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Mergers Acquisitions And Other Restructuring Activities 7th Edition by Donald DePamphilis -Test Bank
Chapter 1: Introduction to Mergers, Acquisitions, and Other Restructuring Activities
Examination Questions and Answers
True/False: Answer True or False to the following questions:
- A divestiture is the sale of all or substantially all of a company or product line to another party for cash or securities. True or False
- The target company is the firm being solicited by the acquiring company. True or False
- A merger of equals is a merger framework usually applied whenever the merger participants are comparable in size, competitive position, profitability, and market capitalization. True or False
- A vertical merger is one in which the merger participants are usually competitors. True or False
- Joint ventures are cooperative business relationships formed by two or more separate parties to achieve common strategic objectives True or False
- Operational restructuring refers to the outright or partial sale of companies or product lines or to downsizing by closing unprofitable or non-strategic facilities. True or False
- The primary advantage of a holding company structure is the potential leverage that can be achieved by gaining effective control of other companies’ assets at a lower overall cost than would be required if the firm were to acquire 100 percent of the target’s outstanding stock. True or False
- Holding companies and their shareholders may be subject to triple taxation. True or False
- Investment bankers offer strategic and tactical advice and acquisition opportunities, screen potential buyers and sellers, make initial contact with a seller or buyer, and provide negotiation support for their clients.
True or False
- Large investment banks invariably provide higher quality service and advice than smaller, so-called boutique investment banks. True or False
- Financial restructuring generally refers to actions taken by the firm to change total debt and equity structure. True or False
- An acquisition occurs when one firm takes a controlling interest in another firm, a legal subsidiary of another firm, or selected assets of another firm. The acquired firm often remains a subsidiary of the acquiring company. True or False
- A leveraged buyout is the purchase of a company using as much equity as possible. True or False
- In a statutory merger, both the acquiring and target firms survive. True or False
- In a statutory merger, the acquiring company assumes the assets and liabilities of the target firm in accordance with the prevailing federal government statutes. True or False
- In a consolidation, two or more companies join together to form a new firm. True or False
- A horizontal merger occurs between two companies within the same industry. True or False
- A conglomerate merger is one in which a firm acquires other firms, which are highly related to its current core business. True or False
- The acquisition of a coal mining business by a steel manufacturing company is an example of a vertical merger. True or False
- The merger of Exxon Oil Company and Mobil Oil Company was considered a horizontal merger. True or False
- Most M&A transactions in the United States are hostile or unfriendly takeover attempts. True or False
- Holding companies can gain effective control of other companies by owning significantly less than 100% of their outstanding voting stock. True or False
- Only interest payments on ESOP loans are tax deductible by the firm sponsoring the ESOP. True or False
- A joint venture rarely takes the legal form of a corporation. True or False
- When investment bankers are paid by a firm’s board to evaluate a proposed takeover bid, their opinions are given in a so-called “fairness letter.” True or False
- Synergy is the notion that the combination of two or more firms will create value exceeding what either firm could have achieved if they had remained independent. True or False
- Operating synergy consists of economies of scale and scope. Economies of scale refer to the spreading of variable costs over increasing production levels, while economies of scope refer to the use of a specific asset to produce multiple related products or services. True or False
- Most empirical studies support the conclusion that unrelated diversification benefits a firm’s shareholders. True or False
- Deregulated industries often experience an upsurge in M&A activity shortly after regulations are removed. True or False
- Because of hubris, managers of acquiring firms often believe their valuation of a target firm is superior to the market’s valuation. Consequently, they often end up overpaying for the firm. True and False
- During periods of high inflation, the market value of assets is often less than their book value. This often creates an attractive M&A opportunity. True or False
- Tax benefits, such as tax credits and net operating loss carry-forwards of the target firm, are often considered the primary reason for the acquisition of that firm. True or False
- Market power is a theory that suggests that firms merge to improve their ability to set product and service selling prices. True or False
- Mergers and acquisitions rarely pay off for target firm shareholders, but they are usually beneficial to acquiring firm shareholders. True or False
- Pre-merger returns to target firm shareholders average about 30% around the announcement date of the transaction. True or False
- Post-merger returns to shareholders often do not meet expectations. However, this is also true of such alternatives to M&As as joint ventures, alliances, and new product introductions. True or False
- Overpayment is the leading factor contributing to the failure of M&As to meet expectations. True or False
- Takeover attempts are likely to increase when the market value of a firm’s assets is more than their replacement value. True or False
- Although there is substantial evidence that mergers pay off for target firm shareholders around the time the takeover is announced, shareholder wealth creation in the 3-5 years following a takeover is often limited.
True or False
- A statutory merger is a combination of two corporations in which only one corporation survives and the merged corporation goes out of existence. True or False
- A subsidiary merger is a merger of two companies where the target company becomes a subsidiary of the parent. True or False
- Consolidation occurs when two or more companies join to form a new company. True or False
- An acquisition is the purchase of an entire company or a controlling interest in a company. True or False
- A leveraged buyout is the purchase of a company financed primarily by debt. This is a term more frequently applied to a firm going private financed primarily by debt. True or False
- Growth is often cited as an important factor in acquisitions. The underlying assumption is that that bigger is
better to achieve scale, critical mass, globalization, and integration. True or False
- The empirical evidence supports the presumption that bigger is always better when it comes to acquisitions.
True or False
- The empirical evidence shows that unrelated diversification is an effective means of smoothing out the business cycle. True or False
- Individual investors can generally diversify their own stock portfolios more efficiently than corporate managers who diversify the companies they manage. True or False
- Financial considerations, such as an acquirer believing the target is undervalued, a booming stock market or falling interest rates, frequently drive surges in the number of acquisitions. True or False
- Regulatory and political change seldom plays a role in increasing or decreasing the level of M&A activity.
True or False
Multiple Choice: Circle only one.
- Which of the following are generally considered restructuring activities?
- A merger
- An acquisition
- A divestiture
- A consolidation
- All of the above
- All of the following are considered business alliances except for
- Joint ventures
- Minority investments
- Licensing agreements
- Which of the following is an example of economies of scope?
- Declining average fixed costs due to increasing levels of capacity utilization
- A single computer center supports multiple business units
- Amortization of capitalized software
- The divestiture of a product line
- Shifting production from an underutilized facility to another to achieve a higher overall operating rate and shutting down the first facility
- A firm may be motivated to purchase another firm whenever
- The cost to replace the target firm’s assets is less than its market value
- The replacement cost of the target firm’s assets exceeds its market value
- When the inflation rate is accelerating
- The ratio of the target firm’s market value is more than twice its book value
- The market to book ratio is greater than one and increasing
- Which of the following is true only of a consolidation?
- More than two firms are involved in the combination
- One party to the combination disappears
- All parties to the combination disappear
- The entity resulting from the combination assumes ownership of the assets and liabilities of the acquiring firm only.
- One company becomes a wholly owned subsidiary of the other.
- Which one of the following is not an example of a horizontal merger?
- NationsBank and Bank of America combine
- S. Steel and Marathon Oil combine
- Exxon and Mobil Oil combine
- SBC Communications and Ameritech Communications combine
- Hewlett Packard and Compaq Computer combine
- Buyers often prefer “friendly” takeovers to hostile ones because of all of the following except for:
- Can often be consummated at a lower price
- Avoid an auction environment
- Facilitate post-merger integration
- A shareholder vote is seldom required
- The target firm’s management recommends approval of the takeover to its shareholders
- Which of the following represent disadvantages of a holding company structure?
- Potential for triple taxation
- Significant number of minority shareholders may create contentious environment
- Managers may have difficulty in making the best investment decisions
- A, B, and C
- A and C only
- Which of the following are not true about ESOPs?
- An ESOP is a trust
- Employer contributions to an ESOP are tax deductible
- ESOPs can never borrow
- Employees participating in ESOPs are immediately vested
- C and D
- ESOPs may be used for which of the following?
- As an alternative to divestiture
- To consummate management buyouts
- As an anti-takeover defense
- A, B, and C
- A and B only
- Which of the following represent alternative ways for businesses to reap some or all of the advantages of M&As?
- Joint ventures and strategic alliances
- Strategic alliances, minority investments, and licensing
- Minority investments, alliances, and licensing
- Franchises, alliances, joint ventures, and licensing
- All of the above
- Which of the following are often participants in the acquisition process?
- Investment bankers
- Proxy solicitors
- All of the above
- The purpose of a “fairness” opinion from an investment bank is
- To evaluate for the target’s board of directors the appropriateness of a takeover offer
- To satisfy Securities and Exchange Commission filing requirements
- To support the buyer’s negotiation effort
- To assist acquiring management in the evaluation of takeover targets
- A and B
- Arbitrageurs often adopt which of the following strategies in a share for share exchange just before or just after
a merger announcement?
- Buy the target firm’s stock
- Buy the target firm’s stock and sell the acquirer’s stock short
- Buy the acquirer’s stock only
- Sell the target’s stock short and buy the acquirer’s stock
- Sell the target stock short
- Institutional investors in private companies often have considerable influence approving or disapproving
proposed mergers. Which of the following are generally not considered institutional investors?
- Pension funds
- Insurance companies
- Bank trust departments
- United States Treasury Department
- Mutual funds
- Which of the following are generally not considered motives for mergers?
- Desire to achieve economies of scale
- Desire to achieve economies of scope
- Desire to achieve antitrust regulatory approval
- Strategic realignment
- Desire to purchase undervalued assets
- Which of the following are not true about economies of scale?
- Spreading fixed costs over increasing production levels
- Improve the overall cost position of the firm
- Most common in manufacturing businesses
- Most common in businesses whose costs are primarily variable
- Are common to such industries as utilities, steel making, pharmaceutical, chemical and aircraft manufacturing
- Which of the following is not true of financial synergy?
- Tends to reduce the firm’s cost of capital
- Results from a better matching of investment opportunities available to the firm with internally generated funds
- Enables larger firms to experience lower average security underwriting costs than smaller firms
- Tends to spread the firm’s fixed expenses over increasing levels of production
- A and B
- Which of the following is not true of unrelated diversification?
- Involves buying firms outside of the company’s primary lines of business
- Involves shifting from a firm’s core product lines into those which are perceived to have higher growth potential
- Generally results in higher returns to shareholders
- Generally requires that the cash flows of acquired businesses are uncorrelated with those of the firm’s existing businesses
- A and D only
- Which of the following is not true of strategic realignment?
- May be a result of industry deregulation
- Is rarely a result of technological change
- Is a common motive for M&As
- A and C only
- Is commonly a result of technological change
- The hubris motive for M&As refers to which of the following?
- Explains why mergers may happen even if the current market value of the target firm reflects its true economic value
- The ratio of the market value of the acquiring firm’s stock exceeds the replacement cost of its assets
- Agency problems
- Market power
- The Q ratio
- Around the announcement date of a merger or acquisition, abnormal returns to target firm shareholders
- Around the announcement date of a merger, acquiring firm shareholders normally earn
- 30% positive abnormal returns
- –20% abnormal returns
- Zero to slightly negative returns
- 100% positive abnormal returns
- 10% positive abnormal returns
- Which of the following is the most common reason that M&As often fail to meet expectations?
- Form of payment
- Large size of target firm
- Inadequate post-merger due diligence
- Poor post-merger communication
- Post-merger financial performance of the new firm is often about the same as which of the following?
- Joint ventures
- Strategic alliances
- Minority investments
- All of the above
- Restaurant chain, Camin Holdings, acquired all of the assets and liabilities of Cheesecakes R Us. The
combined firm is known as Camin Holdings and Cheesecakes R Us no longer exists as a separate entity. The
acquisition is best described as a:
- Tender offer
- Pacific Surfware acquired Surferdude and as part of the transaction both of the firms ceased to exist in their
form prior to the transaction and combined to create an entirely new entity, Wildly Exotic Surfware. Which one of the following terms best describes this transaction?
- Tender offer
- Joint venture
- News Corporation of America announced its intention to purchase shares in another national newspaper chain.
Which one of the following terms best describes this announcement?
- Tender offer
- Merger proposal
- Which one of the following statements accurately describes a merger?
- A merger transforms the target firm into a new entity which necessarily becomes a subsidiary of the acquiring firm
- A new firm is created from the assets and liabilities of the acquirer and target firms
- The acquiring firm absorbs only the assets of the target firm
- The target firm is absorbed entirely into the acquiring firm and ceases to exist as a separate legal entity.
- A new firm is created holding the assets and liabilities of the target firm and its former assets only.
- An investor group borrowed the money necessary to buy all of the stock of a company. Which of the following
terms best describes this transaction?
- Leveraged buyout
- Tender offer
- Joint venture
- A steel maker acquired a coal mining company. Which of the following terms best describes this deal?
- Tender offer
- Joe’s barber shop buys Jose’s Hair Salon. Which of the following terms best describes this deal?
- Joint venture
- Strategic alliance
Case Study Short Essay Examination Questions:
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 2008–2009 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.
- 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.
Answer: The decision to operate ACS as a standalone unit may have been required to gain ACS and board management support. Furthermore, operating ACS as a separate entity helps to preserve the brand and corporate culture of the firm as distinctly separate from customer perception of Xerox as a product company. The major drawbacks of managing ACS in this manner is that it inhibits the ability to realize cost savings by eliminating duplicate overhead and in coordinating sales force activities. Efforts to achieve cross-selling of ACS products to Xerox customers will require close coordination or integration of the two sales forces. A lack of a coordinated effort is likely to confuse and frustrate customers.
Assuming that Xerox was contractually bound to keep ACS separate, I would have recommended moving quickly to eliminate duplicate overhead activities and to integrate the marketing and selling organizations of the two firms in order to realize anticipated synergies. Moreover, co-location of functions and the transfer of personnel between the two organizations would facilitate both technology transfer and the ability to adopt the “best of breed” practices.
- 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?
Answer: Xerox is a product company and ACS is a services firm. Product firms are more familiar with the manufacturing, sale, and servicing of tangible products. The way in which products are sold and serviced is different from how services are provided. In contrast, services are delivered in a distinctly different manner, require a distinctly different skill set, and often require substantially different branding. Moreover, there is little customer overlap and Xerox customer base is more geographically diverse.
Differences between the two firms could enable greater geographic expansion of ACS services. The different skill sets could also encourage technology transfer and learning between the two firms. However, it is likely that Xerox will incur significant expenses in rebranding itself.
- 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: Investor reaction seems reasonable in view of the significant differences between the two firms, the limited near-term synergies, the additional debt, and the increasingly competitive IT services market.
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.
- Why was market share in the confectionery business an important factor in Mars’ decision to acquire Wrigley?
Answer: Firm’s having substantial market relative to their next largest competitor are likely to have lower cost structures due to economies of scale and purchasing, as well as lower sales, general and administrative costs. Such costs can be spread over a larger volume of revenue. Also, the confectionery market is expected to be among the most rapidly growing market and can be expected to accelerate earnings growth and that firm’s share price. The increased brand recognition also allowed the firm’s to gain additional retail merchant shelf space and to introduce each firm’s traditional customers to the other’s products.
- It what way did the acquisition of Wrigley’s represent a strategic blow to Cadbury?
Answer: Not only did this acquisition topple Cadbury from its number one position in the confectionery business but it also eliminated a potential acquisition target for Cadbury. By acquiring Wrigley, Cadbury could have solidified their top spot.
- How might the additional product and geographic diversity achieved by combining Mars and Wrigley benefit the combined firms?
Answer: The broader array of products from chocolate to gum to pet care could insulate the firm to fluctuations in the business cycle. Traditionally, the impact of a downturn in the economy is comparatively mild on these types of firms. The greater product and geographic diversity would tend to reduce the effect even further.
Assessing Procter & Gamble’s Acquisition of Gillette
The potential seemed almost limitless, as Procter & Gamble Company (P&G) announced that it had completed its purchase of Gillette Company (Gillette) in late 2005. P&G’s chairman and CEO, A.G. Lafley, predicted that the acquisition of Gillette would add one percentage point to the firm’s annual revenue growth rate, while Gillette’s chairman and CEO, Jim Kilts, opined that the successful integration of the two best companies in consumer products would be studied in business schools for years to come.
Five years after closing, things have not turned out as expected. While cost savings targets were achieved, operating margins faltered due to lagging sales. Gillette’s businesses, such as its pricey razors, have been buffeted by the 2008–2009 recession and have been a drag on P&G’s top line rather than a boost. Moreover, most of Gillette’s top managers have left. P&G’s stock price at the end of 2010 stood about 12 percent above its level on the acquisition announcement date, less than one-fourth the appreciation of the share prices of such competitors as Unilever and Colgate-Palmolive Company during the same period.
On January 28, 2005, P&G enthusiastically announced that it had reached an agreement to buy Gillette in a share-for-share exchange valued at $55.6 billion. This represented an 18 percent premium over Gillette’s preannouncement share price. P&G also announced a stock buyback of $18 billion to $22 billion, funded largely by issuing new debt. The combined companies would retain the P&G name and have annual 2005 revenue of more than $60 billion. Half of the new firm’s product portfolio would consist of personal care, healthcare, and beauty products, with the remainder consisting of razors and blades, and batteries. The deal was expected to dilute P&G’s 2006 earnings by about 15 cents per share. To gain regulatory approval, the two firms would have to divest overlapping operations, such as deodorants and oral care.
P&G had long been viewed as a premier marketing and product innovator. Consequently, P&G assumed that its R&D and marketing skills in developing and promoting women’s personal care products could be used to enhance and promote Gillette’s women’s razors. Gillette was best known for its ability to sell an inexpensive product (e.g., razors) and hook customers to a lifetime of refills (e.g., razor blades). Although Gillette was the number 1 and number 2 supplier in the lucrative toothbrush and men’s deodorant markets, respectively, it has been much less successful in improving the profitability of its Duracell battery brand. Despite its number 1 market share position, it had been beset by intense price competition from Energizer and Rayovac Corp., which generally sell for less than Duracell batteries.
Suppliers such as P&G and Gillette had been under considerable pressure from the continuing consolidation in the retail industry due to the ongoing growth of Wal-Mart and industry mergers at that time, such as Sears and Kmart. About 17 percent of P&G’s $51 billion in 2005 revenues and 13 percent of Gillette’s $9 billion annual revenue came from sales to Wal-Mart. Moreover, the sales of both Gillette and P&G to Wal-Mart had grown much faster than sales to other retailers. The new company, P&G believed, would have more negotiating leverage with retailers for shelf space and in determining selling prices, as well as with its own suppliers, such as advertisers and media companies. The broad geographic presence of P&G was expected to facilitate the marketing of such products as razors and batteries in huge developing markets, such as China and India. Cumulative cost cutting was expected to reach $16 billion, including layoffs of about 4 percent of the new company’s workforce of 140,000. Such cost reductions were to be realized by integrating Gillette’s deodorant products into P&G’s structure as quickly as possible. Other Gillette product lines, such as the razor and battery businesses, were to remain intact.
P&G’s corporate culture was often described as conservative, with a “promote-from-within” philosophy. While Gillette’s CEO was to become vice chairman of the new company, the role of other senior Gillette managers was less clear in view of the perception that P&G is laden with highly talented top management. To obtain regulatory approval, Gillette agreed to divest its Rembrandt toothpaste and its Right Guard deodorant businesses, while P&G agreed to divest its Crest toothbrush business.
The Gillette acquisition illustrates the difficulty in evaluating the success or failure of mergers and acquisitions for acquiring company shareholders. Assessing the true impact of the Gillette acquisition remains elusive, even after five years. Though the acquisition represented a substantial expansion of P&G’s product offering and geographic presence, the ability to isolate the specific impact of a single event (i.e., an acquisition) becomes clouded by the introduction of other major and often uncontrollable events (e.g., the 2008–2009 recession) and their lingering effects. While revenue and margin improvement have been below expectations, Gillette has bolstered P&G’s competitive position in the fast-growing Brazilian and Indian markets, thereby boosting the firm’s longer-term growth potential, and has strengthened its operations in Europe and the United States. Thus, in this ever-changing world, it will become increasingly difficult with each passing year to identify the portion of revenue growth and margin improvement attributable to the Gillette acquisition and that due to other factors.
- Is this deal a merger or a consolidation from a legal standpoint? Explain your answer.
Answer: The deal is a merger in which P&G will be the surviving firm.
- Is this a horizontal or vertical merger? What is the significance of this distinction? Explain your answer.
Answer: It is a horizontal merger since the two firms are competitors in major product lines. This distinction is
important because the potential for synergies is greatest for firms having the greatest overlap. However, the
greater the overlap, the greater the likelihood antitrust regulators will require divestiture of overlapping
businesses before approving the merger.
- What are the motives for the deal? Discuss the logic underlying each motive you identify.
Answer: a. Economies of scope.
- Economies of scale in production
- Bulk purchasing discounts
- Related diversification into such consumer markets as batteries and razors
- Increased geographic access to such areas as China and India.
- Increased bargaining power with key retailers such as Walmart
- Immediately following the announcement, P&G’s share price dropped by 2 percent and Gillette’s share price rose by 13 percent. Explain why this may have happened?
Answer: P&G’s share price reflected current investor concern about potential EPS dilution. Gillette’s share price rose reflecting the 18 percent offer price premium. The Gillette share price did not rise by the entire 18 percent because of the possibility the deal will be disallowed by antitrust regulators.
- P&G announced that it would be buying back $18 to $22 billion of its stock over the eighteen months
following closing. Much of the cash required to repurchase these shares requires significant new borrowing by
the new companies. Explain what P&G’s objective may have been trying to achieve in deciding to repurchase
stock? Explain how the incremental borrowing help or hurt P&G achieve their objectives?
Answer: The repurchase is an attempt to allay investor fears about EPS dilution. However, the incremental borrowing will erode EPS due to the additional interest expense. Furthermore, by taking on additional debt,
P&G may be limiting its future strategic flexibility.
- Explain how actions required by antitrust regulators may hurt P&G’s ability to realize anticipated synergy. Be
Answer: The divestiture of such businesses would be likely to reduce the projected cost savings generated by eliminating duplicate overhead and related activities.
- Explain some of the obstacles that P&G and Gillette are likely to face in integrating the two businesses. Be specific. How would you overcome these obstacles?
Answer: The cultures between the two firms may differ significantly. P&G’s “not invented here” culture may make it difficult to transfer skills and technologies between product lines in the two firms. Gillette managers may be de-motivated as they see promotion opportunities limited due to P&G’s tendency to hire from within. The likelihood that regulators will require the divestiture overlapping units will limit the ability to realize expected synergies.
To facilitate integration, P&G needs to communicate their intentions to major stakeholder groups as quickly as possible, populate senior positions of the new company with both P&G and Gillette managers, and include managers from both firms on integration teams. The new firm may consider selling the razor and battery businesses to recover some of the purchase price
The Man Behind the Legend at Berkshire Hathaway
Although not exactly a household name, Berkshire Hathaway (“Berkshire”) has long been a high flier on Wall Street. The firm’s share price has outperformed the total return on the Standard and Poor’s 500 stock index in 32 of the 36 years that Warren Buffet has managed the firm. Berkshire Hathaway’s share price rose from $12 per share to $71,000 at the end of 2000, an annual rate of growth of 27%. With revenue in excess of $30 billion, Berkshire is among the top 50 of the Fortune 500 companies.
What makes the company unusual is that it is one of the few highly diversified companies to outperform consistently the S&P 500 over many years. As a conglomerate, Berkshire acquires or makes investments in a broad cross-section of companies. It owns operations in such diverse areas as insurance, furniture, flight services, vacuum cleaners, retailing, carpet manufacturing, paint, insulation and roofing products, newspapers, candy, shoes, steel warehousing, uniforms, and an electric utility. The firm also has “passive” investments in such major companies as Coca-Cola, American Express, Gillette, and the Washington Post.
Warren Buffet’s investing philosophy is relatively simple. It consists of buying businesses that generate an attractive sustainable growth in earnings and leaving them alone. He is a long-term investor. Synergy among his holdings never seems to play an important role. He has shown a propensity to invest in relatively mundane businesses that have a preeminent position in their markets; he has assiduously avoided businesses he felt that he did not understand such as those in high technology industries. He also has shown a tendency to acquire businesses that were “out of favor” on Wall Street.
He has built a cash-generating machine, principally through his insurance operations that produce “float” (i.e., premium revenues that insurers invest in advance of paying claims). In 2000, Berkshire acquired eight firms. Usually flush with cash, Buffet has developed a reputation for being nimble. This most recently was demonstrated in his acquisition of Johns Manville in late 2000. Manville generated $2 billion in revenue from insulation and roofing products and more than $200 million in after-tax profits. Manville’s controlling stockholder was a trust that had been set up to assume the firm’s asbestos liabilities when Manville had emerged from bankruptcy in the late 1980s. After a buyout group that had offered to buy the company for $2.8 billion backed out of the transaction on December 8, 2000, Berkshire contacted the trust and acquired Manville for $2.2 billion in cash. By December 20, Manville and Berkshire reached an agreement.
