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Merger Price Vs. Discounted Cash Flow: A Study
Of Dell
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Boris J. Steffen |
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.
The opinions expressed are those of the author(s) and do not necessarily
reflect the views of the firm, its clients, or Portfolio Media Inc., or
any of its or their respective affiliates. This article is for general
information purposes and is not intended to be and should not be taken as
legal advice.
© 2016, Portfolio Media, Inc. |