribune was unable to sell the Chicago Cubs (which had been expected to
fetch as much as $1 billion) and the minority interest in SportsNet Chicago to help
reduce the debt amid the 2008 credit crisis. The worsening of the recession, accelerated
by the decline in newspaper and TV advertising revenue, as well as newspaper
circulation, thereby eroded the firm's ability to meet its debt obligations.
By filing for Chapter 11 bankruptcy protection, the Tribune Company sought a reprieve
from its creditors while it attempted to restructure its business. Although the extent of
the losses to employees, creditors, and other stakeholders is difficult to determine, some
things are clear. Any pension funds set aside prior to the closing remain with the
employees, but it is likely that equity contributions made to the ESOP on behalf of the
employees since the closing would be lost. The employees would become general
creditors of Tribune. As a holder of subordinated debt, Mr. Zell had priority over the
employees if the firm was liquidated and the proceeds distributed to the creditors.
Those benefitting from the deal included Tribune's public shareholders, including the
Chandler family, which owed 12% of Tribune as a result of its prior sale of the Times
Mirror to Tribune, and Dennis FitzSimons, the firm's former CEO, who received $17.7
million in severance and $23.8 million for his holdings of Tribune shares. Citigroup and
Merrill Lynch received $35.8 million and $37 million, respectively, in advisory fees.
Morgan Stanley received $7.5 million for writing a fairness opinion letter. Finally,
Valuation Research Corporation received $1 million for providing a solvency opinion
indicating that Tribune could satisfy its loan covenants.
What appeared to be one of the most complex deals of 2007, designed to reap huge tax
advantages, soon became a victim of the downward-spiraling economy, the credit
crunch, and its own leverage. A lawsuit filed in late 2008 on behalf of Tribune
employees contended that the transaction was flawed from the outset and intended to
benefit Sam Zell and his advisors and Tribune's board. Even if the employees win, they
will simply have to stand in line with other Tribune creditors awaiting the resolution of
the bankruptcy court proceedings.
Discussion Questions:
1) What is the acquisition vehicle, post-closing organization, form of payment, form of
acquisition, and tax strategy described in this case study?
2) Describe the firm's strategy to finance the transaction?
3) Is this transaction best characterized as a merger, acquisition, leveraged buyout, or
spin-off? Explain your answer.
4) Is this transaction taxable or non-taxable to Tribune's public shareholders? To its
post-transaction shareholders? Explain your answer.
5) Comment on the fairness of this transaction to the various stakeholders involved.
How would you apportion the responsibility for the eventual bankruptcy of Tribune
among Sam Zell and his advisors, the Tribune board, and the largely unforeseen
collapse of the credit markets in late 2008? Be specific.
Answer:
United Parcel Service Goes Public in an Equity IPO
On November 10, 1999, United Parcel Service (UPS) raised $5.47 billion by selling
109.4 million shares of Class B common stock at an offering price of $50 per share in
the biggest IPO by any U.S. firm in history. The share price exploded to $67.38 at the
end of the first day of trading. The IPO represented 9% of the firm's stock and
established the firm's total market value at $81.9 billion (i.e., [$67.38 x 109.4 / .09]).
With 1998 revenue of $24.8 billion, UPS transports more than 3 billion parcels and
documents annually. The company provides services in more than 200 countries.
By issuing only a portion of its Class B stock to the public, UPS was interested in
ensuring that control would remain in the hands of current management. The cash
proceeds of the stock issue were used to buy back about 9% of the Class A voting stock
held by employees and by heirs to the founding Casey family, thereby keeping the total
number of shares outstanding constant. The Class B shares have one vote each, whereas
the Class A shares have 10 votes. In addition, the issuance of Class B stock provides a
currency for making acquisitions. UPS had attempted unsuccessfully to acquire certain
firms that had indicated a strong desire for UPS shares rather than cash.