- To what do you attribute Warren Buffet’s long-term success?
Answer: He is a long-term investor who buys businesses that are typically leaders in their
industries and that he is able to understand. He also tends to buy “out of favor” businesses that
as a result are undervalued. In that regard, he should be viewed as a value investor.
- In what ways might Warren Buffet use “financial synergy” to grow Berkshire Hathaway? Explain your answer.
Answer: Warren Buffest relies on the strong cash generation capabilities of his existing portfolio
of businesses to fund new investments. The synergy arises due to his skill at redeploying these
funds into higher return alternative investments.
America Online Acquires Time Warner:
The Rise and Fall of an Internet and Media Giant
Time Warner, itself the product of the world’s largest media merger in a $14.1 billion deal a decade ago, celebrated its 10th birthday by announcing on January 10, 2000, that it had agreed to be taken over by America Online (AOL) at a 71% premium to its share price on the announcement date. AOL had proposed the acquisition in October 1999. In less than 3 months, the deal, valued at $160 billion as of the announcement date ($178 billion including Time Warner debt assumed by AOL), became the largest on record up to that time. AOL had less than one-fifth of the revenue and workforce of Time Warner, but AOL had almost twice the market value. As if to confirm the move to the new electronic revolution in media and entertainment, the ticker symbol of the new company was changed to AOL. However, the meteoric rise of AOL and its wunderkind CEO, Steve Case, to stardom was to be short-lived.
Time Warner is the world’s largest media and entertainment company, and it views its primary business as the creation and distribution of branded content throughout the world. Its major business segments include cable networks, magazine publishing, book publishing and direct marketing, recorded music and music publishing, and filmed entertainment consisting of TV production and broadcasting as well as interests in other film companies. The 1990 merger between Time and Warner Communications was supposed to create a seamless marriage of magazine publishing and film production, but the company never was able to put that vision into place. Time Warner’s stock underperformed the market through much of the 1990s until the company bought the Turner Broadcasting System in 1996.
Founded in 1985, AOL viewed itself as the world leader in providing interactive services, Web brands, Internet technologies, and electronic commerce services. AOL operates two subscription-based Internet services and, at the time of the announcement, had 20 million subscribers plus another 2 million through CompuServe.
Strategic Fit (A 1999 Perspective)
On the surface, the two companies looked quite different. Time Warner was a media and entertainment content company dealing in movies, music, and magazines, whereas AOL was largely an Internet Service Provider offering access to content and commerce. There was very little overlap between the two businesses. AOL said it was buying access to rich and varied branded content, to a huge potential subscriber base, and to broadband technology to create the world’s largest vertically integrated media and entertainment company. At the time, Time Warner cable systems served 20% of the country, giving AOL a more direct path into broadband transmission than it had with its ongoing efforts to gain access to DSL technology and satellite TV. The cable connection would facilitate the introduction of AOL TV, a service introduced in 2000 and designed to deliver access to the Internet through TV transmission. Together, the two companies had relationships with almost 100 million consumers. At the time of the announcement, AOL had 23 million subscribers and Time Warner had 28 million magazine subscribers, 13 million cable subscribers, and 35 million HBO subscribers. The combined companies expected to profit from its huge customer database to assist in the cross promotion of each other’s products.
Market Confusion Following the Announcement
AOL’s stock was immediately hammered following the announcement, losing about 19% of its market value in 2 days. Despite a greater than 20% jump in Time Warner’s stock during the same period, the market value of the combined companies was actually $10 billion lower 2 days after the announcement than it had been immediately before making the deal public. Investors appeared to be confused about how to value the new company. The two companies’ shareholders represented investors with different motivations, risk tolerances, and expectations. AOL shareholders bought their company as a pure play in the Internet, whereas investors in Time Warner were interested in a media company. Before the announcement, AOL’s shares traded at 55 times earnings before interest, taxes, depreciation, and amortization have been deducted. Reflecting its much lower growth rate, Time Warner traded at 14 times the same measure of its earnings. Could the new company achieve growth rates comparable to the 70% annual growth that AOL had achieved before the announcement? In contrast, Time Warner had been growing at less than one-third of this rate.
Integrating two vastly different organizations is a daunting task. Internet company AOL tended to make decisions quickly and without a lot of bureaucracy. Media and entertainment giant Time Warner is a collection of separate fiefdoms, from magazine publishing to cable systems, each with its own subculture. During the 1990s, Time Warner executives did not demonstrate a sterling record in achieving their vision of leveraging the complementary elements of their vast empire of media properties. The diverse set of businesses never seemed to reach agreement on how to handle online strategies among the various businesses.
Top management of the combined companies included icons such as Steve Case and Robert Pittman of the digital world and Gerald Levin and Ted Turner of the media and entertainment industry. Steve Case, former chair and CEO of AOL, was appointed chair of the new company, and Gerald Levin, former chair and CEO of Time Warner, remained as chair. Under the terms of the agreement, Levin could not be removed until at least 2003, unless at least three-quarters of the new board consisting of eight directors from each company agreed. Ted Turner was appointed as vice chair. The presidents of the two companies, Bob Pittman of AOL and Richard Parsons of Time Warner, were named co-chief operating officers (COOs) of the new company. Managers from AOL were put into many of the top management positions of the new company in order to “shake up” the bureaucratic Time Warner culture.
None of the Time Warner division heads were in favor of the merger. They resented having been left out of the initial negotiations and the conspicuous wealth of Pittman and his subordinates. More profoundly, they did not share Levin’s and Case’s view of the digital future of the combined firms. To align the goals of each Time Warner division with the overarching goals of the new firm, cash bonuses based on the performance of the individual business unit were eliminated and replaced with stock options. The more the Time Warner division heads worked with the AOL managers to develop potential synergies, the less confident they were in the ability of the new company to achieve its financial projections (Munk: 2004, pp. 198-199).
The speed with which the merger took place suggested to some insiders that neither party had spent much assessing the implications of the vastly different corporate cultures of the two organizations and the huge egos of key individual managers. Once Steve Case and Jerry Levin reached agreement on purchase price and who would fill key management positions, their subordinates were given one weekend to work out the “details.” These included drafting a merger agreement and accompanying documents such as employment agreements, deal termination contracts, breakup fees, share exchange processes, accounting methods, pension plans, press releases, capital structures, charters and bylaws, appraisal rights, etc. Investment bankers for both firms worked feverishly on their respective fairness opinions. While never a science, the opinions had to be sufficiently compelling to convince the boards and the shareholders of the two firms to vote for the merger and to minimize postmerger lawsuits against individual directors. The merger would ultimately generate $180 million in fees for the investment banks hired to support the transaction. (Munk: 2004, pp. 164-166).
The Disparity Between Projected and Actual Performance Becomes Apparent
Despite all the hype about the emergence of a vertically integrated new media company, AOL seems to be more like a traditional media company, similar to Bertelsmann in Germany, Vivendi in France, and Australia’s News Corp. A key part of the AOL Time Warner strategy was to position AOL as the preeminent provider of high-speed access in the world, just as it is in the current online dial-up world.
Despite pronouncements to the contrary, AOL Time Warner seems to be backing away from its attempt to become the premier provider of broadband services. The firm has had considerable difficulty in convincing other cable companies, who compete directly with Time Warner Communications, to open up their networks to AOL. Cable companies are concerned that AOL could deliver video over the Internet and steal their core television customers. Moreover, cable companies are competing head-on with AOL’s dial-up and high-speed services by offering a tiered pricing system giving subscribers more options than AOL.
At $23 billion at the end of 2001, concerns mounted about AOL’s leverage. Under a contract signed in March 2000, AOL gave German media giant Bertelsmann, an owner of one-half of AOL Europe, a put option to sell its half of AOL Europe to AOL for $6.75 billion. In early 2002, Bertelsmann gave notice of its intent to exercise the option. AOL had to borrow heavily to meet its obligation and was stuck with all of AOL Europe’s losses, which totaled $600 million in 2001. In late April 2002, AOL Time Warner rocked Wall Street with a first quarter loss of $54 billion. Although investors had been expecting bad news, the reported loss simply reinforced anxieties about the firm’s ability to even come close to its growth targets set immediately following closing. Rather than growing at a projected double-digit pace, earnings actually declined by more than 6% from the first quarter of 2001. Most of the sub-par performance stemmed from the Internet side of the business. What had been billed as the greatest media company of the twenty-first century appeared to be on the verge of a meltdown!
The AOL Time Warner story went from a fairy tale to a horror story in less than three years. On January 7, 2000, the merger announcement date, AOL and Time Warner had market values of $165 billion and $76 billion, respectively, for a combined value of $241 billion. By the end of 2004, the combined value of the two firms slumped to about $78 billion, only slightly more than Time Warner’s value on the merger announcement date. This dramatic deterioration in value reflected an ill-advised strategy, overpayment, poor integration planning, slow post-merger integration, and the confluence of a series of external events that could not have been predicted when the merger was put together. Who knew when the merger was conceived that the dot-com bubble would burst, that the longest economic boom in U.S. history would fizzle, and that terrorists would attach the World Trade Center towers? While these were largely uncontrollable and unforeseeable events, other factors were within the control of those who engineered the transaction.
The architects of the deal were largely incompatible, as were their companies. Early on, Steve Case and Jerry Levin were locked in a power struggle. The companies’ cultural differences were apparent early on when their management teams battled over presenting rosy projections to Wall Street. It soon became apparent that the assumptions underlying the financial projections were unrealistic as new online subscribers and advertising revenue stalled. By mid 2002, the nearly $7 billion paid to buy out Bertelsmann’s interest in AOL Europe caused the firm’s total debt to balloon to $28 billion. The total net loss, including the write down of goodwill, for 2002 reached $100 billion, the largest corporate loss in U.S. history. Furthermore, The Washington Post uncovered accounting improprieties. The strategy of delivering Time Warner’s rich array of proprietary content online proved to be much more attractive in concept than in practice. Despite all the talk about culture of cooperation, business at Time Warner was continuing as it always had. Despite numerous cross-divisional meetings in which creative proposals were made, nothing happened (Munk: 2004, p. 219). AOL’s limited broadband capability and archaic email and instant messaging systems encouraged erosion in its customer base and converting the wealth of Time Warner content to an electronic format proved to be more daunting than it had appeared. Finally, Both the Securities and Exchange Commission and the Justice Department investigated AOL Time Warner due to accounting improprieties. The firm admitted having inflated revenue by $190 million during the 21 month period ending in fall of 2000. Scores of lawsuits have been filed against the firm.
The resignation of Steve Case in January 2003 marked the restoration of Time Warner as the dominant partner in the merger, but with Richard Parsons at the new CEO. On October 16, 2003 the company was renamed Time Warner. Time Warner seemed appeared to be on the mend. Parson’s vowed to simplify the company by divesting non-core businesses, reduce debt, boost sagging morale, and to revitalize AOL. By late 2003, Parsons had reduced debt by more than $6 billion, about $2.6 billion coming from the sale of Warner Music and another $1.2 billion from the sale of its 50% stake in the Comedy Central cable network to the network’s other owner, Viacom Music. With their autonomy largely restored, Time Warner’s businesses were beginning to generate enviable amounts of cash flow with a resurgence in advertising revenues, but AOL continued to stumble having lost 2.6 million subscribers during 2003. In mid-2004, improving cash flow enabled the Time Warner to acquire Advertising.com for $435 million in cash.
- What were the primary motives for this transaction? How would you categorize them in terms of the historical motives for mergers and acquisitions discussed in this chapter?
AOL is buying access to branded products, a huge potential subscriber base, and broadband technology. The new company will be able to deliver various branded content to a diverse set of audiences using high-speed transmission channels (e.g., cable).
This transaction reflects many of the traditional motives for combining businesses:
- Improved operating efficiency resulting from both economies of scale and scope. With respect to so-called back office operations, the merging of data, call centers and other support operations will enable the new company to sustain the same or a larger volume of subscribers with lower overall fixed expenses. Time Warner will also be able to save a considerable amount of expenditures on information technology by sharing AOL’s current online information infrastructure and network to support the design, development and operation of web sites for its various businesses. Advertising and promotion spending should be more efficient, because both AOL and Time Warner can promote their services to the other’s subscribers at minimal additional cost.
- From AOL’s viewpoint, it is integrating down the value chain by acquiring a company that produces original, branded content in the form of magazines, music, and films. By owning this content, AOL will be able to distribute it without having to incur licensing fees.
- Changing technology. First, the trend toward the use of digital rather than analog technology is causing many media and entertainment firms to look to the Internet as a highly efficient way to market and distribute their products. Time Warner had for several years been trying to develop an online strategy with limited success. AOL represented an unusual opportunity to “leap frog” the competition. Second, the market for online services is clearly shifting away from current dial-up access to high-speed transmission. By gaining access to Time Warner’s cable network, enhanced to carry voice, video, and data, AOL will be able to improve both upload and download speeds for its subscribers. AOL has priced this service at a premium to regular dial-up subscriptions.
- AOL was willing to pay a 71 percent premium over Time Warner’s current share price to gain control. This premium is very high by historical standards and assumes that the challenges inherent in making this merger work can be overcome. The overarching implicit assumption is that somehow the infusion of new management into Time Warner can result in the conversion of what is essentially a traditional media company into an internet powerhouse.
- A favorable regulatory environment. Growth on the internet has been fostered by the lack of government regulation. The FCC has ruled that ISPs are not subject to local phone company access charges, e-commerce transactions are not subject to tax, and restrictions on the use of personal information have been limited.
- Although the AOL-Time Warner deal is referred to as an acquisition in the case, why is it technically more correct to refer to it as a consolidation? Explain your answer.
A consolidation refers to two or more businesses combining to form a third company, with no participating firm retaining its original identity. The newly formed company assumes all the assets and liabilities of both companies. Shareholders in both companies exchange their shares for shares in the new company.
- Would you classify this business combination as a horizontal, vertical, or conglomerate transaction? Explain your answer.
If one defines the industry broadly as media and entertainment, this transaction could be described as a vertical transaction in which AOL is backward integrating along the value chain to gain access to Time Warner’s proprietary content and broadband technology. However, a case could be made that it also has many of the characteristics of a conglomerate. If industries are defined more narrowly as magazine and book publishing, cable TV, film production, and music recording, the new company could be viewed as a conglomerate.
- What are some of the reasons AOL Time Warner may fail to satisfy investor expectations?
While AOL has control of the new company in terms of ownership, the extent to which they can exert control in practice may be quite different. AOL could become a captive of the more ponderous Time Warner empire and its 82,000 employees. Time Warner’s management style and largely independent culture, as evidenced by their limited success in leveraging the assets of Time and Warner Communications following their 1990 merger, could rob AOL of its customary speed, flexibility, and entrepreneurial spirit. The key to the success of the new companies will be how quickly they will be able to get new Web applications involving Time Warner content up and operating. Decision-making may slow to a halt if top management cannot cooperate. Roles and responsibilities at the top were ill defined in order to make the combination acceptable to senior management at both firms. It will take time for the managers with the dominant skills and personalities to more clearly define their roles in the new company.
- What would be an appropriate arbitrage strategy for this all-stock transaction?
Arbitrageurs make a profit on the difference between a deal’s offer price and the current price of the target’s stock. Following a merger announcement, the target’s stock price normally rises but not to the offer price reflecting the risk that the transaction will not be consummated. The difference between the offer price and the target’s current stock price is called a discount or spread. In a cash transaction, the arb can lock in this spread by simply buying the target’s stock. In a share for share exchange, the arb protects or hedges against the possibility that the acquirer’s stock might decline by selling the acquirer’s stock short. In the short sale, the arb instructs her broker to sell the acquirer’s shares at a specific price. The broker loans the arb the shares and obtains the stock from its own inventory or borrows it from a customer’s margin account or from another broker. If the acquirer’s stock declines in price, the short seller can buy it back at the lower price and make a profit; if the stock increases, the short seller incurs a loss.
Mattel Overpays for The Learning Company
Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company (TLC), a leading developer of software for toys, in a stock-for-stock transaction valued at $3.5 billion on May 13, 1999. Mattel had determined that TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its allowance for bad debt was inadequate. A $50 million licensing deal also had been prematurely put on the balance sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the children’s software market, Mattel closed on the transaction aware that TLC’s cash flows were overstated.
For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999 net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August, just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad, was leaving the company.
On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an affiliate of Gores Technology Group for rights to a share of future profits. Essentially, the deal consisted of no cash upfront and only a share of potential future revenues. In lieu of cash, Gores agreed to give Mattel 50 percent of any profits and part of any future sale of TLC. In a matter of weeks, Gores was able to do what Mattel could not do in a year. Gores restructured TLC’s seven units into three, set strong controls on spending, sifted through 467 software titles to focus on the key brands, and repaired relationships with distributors. Gores also has sold the entertainment division.
- Why did Mattel disregard the warning signs uncovered during due diligence? Identify which motives for
acquisitions discussed in this chapter may have been at work.
Answer: Deeply concerned about the increasingly important role that software was playing in the development and marketing of toys, Mattel may have been frantic to acquire a leading maker of software for toys to remain competitive. The presumption seems to have been that it made much more sense to buy another company than to develop the software in-house because an acquisition would be much faster. Motives for the acquisition included hubris in that Mattel, knowing that they were acquiring a host of problems, simply assumed that they would be able to fix them. The acquisition also represented a strategic realignment in that they were taking the company into a new direction in employing software more than they had in the past.
- Was this related or unrelated diversification for Mattel? How might this have influenced the outcome?
Answer: The Learning Company represented the application of software to the toy industry; however, it was still a software company. Mattel was in a highly unrelated business. Mattel’s lack of understanding of the business probably contributed to their naiveté in going ahead with the acquisition, despite knowing the problems they were inheriting
- Why could Gores Technology do in a matter of weeks what the behemoth toy company, Mattel, could not
Answer: Gores was in the business of turning around companies. They knew what to do and appreciated the need for speed. Gores also exhibited the ability that eluded Mattel to make quick decisions. Mattel may have been slow to make the needed changes because that could have been seen by investors as an admission by Mattel’s management that they had made a mistake in buying The Learning Company.
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 2000. 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 2010. 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.
- 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.
Answer: The deal was an attempt to generate cost savings from being able to operate manufacturing facilities at a higher average rate (economies of scale), to share common resources such as R&D and staff/overhead activities (economies of scope), gain access to new drugs in the Pharmacia pipeline (related diversification), gain pricing power (market power), and a sense that Pfizer could operate the Pharmacia assets better (hubris). Pfizer seems to believe that “bigger is better” in this high fixed cost industry. Also, with many patents on existing drugs expiring, the firm is hopeful of gaining access to what could be future “blockbuster” drugs.
- Why do you think Pfizer’s stock initially fell and Pharmacia’s increased?
Answer: As a share swap, the drop in Pfizer’s share price reflected investors’ concern about potential future EPS dilution. Pharmacia’s share price hike reflected the generous 38% premium Pfizer was willing to pay for Pharmacia’s stock.
- In your opinion, is this transaction likely to succeed or fail to meet investor expectations? Explain your answer.
Answer: The size of the premium Pfizer is willing to pay may suggest that it is overpaying for Pharmacia and will find it difficult to meet or exceed its cost of capital. While it is true that the combination of the two firms will generate significant cost savings, it is less clear if the combined R&D budgets will result in the development of many potential “blockbuster” drugs. The hurdles that await Pfizer will include melding the two cultures and combating bureaucratic inertia and indecisiveness that often accompany extremely large firms.
- Would you anticipate continued consolidation in the global pharmaceutical industry? Why or why not?
Answer: With the industry focused on growth in EPS, increasing consolidation is likely as firms seek to generate cost savings by buying a competitor, by gaining access to hopefully more productive R&D departments, and by acquiring patents for drugs that could be added to their portfolios. In addition, by buying foreign firms, pharmaceutical firms are engaging in geographic diversification. However, with the global pharmaceutical market growing at a less than a double-digit rate, it is unlikely that individual firms can generate sustainable double-digit earnings growth.
Chapter 3: The Corporate Takeover Market:
Common Takeover Tactics, Anti-Takeover Defenses, and Corporate Governance
Examination Questions and Answers
True/False Questions: Answer true or false to each of the following.
- Friendly takeovers are negotiated settlements that are often characterized by bargaining, which remains undisclosed until the agreement has been signed. True or False
- Concern about their fiduciary responsibility to shareholders and shareholder lawsuits often puts pressure on a target firm’s board of directors to accept an offer if it includes a significant premium to the target’s current share price. True or False
- 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
- The accumulation of a target firm’s stock by arbitrageurs makes purchases of blocks of stock by the bidder easier. True or False
- A successful proxy fight may represent a far less expensive means of gaining control over a target than a
tender offer. True or False
- Public announcements of a proposed takeover are often designed to put pressure on the board of the target firm. True or False
- A tender offer is a proposal made directly to the target firm’s board as the first step leading to a friendly takeover. True or False
- A bear hug involves mailing a letter containing an acquisition proposal to the target’s board without warning and demanding an immediate response. True or False
- Dissident shareholders always undertake a tender offer to change the composition of a firm’s board of
directors. True or False
- A proxy contest is one in which a group of dissident shareholders attempts to obtain representation on a
firm’s board by soliciting other shareholders for the right to vote their shares. True or False
- A hostile tender offer is a takeover tactic in which the acquirer bypasses the target’s board and management and
goes directly to the target’s shareholders with an offer to purchase their shares. True or False
- According to the management entrenchment hypothesis, takeover defenses are designed to protect the
target firm’s management from a hostile takeover. True or False
- The shareholder interests theory suggests that shareholders gain when management resists takeover
attempts. True or False
- A standstill agreement is one in which the target firm agrees not to solicit bids from other potential
buyers while it is negotiating with the first bidder. True or False
- Most takeover attempts may be characterized as hostile bids. True or False
- Litigation is a tactic that is used only by acquiring firms. True or False
- The takeover premium is the dollar or percentage amount the purchase price proposed for a target firm
exceeds the acquiring firm’s share price. True or False
- Concern about their fiduciary responsibility and about stockholder lawsuits puts pressure on the target’s
board to accept the offer. True or False
- The final outcome of a hostile takeover is rarely affected by the composition of the target’s stock
ownership and how stockholders feel about management’s performance. True or False
- Despite the pressure of an attractive purchase price premium, the composition of the target’s board
greatly influences what the board does and the timing of its decisions. True or False
- The target firm’s bylaws may provide significant hurdles for an acquiring firm. True or False
- Bylaws may provide for a staggered board, the inability to remove directors without cause, and
supermajority voting requirements for approval of mergers. True or False
- An acquiring firm may attempt to limit the options of the target’s senior management by making a formal
acquisition proposal, usually involving a public announcement, to the board of the directors of the target. True or False
- A target firm is unlikely to reject a bid without getting a “fairness” opinion from an investment banker
stating that the offer is inadequate. True or False
- By replacing the target’s board members, proxy fights may be an effective means of gaining control
without owning 51% of the target’s voting stock. True or False
- Proxy contests and tender offers are often viewed by acquirers as inexpensive ways to takeover another
firm. True or False
- All materials in a proxy contest must be filed with the SEC before they are sent to shareholders.
True or False
- Federal and state laws make it extremely difficult for a bidder to acquire a controlling interest in a target
without such actions becoming public knowledge. True or False
- Tender offers always consist of an offer to exchange acquirer shares for shares in the target firm.
True or False
- The size of the target firm is the best predictor of the likelihood of being taken over by another firm.
True or False
- Poison pills are a commonly used takeover tactic to remove the management and board of the target firm.
True or False
- Poison pills represent a new class of securities issued by a company to its shareholders, which have no
value unless an investor acquires a specific percentage of the firm’s voting stock. True or False
- In elections involving staggered or classified boards, only one group of board members is up for
reelection each year. True or False
- Golden parachutes are employee severance arrangements, which are triggered whenever a change in
control takes place. They are generally held by a large number of employees at all levels of management throughout the firm. True or False
- Tender offers apply only for share for share exchanges. True or False
- Corporate governance refers to the way firms elect CEOs. True or False
- The threat of hostile takeovers is a factor in encouraging a firm to implement good governance practices.
