On May 31, 2016, Vice Chancellor Laster issued an opinion in the Dell appraisal matter, concluding that the fair value of Dell’s common stock on the closing date of its going-private transaction was $17.62 per share, over 28% higher than the merger price of $13.75 per share.
The majority of the opinion addresses whether the merger price was an indication of fair value for Dell, with three key takeaways:
- The fact that an appraisal action is different from a breach of fiduciary duty claim has valuation implications;
- A leveraged buyout (“LBO”) financial model will not necessarily result in an indication of fair value; and
- The market's pricing of securities may not, in some circumstances, be consistent with the going concern, fair value used to price securities in Delaware appraisal matters -- termed a "valuation gap" by the Court.
Merger Price Does Not Necessarily Equal Fair Value
First, VC Laster states that merger price does not “inevitably equate to fair value,” noting three main factors that “may undermine the potential persuasiveness of the deal price as evidence of fair value.”
- There can be a “substantial delay between the signing date and the closing date.” The Court notes that the deal price provides a data point for market price as of the signing date, but the appraisal valuation date is the closing date.
- “The deal market is unavoidably less efficient at valuing entire companies (including the value of control) than the stock market is at valuing minority shares.”
- Synergies may exist in the merger price, even for a financial buyer.
The Court states that the fair value “could be higher or lower” than the deal price, stating that “[t]he respondent corporation still may be able to establish that the merger price is the best evidence of fair value – and it often will be – but the corporation must carry its burden on that point.”
The Court highlights the difference between appraisal actions and breach of fiduciary duty claims, noting that in the former, “price is all that matters…The sale process is useful to the extent—and only to the extent—that it provides evidence of the company‘s value on the date the merger closed.” VC Laster states that, in this case, “the Company’s process easily would sail through if reviewed under enhanced scrutiny.” However fair the process was in this case, the Court still concluded that the merger price was not fair value.
VC Laster opines that in this case a “combination of factors undercut the relationship between the merger price (or “Final Merger Consideration”) and fair value, undermining the persuasiveness of the former as evidence of the latter.” These include: (i) the use of an LBO pricing model; and (ii) the valuation gap between the market price of Dell’s common stock and the intrinsic value of the company.
The Court notes that while a DCF methodology and an LBO model use similar inputs, they solve for different variables. A DCF method results in the present value of a firm, while an LBO model solves for the internal rate of return assuming a present value (i.e., a price). VC Laster opines that the amount a sponsor is willing to pay may differ from fair value because of “(i) the financial sponsor’s need to achieve IRRs of 20% or more to satisfy its own investors and (ii) limits on the amount of leverage that the company can support and the sponsor can use to finance the deal.” As such, the Court concludes that the “outcome of competition between financial sponsors primarily depends on their relative willingness to sacrifice potential IRR. It does not lead to intrinsic value.”
VC Laster also states that there was “compelling evidence of a significant valuation gap driven by the market’s short-term focus,” driven by analysts’ short-term focus on quarterly results, and a $14 billion investment in the Company for a transformation that had not yet begun to generate results. The Court highlights that there is a difference between short-term expectations of market participants and the fair value of the Company on a going concern basis.
Regarding the go-shop phase that was part of the transaction, the Court notes that the results of the go-shop process reinforce the conclusion that the Original Merger Consideration (which was $0.10 lower than the Final Merger Consideration) did not equate to fair value. The Court points to the fact that the go-shop process, which rarely generates higher bids in management buyout (“MBO”) transactions, led to two higher bids, suggesting that the Original Merger Consideration was low.
In determining the fair value of Dell, the Court ultimately relied on a DCF analysis, and assessed the analyses provided by the experts. In addition to the three key takeaways above, a review of the Court’s assessment of the experts’ DCF analyses is a reminder that the Court will often choose its own set of inputs that it deems appropriate and run its own valuation, though as noted below the Court’s valuation models should always be checked.
Both the Petitioners’ and Respondent’s experts used a DCF analysis to arrive at a fair value for the Company—valuing the Company at $28.61 per share and $12.68 per share, respectively. There were multiple areas in which the experts differed in their implementation of a DCF.
The choice of projections was the primary driver of the different values calculated by the experts. Three sets of projections were provided by Boston Consulting Group (“BCG”) to the special committee (the “Committee”) in January 2013. BCG was hired by the Committee to create a set of independent forecasts to help the Committee consider potential transactions. The three projections were:
- BCG Base Case;
- BCG 25% Case (incorporating 25% realization of $3.3B in cost-savings); and
- BCG 75% Case (incorporating 75% realization of $3.3B in cost-savings).
