Merger Price Vs. Discounted Cash Flow: A Study Of Dell

Law360, New York (July 26, 2016, 12:22 PM ET) -- Rejecting the contention by Dell Inc. that the final merger consideration was the best evidence of its fair value, the Delaware Court of Chancery concluded in an opinion dated May 31, 2016, that the fair value of the common stock of Dell Inc. at the time it was taken private on Oct. 29, 2013, in a management buyout orchestrated by Dell CEO Michael Dell was $17.62 per share, or $31.1 billion. While less than the $28.61 per share, or $50.5 billion calculated by the petitioner’s expert, the court’s ruling represents a premium of approximately 28 percent ($6.8 billion) over the final merger price of $13.75 per share, and a premium of roughly 39 percent ($8.7 billion) to the $12.68 per share calculated by the respondent’s expert.

Dell’s Financial Projections

On Sept. 13, 2012, Dell’s chief financial officer presented the special committee of the board charged with guiding the sales process a set of financial projections reflecting management’s view that Dell was worth approximately $25 billion more than its then-current market capitalization of about $15 billion. Following in November 2012, the committee retained the Boston Consulting Group to create an independent set of financial forecasts. The BCG base case was more pessimistic than Dell management’s projections, but “in-line with recent analyst reports.” BCG’s two other cases were based on the probability of Dell realizing $3.3 billion in cost savings identified by management. The BCG 25 percent case assumed that Dell would realize 25 percent of the savings, while the BCG 75 percent case assumed that 75 percent would be realized. Subsequently in September 2013, Silver Lake and Mr. Dell gave a presentation to the banks that were to finance the merger (“bank case”). As compared to prior iterations, gross profit and earnings before interest, taxes and amortization (EBITA) were lower, revenues were higher while margins were projected to increase. The projections also included $2.6 billion in embedded cost savings, with another $1 billion reported as a separate line item.

Analysis of the Merger Price

The sales process for Dell consisted of a presigning phase and post-signing go-shop period. Evidence underlying the evolution of the original merger consideration of $13.65 per share during the presigning phase demonstrated to the court that it was below Dell’s fair value due to (1) the use of an LBO pricing model that understated the fair value of the company, (2) a significant valuation gap attributable to the market’s short-term focus, and (3) a lack of meaningful presigning competition.

LBO Pricing Model

The court noted that during the presigning phase, the committee engaged only with financial sponsors, who when analyzing how much to bid use a leveraged buyout model, which solves for the range of prices the sponsor can pay while still achieving specific internal rates of return (IRR). What the sponsor is willing to pay therefore differs from fair value due to (1) the sponsor’s objective of achieving an IRR of 20 percent or more, and (2) limitations on how much debt the sponsor can use to finance the transaction. So while the inputs are similar, a discounted cash flow (DCF) analysis solves for the present value of the firm, while an LBO model solves for the IRR.

Concurrently, the court found that the factual record demonstrated that the price negotiations were driven by the sponsors’ willingness to pay based on their LBO pricing models rather than the fair value of the company. JPMorgan valued Dell as a going concern at between $20 and $27 per share using the DCF method. Using the same cash flow projections in an LBO model, however, JPMorgan estimated that even assuming further recapitalizations, a financial sponsor would not willingly pay more than approximately $14.13 per share since it would not then be able to realize a minimum IRR of 20 percent over five years. Consistent with this analysis, the initial expressions of interest from Silver Lake and KKR came in at the low end of what the LBO model indicated, with Silver Lake proposing an all-cash transaction valued at between $11.22 and $12.16 per share, and KKR offering between $12 and $13 per share.

As to next steps, JPMorgan advised the committee that “given comparable LP make-up and return hurdles,” it was “unlikely to see any material difference” between Silver Lake’s offer and what other financial sponsors might pay. Evercore came to similar conclusions during the go-shop period, and at trial, JPMorgan’s lead banker confirmed that LBO shops use essentially the same model. Thus, the court concluded that the result of competition between financial sponsors depends on their willingness to accept a lower IRR and as such, it does not lead to intrinsic value.

