Wednesday, May 31, 2017

PetSmart appraises at merger price

By Anne Sherry, J.D.

PetSmart shareholders who opposed the 2015 going-private merger lost their fight for a 55-percent bump in consideration. Appraising the company at the $83-per-share deal price, the Delaware Court of Chancery observed that accepting the petitioners’ $129-per-share valuation “would be tantamount to declaring that a massive market failure occurred here that caused PetSmart to leave nearly $4.5 billion on the table.” Although the gap between the two valuations could suggest that neither accurately pegged the company’s value, the “robust” sale process and lack of compelling contrary evidence led the court to defer to the deal price (In re Appraisal of PetSmart, Inc., May 26, 2017, Slights, J.).

Towards the end of 2014, the PetSmart board unanimously voted to approve and recommend a merger with BC Partners. The $83 bid was $1.50 higher than the next highest bid and significantly higher than analysts’ price targets. No topping bids emerged, and shareholders—which had been provided with management projections but “cautioned not to place undue reliance” on them—voted overwhelmingly to approve the deal. The merger closed in March.

The appraisal petitioners claimed that a discounted cash flow analysis rooted in management’s projections was a better indicator of the company’s fair value than the deal price. Both the petitioners and PetSmart offered two experts, one to address the reliability of the management projections and the other to address fair value at the time of the merger. Petitioners’ retail expert maintained that PetSmart hit a “speed bump” just before the sales process began, from which it would have rebounded. Their other expert relied on the projections in all respects for his discounted cash flow analysis, recognizing that if the court found those projections are not reliable, it should not rely on his DCF valuation. PetSmart’s own expert opined that the management projections were too aggressive and optimistic and could not be relied upon.

The court framed the dispute in terms of three questions: first, was the transactional process leading to the merger fair, well-functioning, and free of structural impediments to achieving fair value? Second, are the requisite foundations for the performance of a DCF analysis reliable enough to produce a trustworthy indicator of fair value? Finally, is there an evidentiary basis in the record for the court to determine fair value by constructing its own valuation structure outside of the two proffered methodologies?

Sale process. While not perfect, the sale process “came close enough to perfection to produce a reliable indicator of PetSmart’s fair value,” the court wrote in examining the first question. The board retained Morgan Stanley and then JPMorgan, created an ad hoc committee of experienced independent directors, was willing to walk away if it did not get a satisfactory price, and was prepared to take on a proxy fight if the company’s more active stockholders were unhappy with the board’s decision. The board announced to the world that it was open to a merger, and it did not rush the sale.

The petitioners pointed to several factors that they said rendered the deal price an unreliable measure of fair value, but the court rejected these arguments. First, the record was devoid of evidence that a seized credit market actually affected the amount any bidder was willing to offer. Second, although it was true that only financial sponsors submitted bids, private equity bidders did not know that they were only competing with each other. Third, there was no credible support for the notion that the board was forced to sell after the emergence of an activist shareholder. Fourth, the petitioners’ argument that the board was ill-informed was based primarily on a witness’s difficulty remembering certain details at trial. Fifth, any conflicts were minor and were fully disclosed. Finally, the argument that the merger price was stale by the time of closing was speculative at best.

DCF analysis. The court could not end its inquiry upon determining that the merger price was a reliable indicator of fair value; Delaware’s appraisal statute required it to consider “all relevant factors.” The court also had to examine the reliability of the other valuations of PetSmart in the trial record, namely, the discounted cash flow analysis. Ultimately, the court determined that the management projections undergirding the petitioners’ DCF analysis were “saddled with … telltale indicators of unreliability.”

Specifically, PetSmart management did not have a history of creating long-term projections; even management’s short term projections frequently missed the mark; the projections were not created in the ordinary course of business but rather for use in the auction process; and management engaged in the process of creating all of the auction-related projections in the midst of intense pressure from the Board to be aggressive, with the expectation that the projections would be discounted by potential bidders.

Because the projections were not reliable statements of PetSmart’s expected cash flows, any DCF analysis that relied upon them would produce meaningless results, the court wrote. And there was no basis in the record to make further adjustments to the projections or alter the inputs used by the experts to arrive at a more reliable DCF analysis.

The case is No. 10782-VCS.

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