The beneficiaries of the sale include UPS employees from top management to workers
on the loading docks. In a growing trend in U.S. companies to generate greater
employee loyalty and productivity, UPS offered all 330,000 employees worldwide an
opportunity to buy shares in this highly profitable company at prices as low as $20 per
share. Before UPS, the largest IPOs included Conoco in October 1998 at $4.40 billion,
Goldman Sachs in May 1999 at $3.66 billion, Charter Communications in November
1999 at $3.23 billion, and Lucent Technologies in April 1996 at $3 billion.
Discussion Questions:
1) Describe the motivation for UPS to undertake this type of transaction.
Answer:
Albertson's Acquires American Stores
Underestimating the Costs of Integration
In 1999, Albertson's acquired American Stores for $12.5 billion, making it the nation's
second largest supermarket chain, with more than 1000 stores. The corporate marriage
stumbled almost immediately. Escalating integration costs resulted in a sharp downward
revision of its fiscal year 2000 profits. In the quarter ended October 28, 1999, operating
profits fell 15% to $185 million, despite an increase in sales of 1.6% to $8.98 billion.
Albertson's proceeded to update the Lucky supermarket stores that it had acquired in
California and to combine the distribution operations of the two supermarket chains. It
appears that Albertson's substantially underestimated the complexity of integrating an
acquisition of this magnitude. Albertson's spent about $90 million before taxes to
convert more than 400 stores to its information and distribution systems as well as to
change the name to Albertson's. By the end of 1999, Albertson's stock had lost more
than one-half of its value (Bloomberg.com, November 1, 1999).
Discussion Questions:
1) In your judgment, do you think acquirers' commonly (albeit not deliberately)
understate integration costs? Why or why not?
2) Cite examples of expenses you believe are commonly incurred in integrating target
companies.
Answer:
Dell Moves into Information Technology Services
Dell Computer's growing dependence on the sale of personal computers and peripherals
left it vulnerable to economic downturns. Profits had dropped more than 22 percent
since the start of the global recession in early 2008 as business spending on information
technology was cut sharply. Dell dropped from number 1 to number 3 in terms of
market share, as measured by personal computer unit sales, behind lower-cost rivals
Hewlett-Packard and Acer. Major competitors such as IBM and Hewlett-Packard were
less vulnerable to economic downturns because they derived a larger percentage of their
sales from delivering services.
Historically, Dell has grown "organically" by reinvesting in its own operations and
through partnerships targeting specific products or market segments. However, in recent
years, Dell attempted to 'supercharge" its lagging growth through targeted acquisitions
of new technologies. Since 2007, Dell has made ten comparatively small acquisitions
(eight in the United States), purchased stakes in four firms, and divested two
companies. The largest previous acquisition for Dell was the purchase of EqualLogic
for $1.4 billion in 2007.
The recession underscored what Dell had known for some time. The firm had long
considered diversifying its revenue base from the more cyclical PC and peripherals
business into the more stable and less commodity-like computer services business. In
2007, Dell was in discussions about a merger with Perot Systems, a leading provider of
information technology (IT) services, but an agreement could not be reached.
Dell's global commercial customer base spans large corporations, government agencies,
healthcare providers, educational institutions, and small and medium firms. The firm's
current capabilities include expertise in infrastructure consulting and software services,
providing network-based services, and data storage hardware; nevertheless, it was still
largely a manufacturer of PCs and peripheral products. In contrast, Perot Systems offers
applications development, systems integration, and strategic consulting services
through its operations in the United States and ten other countries. In addition, it
provides a variety of business process outsourcing services, including claims processing
and call center operations. Perot's primary markets are healthcare, government, and
other commercial segments. About one-half of Perot's revenue comes from the
healthcare market, which is expected to benefit from the $30 billion the U.S.
government has committed to spending on information technology (IT) upgrades over
the next five years.