Valuation Gap

Factors that the court found to be indicative of a valuation gap between the market’s perception and Dell’s operative reality consisted of the focus on short-term, quarterly results by analysts and investors, the anchoring effect of Dell’s depressed stock price on price negotiations and the long-term horizon of the benefits of the company’s $14 billion investment in its transformation. Dells’ management had recognized the valuation gap going as far back as January 2011, when in a sum-of-the parts analysis, they valued the company at between $22.49 and $27.05 per share at a time when its stock was trading around $14 per share. JPMorgan, Goldman Sachs and BCG later came to similar conclusions, with JPMorgan preparing a DCF analysis in October 2012 that valued the company at between $20 and $27 per share when its stock was trading between $9 and $10 per share, Goldman observing that “illustrative standalone valuation analyses result in valuation outcomes that are significantly higher than the current share price,” and BCG explaining that the company’s “low valuation does not match apparent company strengths and reflects investor concerns. Notwithstanding Dell’s depressed stock price and its anchoring effect on bid formulation and price negotiations, the committee and its advisers used it as the key input to their analyses.

Presigning Competition

The committee initially engaged with two financial sponsors, Silver Lake and KKR. KKR dropped out shortly after its initial expression of interest, however, and the committee engaged with TPG. Before long, TPG also backed out, which left the committee to negotiate with a single bidder, Silver Lake. The committee failed to contact any strategic buyers, despite that HP was an obvious candidate. From the court’s perspective, the lack of meaningful price competition undercut the reliability of the original merger consideration ($13.65 per share), and as it served as the key for offers made during the go-shop period, the reliability of the final merger consideration ($13.75 per share) was similarly impaired.

Post-Signing Phase

Two higher offers emerged during the go-shop, one from Blackstone ($14.25 per share), and one from Icahn (between $13.37 and $14.42 per share). When it appeared that Dell’s shareholders would vote against the merger, the merger agreement was amended to bring the final merger consideration to $13.75 per share. Dell argued on this basis that another party would have topped the offer if it were worth more. The court disagreed, however, finding that though the assertion made sense for large valuation gaps, it was not enough to rule out smaller ones. Explaining why, the court noted that (1) two competing financial sponsors made higher-value, debt-financed offers, which indicated that the original merger consideration was low, and that (2) both of the topping bids were greater than the final merger consideration, which undercut the notion that the final merger consideration was indicative of fair value.

The Court’s DCF Analysis

The court found the primary difference in the valuations presented by the experts to be differences between the financial projections each used. The petitioner’s expert weighted the BCG 25 percent case and the BCG 75 percent case equally to in effect create a BCG 50 percent case. He then weighted the BCG 50 percent case and the bank case equally after adding the additional $1 billion in cost savings to the bank case.

The bank case projections were prepared by Silver Lake using management inputs and endorsed by Mr. Dell at a rating agency presentation. As such, the credibility of the projections was strengthened by the fact that it is a federal felony “to knowingly obtain funds from a financial institution by false or fraudulent pretenses or representations.” The bank case was relatively optimistic, however, and based on Dell’s private company status post-transaction. Since the buyout group planned to manage Dell using the premerger business plan, however, and the administrative savings from not being public were not material given Dell’s size, the court did not find cause for concern.

The respondent’s expert used adjusted versions of the BCG 25 percent case and the bank case. While finding the BCG 25 percent case reliable, the respondent’s expert made adjustments to reflect that (1) the projections had not been updated since January 2013, (2) Dell’s actual operating income for fiscal 2014 was more than 36 percent lower, and (3) projected PC sales revenues for fiscal 2015 and fiscal 2016 appeared to be high. Accordingly, while maintaining the model’s mechanics, formula and internal assumptions, the respondent’s expert revised the revenue projections to reflect decreases in desktop PC shipments, notebook sales and related secondary products.

The respondent’s expert also extended the BCG 25 percent case projections to include a five-year transition period, reasoning that a three-stage model better reflected the operative reality of the company. Though the court expressed its preference for valuations based on contemporaneously prepared management projections as opposed to projections incorporating litigation-driven adjustments, it found the respondent’s expert’s justifications to be persuasive. Ultimately the court concluded that the respondent’s adjusted BCG 25 percent case and adjusted bank case were reliable for use in its own DCF analysis.

