Chancery Adopts Merger Price Sans Cost Savings Reduction

Merlin Partners LP v. AutoInfo, Inc., 2015 Del. Ch. LEXIS 128 (April 30, 2015)

In a Delaware statutory appraisal action, the Chancery once again determined that the merger price trumped values resulting from other valuation analyses. But before “placing full weight on the Merger price,” Vice Chancellor Noble performed a DCF analysis as a check and in so doing provided a useful discussion related to the size premium. In line with the court’s 2014 decision in Huff Fund, the judge also rejected a downward adjustment based on purported merger-related cash savings.

Backstory. The respondent was a public transportation services company. It owned no assets, and it operated under a somewhat unusual business model, relying 100% on independent sales agents in the U.S. and Canada. The agents maintained all client relationships. In contrast, most other transportation logistics companies followed a store model in which brokers were direct employees of the company. Concerned that the market undervalued the company, in summer 2011, the subject company’s board hired an investment bank with extensive experience in the transportation industry to explore strategic options.

The bank observed that the company “consistently traded at valuation multiples well below its peer group due to the Company’s relatively small scale and corresponding lack of interest from the investment community.” The bank also said that, if the company were able to increase its market capitalization from $20 million to about $400 million or $500 million, it would attract more attention from Wall Street and obtain capital at lower cost. The bank’s preliminary valuation showed a range of $0.59 to $1.76 per share, yielding an average of $0.98 per share. The company traded at $0.60 per share at the time.

After some inconclusive efforts to shop the company, the board formally retained the bank to run a sales process. For purposes of the sale, the bank asked management to prepare bottoms-up five-year financial projections, directing that the forecast be optimistic. A representative working on the deal stated: “You certainly don’t want to be conservative and leave potential shareholder value on the table.” Because management had never done long-term projections, managers questioned their ability to achieve an accurate forecast of future performance. One person described the efforts at projecting as “a bit of a chuckle and a bit of a joke.” Ultimately, management developed a forecast by projecting agent revenue, considering each agent’s historical revenue and taking “the most optimistic view of agents’ performance in the marketplace.” Managers assumed that larger agents would grow at a lower percentage than smaller agents but acknowledged there “was no science” behind the assumptions.

Serious accounting deficiencies. The first 10 bidders offered prices ranging from $0.90 to $1.38 per share. Ultimately, a bid at $1.26 per share from a private equity investment (PEI) firm emerged as the highest and most serious offer. As part of due diligence, the PEI firm hired its own financial advisor to test the company’s stated historical earnings and ability to meet projections. The advisor found the company’s financial records were “unusually bad for a publicly traded company.” It noted that the company used QuickBooks accounting software, which, while popular with small businesses, was rarely the tool of choice for public companies. It also was puzzling that the subject, a Florida-based public entity, used a one-office accounting firm based in Connecticut. The PEI firm’s advisor said the subject’s practices violated generally accepted accounting principles. An investigation also showed that the company’s 2012 adjusted EBITDA was nearly a quarter less than management had estimated. In the face of these weaknesses, the bidder lowered the offering price to $0.96 per share. Negotiations between the company’s special committee and the PEI firm ensued, hampered by additional discoveries of accounting deficiencies.

Ultimately the parties reached a deal at $1.05 per share. The bank advising the company declared the deal fair in its fairness opinion, and shareholders approved the merger in April 2013. There was no topping bid between the deal’s announcement and its closing.

Two former common stockholders challenged the transaction and petitioned the Delaware Court of Chancery under the state’s appraisal statute, 8 Del. C. § 262, to determine the fair value of their stock. “Fair value” means “the value to a stockholder of the firm as a going concern, as opposed to the firm’s value in the context of an acquisition or other transaction.”

Both sides engaged “well-qualified” experts to press their positions.

All valuation methodologies in play. The petitioners’ expert valued the company at $2.60 per share. This value was the result of three calculations, which he weighted equally.

In essence, he performed a discounted cash flow (DCF) analysis, using management projections to forecast the company’s future performance. Next, he conducted two comparable companies analyses: For the first treatment, he used a 2012 EBITDA figure he derived from the company’s 2012 10-K; for the second treatment, he used an estimated 2013 EBITDA that he derived from modifying management projections.