True or False
- Corporate governance refers to a system of controls both internal and external to the firm that protects
stakeholders’ interests. True or False
- Stakeholders in a firm refer to shareholders only. True or False
- Corporate anti-takeover defenses are necessarily a sign of bad corporate governance. True or False
- The threat of corporate takeover has little impact on how responsibly a corporate board and management manage a firm. True or False
- Institutional activism has assumed a larger role in ensuring good corporate governance practices in recent years. True or False
- Executive stock option plans have little impact on the way management runs the firm. True or False
- A standstill agreement prevents an investor who has signed the agreement from ever again buying stock in the target firm. True or False
- The primary forms of proxy contests are those for seats on the board of directors, those concerning management proposals, and those seeking to force management to take a particular action. True or False
- Purchasing target stock in the open market is a rarely used takeover tactic. True or False
- In a one-tier offer, the acquirer announces the same offer to all target shareholders. True or False.
- In a two-tiered offer, target shareholders typically received two offers, which potentially have different values. True or False
- A no-shop agreement prohibits the takeover target from seeking other bids. True or False
- Poison pills represent a new class of stock issued by a company to its shareholders, usually as a dividend. True or False
Multiple Choice: Circle only one alternative.
- All of the following are commonly used takeover tactics, except for
- Poison pills
- Bear hug
- Tender offer
- Proxy contest
- According to the management entrenchment theory,
- Management resistance to takeover attempts is an attempt to increase the proposed purchase price premium
- Management resistance to takeover attempts is an attempt to extend their longevity with the target firm
- Shareholders tend to benefit when management resists takeover attempts
- Management attempts to maximize shareholder value
- Describes the primary reason takeover targets resist takeover bids
- Which of the following factors often affects hostile takeover bids?
- The takeover premium
- The composition of the board of the target firm
- The composition of the ownership of the target’s stock
- The target’s bylaws
- All of the above
- All of the following are true of a proxy contest except for
- Are usually successful
- Are sometimes designed to replace members of the board
- Are sometimes designed to have certain takeover defenses removed
- May enable effective control of a firm without owning 51% of the voting stock
- Are often costly
- Purchasing the target firm’s stock in the open market is a commonly used tactic to achieve all of
the following except for
- Acquiring a controlling interest in the target firm without making such actions public knowledge.
- Lowering the average cost of acquiring the target firm’s shares
- Recovering the cost of an unsuccessful takeover attempt
- Obtaining additional voting rights in the target firm
- Strengthening the effectiveness of proxy contests
- All of the following are true of tender offers except for
- Tender offers consist only of offers of cash for target stock
- Are generally considered an expensive takeover tactic
- Are extended for a specific period of time
- Are sometimes over subscribed
- Must be filed with the SEC
- Which of the following are common takeover tactics?
- Bear hugs
- Open market purchases
- Tender offers
- All of the above
- All of the following are common takeover defenses except for
- Poison pills
- Tender offers
- Staggered boards
- Golden parachutes
- All of the following are true of poison pills except for
- They are a new class of security
- Generally prevent takeover attempts from being successful
- Enable target shareholders to buy additional shares in the new company if an unwanted shareholder’s ownership exceeds a specific percentage of the target’s stock
- Delays the completion of a takeover attempt
- May be removed by the target’s board if an attractive bid is received from a so-called “white knight.”
- The following takeover defenses are generally put in place by a firm before a takeover attempt is
- Standstill agreements
- Poison pills
- Corporate restructuring
- The following takeover defenses are generally put in place by a firm after a takeover attempt is
- Staggered board
- Standstill agreement
- Supermajority provision
- Fair price provision
- Which of the following is true about so-called shark repellants?
- They are put in place to strengthen the board
- They include poison pills
- Often consist of the right to issue greenmail
- Involve White Knights
- Involve corporate restructuring
- Which of the following is true? A hostile takeover attempt
- Is generally found to be illegal
- Is one that is resisted by the target’s management
- Results in lower returns to the target firm’s shareholders than a friendly attempt
- Usually successful
- Supported by the target firm’s board and its management
- Which is true of the following? A white knight
- Is a group of dissident shareholders which side with the bidding firm
- Is a group of the target firm’s current shareholders which side with management
- Is a third party that is willing to acquire the target firm at the same price as the bidder but usually removes the target’s management
- Is a firm which is viewed by management as a more appropriate suitor than the bidder
- Is a firm that is willing to acquire only a large block of stock in the target firm
- Which of the following is true about supervoting stock?
- Is a commonly used takeover tactic.
- Is generally encouraged by the SEC
- May have 10 to 100 times of the voting rights of other classes of stock
- Is issued to acquiring firms if they agree not to purchase a controlling interest in the target firm
- Is a widely used takeover defense
- Which of the following factors influences corporate governance practices?
- Securities legislation
- Government regulatory agencies
- The threat of a hostile takeover
- Institutional activism
- All of the above
- Which of the following are commonly considered alternative models of corporate governance?
- Market model
- Control model
- Takeover model
- A & B only
- A & C only
- The market governance model is applicable when which of the following conditions are true?
- Capital markets are liquid
- Equity ownership is widely dispersed
- Ownership and control are separate
- Board members are largely independent
- All of the above
- The control market is applicable when which of the following conditions are true?
- Capital markets are illiquid
- Equity ownership is heavily concentrated
- Board members are largely insiders
- Ownership and control overlap
- All of the above
- The control model of corporate governance is applicable under all of the following conditions except for
- Capital markets are illiquid
- Board members are largely insiders
- Ownership and control overlap
- Equity ownership is widely dispersed
- A, B, & D only
- Which of the following are the basic principles on which the market model is based?
- Management incentives should be aligned with those of shareholders and other major stakeholders
- Transparency of financial statements
- Equity ownership should be widely dispersed
- A & B only
- A, B, and C only
- Which of the following statements best describes the business judgment rule?
- Board members are expected to conduct themselves in a manner that could reasonably be seen as being in the best interests of the shareholders.
- Board members are always expected to make good decisions.
- The courts are expected to “second guess’ decisions made by corporate boards.
- Directors and managers are always expected to make good decisions.
- Board decisions should be subject to constant scrutiny by the courts.
- Over the years, the U.S. Congress has transferred some of the enforcement of securities laws to organizations other than the SEC such as
- Public stock exchanges
- Financial Accounting Standards Board
- Public Accounting Oversight Board
- State regulatory agencies
- All of the above
- Which of the following government agencies can discipline firms with inappropriate governance practices?
- Securities and Exchange Commission
- Federal Trade Commission
- The Department of Justice
- A & C only
- A, B, & C
- Studies show that which of the following combinations of corporate defenses can be most effective in discouraging
- Poison pills and staggered boards
- Poison pills and golden parachutes
- Golden parachutes and staggered boards
- Standstill agreements and White Knights
- Poison Pills and tender offers
- Some of Acme Inc.’s shareholders are very dissatisfied with the performance of the firm’s current management team and want to gain control of the board. To do so, these shareholders offer their own slate of candidates for open spaces on the firm’s board of directors. Lacking the necessary votes to elect these candidates, they are contacting other shareholders and asking them to vote for their slate of candidates. The firm’s existing management and board is asking shareholders to vote for the candidates they have proposed to fill vacant seats on the board. Which of the following terms best describes this scenario?
- Leveraged buyout
b Proxy contest
- None of the above
- Xon Enterprises is attempting to take over Rayon Group. Rayon’s shareholders have the right to buy additional
shares at below market price if Xon (considered by Rayon’s board to be a hostile bidder) buys more than 15 percent of Rayon’s outstanding shares. What term applies to this antitakeover measure?
- Share repellent plan
- Golden parachute plan
- Pac Man defense
- Poison pill
- Greenmail provision
Case Study Short Essay Examination Questions:
Mittal Acquires Arcelor—A Battle of Global Titans in the European Corporate Takeover Market
Ending five months of maneuvering, Arcelor agreed on June 26, 2006, to be acquired by larger rival Mittal Steel Co. for $33.8 billion in cash and stock. The takeover battle was one of the most acrimonious in recent European Union history. Hostile takeovers are now increasingly common in Europe. The battle is widely viewed as a test case as to how far a firm can go in attempting to prevent an unwanted takeover.
Arcelor was created in 2001 by melding steel companies in Spain, France, and Luxembourg. Most of its 90 plants are in Europe. In contrast, most of Mittal’s plants are outside of Europe in areas with lower labor costs. Lakshmi Mittal, Mittal’s CEO and a member of an important industrial family in India, started the firm and built it into a powerhouse through two decades of acquisitions in emerging nations. The company is headquartered in the Netherlands for tax reasons. Prior to the Arcelor acquisition, Mr. Mittal owned 88 percent of the firm’s stock.
Mittal acquired Arcelor to accelerate steel industry consolidation to reduce industry overcapacity. The combined firms could have more leverage in setting prices and negotiating contracts with major customers such as auto and appliance manufacturers and suppliers such as iron ore and coal vendors, and eventually realize $1 billion annually in pretax cost savings.
After having been rebuffed by Guy Dolle, Arcelor’s president, in an effort to consummate a friendly merger, Mittal launched a tender offer in January 2006 consisting of mostly stock and cash for all of Arcelor’s outstanding equity. The offer constituted a 27 percent premium over Arcelor’s share price at that time. The reaction from Arcelor’s management, European unions, and government officials was swift and furious. Guy Dolle stated flatly that the offer was “inadequate and strategically unsound.” European politicians supported Mr. Dolle. Luxembourg’s prime minister, Jean Claude Juncker, said a hostile bid “calls for a hostile response.” Trade unions expressed concerns about potential job loss.
Dolle engaged in one of the most aggressive takeover defenses in recent corporate history. In early February, Arcelor doubled its dividend and announced plans to buy back about $8.75 billion in stock at a price well above the then current market price for Arcelor stock. These actions were taken to motivate Arcelor shareholders not to tender their shares to Mittal. Arcelor also backed a move to change the law so that Mittal would be required to pay in cash. However, the Luxembourg parliament rejected that effort.
To counter these moves, Mittal Steel said in mid-February that if it received more than one-half of the Arcelor shares submitted in the initial tender offer, it would hold a second tender offer for the remaining shares at a slightly lower price. Mittal pointed out that it could acquire the remaining shares through a merger or corporate reorganization. Such rhetoric was designed to encourage Arcelor shareholders to tender their shares during the first offer.
In late 2005, Arcelor outbid German steelmaker Metallgeschaft to buy Canadian steelmaker Dofasco for $5 billion. Mittal was proposing to sell Dofasco to raise money and avoid North American antitrust concerns. Following completion of the Dofasco deal in April 2006, Arcelor set up a special Dutch trust to prevent Mittal from getting access to the asset. The trust is run by a board of three Arcelor appointees. The trio has the power to determine if Dofasco can be sold during the next five years. Mittal immediately sued to test the legality of this tactic.
In a deal with Russian steel maker OAO Severstahl, Arcelor agreed to exchange its shares for Alexei Mordashov’s 90 percent stake in Severstahl. The transaction would give Mr. Mordashov a 32 percent stake in Arcelor. Arcelor also scheduled an unusual vote that created very tough conditions for Arcelor shareholders to prevent the deal with Severstahl from being completed. Arcelor’s board stated that the Severstahl deal could be blocked only if at least 50 percent of all Arcelor shareholders would vote against it. However, Arcelor knew that only about one-third of shareholders actually attend meetings. This is a tactic permissible under Luxembourg law, where Arcelor is incorporated.
Investors holding more than 30 percent of Arcelor shares signed a petition to force the company to make the deal with Severstahl subject to a traditional 50.1 percent or more of actual votes cast. After major shareholders pressured the Arcelor board to at least talk to Mr. Mittal, Arcelor demanded an intricate business plan from Mittal as a condition that had to be met. Despite Mittal’s submission of such a plan, Arcelor still refused to talk. In late May, Mittal raised its bid by 34 percent and said that if the bid succeeded, Mittal would eliminate his firm’s two-tiered share structure, giving the Mittal family shares ten times the voting rights of other shareholders.
A week after receiving the shareholder petition, the Arcelor board rejected Mittal’s sweetened bid and repeated its support of the Severstahl deal. Shareholder anger continued, and many investors said they would reject the share buyback. Some investors opposed the buyback because it would increase Mr. Mordashov’s ultimate stake in Arcelor to 38 percent by reducing the number of Arcelor shares outstanding. Under the laws of most European countries, any entity owning more than a third of a company is said to have effective control. Arcelor cancelled a scheduled June 21 shareholder vote on the buyback. Despite Mr. Mordashov’s efforts to enhance his bid, the Arcelor board asked both Mordashov and Mittal to submit their final bids by June 25.
Arcelor finally agreed to Mittal’s final bid, which had been increased by 14 percent. The new offer consisted of $15.70 in cash and 1.0833 Mittal shares for each Arcelor share. The new bid is valued at $50.54 per Arcelor share, up from Mittal’s initial bid in January 2006 of $35.26. The final offer represented an unprecedented 93 percent premium over Arcelor’s share price of $26.25 immediately before Mittal’s initial bid. Lakshmi Mittal will control 43.5 percent of the combined firm’s stock. Mr. Mordashov would receive a $175 million breakup fee due to Arcelor’s failure to complete its agreement with him. Finally, Mittal agreed not to make any layoffs beyond what Arcelor already has planned.
- Identify the takeover tactics employed by Mittal. Explain why each was used.
Answer: Mittal attempted a friendly takeover by initiating behind the scenes negotiations with Guy Dolle, CEO of Arcelor. However, after being rebuffed publicly, Mittal employed a two-tiered cash and stock tender offer to circumvent the Arcelor board. To counter virulent opposition from both Arcelor management and local politicians, Mittal announced that it would condition the second tier of its tender offer on receiving more than one-half of the Arcelor voting stock. However, the second tier offer would be at a slightly lower price than offered in the first tier. This was done to encourage Arcelor shareholders to participate in the first tier offering. If Mittal could gain a majority of voting shares it would be able to acquire the remaining shares through a backend merger. Moreover, Mittal sued to test the legality of Arcelor’s moving its recently acquired Dofasco operations into a trust to prevent Mittal from selling the operation to help finance the takeover. Mittal also attempted to rally large shareholder support against what were portrayed as Arcelor management’s self-serving maneuvers. Finally, Mittal continued efforts to appeal to shareholders by raising its bid from its initial 22% premium to the then current Arcelor share price to what amounted to a 93% premium and agreeing to eliminate its super-voting stock which had given the Mittal family shares that had ten times the voting rights of other shareholders.
- Identify the takeover defenses employed by Arcelor? Explain why each was used.
Answer: Initially, Guy Dolle attempted to gain support among local politicians and the press to come out against the proposed takeover by emphasizing potential job losses and disruption to local communities. Arcelor also provided its shareholders with an attractive alternative to tendering their shares to Mittal by announcing an $8.75 billion share buy-back at a price well above their then current share price. Arcelor also tried to increase the cost of the transaction to Mittal by seeking a change in the local law that would have required that Mittal pay shareholders only in cash. By putting Dofasco in a trust, Arcelor sought to deprive Mittal of a way of defraying the cost of the takeover by preventing Mittal from selling the asset without the permission of the trustees who were all Arecelor appointees. Arcelor also sought to put a large portion of its stock into “friendly hands” by seeking a white knight. To stretch out the process and raise the cost of a takeover to Mittal, Arcelor refused to engage in direct negotiations with Mittal until they delivered a detailed business plan as to what they proposed to do with the combined firms. Arcelor proceeded to ignore the plan when it was submitted.
- Using the information in this case study, discuss the arguments for and against encouraging hostile corporate takeovers
Answer: Hostile takeovers may be appropriate whenever target management is not working in the best interests of its shareholders (i.e., so-called agency problems). However, while such transactions often are concluded in a negotiated settlement, the subsequent enmity inevitably raises the cost of integration and the ultimate cost of the takeover due to the probable boost in the offer price required to close the deal. While this is good for the target shareholders, it works to the detriment of the acquirer’s shareholders.
- Was Arcelor’s board and management acting to protect their own positions (i.e., the management entrenchment hypothesis) or in the best interests of the shareholders (i.e., the shareholder interests hypothesis)? Explain your answer.
Answer: While it seems on the surface that Arcelor’s management was acting to entrench themselves, the end result was an eye-popping 93% premium paid by Mittal over Arcelor’s share price when the takeover began. Consequently, it is difficult to argue that the end result was not in the best interests of Arcelor’s shareholders.
Verizon Acquires MCI—The Anatomy of Alternative Bidding Strategies
While many parties were interested in acquiring MCI, the major players included Verizon and Qwest. U.S.-based Qwest is an integrated communications company that provides data, multimedia, and Internet-based communication services on a national and global basis. The acquisition would ease the firm’s huge debt burden of $17.3 billion because the debt would be supported by the combined company with a much larger revenue base and give it access to new business customers and opportunities to cut costs.
Verizon Communications, created through the merger of Bell Atlantic and GTE in 2000, is the largest telecommunications provider in the United States. The company provides local exchange, long distance, Internet, and other services to residential, business, and government customers. In addition, the company provides wireless services to over 42 million customers in the United States through its 55 percent–owned joint venture with Vodafone Group PLC. Verizon stated that the merger would enable it to more efficiently provide a broader range of services, give the firm access to MCI’s business customer base, accelerate new product development using MCI’s fiber-optic network infrastructure, and create substantial cost savings.
By mid-2004, MCI had received several expressions of interest from Verizon and Qwest regarding potential strategic relationships. By July, Qwest and MCI entered into a confidentiality agreement and proceeded to perform more detailed due diligence. Ivan Seidenberg, Verizon’s chairman and CEO, inquired about a potential takeover and was rebuffed by MCI’s board, which was evaluating its strategic options. These included Qwest’s proposal regarding a share-for-share merger, following a one-time cash dividend to MCI shareholders from MCI’s cash in excess of its required operating balances. In view of Verizon’s interest, MCI’s board of directors directed management to advise Richard Notebaert, the chairman and CEO of Qwest, that MCI was not prepared to move forward with a potential transaction. The stage was set for what would become Qwest’s laboriously long and ultimately unsuccessful pursuit of MCI, in which the firm would improve its original offer four times, only to be rejected by MCI in each instance even though the Qwest bids exceeded Verizon’s.
After assessing its strategic alternatives, including the option to remain a stand-alone company, MCI’s board of directors concluded that the merger with Verizon was in the best interests of the MCI stockholders. MCI’s board of directors noted that Verizon’s bid of $26 in cash and stock for each MCI share represented a 41.5 percent premium over the closing price of MCI’s common stock on January 26, 2005. Furthermore, the stock portion of the offer included “price protection” in the form of a collar (i.e., the portion of the purchase price consisting of stock would be fixed within a narrow range if Verizon’s share price changed between the signing and closing of the transaction).
The merger agreement also provided for the MCI board to declare a special dividend of $5.60 once the firm’s shareholders approved the deal. MCI’s board of directors also considered the additional value that its stockholders would realize, since the merger would be a tax-free reorganization in which MCI shareholders would be able to defer the payment of taxes until they sold their stock. Only the cash portion of the purchase price would be taxable immediately. MCI’s board of directors also noted that a large number of MCI’s most important business customers had indicated that they preferred a transaction between MCI and Verizon rather than a transaction between MCI and Qwest.
While it is clearly impossible to know for sure, the sequence of events reveals a great deal about Verizon’s possible bidding strategy. Any bidding strategy must begin with a series of management assumptions about how to approach the target firm. It was certainly in Verizon’s best interests to attempt a friendly rather than a hostile takeover of MCI, due to the challenges of integrating these two complex businesses. Verizon also employed an increasingly popular technique in which the merger agreement includes a special dividend payable by the target firm to its shareholders contingent upon their approval of the transaction. This special dividend is an inducement to gain shareholder approval.
Given the modest 3 percent premium over the first Qwest bid, Verizon’s initial bidding strategy appears to have been based on the low end of the purchase price range it was willing to offer MCI. Verizon was initially prepared to share relatively little of the potential synergy with MCI shareholders, believing that a bidding war for MCI would be unlikely in view of the recent spate of mergers in the telecommunications industry and the weak financial position of other competitors. SBC and Nextel were busy integrating AT&T and Sprint, respectively. Moreover, Qwest appeared to be unable to finance a substantial all-cash offer due to its current excessive debt burden, and its stock appeared to have little appreciation potential because of ongoing operating losses. Perhaps stunned by the persistence with which Qwest pursued MCI, Verizon believed that its combination of cash and stock would ultimately be more attractive to MCI investors than Qwest’s primarily all-cash offer, due to the partial tax-free nature of the bid.
Throughout the bidding process, many hedge funds criticized MCI’s board publicly for accepting the initial Verizon bid. Since its emergence from Chapter 11, hedge funds had acquired significant positions in MCI’s stock, with the expectation that MCI constituted an attractive merger candidate. In particular, Carlos Slim Helu, the Mexican telecommunications magnate and largest MCI shareholder, complained publicly about the failure of MCI’s board to get full value for the firm’s shares. Pressure from hedge funds and other dissident MCI shareholders triggered a shareholder lawsuit to void the February 14, 2005, signed merger agreement with Verizon.
In preparation for a possible proxy fight, Verizon entered into negotiations with Carlos Slim Helu to acquire his shares. Verizon acquired Mr. Slim’s 13.7 percent stake in MCI in April 2005. Despite this purchase, Verizon’s total stake in MCI remained below the 15 percent ownership level that would trigger the MCI rights plan.
About 70 percent (i.e., $1.4 billion) of the cash portion of Verizon’s proposed purchase price consisted of a special MCI dividend payable by MCI when the firm’s shareholders approved the merger agreement. Verizon’s management argued that the deal would cost their shareholders only $7.05 billion (i.e., the $8.45 billion purchase price consisting of cash and stock, less the MCI special dividend). The $1.4 billion special dividend reduced MCI’s cash in excess of what was required to meet its normal operating cash requirements.
Qwest consistently attempted to outmaneuver Verizon by establishing a significant premium between its bid and Verizon’s, often as much as 25 percent. Qwest realized that its current level of indebtedness would preclude it from significantly increasing the cash portion of the bid. Consequently, it had to rely on the premium to attract enough investor interest, particularly among hedge funds, to pressure the MCI board to accept the higher bid. However, Qwest was unable to convince enough investors that its stock would not simply lose value once more shares were issued to consummate the stock and cash transaction.
Qwest could have initiated a tender or exchange offer directly to MCI shareholders, proposing to purchase or exchange their shares without going through the merger process. The tender process requires lengthy regulatory approval. However, if Qwest initiated a tender offer, it could trigger MCI’s poison pill. Alternatively, a proxy contest might have been preferable because Qwest already had a bid on the table, and the contest would enable Qwest to lobby MCI shareholders to vote against the Verizon bid. This strategy would have avoided triggering the poison pill.
Ultimately, Qwest was forced to capitulate simply because it did not have the financial wherewithal to increase the $9.9 billion bid. It could not borrow anymore because of its excessive leverage. Additional stock would have contributed to earnings dilution and caused the firm’s share price to fall.
It is unusual for a board to turn down a higher bid, especially when the competing bid was 17 percent higher. In accepting the Verizon bid, MCI stated that a number of its large business customers had expressed a preference for the company to be bought by Verizon rather than Qwest. MCI noted that these customer concerns posed a significant risk in being acquired by Qwest. The MCI board’s acceptance of the lower Verizon bid could serve as a test case of how well MCI directors are conducting their fiduciary responsibilities. The central issue is how far boards can go in rejecting a higher offer in favor of one they believe offers more long-term stability for the firm’s stakeholders.
Ron Perlman, the 1980s takeover mogul, saw his higher all-cash bid rejected by the board of directors of Revlon Corporation, which accepted a lower offer from another bidder. In a subsequent lawsuit, a court overruled the decision by the Revlon board in favor of the Perlman bid. Consequently, from a governance perspective, legal precedent compels boards to accept higher bids from bona fide bidders where the value of the bid is unambiguous, as in the case of an all-cash offer. However, for transactions in which the purchase price is composed largely of acquirer stock, the value is less certain. Consequently, the target’s board may rule that the lower bidder’s shares have higher appreciation potential or at least are less likely to decline than those shares of other bidders.
MCI’s president and CEO Michael Capellas and other executives could collect $107 million in severance, payouts of restricted stock, and monies to compensate them for taxes owed on the payouts. In particular, Capellas stood to receive $39.2 million if his job is terminated “without cause” or if he leaves the company “for good reason.”
- Discuss how changing industry conditions have encouraged consolidation within the telecommunications industry?