In 2008, Hewlett-Packard (HP) paid $13.9 billion for computer services behemoth,
EDS, in an attempt to become a "total IT solutions" provider for its customers. This
event, coupled with a very attractive offer price, revived merger discussions with Perot
Systems. On September 21, 2009, Dell announced that an agreement had been reached
to acquire Perot Systems in an all-cash offer for $30 a share in a deal valued at $3.9
billion. The tender offer (i.e., takeover bid) for all of Perot Systems' outstanding shares
of Class A common stock was initiated in early November and completed on November
19, 2009, with Dell receiving more than 90 percent of Perot's outstanding shares.
Mars Buys Wrigley in One Sweet Deal
Under considerable profit pressure from escalating commodity prices and eroding
market share, Wrigley Corporation, a U.S. based leader in gum and confectionery
products, faced increasing competition from Cadbury Schweppes in the U.S. gum
market. Wrigley had been losing market share to Cadbury since 2006. Mars
Corporation, a privately owned candy company with annual global sales of $22 billion,
sensed an opportunity to achieve sales, marketing, and distribution synergies by
acquiring Wrigley Corporation.
On April 28, 2008, Mars announced that it had reached an agreement to merge with
Wrigley Corporation for $23 billion in cash. Under the terms of the agreement,
unanimously approved by the boards of the two firms, shareholders of Wrigley would
receive $80 in cash for each share of common stock outstanding. The purchase price
represented a 28 percent premium to Wrigley's closing share price of $62.45 on the
announcement date. The merged firms in 2008 would have a 14.4 percent share of the
global confectionary market, annual revenue of $27 billion, and 64,000 employees
worldwide. The merger of the two family-controlled firms represents a strategic blow to
competitor Cadbury Schweppes's efforts to continue as the market leader in the global
confectionary market with its gum and chocolate business. Prior to the announcement,
Cadbury had a 10 percent worldwide market share.
Wrigley would become a separate stand-alone subsidiary of Mars, with $5.4 billion in
sales. The deal would help Wrigley augment its sales, marketing, and distribution
capabilities. To provide more focus to Mars' brands in an effort to stimulate growth,
Mars would transfer its global nonchocolate confectionery sugar brands to Wrigley. Bill
Wrigley, Jr., who controls 37 percent of the firm's outstanding shares, would remain
executive chairman of Wrigley. The Wrigley management team also would remain in
place after closing. The combined companies would have substantial brand recognition
and product diversity in six growth categories: chocolate, nonchocolate confectionary,
gum, food, drinks, and pet-care products. The resulting confectionary powerhouse also
would expect to achieve significant cost savings by combining manufacturing
operations and have a substantial presence in emerging markets.
While mergers among competitors are not unusual, the deal's highly leveraged financial
structure is atypical of transactions of this type. Almost 90 percent of the purchase price
would be financed through borrowed funds, with the remainder financed largely by a
third party equity investor. Mars's upfront costs would consist of paying for closing
costs from its cash balances in excess of its operating needs. The debt financing for the
transaction would consist of $11 billion and $5.5 billion provided by J.P. Morgan Chase
and Goldman Sachs, respectively. An additional $4.4 billion in subordinated debt would
come from Warren Buffet's investment company, Berkshire Hathaway, a nontraditional
source of high-yield financing. Historically, such financing would have been provided
by investment banks or hedge funds and subsequently repackaged into securities and
sold to long-term investors, such as pension funds, insurance companies, and foreign
investors. However, the meltdown in the global credit markets in 2008 forced
investment banks and hedge funds to withdraw from the high-yield market in an effort
to strengthen their balance sheets. Berkshire Hathaway completed the financing of the
purchase price by providing $2.1 billion in equity financing for a 9.1 percent ownership
stake in Wrigley.
Discussion Questions:
1) Why was market share in the confectionery business an important factor in Mars'
decision to acquire Wrigley?
2) It what way did the acquisition of Wrigley's represent a strategic blow to Cadbury?
3) How might the additional product and geographic diversity achieved by combining
Mars and Wrigley benefit the combined firms?
