Every company is different; every merger is different," said the Delaware Court of Chancery in In re: Appraisal of PetSmart, Inc. (Delaware Ch., C.A No. 10782-VCS, May 26, 2017)
Although the discounted cash flow (DCF) model is often considered a gold standard in business valuation tools, this case shows that merger price may sometimes provide a more reliable indicator of fair value in appraisal actions.
Pedigreed Experts, Disparate Conclusions
PetSmart is one of the largest retailers of pet products and services in North America. The company experienced significant growth from 2000 to 2012, capitalizing on a growing pet population and increased spending by pet owners.
PetSmart's growth began to stall in 2012, however, in the face of increasing competition, high management turnover, excessive costs and an ineffective marketing strategy. So, PetSmart's board of directors decided to consider a take-private transaction. In 2014, an investment banking firm estimated that PetSmart's shares were worth $77 to $100 a share.
After courting 27 potential buyers, on March 11, 2015, PetSmart was acquired by a consortium of funds for $83 a share. Prior to the merger, PetSmart traded on the NASDAQ. A group of stockholders refused to accept the buyout price and filed an appraisal rights action. Both sides hired experts to determine the fair value of PetSmart's stock on the merger date.
The shareholders' expert performed a DCF analysis, using projections management prepared specifically for the merger. He arrived at a value of $128.78 a share. By comparison, PetSmart's expert concluded that the merger price was the best indicator of fair value. To settle the discrepancy, the court addressed three questions.
1. Did the Merger Process Yield Fair Value?
In August 2014, PetSmart announced that it was pursuing strategic alternatives, including a possible sale. Of the 27 potential bidders the company contacted, five submitted preliminary bids by October 31, 2014, ranging from $65 to $85. Its stock price closed on October 31, 2014, at $72.35.
By December 2014, the board had two best-and-final offers of $81.50 and $83 a share. The company also obtained a fairness opinion, stating that the merger price of $83 was fair from a financial point of view. More than 99% of PetSmart's voting stockholders approved the merger.
Based on this evidence, the court concluded that the process used to facilitate the going-private merger, "while not perfect, came close enough to perfection to produce a reliable indicator of PetSmart's fair value."
2. Were Management's Projections Reliable?
A valuation method is only as reliable as its underlying assumptions. The shareholders' expert estimated the fair value per share using a DCF model that relied on long-term projections prepared solely for the going-private merger. During his testimony, the expert admitted "garbage in, garbage out," acknowledging that, if the court decided that management's projections aren't reliable, then it shouldn't rely on his DCF analysis.
The court outlined the following five "telltale signs" that projections are unreliable:
1. The company's use of such projections is "unprecedented."
2. The projections were created in anticipation of litigation.
3. The projections were created to obtain benefits outside of the company's ordinary course of business.
4. The projections were inconsistent with a corporation's recent performance.
5. The company had a poor track record of meeting its projections.
The court concluded that PetSmart's projections were "saddled with nearly all of these telltale indicators of unreliability." Specifically, PetSmart's management had never prepared long-term projections in the normal course of business. The court record is also clear that the board of directors exerted "substantial pressure upon management to prepare increasingly more aggressive and ultimately unrealistic long-term projections."
And management acknowledged that potential buyers would discount management's projections, knowing they were an aggressive stance to be used in M&A discussions with potential investors.
As a result, the court rejected the DCF model that the petitioner's expert used to estimate fair value.
3. Does the Evidence Provide a Basis for Alternative DCF Analyses?
It's within a court's discretion to develop its own valuation methodology based on the evidence presented at trial. However, this court found no reason to depart from the experts' analyses and adjust the projections or otherwise alter the assumptions to arrive at a more reliable DCF analysis.
More than One Way to Value a Business
After considering all relevant factors, the court ruled that the most reliable indicator of fair value was PetSmart's merger price because it was arrived at in an "arm's length" negotiation process.
However, there are no one-size-fits-all answers in statutory appraisal rights cases. What's "fair" may vary depending on the facts and circumstances. Consult with Doug to determine what's right for your situation.
DOUGLAS P. SOSNOWSKI, CPA/ABV, ASA, CFF
Douglas P. Sosnowski provides business valuation, forensic accounting, and litigation support services for Brisbane Consulting Group. He has extensive valuation experience and has served as an expert witness, testifying in courts of law throughout the state of New York. Doug has experience consulting with publicly traded entities and valuing a variety of closely held companies in connection with mergers, acquisition and divestitures, business combinations, estate and gift tax planning, ESOPs and purchase price allocations. He also has experience in the quantification of lost income in determining business interruption claims for insurance adjusters. Doug is a member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and the American Society of Appraisers. Doug is a licensed financial advisor holding Series 7 and 66 securities licenses. He graduated with honors from the State University of New York at Buffalo earning his Bachelor of Science degree in business administration with concentrations in accounting and finance.