Answer: Consolidation in the telecommunications industry has been driven by technological and regulatory change. Technological change included the ongoing convergence of voice and data networks and the proliferation of alternatives to landline telephony. Convergence provides for the elimination of the capital expenditures and costs associated with maintaining multiple networks. Moreover, the advent of a single network providing both a data and voice transmission capability provides for more rapid and cost effective development of enhanced communication products and services. Alternative or substitutes for traditional landlines include Internet telephony, wireless, and cable phone service. With respect to regulatory changes, the 1996 Telecommunications Act made it easier for Regional Bell Operating Companies (RBOCs) to merge, and the 2004 court ruling which eliminated the requirement that local phone companies sell access to their networks on a discounted basis to long-distance companies. The latter court ruling made in prohibitively expensive for such long-distance carriers such as AT&T and MCI to package local and long-distance services.
- What alternative strategies could Verizon, Qwest, and MCI have pursued? Was the decision to acquire MCI the best alternative for Verizon? Explain your answer.
Answer: All three firms could have chosen to remain standalone businesses and partnered with other firms possessing the skills and resources they needed to compete more effectively. Verizon, as the second largest carrier in the U.S. telecommunications industry was in the best position to continue as a standalone business. While a strong competitor in the long-distance and Internet IP markets, it lacked access to large local markets and the financial resources to fund future growth. Consequently, merging with a strong competitor seemed to make sense. Qwest was too small to compete in a highly capital intensive industry in which scale was becoming increasingly important. Furthermore, the firm’s excessive leverage limited its ability to finance new product development. Consequently, it viewed a merger as a survival strategy. The decision to acquire MCI seemed to make good strategic sense if it could be accomplished at a reasonable price. The “auction” that took place drove the purchase price to levels that may make it extremely difficult for Verizon to earn back the substantial 41 premium paid over MCI’s share price before the bidding started.
- Who are the winners and losers in the Verizon/MCI merger? Be specific.
Answer: The winners clearly included the MCI shareholders who earned a 41% premium over the pre-bid value of their share price. This is especially true for those who wish to remain long-term investors; however, those with a short-term focus such as hedge funds, believe that they were short-changed by the MCI board which did not choose the highest bid. If the coupling of Verizon rather than Qwest with MCI does indeed result in a more viable firm longer term, MCI’s customers, employees, suppliers, and lenders could also be included among the winners. Qwest and its stakeholders are probably the losers in this instance as the firm’s remaining options are limited and largely involve the disposition of redundant assets to pay off its current $17 billion debt load.
- What takeover tactics were employed or threatened to be employed by Verizon? By Qwest? Be specific.
Answer: Verizon pursued a friendly approach to MCI believing that it could convince MCI’s management and board that it represented the stronger strategic partner. Consequently, its stock was likely to appreciate more than Qwest’s. MCI’s board seemed to have accepted this premise from the outset until investor pressure forced them to consider seriously the higher Qwest bids. Verizon used public pressure by noting that if MCI did not accept their bid that it was due to MCI’s management and board being excessively influenced by the focus of hedge funds on short-term profitability. Verizon also made its final bid contingent on MCI making public its customers discomfort with MCI being acquired by Qwest. Verizon also bought out the largest hostile MCI shareholder, Carlos Slim Helu. Moreover, Verizon made the special dividend to MCI shareholders payable upon approval rather than at closing as an additional inducement to gain MCI shareholder approval of the proposed transaction. Also, Verizon included a disincentive not to close in its merger agreement with MCI in the form of a $200 million break-up fee. Finally, once Verizon had a signed merger agreement with MCI it initiated its S-4 filing in early April even before the bidding was over in order to start the clock on the regulatory approval of the MCI proxy enclosed with the filing and on setting a date for a special MCI shareholders meeting.
Because Qwest did not have an attractive acquisition currency (i.e., stock), it relied heavily on maintaining a sizeable premium over the Verizon bid to attempt to win MCI board approval of its proposals. Qwest used publicity and indirectly or directly aligned themselves with hedge funds, to pressure the MCI board to accept their bid. They also held out the threat of a tender offer, but the submission of the S-4 by Verizon limited the amount of time for implementing a tender offer. Also, Qwest used the threat of a proxy fight to get MCI shareholders to vote against the Verizon agreement. Finally, Qwest threatened to try to block regulatory approval. In the final analysis, Qwest simply did not have the financial resources or the strategic appeal to MCI to win this bidding contest.
- What specific takeover defenses did MCI employ? Be specific.
Answer: MCI employed a poison pill, staggered board, and golden parachute defenses. The poison pill discouraged suitors from buying a large piece of the MCI, which would have triggered the poison pill and increased the cost of the takeover. The staggered board made a proxy fight to remove the board members hostile to a Qwest bid or to withdraw the poison pill in a single year impossible. Golden parachutes also added to the cost of the transaction.
- How did the actions of certain shareholders affect the bidding process? Be specific.
Answer: The hedge funds continuously pressured MCI to accept the higher bid because of their focus on short-term profitability. Individual shareholders attempted to influence the outcome by threatening class action lawsuits arguing that the MCI board was not maximizing shareholder value. These actions forced the MCI board to give the Qwest bid more serious consideration.
- In your opinion, did the MCI board act in the best interests of their shareholders? Of all their stakeholders? Be specific.
Answer: Some might argue that MCI did not act in the best interests of all their shareholders. Those interested in short-term profits, e.g., hedge funds, were dissatisfied with the outcome, while long-term investors may be more enthusiastic because of the perceived more favorable growth prospects of a combined Verizon/MCI than a combined Qwest/MCI.
- Do you believe that the potential severance payments that could be paid to Capellas were excessive? Explain your answer. What are the arguments for and against such severance plans for senior executives?
Answer: Michael Capellas was formerly CEO of Compaq before it was acquired by HP. The severance package was part of the contract he signed when he agreed to be the CEO of MCI. Consequently, MCI is contractually bound to conform to the terms of the contract. Not to do so, would be to breach the contract. Moreover, such lucrative severance benefits should encourage CEOs to hold out for the highest bid rather than simply to protect their positions. In practice, there is little evidence that ‘golden parachutes’ cause CEOs to negotiate more aggressively. In this instance, MCI did not go with the highest bidder. It may be more appropriate if such contracts are subject to shareholder approval.
- Should the antitrust regulators approve the Verizon/MCI merger? Explain your answer.
Answer: Because of the plethora of competing alternatives, it does not appear that consumers will be hurt. However, because of the general lack of alternatives, business customers may experience an increase in cost of telecommunication services. The FCC and FTC may require that the combined firms dispose of certain operations in heavily concentrated regional markets in order to make conditions more competitive.
- Verizon’s management argued that the final purchase price from the perspective of Verizon shareholders was not $8.45 billion but rather $7.05. This was so, they argued, because MCI was paying the difference of $1.4 billion from their excess cash balances as a special dividend to MCI shareholders. Why is this misleading?
Answer: In a merger, such cash would automatically transfer to the acquiring firm and the value of such cash is fully reflected in the actual purchase price received by shareholders at closing. Consequently, this special dividend simply represented an earlier payout to the MCI shareholders rather than a reduction in the purchase price.
Kraft Sweetens the Offer to Overcome Cadbury’s Resistance
Despite speculation that offers from U.S.-based candy company Hershey and the Italian confectioner Ferreiro would be forthcoming, Kraft’s bid on January 19, 2010, was accepted unanimously by Cadbury’s board of directors. Kraft, the world’s second (after Nestle) largest food manufacturer, raised its offer over its initial September 7, 2009, bid to $19.5 billion to win over the board of the world’s second largest candy and chocolate maker. Kraft also assumed responsibility for $9.5 billion of Cadbury’s debt.
Kraft’s initial bid evoked a raucous response from Cadbury’s chairman Roger Carr, who derided the offer that valued Cadbury at $16.7 billion as showing contempt for his firm’s well-known brand and dismissed the hostile bidder as a low-growth conglomerate. Immediately following the Kraft announcement, Cadbury’s share price rose by 45 percent (7 percentage points more than the 38 percent premium implicit in the Kraft offer). The share prices of other food manufacturers also rose due to speculation that they could become takeover targets.
The ensuing four-month struggle between the two firms was reminiscent of the highly publicized takeover of U.S. icon Anheuser-Busch in 2008 by Belgian brewer InBev. The Kraft-Cadbury transaction stimulated substantial opposition from senior government ministers and trade unions over the move by a huge U.S. firm to take over a British company deemed to be a national treasure. However, like InBev’s takeover of Anheuser-Busch, what started as a donnybrook ended on friendly terms, with the two sides reaching final agreement in a single weekend.
Determined to become a global food and candy giant, Kraft decided to bid for Cadbury after the U.K.-based firm spun off its Schweppes beverages business in the United States in 2008. The separation of Cadbury’s beverage and confectionery units resulted in Cadbury becoming the world’s largest pure confectionery firm following the spinoff. Confectionery companies tend to trade at a higher value, so adding the Cadbury’s chocolate and gum business could enhance Kraft’s attractiveness to competitors. However, this status was soon eclipsed by Mars’s acquisition of Wrigley in 2008.
A takeover of Cadbury would help Kraft, the biggest food conglomerate in North America, to compete with its larger rival, Nestle. Cadbury would strengthen Kraft’s market share in Britain and would open India, where Cadbury is among the most popular chocolate brands. It would also expand Kraft’s gum business and give it a global distribution network. Nestle lacks a gum business and is struggling with declining sales as recession-plagued consumers turned away from its bottled water and ice cream products. Cadbury and Kraft fared relatively well during the 2008–2009 global recession, with Cadbury’s confectionery business proving resilient despite price increases in the wake of increasing sugar prices. Kraft had benefited from rising sales of convenience foods because consumers ate more meals at home during the recession.
The differences in the composition of the initial and final Kraft bids reflected a series of crosscurrents. Irene Rosenfeld, the Kraft CEO, not only had to contend with vituperative comments from Cadbury’s board and senior management, but she also was soundly criticized by major shareholders who feared Kraft would pay too much for Cadbury. Specifically, the firm’s largest shareholder, Warren Buffett’s Berkshire Hathaway with a 9.4 percent stake, expressed concern that the amount of new stock that would have to be issued to acquire Cadbury would dilute the ownership position of existing Kraft shareholders. In an effort to placate dissident Kraft shareholders while acceding to Cadbury’s demand for an increase in the offer price, Ms. Rosenfeld increased the offer by 7 percent by increasing the cash portion of the purchase price.
The new bid consisted of $8.17 of cash and 0.1874 new Kraft shares, compared to Kraft’s original offer of $4.89 of cash and 0.2589 new Kraft shares for each Cadbury share outstanding. The change in the composition of the offer price meant that Kraft would issue 265 million new shares compared with its original plan to issue 370 million. The change in the terms of the deal meant that Kraft would no longer have to get shareholder approval for the new share issue, since it was able to avoid the NYSE requirement that firms issuing shares totaling more than 20 percent of the number of shares currently outstanding must receive shareholder approval to do so.
- Which firm is the acquirer and which is the target firm?
Answer: The acquirer is Kraft and the target is Cadbury
- Why did the Cadbury common share price close up 38% on the announcement date, 7% more than the premium built into the offer price?
Answer: The offer price for Cadbury shares announced on Monday September 7, 2009, exceeded the closing price for these share on September 4, 2009, the last day on which the shares had traded. The shares closed on September 9th, up 38%, 7 percent more than the announcement price because investors anticipated another bid from other food companies such as Nestle’s.
- Why did the price of other food manufacturers also increase following the announcement of the attempted takeover?
Answer: Investors anticipated further consolidation in the food manufacturing sector due to the need to realize economies of scale and scope that often is achieved through increased size.
- After four months of bitter and often public disagreement, Cadbury’s and Kraft’s management reached a final agreement in a weekend. What factors do you believe might have contributed to this rapid conclusion?
Answer: Frequently, the first reaction of parties to a negotiation to a proposal is not reflective of their true intentions. Much of the initial reaction represents “posturing” to move the other party more toward their true intentions. Moreover, with the passage of time, both parties to the negotiation are subject to substantial pressure from various stakeholder groups including shareholders and regulators to make a decision. Both parties generally no that time may work against them. For the acquirer, the prospect of being forced to increase the initial offer will elicit shareholder rebuke. Similarly, target firm boards and management are also subject to significant pressure from their largest shareholders who may be supportive of the deal.
- Kraft appeared to take action immediately following Cadbury’s spin-off of Schweppes making Cadbury a pure candy company. Why do you believe that Kraft chose not to buy Cadbury and later divest such noncore businesses as Schweppes?
Answer: Kraft would have had to pay a larger purchase price for the combined Cadbury and Schweppes businesses. It would also have required a longer and more involved due diligence. Finally, the price that they might have been able to receive for Schweppes might have been below its intrinsic value because bidders would have known that Kraft considered Schweppes a noncore asset and would have bid accordingly.
Inbev Acquires an American Icon
For many Americans, Budweiser is synonymous with American beer and American beer is synonymous with Anheuser-Busch (AB). Ownership of the American icon changed hands on July 14, 2008, when beer giant Anheuser Busch agreed to be acquired by Belgian brewer InBev for $52 billion in an all-cash deal. The combined firms would have annual revenue of about $36 billion and control about 25 percent of the global beer market and 40 percent of the U.S. market. The purchase is the most recent in a wave of consolidation in the global beer industry. The consolidation reflected an attempt to offset rising commodity costs by achieving greater scale and purchasing power. While likely to generate cost savings of about $1.5 billion annually by 2011, InBev stated publicly that the transaction is more about the two firms being complementary rather than overlapping.
The announcement marked a reversal from AB’s position the previous week when it said publicly that the InBev offer undervalued the firm and subsequently sued InBev for “misleading statements” it had allegedly made about the strength of its financing. To court public support, AB publicized its history as a major benefactor in its hometown area (St. Louis, Missouri). The firm also argued that its own long-term business plan would create more shareholder value than the proposed deal. AB also investigated the possibility of acquiring the half of Grupo Modelo, the Mexican brewer of Corona beer, which it did not already own to make the transaction too expensive for InBev.
While it publicly professed to want a friendly transaction, InBev wasted no time in turning up the heat. The firm launched a campaign to remove Anheuser’s board and replace it with its own slate of candidates, including a Busch family member. However, AB was under substantial pressure from major investors, including Warren Buffet, to agree to the deal since the firm’s stock had been lackluster during the preceding several years. In an effort to gain additional shareholder support, InBev raised its initial $65 bid to $70. To eliminate concerns over its ability to finance the deal, InBev agreed to fully document its credit sources rather than rely on the more traditional but less certain credit commitment letters. In an effort to placate AB’s board, management, and the myriad politicians who railed against the proposed transaction, InBev agreed to name the new firm Anheuser-Busch InBev and keep Budweiser as the new firm’s flagship brand and St. Louis as its North American headquarters. In addition, AB would be given two seats on the board, including August A. Busch IV, AB’s CEO and patriarch of the firm’s founding family. InBev also announced that AB’s 12 U.S. breweries would remain open.
- Why would rising commodity prices spark industry consolidation?
Answer: Higher prices for basic ingredients tended to erode brewer profit margins. By merging, brewers would be
able to negotiate larger bulk discounts from suppliers, because they would be able to able to purchase larger
quantities. Selling, administrative, and distribution costs tend be lower for suppliers able to sell larger quantities to
individual customers than smaller quantities to many different customers.
- Why would the annual cost savings not be realized until the end of the third year?
Answer: Cost savings would be more rapidly realized if InBev had plants and warehouses geographically close to
AB’s operations which could be consolidated. However, there are few InBev facilities in the U.S., and InBev
pledged as part of the deal to keep AB brewers open and to maintain the St. Louis headquarters facility. While bulk purchasing discounts offered significant savings potential, they can be realized only as existing supplier contracts expire and can be renegotiated. Consequently, savings would be realized gradually as supply contracts expire and through employee attrition.
- What is a friendly takeover? Speculate as to why it may have turned hostile?
Answer: A takeover is said to be friendly if the suitor’s bid is supported by the target’s board and management.
Friendly takeovers often are viewed by acquirers as desirable to minimize the loss of key employees as well as
customer and supplier attrition. When it became clear that AB’s board and management were going to resist
despite an attractive offer price premium, InBev moved quickly to threaten to change the composition of the board
while increasing shareholder pressure on the board by upping the purchase price. Concurrently, InBev took
actions to mute public concerns about the proposed takeover. The more aggressive approach was in sharp contrast
to Microsoft’s more patient approach in its effort to acquire Yahoo, earlier in 2008, which resulted in their failure
to complete the transaction.
- InBev launched a proxy contest to take control of the Anheuser-Busch Board and includes a Busch family member on its slate of candidates. The firm also raised its bid from $65 to $40 and agreed to fully document its loan commitments. Explain how each of these actions helped complete the transaction?
Answer: The Busch family was not unified in rejecting the InBev bid. By including a Busch family member on
their proposed slate of board candidates, InBev believed it could mute some of the hostility to the takeover and
potentially enlist additional Busch family support. Moreover, by raising the bid, InBev was making it increasingly difficult to convince shareholders that they should reject the certainty of the InBev offer in the hope that the AB business plan would result in significant future share price appreciation. Finally, by fully documenting their funding sources, InBev removed any doubt that they would be able to finance the transaction.
- InBev agreed to name the new company Anheuser-Busch InBev, keep Budwieser brand, maintain headquarters in
St. Lous, and not to close any of the firm’s 12 breweries in North America. How might these decisions impact
InBev’s ability to realize projected cost savings?
Answer: By essentially agreeing to maintain the status quo in order to assuage public opinion, InBev effectively
limited their ability to realize significant cost savings from facility consolidation.
Oracle Attempts to Takeover PeopleSoft
PeopleSoft, a maker of human resource and database software, announced on February 9, 2004 that an increased bid by Oracle, a maker of database software, of $26 per share made directly to the shareholders was inadequate. PeopleSoft’s board and management rejected the bid even though it represented a 33% increase over Oracle’s previous offer of $19.50 per share. The PeopleSoft board urged its shareholders to reject the bid in a mailing of its own to its shareholders. If successful, the takeover would be valued at $9.4 billion. After an initial jump to $23.72 a share, PeopleSoft shares had eased to $22.70 a share, well below Oracle’s sweetened offer.
The rejection prolonged a highly contentious and public eight-month takeover battle that has pitted the two firms against each other. PeopleSoft was quick to rebuke publicly Oracle’s original written offer made behind the scenes to PeopleSoft’s management that included a requirement that PeopleSoft respond immediately. At about the same time, Oracle filed its intentions with respect to PeopleSoft with the SEC when its ownership of PeopleSoft stock rose above 5%. Since then, Oracle proposed replacing five of PeopleSoft’s board members with its own nominees at the PeopleSoft annual meeting to be held on March 25, 2004, in addition to increasing the offer price. This meeting was held about two months earlier than its normally scheduled annual meetings. By moving up the schedule for the meeting, investors had less time to buy PeopleSoft shares in order to be able to vote at the meeting, where the two companies will present rival slates for the PeopleSoft board. Oracle seeks to gain a majority on the PeopleSoft board in order to lift the company’s unique “customer assurance” anti-takeover defense. PeopleSoft advised its shareholders to vote no on the slate of potential board members proposed by Oracle. PeopleSoft also announced that it would buyback another $200 million of its shares, following the $350 million buyback program completed last year.
Oracle has said that it will take $9.8 billion (including transaction fees) to complete the deal. The cost of acquiring PeopleSoft could escalate under PeopleSoft’s unusual customer assurance program in which its customers have been offered money-back guarantees if an acquirer reduces its support of PeopleSoft products. Oracle repeated its intention to continue support for PeopleSoft customers and products. The potential liability under the program increased to $1.55 billion. In addition, Oracle will have to pay PeopleSoft’s CEO Craig Conway a substantial multiple of his current annual salary if he loses his job after a takeover. This could cost Oracle an additional $25 to $30 million. Meanwhile, the Federal Trade Commission is reviewing the proposed acquisition of PeopleSoft by Oracle and has expressed concern that it will leave to reduced competition in the software industry.
- Explain why PeopleSoft’s management may have rejected Oracle’s improved offer of $26 per share and why this rejection might have been in the best interests of the PeopleSoft shareholders? What may have PeopleSoft’s management been expecting to happen (Hint: Consider the various post-offer antitakeover defenses that could be put in place)?
Answer: PeopleSoft’s initial rejection may have been intended to solicit additional bids in order to
boost the offer price for the firm’s shares. PeopleSoft’s defenses included moving up the regularly
scheduled shareholders’ meeting to give Oracle less time to buy its shares in the open market, it
cautioned its shareholders not to tender their shares, it proposed a buy back its own shares, and it
put in place a customer assurance program to raise the cost of a takeover. All of these things
were designed to discourage Oracle and to give other potential bidders an opportunity to enter
- Identify at least one takeover tactic being employed by Oracle in its attempt to acquire PeopleSoft. Explain how this takeover tactic(s) works.
Answer: Oracle employed a hostile tender offer to circumvent the PeopleSoft management and board. This involves making a bid directly to the shareholders and offering an attractive premium to encourage them to tender their shares. Other tactics employed by Oracle included a bear hug letter, a proxy contest, and open market share purchases.
- Identify at least one takeover defense or tactic that is in place or is being employed by PeopleSoft. Explain how this defense or tactic is intended to discourage Oracle in its takeover effort.
Answer: The PeopleSoft customer assurance program was designed to raise the cost of the acquisition. Other defenses employed included a golden parachute, share buy-back, and moving up the date of the shareholders’ meeting.
- After initially jumping, PeopleSoft’s share price dropped to about $22 per share, well below Oracle’s sweetened offer. When does this tell you about investors’ expectations about the deal. Why do you believe investors felt the way they did? Be specific.
Answer: Investors did not believe the regulatory agency would approve the transaction.
Alcoa Easily Overwhelms Reynolds’ Takeover Defenses
Alcoa reacted quickly to a three-way intercontinental combination of aluminum companies aimed at challenging its dominance of the Western World aluminum market by disclosing an unsolicited takeover bid for Reynolds Metals in early August 1999. The offer consisted of $4.3 billion, or $66.44 a share, plus the assumption of $1.5 billion in Reynolds’ outstanding debt. Reynolds, a perennial marginally profitable competitor in the aluminum industry, appeared to be particularly vulnerable, since other logical suitors or potential white knights such as Canada’s Alcan Aluminum, France’s Pechiney SA, and Switzerland’s Alusuisse Lonza Group AG were already involved in a three-way merger.
Alcoa’s letter from its chief executive indicated that it wanted to pursue a friendly deal but suggested that it may pursue a full-blown hostile bid if the two sides could not begin discussions within a week. Reynolds appeared to be highly vulnerable because of its poor financial performance amid falling aluminum prices worldwide and because of its weak takeover defenses. It appeared that a hostile bidder could initiate a mail-in solicitation for shareholder consent at any time. Moreover, major Reynolds’ shareholders began to pressure the board. Its largest single shareholder, Highfields Capital Management, a holder of more than four million shares, demanded that the Board create a special committee of independent directors with its own counsel and instruct Merrill Lynch to open an auction for Reynolds.
Despite pressure, the Reynolds’ board rejected Alcoa’s bid as inadequate. Alcoa’s response was to say that it would initiate an all cash tender offer for all of Reynolds’ stock and simultaneously solicit shareholder support through a proxy contest for replacing the Reynolds’ board and dismantling Reynolds’ takeover defenses. Notwithstanding the public posturing by both sides, Reynolds capitulated on August 19, slightly more than two weeks from receipt of the initial solicitation, and agreed to be acquired by Alcoa. The agreement contained a thirty-day window during which Reynolds could entertain other bids. However, if Reynolds should choose to go with another offer, it would have to pay Alcoa a $100 million break-up fee.
Under the agreement, which was approved by both boards, each share of Reynolds was exchanged for 1.06 shares of Alcoa stock. When announced, the transaction was worth $4.46 billion and valued each Reynolds share at $70.88, based on an Alcoa closing price of $66.875 on August 19, 1999. The $70.88 price per share of Reynolds suggested a puny 3.9 percent premium to Reynolds’ closing price of $68.25 as of the close of August 19. The combined annual revenues of the two companies totaled $20.5 billion and accounted for about 21.5 percent of the Western World market for aluminum. To receive antitrust approval, the combined companies were required divest selected operations.
- What was the dollar value of the purchase price Alcoa offered to pay for Reynolds?
Answer: The total dollar value of the transaction was $5.8 billion, consisting of $4.3 billion for the firm’s equity and $1.5 billion in assumed debt.