Terminal Period Perpetuity Growth Rate

The petitioner’s expert used a perpetuity growth rate of 1 percent, while the respondent’s expert used 2 percent. The court found both to be too low given that “the rate of inflation is the floor for a terminal value estimate for a solidly profitable company that does not have an identifiable risk of insolvency.” While selecting 2 percent, the court noted that the growth rate for a mature company such as Dell should be somewhere above inflation and close to gross domestic product, and that a rate of 3 percent could be more appropriate.

Stock-Based Compensation

Both experts agreed that the BCG 25 percent case and the bank case projections should be adjusted to add back the pretax amount of noncash, stock-based compensation. The court concurred.

Nonrecurring Restructuring Charges

The respondent’s expert adjusted the bank case to add back nonrecurring restructuring charges. The court adopted the adjustment.

Tax Rate

The petitioner’s expert used a 21 percent tax rate to calculate Dell’s after-tax free cash flows during the forecast period, which he took from management’s projections and valuation models prepared by Dell’s advisers. The respondent’s expert used a 17.8 percent rate taken from the report of a tax expert for both the projection and transition periods, and a 35.8 percent marginal tax rate for the terminal period. The court found the petitioner’s expert’s tax estimate to be more reliable and consistent with Dell’s operative reality.

Explaining its finding, the court noted that (1) Dell had not paid taxes at the marginal rate since 2000, (2) Dell’s effective tax rate was low due to its ability to defer payment of domestic taxes on profits earned overseas, (3) Dell will never pay domestic taxes on its overseas profits unless it repatriates them, (4) Dell did not deviate from its representation to continue reinvesting overseas profits indefinitely, and (5) it would be speculative for the court to conclude that Dell would begin paying taxes at a rate of 35.8 percent globally as that would be contrary to Dell’s historical practice.

Weighted Average Cost of Capital

In calculating the weighted average cost of capital for purposes of discounting Dell’s cash flows, the experts disagreed on every input with the exception of the risk-free rate, which they estimated at 3.31 percent.

Cost of Debt

On the merger closing date, the yield to maturity on long-term BBB-rated bonds was 4.95 percent. The court adopted this metric as Dell’s cost of debt.

Capital Structure

The petitioner’s expert used Dell’s premerger announcement ratio of debt-to-total capital to calculate that 75.25 percent of Dell’s capital structure should be equity. The respondent’s expert used the average ratio of Dell's equity-to-total capital calculated on a quarterly basis between Jan. 12, 2011, and Jan. 11, 2013, to estimate that 74.75 percent of Dell’s capital structure should be equity. Finding both methods reasonable, the court selected 75 percent.

Beta

The petitioner’s expert estimated Dell’s beta to be 1.35 based on analysis of its peers. The respondent’s expert estimated Dell’s beta to be 1.31 analyzing weekly excess stock returns over a two-year period. The court selected the respondent’s expert’s estimate of 1.31 explaining that a beta that is specific to a firm is more targeted than a blended beta calculated from peer companies.

Equity Risk Premium

The petitioner’s expert used a forward-looking equity risk premium of 5.5 percent. The respondent’s expert used a blended historical and supply-side equity risk premium of 6.41 percent. The court selected the supply-side equity risk premium of 6.11 percent.

Adjustments to Cash

Dell had $11.040 billion in cash and $5.054 billion in debt on its balance sheet at the time of the merger. Adding back $172 million in transaction costs to the net of cash and debt, the company had $6.158 billion in net cash. The petitioner’s expert added back the entire amount of net cash to the valuation, while the respondent’s expert subtracted $3 billion for working capital, $2 billion for restricted cash, $2.24 billion for deferred taxes, and $3 billion for contingent taxes.

The court concluded that Dell needed at least $3 billion in working capital. Evidence also showed that while $2 billion of Dell’s cash was restricted, Dell had accessed $0.8 billion. Consequently, the court subtracted $3 billion for working capital and $1.2 billion for restricted cash. Consistent with its analysis of Dell’s tax rate, the court rejected the $2.24 billion adjustment for deferred taxes on Dells’ foreign profits. Similarly, finding the entire amount excessive, the court reduced the contingent tax liability to $650 million based on what was probable and reasonably estimable.