Answer:
Exhibit 15-1. Structuring the Transaction
Step 1: Kraft creates a shell subsidiary (Kraft Sub) and transfers Post assets and
liabilities and $300 million in Kraft debt into the shell in exchange for Kraft Sub stock
plus $660 million in Kraft Sub debt securities. Kraft also implements an exchange offer
of Kraft Sub for Kraft common stock.
Step 2:
Kraft Sub, as an independent company, is merged in a forward triangular tax-free
merger with a sub of Ralcorp (Ralcorp Sub) in which Kraft Sub shares are exchanged
for Ralcorp shares, with Ralcorp Sub surviving.4
Sara Lee Attempts to Create Value through Restructuring
After spurning a series of takeover offers, Sara Lee, a global consumer goods company,
announced in early 2011 its intention to split the firm into two separate publicly traded
companies. The two companies would consist of the firm's North American retail and
food service division and its international beverage business. The announcement comes
after a long string of restructuring efforts designed to increase shareholder value. It
remains to be seen if the latest effort will be any more successful than earlier efforts.
Reflecting a flawed business strategy, Sara Lee had struggled for more than a decade to
create value for its shareholders by radically restructuring its portfolio of businesses.
The firm's business strategy had evolved from one designed in the mid-1980s to market
a broad array of consumer products from baked goods to coffee to underwear under the
highly recognizable brand name of Sara Lee into one that was designed to refocus the
firm on the faster-growing food and beverage and apparel businesses. Despite acquiring
several European manufacturers of processed meats in the early 1990s, the company's
profits and share price continued to flounder.
In September 1997, Sara Lee embarked on a major restructuring effort designed to
boost both profits, which had been growing by about 6% during the previous five years,
and the company's lagging share price. The restructuring program was intended to
reduce the firm's degree of vertical integration, shifting from a manufacturing and sales
orientation to one focused on marketing the firm's top brands. The firm increasingly
viewed itself as more of a marketing than a manufacturing enterprise.
Sara Lee outsourced or sold 110 manufacturing and distribution facilities over the next
two years. Nearly 10,000 employees, representing 7% of the workforce, were laid off.
The proceeds from the sale of facilities and the cost savings from outsourcing were
either reinvested in the firm's core food businesses or used to repurchase $3 billion in
company stock. 1n 1999 and 2000, the firm acquired several brands in an effort to
bolster its core coffee operations, including such names as Chock Full o'Nuts, Hills
Bros, and Chase & Sanborn.
Despite these restructuring efforts, the firm's stock price continued to drift lower. In an
attempt to reverse the firm's misfortunes, the firm announced an even more ambitious
restructuring plan in 2000. Sara Lee would focus on three main areas: food and
beverages, underwear, and household products. The restructuring efforts resulted in the
shutdown of a number of meat packing plants and a number of small divestitures,
resulting in a 10% reduction (about 13,000 people) in the firm's workforce. Sara Lee
also completed the largest acquisition in its history, purchasing The Earthgrains
Company for $1.9 billion plus the assumption of $0.9 billion in debt. With annual
revenue of $2.6 billion, Earthgrains specialized in fresh packaged bread and refrigerated
dough. However, despite ongoing restructuring activities, Sara Lee continued to
underperform the broader stock market indices.
In February 2005, Sara Lee executed its most ambitious plan to transform the firm into
a company focused on the global food, beverage, and household and body care
businesses. To this end, the firm announced plans to dispose of 40% of its revenues,
totaling more than $8 billion, including its apparel, European packaged meats, U.S.
retail coffee, and direct sales businesses.
In 2006, the firm announced that it had completed the sale of its branded apparel
business in Europe, Global Body Care and European Detergents units, and its European
meat processing operations. Furthermore, the firm spun off its U.S. Branded Apparel
unit into a separate publicly traded firm called HanesBrands Inc. The firm raised more
than $3.7 billion in cash from the divestitures. The firm was now focused on its core
businesses: food, beverages, and household and body care.