The opinion stated that “BCG believed the BCG 25% Case was attainable and the most reasonable set of projections in light of the Company’s performance with past cost-savings initiatives” and that the “Committee doubted that the Company could achieve the BCG 75% Case, which implied margins in FY 2015 higher than the Company or its competitors had ever achieved.”
Another set of projections was presented in September 2013 to the banks financing the merger (the “Bank Case”). The Bank Case projected increasing margins over the next five years, and $3.6 billion in cost savings, with $2.6 billion built into the forecasts and $1 billion appearing as a separate line item.
The Petitioners’ expert equally weighted the BCG 25% Case and the BCG 75% Case, effectively creating a BCG 50% Case. The Petitioners’ expert then weighted this equally with the Bank Case, a set of projections provided to banks in connection with financing the transaction. The Petitioners’ expert also incorporated an additional $1 billion in cost savings to the Bank Case. The Respondent’s expert adjusted both the BCG 25% Case and the Bank Case.
The Respondent’s expert adjusted the BCG 25% Case to account for lower Company and market performance. The BCG 25% Case was not updated after its preparation in January 2013; however, the Company’s FY 2014 operating income fell short of the BCG 25% Case by 36% and PC sales revenue projections for FY 2015 and FY 2016 “appeared high once IDC reported lower rates of PC shipments in August 2013.”
The Court notes that while “ generally speaking, its appraisal jurisprudence is skeptical of litigation-driven adjustments to management projections, [the Respondent’s expert] persuasively justified his changes.” The Court concluded that the Respondent’s expert’s adjusted BCG 25% Case is “a reliable set of forecasts” but were likely “relatively conservative.”
The Court also concludes that the Respondent’s expert’s adjusted Bank Case, which was adjusted to “account for non-recurring restructuring expenses and for stock-based compensation,” is a reliable forecast for the company.
The second area in which the experts differed was the long-term growth rate for the terminal period. The Petitioners’ expert used a growth rate of 1% and the Respondent’s expert used a growth rate of 2%. VC Laster noted the Court’s use of inflation as a floor for terminal value and stated that a growth rate of 2% is “arguably too low.” VC Laster noted that a 3% rate “could be more appropriate,” given “the Company’s status as a mature Company whose growth rate should fall somewhere above inflation and close to GDP.” The Court ultimately used a growth rate of 2%.
The third area in which the experts disagreed was the tax rate to apply to Dell’s cash flows. The Court adopted the rate used by the Petitioners’ expert of 21%, based in part on valuation models prepared by the Company’s financial advisors. The Respondent’s expert used two rates: 17.8% for the projection period, based on the report of a tax expert and 35.8% for the terminal period, based on the marginal tax rate. VC Laster noted that the Company has not paid taxes at the marginal rate since at least 2000, due, in part, to the Company’s ability to defer payment of domestic taxes on income earned overseas.
Fourth, the experts disagreed on most components of the weighted average cost of capital, including the following:
- Cost of Debt: The Court used the long-term rate on BBB rated bonds given the Company’s downgrade by S&P from A” to “BBB” in May 2013.
- Capital Structure: The Petitioners’ expert used Dell’s pre-announcement capital structure of 75.25% equity. The Respondent’s expert used an average ratio from January 12, 2011 to January 11, 2013 of 74.75% equity. The Court deemed both approaches to be reasonable and selected a capital structure of 75% equity.
- Beta: The Court used the Respondent’s expert’s beta based on the Company’s historical 2-year weekly beta, rather than the Petitioners’ expert’s beta based on peers.
- Equity Risk Premium (“ERP”): The Petitioners’ expert used a forward-looking ERP of 5.5%. The Respondent’s expert used a blended historical and supply-side ERP of 6.41%. The Court used the supply-side ERP of 6.11%.
Using the inputs noted above, as well as certain adjustments to cash, the Court averaged the DCF result of $16.43 per share using the adjusted BCG 25% Case projections, and the DCF result of $18.81 per share using the adjusted Bank Case projections, to arrive at a fair value of $17.62 per share.
Subsequent to the Court’s opinion, on June 6, 2016, Petitioners filed a “Motion to Alter or Amend the Court’s May 31, 2016 Memorandum Opinion, or in the Alternative, for Reargument,” arguing that there is a mathematical error in the Court’s DCF analysis. This issue has not been resolved as of the writing of this client alert.