- Describe the various takeover tactics Alcoa employed in its successful takeover of Reynolds. Why were these
Answer: Alcoa employed a bear hug letter and threatened to implement simultaneously a proxy contest and tender offer. These tactics were employed to increase pressure on Reynolds’ board to accept the offer.
- Why do you believe Reynolds’ management rejected Alcoa’s initial bid as inadequate?
Answer: Reynolds’ was trying to gain time to solicit additional bids.
- In your judgment, why was Alcoa able to complete the transaction by offering such a small premium
over Reynolds’ share price at the time the takeover was proposed?
Answer: Other logical bidders for Reynolds were involved in a 3-way merger. Reynolds’
shareholders accepted the paltry premium, because they believed that they would be better off over
the long-term as part of Alcoa.
Pfizer Acquires Warner-Lambert in a Hostile Takeover
In 1996 Pfizer and Warner Lambert (Warner) agreed to co-market worldwide the cholesterol-lowering drug Lipitor, which had been developed by Warner. The combined marketing effort was extremely successful with combined 1999 sales reaching $3.5 billion, a 60% increase over 1998. Before entering into the marketing agreement, Pfizer had entered into a confidentiality agreement with Warner that contained a standstill clause that, among other things, prohibited Pfizer from making a merger proposal unless invited to do so by Warner or until a third party made such a proposal.
In late 1998, Pfizer became aware of numerous rumors of a possible merger between Warner and some unknown entity. William C. Steere, chair and CEO of Pfizer, sent a letter on October 15, 1999, to Lodeijk de Vink, chair and CEO of Warner, inquiring about the potential for Pfizer to broaden its current strategic relationship to include a merger. More than 2 weeks passed before Steere received a written response in which de Vink expressed concern that Steere’s letter violated the spirit of the standstill agreement by indicating interest in a merger. Speculation about an impending merger between Warner and American Home Products (AHP) came to a head on November 19, 1999, when an article appeared in the Wall Street Journal announcing an impending merger of equals between Warner and AHP valued at $58.3 billion.
The public announcement of the agreement to merge between Warner and AHP released Pfizer from the standstill agreement. Tinged with frustration and impatience at what Pfizer saw as stalling tactics, Steere outlined in the letter the primary reasons why the proposed combination of the two companies made sense to Warner’s shareholders. In addition to a substantial premium over Warner’s current share price, Pfizer argued that combining the companies would result in a veritable global powerhouse in the pharmaceutical industry. Furthermore, the firm’s product lines are highly complementary, including Warner’s over-the-counter drug presence and substantial pipeline of new drugs and Pfizer’s powerful global marketing and sales infrastructure. Steere also argued that the combined companies could generate annual cost savings of at least $1.2 billion annually within 1 year following the completion of the merger. These savings would come from centralizing computer systems and research and development (R&D) activities, consolidating more than 100 manufacturing facilities, and combining two headquarters and multiple sales and administrative offices in 30 countries. Pfizer also believed that the two companies’ cultures were highly complementary.
In addition to the letter from Steere to de Vink, on November 4, 1999, Pfizer announced that it had commenced a legal action in the Delaware Court of Chancery against Warner, Warner’s directors, and AHP. The action sought to enjoin the approximately $2 billion termination fee and the stock option granted by Warner-Lambert to AHP to acquire 14.9% of Warner’s common stock valued at $83.81 per share as part of their merger agreement. The lawsuit charged that the termination fee and stock options were excessively onerous and were not in the best interests of the Warner shareholders because they would discourage potential takeover attempts.
On November 5, 1999, Warner explicitly rejected Pfizer’s proposal in a press release and reaffirmed its commitment to its announced business combination with AHP. On November 9, 1999, de Vink sent a letter to the Pfizer board in which he expressed Warner’s disappointment at what he perceived to be Pfizer’s efforts to take over Warner as well as Pfizer’s lawsuit against the firm. In the letter, he stated Warner-Lambert’s belief that the litigation was not in the best interest of either company’s stockholders, especially in light of their co-promotion of Lipitor, and it was causing uncertainty in the financial markets. Not only did Warner reject the Pfizer bid, but it also threatened to cancel the companies’ partnership to market Lipitor.
Pfizer responded by exploiting a weakness in the Warner Lambert takeover defenses by utilizing a consent solicitation process that allows shareholders to change the board without waiting months for a shareholders’ meeting. Pfizer also challenged in court two provisions in the contract with AHP on the grounds that they were not in the best interests of the Warner Lambert shareholders because they would discourage other bidders. Pfizer’s offers for Warner Lambert were contingent on the removal of these provisions. On November 12, 1999, Steere sent a letter to de Vink and the Warner board indicating his deep disappointment as a result of their refusal to consider what Pfizer believes is a superior offer to Warner. He also reiterated his firm’s resolve in completing a merger with Warner. Not hearing anything from Warner management, Pfizer decided to go straight to the Warner shareholders on November 15, 1999, in an attempt to change the composition of the board and to get the board to remove the poison pill and break-up fee.
In the mid-November proxy statement sent to Warner shareholders, Pfizer argued that the current Warner Lambert board has approved a merger agreement with American Home, which provides 30% less current value to the Warner-Lambert stockholders than the Pfizer merger proposal. Moreover, Warner shareholders would benefit more in the long run in a merger with Pfizer, because the resulting firm would be operationally and financially stronger than a merger created with AHP. Pfizer also argued that its international marketing strength is superior in the view of most industry analysts to that of American Home and will greatly enhance Warner-Lambert’s foreign sales efforts. Pfizer stated that Warner Lambert was not acting in the best interests of its shareholders by refusing to even grant Pfizer permission to make a proposal. Pfizer also alleged that Warner Lambert is violating its fiduciary responsibilities by approving the merger agreement with American Home in which AHP is entitled to a termination fee of approximately $2 billion.
Pressure intensified from all quarters including such major shareholders as the California Public Employees Retirement System and the New York City Retirement Fund. After 3 stormy months, Warner Lambert agreed on February 8, 2000, to be acquired by Pfizer for $92.5 billion, forming the world’s second largest pharmaceutical firm. Although they were able to have the Warner poison pill overturned in court as being an unreasonable defense, Pfizer was unsuccessful in eliminating the break-up fee and had to pay AHP the largest such fee in history. The announced acquisition of Warner Lambert by Pfizer ended one of the most contentious corporate takeover battles in recent memory.
- What takeover defenses did Warner employ to ward off the Pfizer merger proposal? What tactics
did Pfizer employ to overcome these defenses? Comment on the effectiveness of these defenses.
- What takeover defenses did Warner employ to ward off the Pfizer merger proposal? Warner invoked the protection of a standstill agreement Pfizer had signed in order to obtain the exclusive right to promote Lipitor in certain foreign markets and in partnership with Warner in the U.S. The standstill agreement prohibited Pfizer from making a merger proposal unless invited to do so by Warner or until a third party made such a proposal. Warner also employed stalling tactics by being slow to respond to Pfizer’s letter indicating its interest in a possible merger. This additional time enabled Warner to consummate negotiations with its preferred merger partner, AHP (i.e., a white knight). Warner and AHP’s agreement included a number of tactics designed to discourage a third party from making a bid for Warner. These included a huge $2 billion breakup fee payable to AHP by Warner and an option or poison pill given to AHP to buy a block of Warner stock that would have prevented the Pfizer/Warner combination from qualifying for a pooling of interests.
- What tactics did Pfizer employ to overcome these defenses? Following the public announcement of a merger agreement with AHP, Pfizer argued that they had been released from the agreement. Pfizer also attempted to encourage Warner shareholders to reject the proposed merger with AHP by offering a substantial premium for their stock over what they were being offered by AHP. The acceptance of the Pfizer proposal was made conditional on the removal of the breakup fee and the option granted to AHP. Pfizer also initiated legal action against Warner, Warner’s directors, and AHP to eliminate the fee and the stock option arguing that they were excessive. Pfizer also argued that Warner’s board had breached their fiduciary responsibility by entering into such an agreement. Warner also argued that Warner shareholders would benefit more in the long-term by holding Pfizer stock because of the better strategic fit between Pfizer and Warner. Finally, Pfizer utilized a consent solicitation process that allowed Warner shareholders to change the board without waiting months for a shareholders’ meeting. The net effect of all of these actions was to cause Warner’s board to relent to the increasing pressure to accept the Pfizer offer from Warner shareholders.
- What other defenses do you think Warner could or should have employed? Comment on the effectiveness of each alternative defense you suggest Warner could have employed?
Answer: Warner could have employed additional postbid defenses in an effort to raise Pfizer’s offer price. Such defenses could have included a share buyback plan or litigation. The buyback plan could have effectively raised the total cost of the acquisition to Pfizer and removed those outstanding shares from the hands of those most likely to have sold to Pfizer. However, such a move would have required substantial additional borrowing and could have reduced the attractiveness of Warner to AHP. Warner could have counter-sued Pfizer arguing that the break-up fee and poison pill given to AHP were reasonable in view of the actual and potential costs that would be incurred by AHP if it were not able to merge with Warner. However, the size of the fee and the poison pill made it appear that they were primarily intended to discourage third parties from making a bid rather than for compensating AHP for its real or potential expenses.
- What factors may have contributed to Warner Lambert’s rejection of the Pfizer proposal?
Answer: It is unclear what the true motives were behind Warner’s rejection of the Pfizer bid. The shareholders interests’ hypothesis would argue that Warner’s board was simply holding out for a more attractive bid from Pfizer. The management entrenchment theory would suggest that Warner’s management and board found the AHP proposal more attractive because of an understanding that they may be retained following the merger. The unusual size of the breakup fee and poison pill and the apparent superior strategic fit between Warner and Pfizer suggest that indeed Warner management and board members may have been trying to entrench themselves in their efforts to ward off the Pfizer bid.
- What factors may make it difficult for this merger to meet or exceed industry average returns? What are the implications for the long-term financial performance of the new firm of only using Pfizer stock to purchase Warner Lambert shares?
Answer: The huge premium paid for Warner means that Pfizer had to issue a substantial number of new shares to acquire 100% of Warner Lambert’s outstanding stock. If the perceived synergies are not realized within a reasonable period of time, it is likely that the resultant decrease in the combined firm’s EPS will cause Pfizer’s share price to under-perform the overall stock market.
- What is a standstill agreement and why might it have been included as a condition for the Pfizer-Warner Lambert Lipitor distribution arrangement? How did the standstill agreement affect Pfizer’s effort to merge with Warner Lambert? Why would Warner Lambert want a standstill agreement?
Answer: A standstill agreement entered into by a potential target firm is designed to prevent a signatory from attempting to takeover the firm. Warner included this in the distribution agreement, because it realized that it had sufficient leverage at that time to induce Pfizer to enter into such an agreement. The agreement in effect gave Warner time to negotiate the sale of the firm to what the board thought was a better partner than Pfizer.
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.
- 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?
Answer: Compaq’s PC business had been losing market share for some time. Compaq shareholders believed that the long-term appreciation of HP stock would exceed that of Compaq’s shares.
- 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: Yes. HP’s board and management are the agents of the shareholders and in theory they are doing what is in the best interests of the shareholders. Therefore, they should be able to use company funds to publicize their position to the shareholders as their representatives.
TYCO Rescues AMP from Allied Signal
In late November 1998, Tyco International Ltd., a diversified manufacturing and service company, agreed to acquire AMP Inc., an electrical components supplier, for $11.3 billion. In doing so, AMP successfully fended off a protracted takeover attempt by AlliedSignal Inc. As part of the merger agreement with Tyco, AMP rescinded its $165 million share buyback offer and its plan to issue an additional 25 million shares to fund its defense efforts. Tyco, the world’s largest electronics connector company, saw the combination with AMP as a means of becoming the lowest cost producer in the industry.
Lawrence Bossidy, CEO of AlliedSignal, telephoned an AMP director in mid-1998 to inquire about AMP’s interest in a possible combination of their two companies. The inquiry was referred to the finance committee of the AMP board, which expressed no interest in merging with AlliedSignal. By early August, AlliedSignal announced its intention to initiate an unsolicited tender offer to acquire all of the outstanding shares of AMP common stock for $44.50 per share to be paid in cash. The following week AlliedSignal initiated such an offer and sent a letter to William J. Hudson, then CEO of AMP, requesting a meeting to discuss a possible business combination. Bossidy also advised AMP of AlliedSignal’s intention to file materials shortly with the SEC as required by federal law to solicit consents from AMP’s shareholders. The consent solicitation materials included proposals to increase the size of AMP’s board from 11 to 28 members and to add 17 AlliedSignal nominees, all of whom were directors or executive officers of AlliedSignal. Within a few days, the AMP board announced its intentions to continue to aggressively pursue its current strategic initiatives, because the AlliedSignal offer did not fully reflect the values inherent in AMP businesses. In addition, the AMP board also replaced Hudson with Robert Ripp as chair and CEO of AMP.
The AMP board also authorized an amendment to the AMP rights agreement dated October 25, 1989. The amendment provided that the rights could not be redeemed if there were a change in the composition of the AMP board following the announcement of an unsolicited acquisition proposal such that the current directors no longer comprised a majority of the board. A transaction not approved by AMP’s board and involving the acquisition by a person or entity of 20% or more of AMP’s common stock was defined as an unsolicited acquisition proposal.
By early September, AlliedSignal amended its tender offer to reduce the number of shares of AMP common stock it was seeking to purchase to 40 million shares. AlliedSignal also stated that it would undertake another offer to acquire the remaining shares of AMP common stock at a price of $44.50 in cash following consummation of its offer to purchase up to 40 million shares. In concert with its tender offer, AlliedSignal also announced its intention to solicit consents for a proposal to amend AMP’s bylaws. The proposed amendment would strip the AMP board of all authority over the AMP rights agreement and any similar agreements and to vest such authority in three individuals selected by AlliedSignal. In response, the AMP board unanimously determined that the amended offer from AlliedSignal was not in the best interests of AMP shareholders. The AMP board also approved another amendment to the AMP rights agreement, lowering the threshold that would make the rights redeemable from 20% to 10% of AMP’s shares outstanding. AlliedSignal immediately modified its tender offer by reducing the number of shares it wanted to purchase from 40 million to 20 million shares at $44.50 per share.
AMP announced a self-tender offer to purchase up to 30 million shares of AMP common stock at $55 per share. The AMP self-tender offer was intended to provide AMP shareholders with an opportunity to sell a portion of their shares of common stock at a price in excess of AlliedSignal’s $44.50 per share offer. Also, on September 28, 1998, AMP stated its intention to create a new ESOP that would hold 25 million shares of AMP common stock. Allied Signal indicated that if the self-tender were consummated, it would reduce the consideration to be paid in any further Allied Signal offers to $42.62 per share
Credit Suisse, AMP’s investment banker, approached a number of firms, including Tyco, concerning their possible interest in acquiring AMP. In early November, Tyco stepped forward as a possible white knight. Based on limited information, L. Dennis Kozlowski, Tyco’s CEO, set the preliminary valuation of AMP at $50.00 per share. This value assumed a transaction in which AMP shares would be exchanged for Tyco shares and was subject to the completion of appropriate due diligence.
In mid-November, Ripp and Bossidy met at Bossidy’s request. Bossidy indicated that AlliedSignal would be prepared to increase its proposed acquisition price for AMP by a modest amount and to include stock for a limited portion of the total purchase price. The revised offer also would include a minimum share exchange ratio for the equity portion of the purchase price along with an opportunity for AMP shareholders to participate in any increase in AlliedSignal’s stock before the closing. The purpose of including equity as a portion of the purchase price was to address the needs of certain AMP shareholders, who had a low tax basis in the stock and who wanted a tax-free exchange. Ripp indicated that the AMP board expected a valuation of more than $50.00 per share.
Tyco indicated a willingness to increase its offer to at least $51.00 worth of Tyco common shares for each share of AMP common stock. The offer also would include protections similar to those offered in AlliedSignal’s most recent proposal. On November 20, 1998, the AMP board voted unanimously to approve the merger agreement and to recommend approval of the merger to AMP’s shareholders. They also voted to terminate the AMP self-tender offer, the ESOP, and AMP’s share repurchase plan and to amend the AMP rights agreement so that it would not apply to the merger with Tyco.
In early August, AlliedSignal filed a complaint against AMP in the United States District Court against the provisions of the AMP rights agreement. The complaint also questioned the constitutionality of certain anti-takeover provisions of Pennsylvania state statutes. Concurrently, AMP shareholders filed four shareholder class-action lawsuits against AMP and its board of directors. The suits alleged that AMP and its directors improperly refused to consider the original AlliedSignal offer and wrongfully relied on the provisions of the AMP rights agreement and Pennsylvania law to block the original AlliedSignal offer.
In late August, AMP filed a complaint in the United States District court against AlliedSignal, seeking an injunction to prevent AlliedSignal from attempting to pack the AMP board of directors with AlliedSignal executive officers and directors. The complaint also alleged that the Schedule 14D-1 SEC filing by Allied-Signal was false and misleading. The complaint alleged that the filing failed to disclose that some of AlliedSignal’s proposed directors had conflicts of interest and that the packing of the board would prevent current board members from executing their fiduciary responsibilities to AMP shareholders.
In early October, the court agreed with AMP and enjoined AlliedSignal’s board-packing consent proposals until it stated unequivocally that its director nominees have a fiduciary duty solely to AMP under Pennsylvania law. The court also denied AlliedSignal’s request to deactivate anti-takeover provisions in the AMP rights agreement. The court further held that shareholders might not sue the board for rejecting the AlliedSignal proposal.
AlliedSignal immediately filed in the United States Court of Appeals for the Third Circuit. The court ordered that although AlliedSignal could proceed with the consent solicitation, its representatives could not assume positions on the AMP board until the court of appeals completed its deliberations. The district court ruled that the shares of AMP common stock acquired by AlliedSignal are “control shares” under Pennsylvania law. As a result, the court enjoined AlliedSignal from voting its AMP shares unless AlliedSignal’s voting rights are restored under Pennsylvania law. AlliedSignal was able to overturn the lower court ruling on appeal.
- What types of takeover tactics did AlliedSignal employ?
AlliedSignal reinforced its bear hug of AMP with its public announcement of its intent to initiate a tender offer for all of AMP. The move was designed to put pressure on the AMP Board and management. Following AMP’s rebuff, AlliedSignal initiated a “creeping” tender offer for a portion of AMP’s outstanding shares. AlliedSignal also employed a consent solicitation to gain effective control of the AMP Board through “packing” the Board with sympathetic representatives and to neutralize the AMP Rights Agreement (poison pill) without having to call a special AMP shareholders’ meeting. AlliedSignal also used litigation to attempt to thwart AMP’s efforts to prevent AlliedSignal from voting its shares.
- What steps did AlliedSignal take to satisfy federal securities laws?
As required by federal securities laws, AlliedSignal informed the AMP Board of its intentions to acquire AMP through a hostile tender offer and to file the appropriate schedules with the SEC. AlliedSignal proceeded to file the necessary disclosure documents and consent solicitation materials to be used to obtain consents from AMP shareholders with respect to a series of proposals with the SEC.
- What anti-takeover defenses were in place at AMP prior to AlliedSignal’s offer?
The AMP Rights Agreement, a poison pill, was its primary defense in place before the bid.
- How did the AMP Board use the AMP Rights Agreement to encourage AMP shareholders to vote against
If the AMP Board lost majority control following the purchase of more than 20 percent of AMP’s stock by a single individual or entity, the rights could not be redeemed.
- What options did AlliedSignal have to neutralize or circumvent AMP’s use of the Rights Agreement?
AlliedSignal choose to reduce the number of shares it would purchase through its partial tender offer to ensure that it stayed below the 20 percent ownership threshold, which if exceeded would trigger AMP’s poison pill. However, AlliedSignal could have increased its offer price to put more pressure on the AMP Board to accept its unsolicited bid.
- Why did AlliedSignal, after announcing it had purchased 20 million AMP shares at $44.50, indicate that it would reduce the price paid in any further offers it might make?
AlliedSignal was trying to frighten AMP shareholders into tendering their shares at $44.50. This may have been a prelude to a tender offer for more shares at a later date.
- What other takeover defenses did AMP employ in its attempt to thwart AlliedSignal?
Initially, AMP employed the “just say no” defense to buy time to add more defenses. The Board cleverly used the AMP Rights Plan to discourage AlliedSignal from immediately moving ahead with its proposed $10 billion tender offer for all of AMP’s shares. The Board initiated a stock buy-back plan for 30 million shares at $55.00. This was intended to reduce the number of shares available for purchase by AlliedSignal and to communicate to the market what AMP thought its shares were worth. The presumption is that shareholders most likely to sell in a buy-back are the least loyal to the company and are most likely to sell in a tender offer. In addition, AMP set up an ESOP enabling it to place some number of AMP shares in “friendly” hands. Finally, AMP used litigation to attempt to block AlliedSignal from voting its shares. Note that as part of the merger agreement with Tyco, these defenses were deactivated. The self-tender and ESOP were terminated and the Rights Plan amended so that it would not apply to the merger with Tyco.
- How did both AMP and AlliedSignal use litigation in this takeover battle?
AMP used Pennsylvania anti-takeover statutes to try to block Allied Signal’s ability to vote its shares and to prevent AlliedSignal from taking control of the AMP Board through its consent solicitation. Both sides used lawsuits to increase the cost of the acquisition and to wear down their opponents.
- Should state laws be used to protect companies from hostile takeovers?
The empirical evidence suggests that target shareholders benefit greatly from a hostile takeover, while the acquirer’s shareholders’ may experience modest negative abnormal returns. Some critics of M&A’s argue that the gains to the target shareholders are more than offset by the damage to other constituent groups including employees, communities, customers, and suppliers.
- Was AMP’s Board and management acting to protect their own positions (i.e., the Management Entrenchment Hypothesis) or in the best interests of the shareholders (i.e., the Shareholder Interests Hypothesis)?
As a result of their resistance, AMP’s Board was able to secure for its shareholders an additional 15 percent
premium to the original AlliedSignal offer.
Chapter 11: Structuring the Deal:
Payment and Legal Considerations
Answers to End of Chapter Discussion Questions
Examination Questions and Answers
True/False Questions: Answer True or False to the following questions:
- Deal structuring is fundamentally about satisfying as many of the primary objectives of the parties involved and deciding how risk will be shared. True or False
- The acquisition vehicle is the legal structure used to acquire the target. True or False
- Such legal structures as holding company, joint venture, and limited liability corporations are suitable only for acquisition vehicles but not post closing organizations. True or False
- Employee stock ownership plans cannot be legally used to acquire companies. True or False
- Form of payment refers only to the acquirer’s common stock used to make up the purchase price paid to target shareholders. True or False
- The appropriate deal structure is that which satisfies, without regard to risk, as many of the primary objectives of the parties involved as necessary to reach overall agreement. True or False
- Form of payment may consist of something other than cash, stock, or debt such as tangible and intangible assets.
True or False
- If the form of acquisition is a statutory merger, the seller retains all known, unknown or contingent liabilities.
True or False
- The form of payment does not affect whether a transaction is taxable to the seller’s shareholders. True or False
- The assumption of seller liabilities by the buyer in a merger may induce the seller to demand a higher selling price. True or False
- The acquirer may reduce the total cost of an acquisition by deferring some portion of the purchase price. True or False
- A holding company structure is the preferred post-closing organization if the acquiring firm is interested in integrating the target firm immediately following acquisition. True or False
- The acquired company should be fully integrated into the acquiring company if an earn-out is used to consummate the transaction. True or False
- When buyers and sellers cannot reach agreement on price, other mechanisms can be used to close the gap. These include balance sheet adjustments, earn-outs, rights to intellectual property, and licensing fees. True or False
- In a balance sheet adjustment, the buyer increases the total purchase price by an amount equal to the decrease in net working capital or shareholders’ equity of the target company. True or False
- Because they can be potentially so lucrative to sellers, earn-outs are sometimes used to close the gap between what the seller wants and what the buyer might be willing to pay. True or False
- Earn-outs tend to shift risk from the seller to the buyer in that a higher price is paid only when the seller has met or exceeded certain performance criteria. True or False
- Rights to intellectual property, royalties from licenses and employment agreements are often used to close the gap on price between what the seller wants and what the buyer is willing to pay because the income generated is tax free to the recipient. True or False
- Asset purchases require the acquiring company to buy all or a portion of the target company’s assets and to assume at least some of the target’s liabilities in exchange for cash or stock. True or False
- Stock purchases involve the exchange of the target’s stock for cash, debt, stock of the acquiring company, or some combination. True or False
- Sellers may find a sale of assets attractive because they are able to maintain their corporate existence and therefore ownership of tangible assets not acquired by the buyer and intangible assets such as licenses, franchises, and patents. True or False
- In a statutory merger, only assets and liabilities shown on the target firm’s balance sheet automatically transfer to the acquiring firm. True or False
- Statutory mergers are governed by the statutory provisions of the state in which the surviving entity is chartered. True or False
- Staged transactions may be used to structure an earn-out, to enable the target to complete the development of a technology or process, to await regulatory approval, to eliminate the need to obtain shareholder approval, and to minimize cultural conflicts with the target. True or False
- Decisions made in one area of a deal structure rarely affect other areas of the overall deal structure.
True or False
- The acquisition vehicle refers to the legal structure created to acquire the target company. True or False
- A post-closing organization must always be a C corporation. True or False
- A holding company is an example of either an acquisition vehicle or post-closing organization. True or False
- The forward triangular merger involves the acquisition subsidiary being merged with the target and the target surviving. True or False
- The reverse triangular merger involves the acquisition subsidiary being merged with the target and subsidiary surviving. True or False
- By acquiring the target firm through the JV, the corporate investor limits the potential liability to the extent of their investment in the JV corporation. True or False
- ESOP structures are rarely used vehicles for transferring the owner’s interest in the business to the employees in small, privately owned firms. True or False
- Non-U.S. buyers intending to make additional acquisitions may prefer a holding company structure.
True or False
- If the acquirer is interested in integrating the target business immediately following closing, the holding structure may be most desirable. True or False
- Decision-making in JVs and partnerships is likely to be faster than in a corporate structure. Consequently, JVs and partnerships are more commonly used if speed is desired during the post-closing integration. True or False
- A corporate structure is the preferred post-closing organization when an earn-out is involved in acquiring the target firm. True or False
- In an earnout agreement, the acquirer must directly control the operations of the target firm to ensure the target firm adheres to the terms of the agreement. True or False.
- When the target is a foreign firm, it is often appropriate to operate it separately from the rest of the acquirer’s operations because of the potential disruption from significant cultural differences. True or False
- A financial buyer may use a holding company structure because they expect to sell the firm within a relatively short time period. True or False
- A partnership or JV structure may be appropriate acquisition vehicle if the risk associated with the target firm is
believed to be high. True or False
- Sellers who are structured as C corporations generally prefer to sell assets for cash than acquirer stock because of more favorable tax treatment. True or False
- Whether cash is the predominant form of payment will depend on a variety of factors. These include the acquirer’s current leverage, potential near-term earnings per share dilution of issuing new shares, the seller’s preference for cash or acquirer stock, and the extent to which the acquirer wishes to maintain control over the combined firms. True or False
- Acquirer stock is a rarely used form of payment in large transactions. True or False
- The seller’s preference for stock or cash will reflect their desire for liquidity, the attractiveness of the acquirer’s shares, and whether the seller is organized as a joint venture corporation. True or False
- A bidder may choose to use cash rather than to issue voting shares if the voting control of its dominant shareholder is threatened as a result of the issuance of voting stock to acquire the target firm. True or False
- Using stock as a form of payment is generally less complicated than using cash from the buyer’s point of view. True or False
- The use of convertible preferred stock as a form of payment provides some downside protection to sellers in the form of continuing dividends, while providing upside potential if the acquirer’s common stock price increases above the conversion point. True or False
- Bidders may use a combination of cash and non-cash forms of payment as part of their bidding strategies to broaden the appeal to target shareholders. True or False
- The risk to the bidder associated with bidding strategy of offering target firm shareholders multiple payment options is that the range of options is likely to discourage target firm shareholders from participating in the bidder’s tender offer for their shares. True or False.
- The multiple option bidding strategy introduces a certain level of uncertainty in determining the amount of cash the acquirer will have to ultimately pay out to target firm shareholders, since the number choosing the all cash or cash and stock option is not known prior to the completion of the tender offer. True or False
- Balance sheet adjustments most often are used in purchases of stock when the elapsed time between the agreement on price and the actual closing date is short. True or False
- Buyers and sellers generally view purchase price adjustments as a form of insurance against any erosion or accretion in assets, such as plant and equipment. True or False.
- An earnout agreement is a financial contract whereby a portion of the purchase price of a company is to be paid to the buyer in the future contingent on the realization of a previously agreed upon future earnings level or some other performance measure. True or False
- The value of an earnout payment is never subject to a cap so as not to discourage the seller from working diligently to exceed the payment threshold. True or False
- Earnouts tend to shift risk from the seller to the acquirer in that a higher price is paid only when the seller or acquired firm has met or exceeded certain performance criteria. True of False
- Offering sellers consulting contracts to defer a portion of the purchase price is illegal in most states. True or False
- Collar agreements provide for certain changes in the exchange ratio contingent on the level of the acquirer’s share price around the effective date of the merger. True or False
- A fixed exchange collar agreement may involve a fixed exchange ratio as long as the acquirer’s share price remains within a narrow range, calculated as of the effective date of the signing of the agreement of purchase and sale. True or False
- Both the acquirer and target boards of directors have a fiduciary responsibility to demand that the merger terms be renegotiated if the value of the offer made by the bidder changes materially relative to the value of the target’s stock or if their has been any other material change in the target’s operations. True or False
- Stock purchases involve the exchange of the target’s stock for acquirer stock only. True or False.
- If an acquirer buys most of the operating assets of a target firm, the target generally is forced to
liquidate its remaining assets and pay the after-tax proceeds to its shareholders. True or False
Multiple Choice (Circle only one)
- Which of the following should be considered important components of the deal structuring process?
- Legal structure of the acquiring and selling entities
- Post closing organization
- Tax status of the transaction
- What is being purchased, i.e., stock or assets
- All of the above
- Which of the following may be used as acquisition vehicles?
- Limited liability corporation
- Corporate shell
- All of the above
- In a statutory merger,
- Only known assets and liabilities are automatically transferred to the buyer.
- Only known and unknown assets are transferred to the buyer.
- All known and unknown assets and liabilities are automatically transferred to the buyer except for those the seller agrees to retain.
- The total consideration received by the target’s shareholders is automatically taxable.
- None of the above.
- Which of the following is not a characteristic of a joint venture corporation?
- Profits and losses can be divided between the partners disproportionately to their ownership shares.
- New investors can become part of the JV corporation without having to dissolve the original JV corporate structure.
- The JV corporation can be used to acquire other firms.
- Investors’ liability is limited to the extent of their investment.
- The JV corporation may be subject to double taxation.
- Which of the following are commonly used to close the gap between what the seller wants and what the buyer is willing to pay?
- Consulting contracts offered to the seller
- Employment contracts offered to the seller
- Giving seller rights to license a valuable technology or process
- All of the above.
- Which of the following is a disadvantage of balance sheet adjustments?
- Protects buyer from eroding values of receivable before closing
- Audit expense
- Protects seller from increasing values of receivables before closing
- Protects from decreasing values of inventories before closing
- Protects seller from increasing values of inventories before closing
- Which of the following are disadvantages of an asset purchase?
- Asset write-up
- May require consents to assignment of contracts
- Potential for double-taxation of buyer
- May be subject to sales, use, and transfer taxes
- B and D
- Which of the following is not true of mergers?
- Liabilities and assets transfer automatically
- May be subject to transfer taxes.
- No minority shareholders remain.
- May be time consuming due to need for shareholder approvals.
- May have to pay dissenting shareholders appraised value of stock
- Which of the following is true of collar arrangements?
- A fixed or constant share exchange ratio is one in which the number of acquirer shares exchanged for each target share is unchanged between the signing of the agreement of purchase and sale and closing.
- Collar agreements provide for certain changes in the exchange ratio contingent on the level of the acquirer’s share price around the effective date of the merger.
- A fixed exchange collar agreement may involve a fixed exchange ratio as long as the acquirer’s share price remains within a narrow range, calculated as of the effective date of merger.
- A fixed payment collar agreement guarantees that the target firm shareholder receives a certain dollar value in terms of acquirer stock as long as the acquirer’s stock remains within a narrow range, and a fixed exchange ratio if the acquirer’s average stock price is outside the bounds around the effective date of the merger.
- All of the above.
- Which of the represent disadvantages of a cash purchase of target stock?
- Buyer responsible for known and unknown liabilities.
- Buyer may avoid need to obtain consents to assignments on contracts.
- NOLs and tax credits pass to the buyer.
- No state sales transfer, or use taxes have to be paid.
- Enables circumvention of target’s board in the event a hostile takeover is initiated.
- The form of acquisition refers to which of the following:
- Tax status of the transaction
- Acquisition vehicle
- What is being acquired, i.e., stock or assets
- Form of payment
- How the transaction will be displayed for financial reporting purposes
- The tax status of the transaction may influence the purchase price by
- Raising the price demanded by the seller to offset potential tax liabilities
- Reducing the price demanded by the seller to offset potential tax liabilities
- Causing the buyer to lower the purchase price if the transaction is taxable to the target firm’s shareholders
- Forcing the seller to agree to defer a portion of the purchase price
- Forcing the buyer to agree to defer a portion of the purchase price
- The seller’s insistence that the buyer agree to purchase its stock may encourage the buyer to
- offer a lower purchase price because it is assuming all of the target firm’s liabilities
- offer a higher purchase price because it is assuming all of the target firm’s liabilities
- offer a lower purchase price because it is receiving all of the target’s tax benefits
- use its stock rather than cash to purchase the target firm
- use cash rather than its stock to purchase the target firm
- A holding company may be used as a post-closing organizational structure for all but which of the following reasons?
- A portion of the purchase price for the target firm included an earn-out
- The target firm has a substantial amount of unknown liabilities
- The acquired firm’s culture is very different from that of the acquiring firm
- Profits from operations are not taxable
- The transaction involves a cross border transaction
- Form of payment can involve which of the following:
- Cash and stock
- Rights, royalties and fees
- All of the above
- A “floating or flexible share exchange ratio is used primarily to
- Protect the value of the transaction for the acquirer’s shareholders
- Protect the value of the transaction for the target’s shareholders
- Minimize the number of new acquirer shares that must be issued
- Increase the value for the acquiring firm
- Increase the value for the target firm
Case Study Short Essay Examination Questions
Boston Scientific Overcomes Johnson & Johnson to Acquire Guidant—A Lesson in Bidding Strategy
Johnson & Johnson, the behemoth American pharmaceutical company, announced an agreement in December 2004 to acquire Guidant for $76 per share for a combination of cash and stock. Guidant is a leading manufacturer of implantable heart defibrillators and other products used in angioplasty procedures. The defibrillator market has been growing at 20 percent annually, and J&J desired to reenergize its slowing growth rate by diversifying into this rapidly growing market. Soon after the agreement was signed, Guidant’s defibrillators became embroiled in a regulatory scandal over failure to inform doctors about rare malfunctions. Guidant suffered a serious erosion of market share when it recalled five models of its defibrillators.
The subsequent erosion in the market value of Guidant prompted J&J to renegotiate the deal under a material adverse change clause common in most M&A agreements. J&J was able to get Guidant to accept a lower price of $63 a share in mid-November. However, this new agreement was not without risk.
The renegotiated agreement gave Boston Scientific an opportunity to intervene with a more attractive informal offer on December 5, 2005, of $72 per share. The offer price consisted of 50 percent stock and 50 percent cash. Boston Scientific, a leading supplier of heart stents, saw the proposed acquisition as a vital step in the company’s strategy of diversifying into the high-growth implantable defibrillator market.
Despite the more favorable offer, Guidant’s board decided to reject Boston Scientific’s offer in favor of an upwardly revised offer of $71 per share made by J&J on January 11, 2005. The board continued to support J&J’s lower bid, despite the furor it caused among big Guidant shareholders. With a market capitalization nine times the size of Boston Scientific, the Guidant board continued to be enamored with J&J’s size and industry position relative to Boston Scientific.
Boston Scientific realized that it would be able to acquire Guidant only if it made an offer that Guidant could not refuse without risking major shareholder lawsuits. Boston Scientific reasoned that if J&J hoped to match an improved bid, it would have to be at least $77, slightly higher than the $76 J&J had initially offered Guidant in December 2004. With its greater borrowing capacity, Boston Scientific knew that J&J also had the option of converting its combination stock and cash bid to an all-cash offer. Such an offer could be made a few dollars lower than Boston Scientific’s bid, since Guidant investors might view such an offer more favorably than one consisting of both stock and cash, whose value could fluctuate between the signing of the agreement and the actual closing. This was indeed a possibility, since the J&J offer did not include a collar arrangement.
Boston Scientific decided to boost the new bid to $80 per share, which it believed would deter any further bidding from J&J. J&J had been saying publicly that Guidant was already “fully valued.” Boston Scientific reasoned that J&J had created a public relations nightmare for itself. If J&J raised its bid, it would upset J&J shareholders and make it look like an undisciplined buyer. J&J refused to up its offer, saying that such an action would not be in the best interests of its shareholders. Table 1 summarizes the key events timeline.
Boston Scientific and Johnson & Johnson Bidding Chronology
|December 15, 2004||J&J reaches agreement to buy Guidant for $25.4 billion in stock and cash.|
|November 15, 2005||Value of J&J deal is revised downward to $21.5 billion.|
|December 5, 2005||Boston Scientific offers $25 billion.|
|January 11, 2006||Guidant accepts a J&J counteroffer valued at $23.2 billion.|
|January 17, 2006||Boston Scientific submits a new bid valued at $27 billion.|
|January 25, 2006||Guidant accepts Boston Scientific’s bid when J&J fails to raise its offer.|
A side deal with Abbott Labs made the lofty Boston Scientific offer possible. The firm entered into an agreement with Abbott Laboratories in which Boston Scientific would divest Guidant’s stent business while retaining the rights to Guidant’s stent technology. In return, Boston Scientific received $6.4 billion in cash on the closing date, consisting of $4.1 billion for the divested assets, a loan of $900 million, and Abbott’s purchase of $1.4 billion of Boston Scientific stock. The additional cash helped fund the purchase price. This deal also helped Boston Scientific gain regulatory approval by enabling Abbott Labs to become a competitor in the stent business. Merrill Lynch and Bank of America each would lend $7 billion to fund a portion of the purchase price and provide the combined firms with additional working capital.
To complete the transaction, Boston Scientific paid $27 billion, consisting of cash and stock, to Guidant shareholders and another $800 million as a breakup fee to J&J. In addition, the firm is burdened with $14.9 billion in new debt. Within days of Boston Scientific’s winning bid, the firm received a warning from the U.S. Food and Drug Administration to delay the introduction of new products until the firm’s safety procedures improved.
Between December 2004, the date of Guidant’s original agreement with J&J, and January 25, 2006, the date of its agreement with Boston Scientific, Guidant’s stock rose by 16 percent, reflecting the bidding process. During the same period, J&J’s stock dropped by a modest 3 percent, while Boston Scientific’s shares plummeted by 32 percent.
As a result of product recalls and safety warnings on more than 50,000 Guidant cardiac devices, the firm’s sales and profits plummeted. Between the announcement date of its purchase of Guidant in December 2005 and year-end 2006, Boston Scientific lost more than $18 billion in shareholder value. In acquiring Guidant, Boston Scientific increased its total shares outstanding by more than 80 percent and assumed responsibility for $6.5 billion in debt, with no proportionate increase in earnings. In early 2010, Boston Scientific underwent major senior management changes and spun off several business units in an effort to improve profitability. Ongoing defibrillator recalls could shave the firm’s revenue by $0.5 billion during the next two years. In 2010, continuing product-related problems forced the firm to write off $1.8 billion in impaired goodwill associated with the Guidant acquisition. At less than $8 per share throughout most of 2010, Boston Scientific’s share price is about one-fifth of its peak of $35.55 on December 5, 2005, the day the firm announced its bid for Guidant.
- What were the key differences between J&J’s and Boston Scientific’s bidding strategy? Be specific.
Answer: J&J’s style could be characterized as self-assured and reactive and Boston Scientific’s as opportunistic and nimble. J&J was willing to reopen their bid for Guidant by executing the material adverse change clause in the agreement of purchase and sale and to renegotiate aggressively a much lower offer price. While they had contractual right to do so, the nearly 21 percent reduction in the offer price demanded by J&J appears to have been overly aggressive, perhaps with little regard for the possibility of attracting other bidders. J&J may have assumed that given their size and financial muscle, that there would be few, if any, alternative bidders for Guidant. J&J was not proactive in trying to close the deal; rather, they allowed Boston Scientific to set the price and then they would react to it. Perhaps, expressing more than its share of hubris, it announced the price at which they believed that Guidant was fully valued. The implication was that any bid above that level would be foolhardy.
In contrast, Boston Scientific saw the change in the offer price as an opportunity to leapfrog into the dominant position in the fast growing stent market. Aware that their financial resources were sorely limited they recognized the need early on to raise funds by selling non-core Guidant assets once the purchase of Guidant was complete. Boston Scientific went “shopping” for bidders for such assets with their contingent upon Boston Scientific’s closing the Guidant deal. Furthermore, Boston Scientific recognized that by announcing when they though Guidant was fully valued that they were placing a ceiling on what they could bid without angering their shareholders. Seizing the opportunity, Boston Scientific moved to top significantly that price.
- What might J&J have done differently to avoid igniting a bidding war?
Answer: Immediately following its announcement that it had reached an agreement to be acquired by Johnson and Johnson (J&J), Guidant defibrillators became embroiled in a regulatory scandal over failure to inform doctors about rare malfunctions. This resulted in serious erosion in Guidant’s market value and prompted J&J to renegotiate down the purchase price. The renegotiated agreement gave Boston Scientific an opportunity to intervene with a more attractive bid. J&J could have avoided the subsequent bidding war by not having renegotiated the price.
- What evidence is given that J&J may not have taken Boston Scientific as a serious bidder?
Answer: J&J announced publicly that Guidant was fully valued at its cash and stock bid of $76 per Guidant share. The firm refused to raise its bid to the higher Boston Scientific bid of $80, possibly believing that the already highly levered firm could not finance the bid. J&J had created a public relations nightmare for itself if it raised its bid, since that would upset J&J shareholders and make it look like an undisciplined bidder. J&J refused to up its offer saying that such a move would not be in the best interests of its shareholders. J&J apparently had not anticipated the “side deal” that Guidant had made with Abbot Labs in which it agreed to acquire Guidant’s stent business, with Boston Scientific retaining the rights to use Guidant stent technology. The $6.4 billion received from Abbot Labs helped Boston Scientific pay the cash portion of the purchase price for Guidant and to reduce its leverage.
- Explain how differing assumptions about market growth, potential synergies, and the size of the potential liability related to product recalls affected the bidding?
Answer: The potential product related liability initiated the bidding war as it provided Boston Scientific with an opportunity to intervene in what had been a signed agreement. J&J and Boston Scientific simply had different expectations for the growth of the defibrillator market and the potential synergies when integrated. Boston Scientific must have believed that the future growth would remain strong, the synergies would be greater if Guidant were integrated with it rather than J&J, and that future potential liabilities from federal investigation and lawsuits were manageable.
Buyer Consortium Wins Control of ABN Amro
The biggest banking deal on record was announced on October 9, 2007, resulting in the dismemberment of one of Europe’s largest and oldest financial services firms, ABN Amro (ABN). A buyer consortium consisting of The Royal Bank of Scotland (RBS), Spain’s Banco Santander (Santander), and Belgium’s Fortis Bank (Fortis) won control of ABN, the largest bank in the Netherlands, in a buyout valued at $101 billion.
European banks had been under pressure to grow through acquisitions and compete with larger American rivals to avoid becoming takeover targets themselves. ABN had been viewed for years as a target because of its relatively low share price. However, rival banks were deterred by its diverse mixture of businesses, which was unattractive to any single buyer. Under pressure from shareholders, ABN announced that it had agreed, on April 23, 2007, to be acquired by Barclay’s Bank of London for $85 billion in stock. The RBS-led group countered with a $99 billion bid consisting mostly of cash. In response, Barclay’s upped its bid by 6 percent with the help of state-backed investors from China and Singapore. ABN’s management favored the Barclay bid because Barclay had pledged to keep ABN intact and its headquarters in the Netherlands. However, a declining stock market soon made Barclay’s mostly stock offer unattractive.
While the size of the transaction was noteworthy, the deal is especially remarkable in that the consortium had agreed prior to the purchase to split up ABN among the three participants. The mechanism used for acquiring the bank represented an unusual means of completing big transactions amidst the subprime-mortgage-induced turmoil in the global credit markets at the time. The members of the consortium were able to select the ABN assets they found most attractive. The consortium agreed in advance of the acquisition that Santander would receive ABN’s Brazilian and Italian units; Fortis would obtain the Dutch bank’s consumer lending business, asset management, and private banking operations, and RBS would own the Asian and investment banking units. Merrill Lynch served as the sole investment advisor for the group’s participants. Caught up in the global capital market meltdown, Fortis was forced to sell the ABN Amro assets it had acquired to its Dutch competitor ING in October 2008.
- In your judgment, what are likely to be some of the major challenges in assembling a buyer consortium to acquire and subsequently dismember a target firm such as ABN Amro? In what way do you thing the use of a single investment advisor might have addressed some of these issues?
Answer: Finding willing and financially able partners with a synergistic fit to a specific target firm is difficult. Multiple investment banking advisors for each consortium participant having different agendas could imperil the coordination of activities within the group. The process was made easier in the ABN deal with a single investment advisor, Merrill Lynch, coordinating the effort. Moreover, dismantling institutions of this size is complex in terms of the sheer number and diversity of customers, the cultural and language differences among ABN’s 105,000 employees, disparate IT systems, and multiple legal jurisdictions.
- The ABN Amro transaction was completed at a time when the availability of credit was limited due to the sub-prime mortgage loan problem originating in the United States. How might the use of a group rather than a single buyer have facilitated the purchase of ABN Amro?
Answer: No single bank had the ability to raise sufficient cash to finance the transaction. However, individual banks could raise sufficient cash at an acceptable rate of interest based on the synergy that could be realized if they could acquire only those assets that represented a good fit for their core businesses.
- The same outcome could have been achieved if a single buyer had reached agreement with other banks to acquire selected pieces of ABN before completing the transaction. The pieces could then have been sold at the closing. Why might the use of the consortium been a superior alternative?
Answer: Pre-selling businesses before closing is a technique that makes sense mostly for target firms whose assets are managed largely independently. Consequently, such assets can be easily divested upon closing to other parties who had agreed to buy them at closing. However, for firms whose assets are interdependent in terms of IT systems and centers, and other support activities, disposition is more difficult. The process of breaking up the firm is best done subsequent to closing when the acquiring firm or firms have full access to employees, customers, and records and can break up the businesses have access to more accurate and timely information.
Pfizer Acquires Wyeth Labs Despite Tight Credit Markets
Pfizer and Wyeth began joint operations on October 22, 2009, when Wyeth shares stopped trading and each Wyeth share was converted to $33 in cash and 0.985 of a Pfizer share. Valued at $68 billion, the cash and stock deal was first announced in late January of 2009. The purchase price represented a 12.6 percent premium over Wyeth’s closing share price the day before the announcement. Investors from both firms celebrated as Wyeth’s shares rose 12.6 percent and Pfizer’s 1.4 percent on the news. The announcement seemed to offer the potential for profit growth, despite storm clouds on the horizon.
As is true of other large pharmaceutical companies, Pfizer expects to experience serious erosion in revenue due to expiring patent protection on a number of its major drugs. Pfizer faced the expiration of patent rights in 2011 to the cholesterol-lowering drug Lipitor, which accounted for 25 percent of the firm’s $52 billion in 2008 revenue. Pfizer also faces 14 other patent expirations through 2014 on drugs that, in combination with Lipitor, contribute more than one-half of the firm’s total revenue. Pfizer is not alone, Merck, Bristol-Myers Squibb, and Eli Lilly are all facing significant revenue reduction due to patent expirations during the next five years as competition from generic drugs undercuts their pricing. Wyeth will also be losing its patent protection on its top-selling drug, the antidepressant Effexor XR.
Pfizer’s strategy appears to have been to acquire Wyeth at a time when transaction prices were depressed because of the recession and tight credit markets. Pfizer anticipates saving more than $4 billion annually by combining the two businesses, with the savings being phased in over three years. Pfizer also hopes to offset revenue erosion due to patent expirations by diversifying into vaccines and arthritis treatments.
By the end of 2008, Pfizer already had a $22.5 billion commitment letter in order to obtain temporary or “bridge” financing and $26 billion in cash and marketable securities. Pfizer also announced plans to cut its quarterly dividend in half to $0.16 per share to help finance the transaction. However, there were still questions about the firm’s ability to complete the transaction in view of the turmoil in the credit markets.
Many transactions that were announced during 2008 were never closed because buyers were unable to arrange financing and would later claim that the purchase agreement had been breached due to material adverse changes in the business climate. Such circumstances, they would argue, would force them to renege on their contracts. Usually, such contracts contain so-called reverse termination fees, in which the buyer would agree to pay a fee to the seller if they were unwilling to close the deal. This is called a reverse termination or breakup fee because traditionally breakup fees are paid by a seller that chooses to break a contract with a buyer in order to accept a more attractive offer from another suitor.
Negotiations, which had begun in earnest in late 2008, became increasingly contentious, not so much because of differences over price or strategy but rather under what circumstances Pfizer could back out of the deal. Under the terms of the final agreement, Pfizer would have been liable to pay Wyeth $4.5 billion if its credit rating dropped prior to closing and it could not finance the transaction. At about 6.6 percent of the purchase price, the termination fee was about twice the normal breakup fee for a transaction of this type.
What made this deal unique was that the failure to obtain financing as a pretext for exit could be claimed only under very limited circumstances. Specifically, Pfizer could renege only if its lenders refused to finance the transaction because of a credit downgrade of Pfizer. If lenders refused to finance primarily for this reason, Wyeth could either demand that Pfizer attempt to find alternative financing or terminate the agreement. If Wyeth had terminated the agreement, Pfizer would have been obligated to pay the termination fee.
Using Form of Payment as a Takeover Strategy:
Chevron’s Acquisition of Unocal
Unocal ceased to exist as an independent company on August 11, 2005 and its shares were de-listed from the New York Stock Exchange. The new firm is known as Chevron. In a highly politicized transaction, Chevron battled Chinese oil-producer, CNOOC, for almost four months for ownership of Unocal. A cash and stock bid by Chevron, the nation’s second largest oil producer, made in April valued at $61 per share was accepted by the Unocal board when it appeared that CNOOC would not counter-bid. However, CNOOC soon followed with an all-cash bid of $67 per share. Chevron amended the merger agreement with a new cash and stock bid valued at $63 per share in late July. Despite the significant difference in the value of the two bids, the Unocal board recommended to its shareholders that they accept the amended Chevron bid in view of the growing doubt that U.S. regulatory authorities would approve a takeover by CNOOC.
In its strategy to win Unocal shareholder approval, Chevron offered Unocal shareholders three options for each of their shares: (1) $69 in cash, (2) 1.03 Chevron shares; or (3) .618 Chevron shares plus $27.60 in cash. Unocal shareholders not electing any specific option would receive the third option. Moreover, the all-cash and all-stock offers were subject to proration in order to preserve an overall per share mix of .618 of a share of Chevron common stock and $27.60 in cash for all of the 272 million outstanding shares of Unocal common stock. This mix of cash and stock provided a “blended” value of about $63 per share of Unocal common stock on the day that Unocal and Chevron entered into the amendment to the merger agreement on July 22, 2005. The “blended” rate was calculated by multiplying .618 by the value of Chevron stock on July 22nd of $57.28 plus $27.60 in cash. This resulted in a targeted purchase price that was about 56 percent Chevron stock and 44 percent cash.
This mix of cash and stock implied that Chevron would pay approximately $7.5 billion (i.e., $27.60 x 272 million Unocal shares outstanding) in cash and issue approximately 168 million shares of Chevron common stock (i.e., .618 x 272 million of Unocal shares) valued at $57.28 per share as of July 22, 2005. The implied value of the merger on that date was $17.1 billion (i.e., $27.60 x 272 million Unocal common shares outstanding plus $57.28 x 168 million Chevron common shares). An increase in Chevron’s share price to $63.15 on August 10, 2005, the day of the Unocal shareholders’ meeting, boosted the value of the deal to $18.1 billion.
Option (1) was intended to appeal to those Unocal shareholders who were attracted to CNOOC’s all cash offer of $67 per share. Option (2) was designed for those shareholders interested in a tax-free exchange. Finally, it was anticipated that option (3) would attract those Unocal shareholders who were interested in cash but also wished to enjoy any appreciation in the stock of the combined companies.
The agreement of purchase and sale between Chevron and Unocal contained a “proration clause.” This clause enabled Chevron to limit the amount of total cash it would payout under those options involving cash that it had offered to Unocal shareholders and to maintain the “blended” rate of $63 it would pay for each share of Unocal stock. Approximately 242 million Unocal shareholders elected to receive all cash for their shares, 22.1 million opted for the all-stock alternative, and 10.1 million elected the cash and stock combination. No election was made for approximately .3 million shares. Based on these results, the amount of cash needed to satisfy the number shareholders electing the all-cash option far exceeded the amount that Chevron was willing to pay. Consequently, as permitted in the merger agreement, the all-cash offer was prorated resulting in the Unocal shareholders who had elected the all-cash option receiving a combination of cash and stock rather than $69 per share. The mix of cash and stock was calculated as shown in Exhibit 1.
|Exhibit 1. Prorating All-Cash Elections|
|1. Determine the available cash election amount (ACEA): Aggregate cash amount minus the amount of cash to be paid to Unocal shareholders selecting the combination of cash and stock (i.e., Option 3).
ACEA = $27.60 x 272 million (Unocal shares outstanding) – 10.1
million (shares electing cash and stock option) x $27.60
= $7.5 – $.3
= $7.2 billion
2. Determine the elected cash amount (ECA): Amount equal to $69 multiplied by the
number of shares of Unocal common stock electing the all-cash option.
ECA = $69 x 242 million = $16.7 billion
3. Determine the cash proration factor (CPF): ACEA/ECA
CPF = $7.2 / $16.7 = .4311
4. Determine the prorated cash merger consideration (PCMC): An amount in cash equal
to $69 multiplied by the cash proration factor.
PCMC = $69 x .4311 = $29.74
5. Determine the prorated stock merger consideration (PSMC): 1.03 multiplied by 1 – CPF.
PSMC = 1.03 x (1- .4311) = .5860
6. Determine the stock and cash mix (SCM): Sum of the prorated cash (PCMC) and stock
(PSMC) merger considerations exchanged for each share of Unocal common stock.
SCM = $29.74 + .5860 of a Chevron share
If too many Unocal shareholders had elected to receive Chevron stock, those making the all-stock election would not have received 1.03 shares of Chevron stock for each share of Unocal stock. Rather, they would have received a mix of stock and cash to help preserve the approximate 56 percent stock and 44 percent cash composition of the purchase price desired by Chevron. For illustration only, assume the number of Unocal shares to be exchanged for the all-cash and all-stock options are 22.1 and 242 million, respectively. This is the reverse of what actually happened. The mix of stock and cash would have been prorated as shown in Exhibit 2.
|Exhibit 12. Prorating All-Stock Elections|
|1. Determine the available cash election amount (ACEA): Same as step 1 above.
ACEA = $7.2 billion
2. Determine the elected cash amount (ECA): Amount equal to $69 multiplied by the number of shares of Unocal common stock electing the all-cash option.
ECA = $69 x 22.1 million = $1.5 billion
3. Determine the excess cash amount (EXCA): Difference between ACEA and ECA.
EXCA = $7.2 – $1.5 = $5.7
4. Determine the prorated cash merger consideration (PCMC): EXCA divided by number of Unocal shares elected the all-stock option.
PCMC = $5.7 / 242 million = $23.55
5. Determine the stock proration factor (SPF): $69 minus the prorated cash merger
consideration divided by $69.
SPF = ($69 – $23.55) / $69 = .$45.45 / $69 = .6587
6. Determine the prorated stock price consideration (PSPC): The number of shares of
Chevron stock equal to 1.03 multiplied by the stock proration factor.
PSPC = 1.03 x .6587 = .6785
7. Determine the stock and cash mix (SCM): Each Unocal share to be exchanged in an
all-stock election is converted into the right to receive the prorated cash merger
consideration and the prorated stock merger consideration.
SCM = $23.55 + .6785 of a Chevron share for each Unocal share
It is typical of large transactions in which the target has a large, diverse shareholder base that acquiring firms offer target shareholders a “menu” of alternative forms of payment. The objective is to enhance the likelihood of success by appealing to a broader group of shareholders. To the unsophisticated target shareholder, the array of options may prove appealing. However, it is likely that those electing all-cash or all-stock purchases are likely to be disappointed due to probable proration clauses in merger contracts. Such clauses enable the acquirer to maintain an overall mix of cash and stock in completing the transaction. This enables the acquirer to limit the amount of cash they must borrow or the number of new shares they must issue to levels they find acceptable.
- What was the form of payment employed by both bidders for Unocal? In your judgment, why were they
different? Be specific.
Answer: Chevron offered Unocal shareholders three options including all cash, all stock, and a combination of both. CNOOC countered with an all-cash bid. CNOOC tried to appeal to those Unocal shareholders who wanted certainty of purchase price, since Chevron stock was not subject to a collar and could lose value between signing and closing. CNOOC also felt that Unocal shareholders would not find the firm’s shares attractive since the firm was not well-known to U.S. investors. Chevron was trying to appeal to a variety of shareholder groups, each of whom had a different payment preference. The all-cash option appealed to those Unocal shareholders who might be attracted to the CNOOC all-cash bid. The stock option appealed to those who wanted a tax-free transaction. The final option appealed those who wanted both certainty of purchase price and the opportunity to participate in potential appreciation of the value of the combined firms.
- How did Chevron use the form of payment as a potential takeover strategy?
Answer: As explained in (1), Chevron used the form of payment to segment the Unocal stockholders to reflect their different payments’ preferences. In doing so, Chevron reasoned that they would attract a larger percentage of Unocal shareholders than the CNOOC all-cash bid, which appealed primarily to Unocal shareholders with a strong preference for liquidity.
- Is the “proration clause” found in most merger agreements in which target shareholders are given several ways in which they can choose to be paid for their shares in the best interests of the target shareholders? In the best interests of the acquirer? Explain your answer.
Answer: While proration clauses are common in transactions involving multiple forms of payment, one could argue that they are deceptive for unsophisticated target shareholders choosing an all-cash or all-stock bid. Such shareholders may not realize that it is likely that they will get both cash and stock depending on the number of shareholders electing each option. The proration clause is clearly in the interests of the acquiring shareholder in that it enables the acquirer to have some control over the proportion of cash and stock paid out. By limiting the amount of cash, the amount of borrowing by the acquirer is limited. Similarly, the potential EPS dilution is limited by capping the number of new acquirer shares issued in exchange for target shares.
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.
- Describe Blackstone’s negotiating strategy with EOP in its effort to counter Vornado’s bids. Be specific.
Answer: Blackstone continued to increase its offer price in response to Vornado’s offers. However, each Blackstone counteroffer was always less than the Vornado offer. Blackstone was relying on an all-cash price to be more attractive than Vornado’s cash and stock offer to EOP shareholders in terms of certainty of value. Furthermore, Blackstone was willing to increase its offer price only if EOP was willing to increase the size of the break-up fee. In doing so, Blackstone was protecting itself from added costs of continued negotiations and was increasing the price an alternative bidder would have to pay in order to acquire EOP.
- What could Vornado have done to assuage EOP’s concerns about the certainty of the value of the stock portion of its offer?
Answer: Vornado could have offered EOP shareholders a collar arrangement in which it would offer more Vornado shares for each share of EOP if Vornado shares declined in value between the time of signing of a definitive agreement and closing. In this manner, EOP shareholders could have been assured of maintaining the value of the purchase price offered by Vornado. Vornado may have been reluctant to offer such an arrangement due to the potential earnings dilution resulting from having to issue more shares.
- 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: EOP’s share price dropped to just below the Blackstone offer price, reflecting the potential risk that the deal would not close. Vornado’s share price rose sharply possibly as a result of investor relief that Vornado lost. Investors may have believed that Vornado’s offer was excessive and that the resulting increase in new Vornado shares would significantly dilute current shareholders ownership of Vornado. The sharp positive reaction by shareholders to news that Vornado had lost the auction may suggest that current shareholders would not have approved the purchase of EOP anyway.
Vivendi Universal and GE Combine Entertainment Assets to Form NBC Universal
Ending a four-month-long auction process, Vivendi Universal SA agreed on October 5, 2003, to sell its Vivendi Universal Entertainment (VUE) businesses, consisting of film and television assets, to General Electric Corporation’s wholly owned NBC subsidiary. Vivendi received a combination of GE stock and stock in the combined company valued at approximately $14 billion. Vivendi would combine the Universal Pictures movie studio, its television production group, three cable networks, and the Universal theme parks with NBC. The new company would have annual revenues of $13 billion based on 2003 pro forma statements.
This transaction was among many made by Vivendi in its effort to restore the firm’s financial viability. Having started as a highly profitable distributor of bottled water, the French company undertook a diversification spree in the 1990s, which pushed the firm into many unrelated enterprises and left it highly in debt. With its stock plummeting, Vivendi had been under considerable pressure to reduce its leverage and refocus its investments.
Applying a multiple of 14 times estimated 2003 EBITDA of $3 billion, the combined company had an estimated value of approximately $42 billion. This multiple is well within the range of comparable transactions and is consistent with the share price multiples of television media companies at that time. Of the $3 billion in 2003 EBITDA, GE would provide $2 billion and Vivendi $1 billion. This values GE’s assets at $28 billion and Vivendi’s at $14 billion. This implies that GE assets contribute two thirds and Vivendi’s one third of the total market value of the combined company.
NBC Universal’s total assets of $42 billion consist of VUE’s assets valued at $14 billion and NBC’s at $28 billion. Vivendi chose to receive an infusion of liquidity at closing consisting of $4.0 billion in cash by selling its right to receive $4 billion in GE stock and the transfer of $1.6 billion in debt carried by VUE’s businesses to NBC Universal.
Vivendi would retain an ongoing approximate 20 percent ownership in the new company valued at $8.4 billion after having received $5.6 billion in liquidity at closing. GE would have 80 percent ownership in the new company in exchange for providing $5.6 billion in liquidity (i.e., $4 billion in cash and assuming $1.6 billion in debt). Vivendi had the option to sell its 20 percent ownership interest in the future, beginning in 2006, at fair market value. GE would have the first right (i.e., the first right of refusal) to acquire the Vivendi position. GE anticipated that its 80 percent ownership position in the combined company would be accretive for GE shareholders beginning in the second full year of operation.
- From a legal standpoint, identify the acquirer and the target firms?
Answer: The acquirer is GE’s wholly owned NBC subsidiary, while the target firm is Vivendi’s wholly owned Vivendi Universal Entertainment subsidiary.
- What is the form of acquisition? Why might the parties involved in the transaction have agreed to this form?
Answer: Purchase of assets. The purchase of assets allows GE/NBC to acquire only assets it finds most attractive. Moreover, the purchase of assets transfers to NBC all rights Vivendi held to these assets, including logos, right to license content, etc. By selling assets, Vivendi retains the rights to any tangible or intangible assets owned by VUE but not sold to NBC. However, by buying only assets, NBC must pay transfer taxes as asset ownership is transferred.
- What is the form of acquisition vehicle and the post-closing organization? Why do you think the legal entities you have identified were selected?
Answer: Form of acquisition vehicle is a C-Corporation (NBC) and the post-closing organization is a joint venture corporation. A parent in a holding company framework owns both. GE may have wanted to defer a portion of the purchase price and Vivendi wanted to share in the long-term upside growth potential of the JV.
- What is the form of payment or total consideration? Why do you think this form of payment may have been selected by the parties involved?
Answer: A combination of GE stock and NBC Universal stock plus $1.6 billion in assumed debt plus the present value of the future sale of Vivendi’s remaining 20% ownership in NBC Universal. Vivendi wanted to share in the upside potential of the JV, and GE wanted to defer a portion of the purchase price.
- Is this transaction likely to be non-taxable, wholly taxable, or partially taxable to Vivendi? Explain your answer.
Answer: The $5.4 billion in liquidity (i.e., $3.8 billion in cash plus $1.6 billion in assumed debt) paid to Vivendi at closing would be wholly taxable, while the remaining 20% equity ownership position in NBC Universal would not be taxable until the equity is sold. Note that the $1.6 billion is assumed debt is taxable to Vivendi as they received the money but have been relieved of the obligation to repay. The loan now becomes taxable income to Vivendi.
- Based on a total valuation of $42 billion, Vivendi’s assets contributed one-third and GE’s two-thirds of the total value of NBC Universal. However, after the closing, Vivendi would only own a 20% equity position in the combined business. Why?
Answer: Vivendi’s contribution to the $42 billion was estimated to be $14 billion or approximately one-third of the total value. However, Vivendi choose to receive a liquidity infusion at closing totaling $5.4 billion, while deferring the remaining $8.6 billion (i.e., $14 billion – $5.4 billion) until it had a right to sell its remaining interest in NBC Universal after 2006. Consequently, its percentage ownership in NBC Universal was reduced to 20% ($8.6 / $42) from 33% ($14 / $42).
| News Corp.’s Power Play in Satellite Broadcasting
The share prices of Rupert Murdoch’s News Corp., Fox Entertainment Group Inc., and Hughes Electronics Corp. (a subsidiary of General Motors Corporation) tumbled immediately following the announcement that News Corp had reached an agreement to take a controlling interest in Hughes on April 10, 2003. Immediately following the announcement, shares of Fox fell by 17 percent, News Corp.’s ADRs (i.e., shares issued by foreign firms trading on U.S. stock exchanges) by 6.5 percent and Hughes by 9.8 percent.
Hughes Electronics is a world leader in providing digital television entertainment, broadband satellite networks and services (DirecTV), and global video and data broadcasting. The News Corporation is a diversified international media and entertainment company with operations in a number of industry segments, including filmed entertainment, television, cable network programming, magazines and inserts, newspapers and book publishing.
News Corp.’s Chairman Rupert Murdoch, had pursued control of Hughes, the parent company of DirecTV, for several years. News Corp.’s bid valued at about $6.6 billion to acquire control of Hughes Electronics Corp. and its DirecTV unit gives News Corp a U.S. presence to augment its satellite TV operations in Britain and Asia. In one bold move, News Corp became the second largest provider of pay-TV service to U.S. homes, second only to Comcast. By transferring News Corp.’s stake in Hughes to Fox, Fox gained control over 11 million subscribers. It gives Fox more leverage for its cable networks when negotiating rights fees with cable operators that compete with DirecTV. In negotiating with film studios or sports companies over pay television rights, News Corp. is now the only global customer, with satellite systems spanning Europe, Asia, and Latin America. Moreover, News Corp. can cross-promote among DirecTV and its others businesses (e.g., packaging DirecTV subscriptions with subscriptions to TV Guide).
General Motors was motivated to sell its investment in Hughes because of its poor financial performance in recent years and GM’s need for cash. GM and Hughes had first agreed to a deal with rival satellite broadcaster EchoStar Communications Inc. However, the deal was blocked by antitrust regulators. Subsequent discussions between GM/Hughes with SBC Communications and Liberty Media proved unproductive with these firms offering primarily a share for share exchange. GM’s desire to quickly pull cash out of Hughes made News Corp.’s offer the most attractive. Consequently, they chose to accept News Corp.’s proposal rather than pursue a riskier proposal for a Hughes’ management-sponsored leveraged buyout.
News Corp. financed its purchase of a 34.1% stake in Hughes (i.e., GM’s 20% ownership and 14.1% from public shareholders) by paying $3.1 billion in cash to GM, plus 34.3 million in nonvoting American depository receipts (ADRs) in News Corp. shares. Hughes’ public shareholders will be paid with 122.2 million nonvoting ADRs in News Corp. Each ADR is equivalent to four News Corp. shares. The resulting issue of 156.5 million shares would dilute News Corp. shareholders by about 13%. Immediately following closing, News Corp.’s ownership interest was transferred to Fox in exchange for a $4.5 billion promissory note from Fox and 74 million new Fox shares. This transfer will saddle Fox with $4.5 billion in debt. This debt would need to be serviced by Fox’s cash flow and could limit Fox’s access to new capital.
Now that News Corp. controls DirecTV through its 81 percent ownership in Fox, it must find away to revitalize DirecTV. Against tough cable-TV competition, DirecTV has experienced a 20% turnover rate among its subscribers, due in part to GM’s benign neglect while it looked for a buyer. News Corp. will now have to compete against larger, better financed cable operations, as well as the nimble, low cost EchoStar Communications Corp’s Dish Network. As an indication of the extent to which Hughes has stumbled in recent years, News Corp. made a formal bid to acquire all of Hughes for about $25 billion in cash in 2001. News Corp.’s current investment stake implies a valuation of less the $20 billion for 100 percent ownership of Hughes (i.e., $6.6 billion/.341).
1. Why did the share prices of News Corp., Fox, and Hughes fall precipitously following the
announcement? Explain your answer.
Answer: The transaction was financed entirely by stock, resulting in 156.5 million new shares of News Corp stock being issued. This threatened to dilute the ownership position of existing News Corp shareholders. Further, the transfer of News Corp ownership interest to Fox resulted in Fox issuing 74 million new shares to News Corp and issuing a promissory note to News Corp for $4.5 billion. The new Fox shares diluted existing Fox shareholders’ ownership and the additional debt reduced its ability to undertake new investment in Hughes. Consequently, the original Hughes public shareholders now held Fox shares, which had limited growth prospects because of the substantial increase in the firm’s leverage.
2. How did News Corp.’s proposed deal structure better satisfy GM’s needs than those of other
Answer: GM needed cash and most alternative bidders were offering only stock. Moreover, the
potential LBO offered by Hughes’ management assumed more risk than GM was willing to
3. How can it be said that News Corp. obtained a controlling interest in Hughes when its stake
amounted to only about one-third of Hughes outstanding voting shares? Explain your answer.
| Answer: News Corp acquired GM’s 20% block and 14.1% of the public shareholders’ stock. The
remaining Hughes shares were widely distributed among individual investors and employees.
Consequently, News Corp could pool its voting shares to dominate most issues such as the
election of Hughes board members, decisions to merge Hughes with another firm, antitakeover
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.
- What is the acquisition vehicle used to acquire the target company, Upstart Corporation? Why was this legal structure used?
Answer: The acquisition vehicle is a joint venture corporation. This legal structure was used to mitigate risk by spreading the investment in Upstart between BigCo and HiTech and also to bring a partner whose management style and skill was more compatible with Upstart’s culture and core competencies.
- How would you characterize the post-closing organization? Why was this organizational structure used?
Answer: The post closing organization is a holding company framework. This post closing structure was chosen to preserve Upstart’s innovative culture, enable Upstart’s management to continue to operate as a largely independent entity, and to facilitate the divestiture of Upstart if that became necessary.
- What is the form of payment? Why was it used?
Answer: The form of payment is a combination of cash and stock for the Upstart’s outstanding stock. This form of payment was used to satisfy the cofounder’s desire for a tax-free transaction because of their low basis in the stock and to satisfy the wishes of the remaining shareholders for cash.
- What was the form of acquisition? How does this form of acquisition protect the acquiring company’s rights to HiTech’s proprietary technology?
Answer: The form of acquisition was a purchase of stock. This is preferable in this instance because of the importance of ensuring that all rights to Upstart’s core technology are transferred to the acquirer, New Horizons Inc. In a stock purchase, all assets and liabilities, on or off the balance sheet, tangible or intangible, pass to the acquirer by rule of law.
- How would the use of purchase accounting affect the balance sheets of the combined companies?
Answer: Assuming the acquirer adopted a Section 338 election, Upstart’s assets would have been revalued with a portion of purchase price being allocated to its tangible and intangible assets. Any unallocated portion of the purchase price would have been booked as goodwill. Under the FASB rules pertaining to goodwill promulgated in 2001, no portion of the goodwill would be amortized. The write-up of assets would have resulted in greater tax deductions and would have increased after-tax cash flow.
- Was the transaction non-taxable, partially taxable, or wholly taxable to HiTech shareholders? Why?
Answer: The transaction would have been partially taxable. It would have been tax-free for those receiving stock and taxable to those receiving cash.
Consolidation in the Wireless Communications Industry: Vodafone Acquires AirTouch
Deregulation of the telecommunications industry has resulted in increased consolidation. In Europe, rising competition is the catalyst driving mergers. In the United States, the break up of AT&T in the mid-1980s and the subsequent deregulation of the industry has led to key alliances, JVs, and mergers, which have created cellular powerhouses capable of providing nationwide coverage. Such coverage is being achieved by roaming agreements between carriers and acquisitions by other carriers. Although competition has been heightened as a result of deregulation, the telecommunications industry continues to be characterized by substantial barriers to entry. These include the requirement to obtain licenses and the need for an extensive network infrastructure. Wireless communications continue to grow largely at the expense of traditional landline services as cellular service pricing continues to decrease. Although the market is likely to continue to grow rapidly, success is expected to go to those with the financial muscle to satisfy increasingly sophisticated customer demands. What follows is a brief discussion of the motivations for the merger between Vodafone and AirTouch Communications. This discussion includes a description of the key elements of the deal structure that made the Vodafone offer more attractive than a competing offer from Bell Atlantic.