In contrast, the company’s expert found both the DCF analysis and the comparable companies analyses inappropriate under the circumstances. He noted that a key component, management projections, here was unreliable and generated an unreliable indicator of value. At the same time, he performed a DCF analysis “for illustrative purposes” for his rebuttal. For this analysis, he said he used five-year “base case” projections the acquirer had prepared during due diligence. The company’s expert noted, however, that those projections also did not yield a reliable indication of fair value. And he explained that the DCF outcome did not affect his value conclusion.

Further, the company’s expert contended that in this case a comparable companies analysis lacked the data necessary to perform it accurately.

He analyzed the merger price and the market evidence to determine the strength of the sales process and decided the merger price was the best indicator of fair value. But he decided to adjust the price downward to the tune of $1.4 million per year (before tax) to factor out cost savings related to the merger. He explained that one group of cost savings included public-company costs the company would eliminate once it stopped trading as a public company; the other group included savings related to executive compensation. He said that, according to academic literature, “target firms capture virtually all of the value created by corporate combinations through the price paid by the acquirer.” Backing out the anticipated cost savings, the company’s expert arrived at a fair value of $0.97 per share.

The court took issue with all expert valuations but overall found the company’s expert most credible.

‘Indisputably optimistic’ projections. Given the problematic management projections, the Chancery swiftly dismissed the significance of the petitioners’ expert’s DCF analysis. This was an instance where management had never prepared projections in the ordinary course of business and, when it did, it did so to “maximize the effort to market the company.” The projections were “indisputably optimistic,” the court said, such that the petitioners’ own expert noted he would have “implied a discount factor to back out the optimism if the record had provided a basis for calculating one.” All of these factors triggered skepticism about the reliability of the projections. Also, the record showed that management had no trust in its own ability to forecast, which made the projections all the more unreliable.

Failure to consider size in comp selection. According to the Chancery, there were at least two reasons not to trust the petitioner expert’s comparable companies analyses. For one, the companies the petitioners’ expert used as points of comparison were all significantly larger than the subject company. All but two of the comparables had a market capitalization of more than 10 times that of the subject.

In testimony, the petitioners’ expert contended there was no meaningful relationship between size and a company’s multiples. He said he did not remember “ever discriminating inclusion in comparable companies based on company size … [because] size itself should not have an impact on the ultimate valuation.”

The court found this statement unconvincing. It noted that there was empirical support in the valuation literature and in the court’s decisions for discriminating among comparables based on size. Also, the company’s expert in his publications suggested that it was inappropriate to choose comparables “without regard to relative market capitalization without otherwise controlling for risk and other differences.” Further, the investment bank overseeing the sales process had extensive experience in the transportation sector and noted that the market usually perceived smaller firms to be riskier and valued them at lower multiples. The market afforded premium multiples to larger companies, considering them more stable, a representative of the bank said.

The court noted that, before the investment bank issued its fairness opinion, it prepared its own comparable companies analysis. It opted to use a lower multiple range based on the differences between the subject company and comparable companies. The differences focused on size, business model, and the quality of management.

Another of the court’s concerns was the failure of the petitioners’ expert to account for the risk that attached to the subject’s 100% agent-based business model. The market perceived this model to be inferior to the company store model. According to testimony from a representative of the investment bank, “agent-based models … are generally less desirable. They’re perceived as riskier. The company does not have control over the customer relationship. The agent does.”

The court observed that, at trial, the petitioners’ expert was unable to identify which of the comparables used which type of business model but “suspected” most of them were agent-based businesses. In contrast, based on its knowledge of the industry, the investment bank advising the company used a below-median multiple for its comparable analysis, the court pointed out.

Because size and business model influenced the multiples at which companies traded in the transportation brokerage industry, the court declined to give any weight to the values resulting from the petitioner expert’s comparable analyses. That the values were unreliable seemed borne out by the bids the company received during the sales process, all of them implying market multiples well below those produced by the petitioners’ expert, the court said. Moreover, the company sold at a price less than half of the expert’s comparable companies valuations.

