Compromised projections compel Chancery to ‘defer’ to deal price

BVWireIssue #179-1
August 2, 2017

A recent statutory appraisal decision from the Delaware Court of Chancery offered a familiar valuation contest between the discounted cash flow analysis and the merger price. Shareholders opposed to the going-private merger of PetSmart claimed that their discounted cash flow analysis was the best indicator of fair value. The company advocated in favor of the merger price. The court’s decision zeroed in on the management projections.

The significance of the projections wasn’t lost on the parties, both of which retained projections experts as well as valuation experts. The petitioners’ projections expert said the forecasts met industry standards and reliably predicted the company’s future cash flows. The company’s projections expert dismissed them as being “overly optimistic and wholly unreliable.” The forecasts were the product of a management team that had no experience creating long-term projections and that could not draw on past examples for guidance because the company never created long-term projections in the ordinary course of business, this expert noted.

The petitioners’ valuation expert developed a WACC-based DCF analysis that yielded a fair value of $128.78 per share. The company’s expert allowed that financial analysts (and courts) often consider the DCF analysis the “gold standard.” But for a sound analysis, “one must use the ‘expected’ (as opposed to ‘hoped for’) future cash flows of the business,” he said. Here, the management projections were “entirely unreliable.” He concluded the sales price, $83 per share, represented fair value.

‘Telltale indicators of unreliability’: There was a “vast delta between the valuations generated by the parties’ proffered methodologies,” the court noted. It said it would resist the temptation to conclude neither outcome reflected the company’s fair value or to strike a balance between the two results. The appraisal process was adversarial and required it to consider the facts presented, the court pointed out.

There were two key questions: (1) whether the sales process leading to the merger was “fair, well-functioning and free of structural impediments to achieving fair value for the Company”; and (2) whether there was a reliable foundation for the DCF analysis. As to the sales process, the court found the auction “came close to perfection to produce a reliable indicator of PetSmart’s fair value.” The final price was higher than PetSmart stock had ever traded, the court observed. In terms of the DCF, the court stated that the “first key to a reliable DCF analysis is the availability of reliable projections of future expected cash flows.” Here, the projections underlying the petitioners’ DCF analysis were “saddled with nearly all of [the] telltale indicators of unreliability.”

Using the price the petitioners’ expert determined “would be tantamount to declaring a massive market failure occurred here that caused PetSmart to leave nearly $4.5 billion on the table,” the court said. It declined to go there, instead opting to “defer” to the deal price, “because that is what the evidence presented in this case requires.”

A digest of In re PetSmart, Inc., 2017 Del. Ch. LEXIS 89 (May 26, 2017), and the court’s opinion, will be available soon at BVLaw.

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