In late 2008, Sara Lee announced that it would close its kosher meat processing
business and sold its retail coffee business. In 2009, the firm sold its Household and
Body Care business to Unilever for $1.6 billion and its hair care business to Procter &
Gamble for $0.4 billion.
In 2010, the proceeds of the divestitures made the prior year were used to repurchase
$1.3 billion of Sara Lee's outstanding shares. The firm also announced its intention to
repurchase another $3 billion of its shares during the next three years. If completed, this
would amount to about one-third of its approximate $10 billion market capitalization at
the end of
What remains of the firm are food brands in North America, including Hillshire Farm,
Ball Park, and Jimmy Dean processed meats and Sara Lee baked goods and
Earthgrains. A food distribution unit will also remain in North America, as will its
beverage and bakery operations. Sara Lee is rapidly moving to become a food,
beverage, and bakery firm. As it becomes more focused, it could become a takeover
target.
Has the 2005 restructuring program worked? To answer this question, it is necessary to
determine the percentage change in Sara Lee's share price from the announcement date
of the restructuring program to the end of 2010, as well as the percentage change in the
share price of HanesBrands Inc., which was spun off on August 18, 2006. Sara Lee
shareholders of record received one share of HanesBrands Inc. for every eight Sara Lee
shares they held.
Sara Lee's share price jumped by 6% on the February 21, 2004 announcement date,
closing at $19.56. Six years later, the stock price ended 2010 at $14.90, an approximate
24% decline since the announcement of the restructuring program in early 2005.
Immediately following the spinoff, HanesBrands' stock traded at $22.06 per share; at
the end of 2010, the stock traded at $25.99, a 17.8% increase.
A shareholder owning 100 Sara Lee shares when the spin-off was announced would
have been entitled to 12.5 HanesBrands shares. However, they would have actually
received 12 shares plus $11.03 for fractional shares (i.e., 0.5 × $22.06).
A shareholder of record who had 100 Sara Lee shares on the announcement date of the
restructuring program and held their shares until the end of 2010 would have seen their
investment decline 24% from $1,956 (100 shares × $19.56 per share) to $1,486.56 by
the end of 2010. However, this would have been partially offset by the appreciation of
the HanesBrands shares between 2006 and 2010. Therefore, the total value of the
hypothetical shareholder's investment would have decreased by 7.5% from $1,956 to
$1,809.47 (i.e., $1,486.56 + 12 HanesBrands shares × $25.99 + $11.03). This compares
to a more modest 5% loss for investors who put the same $1,956 into a Standard &
Poor's 500 stock index fund during the same period.
Why did Sara Lee underperform the broader stock market indices during this period?
Despite the cumulative buyback of more than $4 billion of its outstanding stock, Sara
Lee's fully diluted earnings per share dropped from $0.90 per share in 2005 to $0.52 per
share in 2009. Furthermore, the book value per share, a proxy for the breakup or
liquidation value of the firm, dropped from $3.28 in 2005 to $2.93 in 2009, reflecting
the ongoing divestiture program. While the HanesBrands spin-off did create value for
the shareholder, the amount was far too modest to offset the decline in Sara Lee's
market value. During the same period, total revenue grew at a tepid average annual rate
of about 3% to about $13 billion in 2009.
Case Study Discussion Questions:
1) In what sense is the Sara Lee business strategy in effect a breakup strategy? Be
specific.
2) Would you expect investors to be better off buying Sara Lee stock or investing in a
similar set of consumer product businesses in their own personal investment portfolios?
Explain your answer.
3) Speculate as to why the 2005 restructure program appears to have been unsuccessful
in achieving a sustained increase in Sara Lee's earnings per share and in turn creating
value for the Sara Lee shareholders?
4) Why is a breakup strategy conceptually simple to explain but often difficult to
implement? Be specific.
5) Explain why Sara Lee may have chosen to spin-off rather than to divest HanesBrands
Inc.? Be specific.
Answer:
