Business Valuation and Corporate Restructuring Chapter Nine
Kraft-Cadbury January 2010 Cadbury reluctantly agrees to be acquired by Kraft. Cadbury—British confectioner: Cadbury chocolates, Trident, Dentyne Kraft—America’s largest food company: Kraft cheeses, Oscar Mayer meats, Oreo cookies
Combination Large Combination became world’s largest confectioner company. Kraft ~ 100,000 employees, $40.4b revenue Cadbury ~ 45,000 employees, £5.4b revenue
Premium • Kraft paid 60% in cash and 40% in new shares. • Kraft paid 62% more for Cadbury than the price of its shares just before the acquisition. • £8.50 vs. £5.25 • Why?
Clear Winners • Cadbury shareholders, received £4.6b (= $7.4b) more for their shares as a result. • Banker and lawyers • Kraft--$390m for advisory fees and to arrange financing • Cadbury--$50-56m • CEOs • Irene Rosenfeld, Kraft, $26m for leadership • Todd Stitzer, Cadbury, $30m shares/options
Questions Why was Kraft willing to pay £8.50/share when market price was lower at £5.25? If Kraft had the valuation right, why didn’t the market bid up the price of Cadbury? If the value was there, why didn’t Cadbury managers create more value? Who should make the final call on restructuring, managers or investors?
Corporate Restructuring Asset mix Capital structure Ownership Friendly and hostile acquisitions Purchases or sales of divisions Spin-offs (of divisions to shareholders) Carve-outs (of divisions, sold to public) LBOs
Outline Business valuation Market for corporate control Motives for business restructuring: Tax shields Enhanced management incentives Shareholder control of free cash flow Survey of evidence on the economic merits of mergers, LBOs, and the Daimler-Chrysler merger
Valuing a Business Valuation used to analyze many activities, such as mergers, LBOs, and analysts’ search for undervalued stocks Value a company’s assets or equity? Going concern or liquidation? Minority interest or controlling interest?
Assets or Equity? When an acquiring firm purchases a target, it often assumes the target’s liabilities. It is as if acquirer paid a down payment (equity E) to purchase the entire firm (E+D), and borrowed same amount (D) as target’s debt. Kraft paid £14b total = £11.9b for Cadbury equity and assumed £2.1b Cadbury debt .
Dead or Alive? Liquidation value is the cash generated by terminating the business. Going concern value is the present value of the future cash flows from continuing to operate the business. Usually the fair market value (FMV) is the higher of the two values. See Figure 9.1.
FIGURE 9.1 The Fair Market Value of a Business Is Usually the Higher of Its Liquidation Value and Its Going-Concern Value
Exception Because of agency costs, managers might choose to continue a business whose going concern value < its liquidation value. This can happen if minority shareholders cannot force liquidation. In most large American public companies, effective control devolves to the board of directors and incumbent management.
Minority Interest or Control? Market value measures the worth of a business to minority owners. Market value is not necessarily an indicator of what price a controlling interest might trade. Cadbury’s market value of £9.5b vs. £14b paid by Kraft. For privately held firms, there might be no market value.
Discounted Cash Flow Valuation FMV of firm = PV of expected cash flows to owners and creditors Discount rate should be WACC Value of equity = Value of firm – Value of debt
Free Cash Flow Free cash flow = EBIT(1-Tax rate) (after tax flows to debtholders and shareholders if no debt) + Depreciation (noncash expense) - Capital Expenditures - Working capital investments (omitting excess cash) Extra cash generated treated as separate add-on.
Terminal Value FMV of firm = PV of FCF before terminal date + Terminal value The challenge is to estimate terminal value. Consider five alternative ways. Avoid picking the best, or taking a simple average. Try to understand why the different techniques give rise to different numbers.
Liquidation Value Usually grossly underestimates value.
Book Value Usually provides a conservative value.
Warranted Price-to-Earnings Multiple Multiply earnings E that are estimated for the end of the forecast horizon by a “warranted” P/E. Add to firm’s liabilities, to obtain value of firm. Warranted means suitable for the stage the company will be when the terminal date arrives. Technique also applies to sales, market-to-book ratio, etc.
No-Growth Perpetuity Terminal value of no-growth firm = FCFT+1 / KW where capital expenditures are about the same as depreciation charges and net working capital is steady, so that FCFT+1 = EBIT(1-Tax rate).
Perpetual Growth Terminal value of a growing firm = FCFT+1 / KW-g where care must be taken about assuming that g is not too large, as companies that grow faster than the economy eventually become the economy. For the economy, g is 2-3% + inflation.
The Forecast Horizon Terminal values of growing businesses can easily exceed 60% of firm value. Typical to choose a terminal date when the firm reaches maturity
Example in Table 9.1 Use 5-year pro forma projection, with the terminal date at the end Date of evaluation is Dec 31, 2010 Assumptions: %-of-sales (see Table 2.3, Chapter 2) 7% growth rate in sales (per analysts’ projections) prior to terminal period 4% growth rate in terminal period WACC = 7.9% as per Chapter 8
TABLE 9.1 Discounted Cash Flow Valuation of Sensient Technologies Corporation ($ millions except per share)
Problems with Present Value Approaches to Valuation In comparison with valuing a project, valuing a business: Has a longer life (indefinite) Has cash flows that grow over time, as opposed to decline over time Has cash flows that go to the owner only when management chooses to distribute them
Valuation Based on Comparable Trades Part art and part science Select comparable trades to value the business Based on DCF, choose comparison firms with similar cash flow patterns, similar businesses, and similar risks. Also, try to choose similar growth prospects and similar capital structures.
Figure 9.2 Compare Sensient to representative competitors in “specialty chemicals and related industries.” Focus on IFF and MKC. Sensient’s relative growth (sales, EPS) and financial risk? Interest coverage ratios?
TABLE 9.2 Using Comparable Public Companies to Value Sensient Technologies Corporation (December 31, 2010)
TABLE 9.2 Using Comparable Public Companies to Value Sensient Technologies Corporation (December 31, 2010) (cont.)
P/X? • Price (P) per: • current income • sales • invested capital
Greater Weight to ? • Income more closely tied to value • Enterprise value more reliable, to avoid financing effects in P/E • Stable ratios more reliable • Smaller size, lower growth, precarious capital structure places Sensient in lower portion of group Compare best guess $36 vs. $36.73 actual.
Lack of Marketability Stocks of privately held firms are less liquid than stocks of publicly held firms. Liquidity discount is about 25%.
The Market for Control Because control is valuable, trades of controlling interest shares are typically priced differently than shares of minority interest shares. Figure 9.2 illustrates this. In this Figure, FMVm is the least the acquirer can expect to pay, while FMVc is the most the acquirer should be willing to pay. c/m is the value of control.
FIGURE 9.2 FMV of a Corporation to Investors Seeking Control May Exceed FMV to Minority Investors
What Price Control? FMVc = FMVm + Enhancements FMVm is often called the target firm’s stand-alone value. The enhancements to value reflect the changes the acquirer would make to the target’s business. Enhancements = PV of all value-increasing changes due to the acquisition.
Controlling Interest in a Publicly Traded Company FMVc = Market value of business+ Enhancements Table 9.3 displays some interesting information about premiums, rising until recent recession and then declining Examine each column, and look at the range in the rightmost column in respect to premiums.
Financial Reasons for Restructuring There are many possible benefits stemming from acquisitions. Cost savings in manufacturing, marketing, distribution and overhead. Better access to financial markets. Enhanced investment opportunities. Next, consider three additional reasons.
Tax Shields Consider a mature publicly traded firm with stable cash flows that is paying tax. Suppose that the firm’s management does an LBO in which they purchase most of the stock, paying for it by taking out leverage. The resulting debt creates increased tax shields along with increased costs of financial distress. Of course, LBO is not necessary to capture tax shields.
Incentive Effects Tax shields shift wealth from taxpayers to shareholders. Additional debt also leaves less room for managers to pursue their own interests over those of shareholders.
Controlling Free Cash Flow A company might be run as if it faced a multitude of goals. Large, mature firms might generate significant amounts of free cash flow. Boards might work in consort with management, rather than overseeing shareholders’ interests. Restructurings might also refocus a company’s goal on maximizing shareholder interests.
New Slates of Directors SEC imposed new regulations, beginning November 2010. Qualified (3% of shares/ 3 years ownership) shareholders can propose up to 25% of board positions. Before, shareholders could only vote to withhold approval of directors on ballots. Proposing new slate of directors required costly proxy battle.
Goals Pay out more cash through buybacks Sell underperforming assets Put company up for sale Carl Icahn: “We do the job the LBO guys do, but for all the shareholders.”
Does Activist Investing Work? Klein and Zur (2009): 151 hedge fund activists, 154 other activists Activists earned 5.1 – 10.2% more than counterparts in period surrounding announcement of activists’ intentions Earned 11.4 – 17.8% in year following Achieved 60 – 65% success rate in securing management acquiescence
The Empirical Evidence Do corporate restructurings create value? The premiums paid by acquirers indicate that the shareholders of target firms benefit (Table 9.3) Evidence that shareholders of acquiring firms also benefit, but gain is small and range of outcomes is large
Mega-Mergers Largest 1% of mergers by transaction size 1980-2006, mega-mergers’ accounted for 43% of all transaction outlays on mergers Generated return of -3.5% = -$415.5b Other 99% generated return of 1.5%
Management Buyouts Kaplan study 1980-1986: 2 years following management buyouts (LBOs) Return on operating assets increased by 36% Capex/assets fell by 5.7% (statistically insignificant) FCF/assets increased by 85% Market-adjusted return to all sources of capital for the best firms increased by 28%
1990-2006 Numbers not quite as large, but performance still superior Return to capital, market and risk adjusted ~ 41% Sources of improvement are higher operating leverage, financial leverage, replacement of CEO right after buyout
Cadbury Buyout • Attraction of Cadbury to Kraft? • Distribution channels in emerging markets such as India and Mexico • Cost savings of $675m in 3 years • Capitalized after-tax value at 3% growth, 35% tax rate, and 10% discount rate is $6b = 0.65 x $675m / (0.10 – 0.03)