Sales process substantiates merger price. The company’s expert advocated in favor of the merger price, subject to cost savings adjustments. His proposition prompted at least three objections from the petitioners.

Speaking categorically, they contended the merger price was not a valid business valuation method. Moreover, a court could not rely on the price if there was no business valuation analysis to corroborate the merger price. Finally, even if the merger price were a legitimate indicator of value, it was not in this case because of the deficient sales process.

The Chancery gave little consideration to the first two contentions. It pointed out that in other statutory appraisal cases the court had exclusively relied on the merger price where that price proved to be the best indicator of value. Also, there was no requirement to substantiate the merger price through a particular valuation methodology. And, in this instance, the sales process validated the price. The process was comprehensive; it included arm’s-length negotiations, a lack of compulsion, and the parties’ having had adequate information. The merger price reflected a 22% premium to the company’s average stock price during the six months that preceded the last trading day before the public announcement of the merger. It was noteworthy that, in the two years before the merger, the company’s stock price never even reached $1.00 and that the merger price surpassed the highest price the stock had commanded during the previous five years, the court observed.

Also, the company retained an experienced investment bank to direct the process. “Part of the reason for hiring the bank would have been to educate the market and assure the company that was not leaving value on the table,” the court noted. Even if the market had little information on the company before the sales process began, it gained ample information as the sale proceeded, the court added.

DCF as check on merger price. Before committing to the merger price, however, the Chancery performed its own DCF analysis. It said it used the financial projections the acquirer’s financial advisor prepared during the due diligence process. Not only did the company argue that they were a more accurate forecast of the company’s future performance than the projections its management had created, but also the petitioners’ expert agreed that they were reasonably reliable.

The court noted a disagreement between the two experts as to the weighted average cost of capital (WACC) input. The company’s expert used a WACC of 17.57%, whereas the petitioners’ expert used 11.30%. The debate boiled down to the percentage of the equity size premium that was added to the company’s cost of equity. Both experts used the capital asset pricing of equity (CAPM), and both added a size premium. Whereas the petitioners’ expert used 3.81%, the company’s expert used 11.65%.

Both relied on 2013 data from Ibbotson Associates, but while the petitioners’ expert opted for the microcap category including the 9th and 10th percentiles—companies whose market capitalizations ranged from $1.13 million to $514.2 million—the company’s expert used the 10z subdecile—featuring companies with market capitalizations from $1.13 million to $96.2 million. At the time of the merger, the subject’s market capitalization was about $30 million.

The petitioners’ expert said he would have used a size premium close to the 10z category or even the 10z category itself, but he thought it necessary “to strip out a marketability factor.” The court found this type of adjustment to the size premium was plainly in conflict with the court’s ruling in Gearreald v. Just Care, Inc., 2012 Del. Ch. LEXIS 91 (April 30, 2012) (available at BVLaw). It dismissed the petitioners’ argument that an illiquidity discount, as proposed in Gearreald, was distinct from the marketability discount applicable here. That distinction may apply in a separate context, the court said, but here the company’s “cost of capital directly affects transactions between the Company and providers of capital, and is thus part of its value as a going concern.”

The court selected the 10z size premium and a WACC of 17.5% and arrived at a DCF-based fair value of about $0.93 per share on the merger date. Ultimately, it decided against ascribing any weight to the DCF-derived value and adopted the merger price.

Insufficient basis for cost savings claim. In so doing, the court rejected the company expert’s downward adjustment to the merger price; the adjustment was based on the principle that the appraisal award must not include merger-specific value. The expert’s calculation relied on adjustments the acquirer’s financial advisor had made when it prepared its base case projections during the due diligence process. The court said it was unclear how the financial advisor had arrived at its numbers. The Chancery declined to allow for a “near automatic reduction in price,” finding that doing so would unduly reverse the burden on the party militating for the adjustments. Here, the company had failed to show that a downward adjustment to the merger price was warranted, the Chancery concluded. Consequently, the fair value of the company’s shares was the $1.05-per-share merger price.