The DCF Analysis Conclusion

In determining the fair value of Dell’s equity per share, the court accepted the parties’ calculation of 1,765,369,276 fully diluted shares outstanding. Using the respondent’s expert’s BCG 25 percent case and aforementioned inputs, the court’s DCF analysis yielded a fair value of $16.43 per share. By comparison, using the respondent’s expert’s adjusted bank case together with the preceding inputs resulted in a fair value per share of $18.81. Having no reason to prefer one realistic case over the other, the court weighed them equally to derive a fair value per share of $17.62. As it was impossible to measure the degree of mispricing inherent to the sales process, the court did not give weight to the final merger consideration.

Key Findings

Though relevant, the court did not find the merger price to be the best indication of Dell’s fair value, observing that to show that the directors satisfied their fiduciary duties in running the sales process is not the same as proving that the deal price is the best evidence of a firm’s fair value. In Dell’s case, the LBO pricing model understated the company’s fair value. The short-term focus of the market and anchoring effect of Dell’s depressed stock price on negotiations also indicated that a significant valuation gap existed between the market’s perception and Dell’s operative reality. In turn, the lack of meaningful presigning competition undermined the reliability of the original as well as final merger prices as indications of Dell’s fair value.

While expressing a preference for DCF valuations based on contemporaneously prepared management projections rather than those incorporating litigation-driven adjustments, the court found the respondent’s expert’s adjustments to be persuasive, including that for the add-backs of noncash, stock-based compensation and nonrecurring restructuring costs, noting that it had used adjusted projections in past cases where the expert provided adequate support. In selecting a terminal period growth rate, the court explained that the lower bound for a solidly profitable company having no identifiable risk of insolvency is the rate of inflation, and that once an industry has matured, a firm will grow at roughly the rate of nominal GDP. With respect to taxes, the court decided it would be speculative and contrary to the company’s operative reality to choose a date when Dell would begin to repatriate foreign earnings and consequently pay taxes on all of its global profits at the U.S. marginal tax rate.

In calculating Dell’s weighted average cost of capital (WACC), the court accepted the risk-free rate agreed to by the experts. For the cost of debt, the court selected the yield on long-term, BBB bonds as of the merger closing date, and for the capital structure, the median of the expert’s estimates. The beta adopted by the court was derived from analysis of weekly excess returns specific to Dell rather than to a blend calculated from its peers, while the equity risk premium chosen was based on the supply-side method calculation.

The dispute over how much excess cash should be added to the valuation focused on subtractions for working capital, restricted cash, deferred taxes and contingent taxes. Fact witness testimony and contemporaneous documents demonstrated that the amount of excess cash should be reduced to account for Dell’s working capital requirements and cash restrictions. The court reduced the amount of the deduction for restricted cash, however, due to Dell’s having accessed a significant portion of the purportedly restricted balance. By comparison, the court rejected the deduction for deferred taxes in its entirety since it was attributable to Dell’s foreign earnings, and the issue was as such resolved with the court’s acceptance of Dell’s representations that it would reinvest its overseas earnings indefinitely and therefore not pay U.S. taxes on the related income. As for the contingent tax liability, though concluding that it was excessive to subtract the entire amount given that Dell and its advisers considered it more likely than not that the related tax positions were reasonable, the court reduced the amount based on evidence that it was probable and reasonably estimable that Dell would pay a portion of the liability in the future.

—By Boris J. Steffen, RSM US LLP

Boris Steffen is a director and the Southeast leader of the financial investigations and dispute advisory services at RSM US LLP, where he serves as a financial adviser and testifying expert for corporations, financial institutions, government agencies, investment funds and law firms in cases involving bankruptcy and restructuring, antitrust and competition policy, commercial contracts, fraud, intellectual property, international arbitration, mergers and acquisitions, securities, valuation and tax controversy matters. Steffen has consulted or testified in high-stakes merger and acquisition litigation in the Delaware Court of Chancery, in bankruptcy disputes and in numerous other investigations elsewhere.

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