Vodafone is a wireless communications company based in the United Kingdom. The company is located in 13 countries in Europe, Africa, and Australia/New Zealand. Vodafone reaches more than 9.5 million subscribers. It has been the market leader in the United Kingdom since 1986 and as of 1998 had more than 5 million subscribers in the United Kingdom alone. The company has been very successful at marketing and selling prepaid services in Europe. Vodafone also is involved in a venture called Globalstar, LP, a limited partnership with Loral Space and Communications and Qualcomm, a phone manufacturer. “Globalstar will construct and operate a worldwide, satellite-based communications system offering global mobile voice, fax, and data communications in over 115 countries, covering over 85% of the world’s population”.
Vodafone’s focus is on global expansion. They are expanding through partnerships and by purchasing licenses. Notably, Vodafone lacked a significant presence in the United States, the largest mobile phone market in the world. For Vodafone to be considered a truly global company, the firm needed a presence in the Unites States. Vodafone’s strategy is focused on maintaining high growth levels in its markets and increasing profitability; maintaining their current customer base; accelerating innovation; and increasing their global presence through acquisitions, partnerships, or purchases of new licenses. Vodafone’s current strategy calls for it to merge with a company with substantial market share in the United States and Asia, which would fill several holes in Vodafone’s current geographic coverage.
The company is very decentralized. The responsibilities of the corporate headquarters in the United Kingdom lie in developing corporate strategic direction, compiling financial information, reporting and developing relationships with the various stock markets, and evaluating new expansion opportunities. The management of operations is left to the countries’ management, assuming business plans and financial measures are being met. They have a relatively flat management structure. All of their employees are shareowners in the company. They have very low levels of employee turnover, and the workforce averages 33 years of age.
AirTouch Communications launched its first cellular service network in 1984 in Los Angeles during the opening ceremonies at the 1984 Olympics. The original company was run under the name PacTel Cellular, a subsidiary of Pacific Telesis. In 1994, PacTel Cellular spun off from Pacific Telesis and became AirTouch Communications, under the direction of Chair and Chief Executive Officer Sam Ginn. Ginn believed that the most exciting growth potential in telecommunications is in the wireless and not the landline services segment of the industry. In 1998, AirTouch operated in 13 countries on three continents, serving more than 12 million customers, as a worldwide carrier of cellular services, personal communication services (PCS), and paging services. AirTouch has chosen to compete on a global front through various partnerships and JVs. Recognizing the massive growth potential outside the United States, AirTouch began their global strategy immediately after the spin-off.
AirTouch has chosen to differentiate itself in its domestic regions based on the concept of “Superior Service Delivery.” The company’s focus is on being available to its customers 24 hours a day, 7 days a week and on delivering pricing options that meet the customer’s needs. AirTouch allows customers to change pricing plans without penalty. The company also emphasizes call clarity and quality and extensive geographic coverage. The key challenges AirTouch faces on a global front is in reducing churn (i.e., the percentage of customers leaving), implementing improved digital technology, managing pressure on service pricing, and maintaining profit margins by focusing on cost reduction. Other challenges include creating a domestic national presence.
AirTouch is decentralized. Regions have been developed in the U.S. market and are run autonomously with respect to pricing decisions, marketing campaigns, and customer care operations. Each region is run as a profit center. Its European operations also are run independently from each other to be able to respond to the competitive issues unique to the specific countries. All employees are shareowners in the company, and the average age of the workforce is in the low to mid-30s. Both companies are comparable in terms of size and exhibit operating profit margins in the mid-to-high teens. AirTouch has substantially less leverage than Vodafone.
Vodafone began exploratory talks with AirTouch as early as 1996 on a variety of options ranging from partnerships to a merger. Merger talks continued informally until late 1998 when they were formally broken off. Bell Atlantic, interested in expanding its own mobile phone business’s geographic coverage, immediately jumped into the void by proposing to AirTouch that together they form a new wireless company. In early 1999, Vodafone once again entered the fray, sparking a sharp takeover battle for AirTouch. Vodafone emerged victorious by mid-1999.
Motivation for the Merger
The merger would create a more competitive, global wireless telecommunications company than either company could achieve separately. Moreover, both firms shared the same vision of the telecommunications industry. Mobile telecommunications is believed to be the among the fastest-growing segment of the telecommunications industry, and over time mobile voice will replace large amounts of telecommunications traffic carried by fixed-line networks and will serve as a major platform for voice and data communication. Both companies believe that mobile penetration will reach 50% in developed countries by 2003 and 55% and 65% in the United States and developed European countries, respectively, by 2005.
Scale, operating strength, and complementary assets were given as compelling reasons for the merger. The combination of AirTouch and Vodafone would create the largest mobile telecommunication company at the time, with significant presence in the United Kingdom, United States, continental Europe, and Asian Pacific region. The scale and scope of the operations is expected to make the combined firms the vendor of choice for business travelers and international corporations. Interests in operations in many countries will make Vodafone AirTouch more attractive as a partner for other international fixed and mobile telecommunications providers. The combined scale of the companies also is expected to enhance its ability to develop existing networks and to be in the forefront of providing technologically advanced products and services.
Anticipated synergies include after-tax cost savings of $340 million annually by the fiscal year ending March 31, 2002. The estimated net present value of these synergies is $3.6 billion discounted at 9%. The cost savings arise from global purchasing and operating efficiencies, including volume discounts, lower leased line costs, more efficient voice and data networks, savings in development and purchase of third-generation mobile handsets, infrastructure, and software. Revenues should be enhanced through the provision of more international coverage and through the bundling of services for corporate customers that operate as multinational businesses and business travelers.
AirTouch’s Board Analyzes Options
Morgan Stanley, AirTouch’s investment banker, provided analyses of the current prices of the Vodafone and Bell Atlantic stocks, their historical trading ranges, and the anticipated trading prices of both companies’ stock on completion of the merger and on redistribution of the stock to the general public. Both offers were structured so as to constitute essentially tax-free reorganizations. The Vodafone proposal would qualify as a Type A reorganization under the Internal Revenue Service Code; hence, it would be tax-free, except for the cash portion of the offer, for U.S. holders of AirTouch common and holders of preferred who converted their shares before the merger. The Bell Atlantic offer would qualify as a Type B tax-free reorganization. Table 1 highlights the primary characteristics of the form of payment (total consideration) of the two competing offers.
|Table 1. Comparison of Form of Payment/Total Consideration|
|5 shares of Vodafone common plus $9 for each share of AirTouch common||1.54 shares of Bell Atlantic for each share of AirTouch common subject to the transaction being treated as a pooling of interest under U.S. GAAP.|
|Share exchange ratio adjusted upward 9 months out to reflect the payment of dividends on the Bell Atlantic stock.|
|A share exchange ratio collar would be used to ensure that AirTouch shareholders would receive shares valued at $80.08. If the average closing price of Bell Atlantic stock were less than $48, the exchange ratio would be increased to 1.6683. If the price exceeded $52, the exchange rate would remain at 1.54.1
|1The collar guarantees the price of Bell Atlantic stock for the AirTouch shareholders because $48 ´ 1.6683 and $52 ´ 1.54 both equal $80.08.|
Morgan Stanley’s primary conclusions were as follows:
- Bell Atlantic had a current market value of $83 per share of AirTouch stock based on the $53.81 closing price of Bell Atlantic common stock on January 14, 1999. The collar would maintain the price at $80.08 per share if the price of Bell Atlantic stock during a specified period before closing were between $48 and $52 per share.
- The Vodafone proposal had a current market value of $97 per share of AirTouch stock based on Vodafone’s ordinary shares (i.e., common) on January 17, 1999.
- Following the merger, the market value of the Vodafone American Depository Shares (ADSs) to be received by AirTouch shareholders under the Vodafone proposal could decrease.
- Following the merger, the market value of Bell Atlantic’s stock also could decrease, particularly in light of the expectation that the proposed transaction would dilute Bell Atlantic’s EPS by more than 10% through 2002.
In addition to Vodafone’s higher value, the board tended to favor the Vodafone offer because it involved less regulatory uncertainty. As U.S. corporations, a merger between AirTouch and Bell Atlantic was likely to receive substantial scrutiny from the U.S. Justice Department, the Federal Trade Commission, and the FCC. Moreover, although both proposals could be completed tax-free, except for the small cash component of the Vodafone offer, the Vodafone offer was not subject to achieving any specific accounting treatment such as pooling of interests under U.S. generally accepted accounting principles (GAAP).
Recognizing their fiduciary responsibility to review all legitimate offers in a balanced manner, the AirTouch board also considered a number of factors that made the Vodafone proposal less attractive. The failure to do so would no doubt trigger shareholder lawsuits. The major factors that detracted from the Vodafone proposal were that it would not result in a national presence in the United States, the higher volatility of its stock, and the additional debt Vodafone would have to assume to pay the cash portion of the purchase price. Despite these concerns, the higher offer price from Vodafone (i.e., $97 to $83) won the day.
Acquisition Vehicle and Post Closing Organization
In the merger, AirTouch became a wholly owned subsidiary of Vodafone. Vodafone issued common shares valued at $52.4 billion based on the closing Vodafone ADS on April 20, 1999. In addition, Vodafone paid AirTouch shareholders $5.5 billion in cash. On completion of the merger, Vodafone changed its name to Vodafone AirTouch Public Limited Company. Vodafone created a wholly owned subsidiary, Appollo Merger Incorporated, as the acquisition vehicle. Using a reverse triangular merger, Appollo was merged into AirTouch. AirTouch constituted the surviving legal entity. AirTouch shareholders received Vodafone voting stock and cash for their AirTouch shares. Both the AirTouch and Appollo shares were canceled. After the merger, AirTouch shareholders owned slightly less than 50% of the equity of the new company, Vodafone AirTouch. By using the reverse merger to convey ownership of the AirTouch shares, Vodafone was able to ensure that all FCC licenses and AirTouch franchise rights were conveyed legally to Vodafone. However, Vodafone was unable to avoid seeking shareholder approval using this method. Vodafone ADS’s traded on the New York Stock Exchange (NYSE). Because the amount of new shares being issued exceeded 20% of Vodafone’s outstanding voting stock, the NYSE required that Vodafone solicit its shareholders for approval of the proposed merger.
Following this transaction, the highly aggressive Vodafone went on to consummate the largest merger in history in 2000 by combining with Germany’s telecommunications powerhouse, Mannesmann, for $180 billion. Including assumed debt, the total purchase price paid by Vodafone AirTouch for Mannesmann soared to $198 billion. Vodafone AirTouch was well on its way to establishing itself as a global cellular phone powerhouse.
- Did the AirTouch board make the right decision? Why or why not?
Answer: Yes, Vodafone offered a higher per share price and was less likely than BellSouth to be rejected by regulators.
- How valid are the reasons for the proposed merger?
Answer: Vodafone was intent on becoming a global carrier. To achieve this goal, it was necessary for the firm to achieve substantial coverage in the U.S. By acquiring AirTouch, Vodafone was able to obtain a substantial portion of this coverage. The additional scale and operating capabilities provided substantial cost savings opportunities. The combination of AirTouch and Vodafone would create the largest mobile telecommunication company at the time. With interests in operations in many countries; the combined Vodafone AirTouch becomes more attractive as a partner for other international fixed and mobile telecommunications providers. The combined scale of the companies should enhance their ability to develop existing networks and to be in the forefront of providing technologically advanced products and services.
- What are the potential risk factors related to the merger?
Answer: The risks include the potential for having overpaid and for not being able to earn Vodafone’s cost of capital on the acquired assets. Moreover, the acquisition was made with the understanding that the global market for cellular services would continue to grow rapidly. This growth may be necessary for Vodafone to earn back the premium it paid for AirTouch. Any slowdown in growth could result in a price war and deteriorating profitability as carriers compete for market share in a maturing market.
- Is this merger likely to be tax free, partially tax free, or taxable? Explain your answer.
Answer: The merger would be partially tax-free. No taxes would be due on the AirTouch shares exchanged for Vodafone shares; however, the $9 per share received by AirTouch shareholders would be taxable.
- What are some of the challenges the two companies are likely to face while integrating the businesses?
Answer: While no integration is ever easy, the two companies are compatible in many ways. They are managed on a decentralized basis, have a shared vision of how to grow the cellular business, and have relatively young workforces. However, both firms have employed the use of partnering arrangements to extend their cellular coverage beyond their borders. Consequently, there is the potential for overlapping agreements to create substantial redundancy and costs. Vodafone has a reputation for leaving its subsidiaries alone as long as they achieve their required financial returns. AirTouch was experiencing considerable problems with customer churn, which if not staunched quickly, could bring intervention from the parent. From a marketing perspective, Vodafone wants to establish its brand in the U.S. This must be done in a way that does not degrade the value of the AirTouch brand as long as it is widely recognized by consumers.
JDS Uniphase–SDL Merger Results in Huge Write-Off
What started out as the biggest technology merger in history up to that point saw its value plummet in line with the declining stock market, a weakening economy, and concerns about the cash-flow impact of actions the acquirer would have to take to gain regulatory approve. The $41 billion mega-merger, proposed on July 10, 2000, consisted of JDS Uniphase (JDSU) offering 3.8 shares of its stock for each share of SDL’s outstanding stock. This constituted an approximate 43% premium over the price of SDL’s stock on the announcement date. The challenge facing JDSU was to get Department of Justice (DoJ) approval of a merger that some feared would result in a supplier (i.e., JDS Uniphase–SDL) that could exercise enormous pricing power over the entire range of products from raw components to packaged products purchased by equipment manufacturers. The resulting regulatory review lengthened the period between the signing of the merger agreement between the two companies and the actual closing to more than 7 months. The risk to SDL shareholders of the lengthening of the time between the determination of value and the actual receipt of the JDSU shares at closing was that the JDSU shares could decline in price during this period.
Given the size of the premium, JDSU’s management was unwilling to protect SDL’s shareholders from this possibility by providing a “collar” within which the exchange ratio could fluctuate. The absence of a collar proved particularly devastating to SDL shareholders, which continued to hold JDSU stock well beyond the closing date. The deal that had been originally valued at $41 billion when first announced more than 7 months earlier had fallen to $13.5 billion on the day of closing.
JDSU manufactures and distributes fiber-optic components and modules to telecommunication and cable systems providers worldwide. The company is the dominant supplier in its market for fiber-optic components. In 1999, the firm focused on making only certain subsystems needed in fiber-optic networks, but a flurry of acquisitions has enabled the company to offer complementary products. JDSU’s strategy is to package entire systems into a single integrated unit, thereby reducing the number of vendors that fiber network firms must deal with when purchasing systems that produce the light that is transmitted over fiber. SDL’s products, including pump lasers, support the transmission of data, voice, video, and internet information over fiber-optic networks by expanding their fiber-optic communications networks much more quickly and efficiently than would be possible using conventional electronic and optical technologies. SDL had approximately 1700 employees and reported sales of $72 million for the quarter ending March 31, 2000.
As of July 10, 2000, JDSU had a market value of $74 billion with 958 million shares outstanding. Annual 2000 revenues amounted to $1.43 billion. The firm had $800 million in cash and virtually no long-term debt. Including one-time merger-related charges, the firm recorded a loss of $905 million. With its price-to-earnings (excluding merger-related charges) ratio at a meteoric 440, the firm sought to use stock to acquire SDL, a strategy that it had used successfully in eleven previous acquisitions. JDSU believed that a merger with SDL would provide two major benefits. First, it would add a line of lasers to the JDSU product offering that strengthened signals beamed across fiber-optic networks. Second, it would bolster JDSU’s capacity to package multiple components into a single product line.
Regulators expressed concern that the combined entities could control the market for a specific type of pump laser used in a wide range of optical equipment. SDL is one of the largest suppliers of this type of laser, and JDS is one of the largest suppliers of the chips used to build them. Other manufacturers of pump lasers, such as Nortel Networks, Lucent Technologies, and Corning, complained to regulators that they would have to buy some of the chips necessary to manufacture pump lasers from a supplier (i.e., JDSU), which in combination with SDL, also would be a competitor. As required by the Hart–Scott–Rodino (HSR) Antitrust Improvements Act of 1976, JDSU had filed with the DoJ seeking regulatory approval. On August 24, the firm received a request for additional information from the DoJ, which extended the HSR waiting period. On February 6, JDSU agreed as part of a consent decree to sell a Swiss subsidiary, which manufactures pump lasers chips, to Nortel Networks Corporation, a JDSU customer, to satisfy DoJ concerns about the proposed merger. The divestiture of this operation set up an alternative supplier of such chips, thereby alleviating concerns expressed by other manufacturers of pump lasers that they would have to buy such components from a competitor.
The Deal Structure
On July 9, 2000, the boards of both JDSU and SDL unanimously approved an agreement to merge SDL with a newly formed, wholly owned subsidiary of JDS Uniphase, K2 Acquisition, Inc. K2 Acquisition, Inc. was created by JDSU as the acquisition vehicle to complete the merger. In a reverse triangular merger, K2 Acquisition Inc. was merged into SDL, with SDL as the surviving entity. The postclosing organization consisted of SDL as a wholly owned subsidiary of JDS Uniphase. The form of payment consisted of exchanging JDSU common stock for SDL common shares. The share exchange ratio was 3.8 shares of JDSU stock for each SDL common share outstanding. Instead of a fraction of a share, each SDL stockholder received cash, without interest, equal to dollar value of the fractional share at the average of the closing prices for a share of JDSU common stock for the 5 trading days before the completion of the merger.
Under the rules of the NASDAQ National Market, on which JDSU’s shares are traded, JDSU is required to seek stockholder approval for any issuance of common stock to acquire another firm. This requirement is triggered if the amount issued exceeds 20% of its issued and outstanding shares of common stock and of its voting power. In connection with the merger, both SDL and JDSU received fairness opinions from advisors employed by the firms.
The merger agreement specified that the merger could be consummated when all of the conditions stipulated in the agreement were either satisfied or waived by the parties to the agreement. Both JDSU and SDL were subject to certain closing conditions. Such conditions were specified in the September 7, 2000 S4 filing with the SEC by JDSU, which is required whenever a firm intends to issue securities to the public. The consummation of the merger was to be subject to approval by the shareholders of both companies, the approval of the regulatory authorities as specified under the HSR, and any other foreign antitrust law that applied. For both parties, representations and warranties (statements believed to be factual) must have been found to be accurate and both parties must have complied with all of the agreements and covenants (promises) in all material ways.
The following are just a few examples of the 18 closing conditions found in the merger agreement. The merger is structured so that JDSU and SDL’s shareholders will not recognize a gain or loss for U.S. federal income tax purposes in the merger, except for taxes payable because of cash received by SDL shareholders for fractional shares. Both JDSU and SDL must receive opinions of tax counsel that the merger will qualify as a tax-free reorganization (tax structure). This also is stipulated as a closing condition. If the merger agreement is terminated as a result of an acquisition of SDL by another firm within 12 months of the termination, SDL may be required to pay JDSU a termination fee of $1 billion. Such a fee is intended to cover JDSU’s expenses incurred as a result of the transaction and to discourage any third parties from making a bid for the target firm.
The Aftermath of Overpaying
Despite dramatic cost-cutting efforts, the company reported a loss of $7.9 billion for the quarter ending June 31, 2001 and $50.6 billion for the 12 months ending June 31, 2001. This compares to the projected pro forma loss reported in the September 9, 2000 S4 filing of $12.1 billion. The actual loss was the largest annual loss ever reported by a U.S. firm up to that time. The fiscal year 2000 loss included a reduction in the value of goodwill carried on the balance sheet of $38.7 billion to reflect the declining market value of net assets acquired during a series of previous transactions. Most of this reduction was related to goodwill arising from the merger of JDS FITEL and Uniphase and the subsequent acquisitions of SDL, E-TEK, and OCLI..
The stock continued to tumble in line with the declining fortunes of the telecommunications industry such that it was trading as low as $7.5 per share by mid-2001, about 6% of its value the day the merger with SDL was announced. Thus, the JDS Uniphase–SDL merger was marked by two firsts—the largest purchase price paid for a pure technology company and the largest write-off (at that time) in history. Both of these infamous “firsts” occurred within 12 months.
- What is goodwill? How is it estimated? Why did JDS Uniphase write down the value of its goodwill in 2001? Why does this reflect a series of poor management decisions with respect to mergers completed between 1999 and early 2001?
Answer: In theory, goodwill represents the value of the acquired firm’s intangible value including brand, intellectual property, good customer relations, and high employee morale. Goodwill is calculated as the excess of the purchase price over the target’s net book assets (i.e., the sum of the book value of equity of the acquired company plus revalued assets less revalued liabilities. The $38.7 billion write-down of the firm’s goodwill reflected the declining market value of the assets acquired through a series of acquisitions. This write-down reflected the cumulative impact over time of management’s tendency to pay well above the actual economic value of the firms they acquired. Because of this overpayment, JDS was unable to earn its cost of capital and the value of its stock fell below its net book assets, thereby necessitating a write-down of goodwill.
- How might the use of stock, as an acquisition “currency,” have contributed to the sustained decline in JDS Uniphase’s stock through mid-2001? In your judgment what is the likely impact of the glut of JDS Uniphase shares in the market on the future appreciation of the firm’s share price? Explain your answer.
Answer: The lofty JDSU share price in 1999 and early 2000 made it a very attractive acquisition “currency.” Management presumed that projected synergies would result in a more than proportional increase in future earnings sufficient to offset the huge increase in shares issued to complete JDSU’s string of acquisitions. JDSU issued almost 340 million shares to acquire SDL alone, resulting in the combined firms having more than 1.2 billion shares outstanding in early 2001. The huge amount of shares on the market resulted in a dilution of current shareholder claims on future JDSU earnings.
- What are the primary differences between a forward and a reverse triangular merger? Why might JDS Uniphase have chosen to merge its K2 Acquisition Inc. subsidiary with SDL in a reverse triangular merger? Explain your answer.
Answer: Forward triangular mergers are used in tax-free asset acquisitions, no more than 50% of the purchase price can be cash, and either voting or non-voting stock may be used. A reverse triangular merger is used in tax-free stock acquisitions, only 20% of the purchase price may be cash, and only voting stock may be used in the purchase price. The reverse merger is most commonly used to effect tax-free stock acquisitions in which the form of payment is predominately the acquirer’s voting stock. Although the reverse triangular merger is similar to a Type B reorganization in which the acquiring company purchases the target’s stock in exchange for its stock, it permits the acquirer to use up to 20% cash. This could not be done in a pure Type B reorganization. The reverse merger may also avoid the need for parent company shareholder approval. Since the target firm remains in existence, the target can retain any nonassignable franchise, lease, or other valuable contract rights. Moreover, by avoiding the dissolution of the target firm, the acquirer avoids the possible acceleration of loans outstanding. Finally, insurance, banking, and public utility regulators may require the target to remain in existence in exchange for their granting regulatory approval.
- Discuss various methodologies you might use to value assets acquired from SDL such as existing technologies, “core” technologies, trademarks and trade names, assembled workforce, and deferred compensation?
Answer: The value of intellectual property may be estimated by looking at recent comparable sales, by estimating the cost of replacing such assets, by computing the present value of royalties generated if such assets were licensed, or by treating the asset as a real option. The costs of locating, interviewing, hiring, and training workers may be used to estimate the value of the workforce. The estimated value of deferred compensation is the present value of net cash inflows from workers, some portion of whose compensation has been deferred, less cash outflows experienced when the deferred compensation is actually paid.
- Why do boards of directors of both acquiring and target companies often obtain so-called “fairness opinions” from outside investment advisors or accounting firms? What valuation methodologies might be employed in constructing these opinions? Should stockholders have confidence in such opinions? Why/why not?
Answer: Fairness opinions are often obtained to minimize potential liability from shareholder lawsuits which might ensue if it is later determined that the acquirer “overpaid” for the target firm or that the target firm’s shareholders received less than fair market value for their stock. Valuation methodologies include income, market-based methods, asset-oriented methods, cost methods, and a weighted average of multiple valuation methods. Since the investment bank and the accounting firm issuing the opinions stand to realize greater fee income if the transaction occurs, there is the potential for a conflict of interest.