U.S. Bank N.A. v. Verizon Communications Inc., 2013 U.S. Dist. LEXIS 8521 (Jan. 22, 2013)
What happens when a well-established, highly-credentialed appraiser makes reasonable and well-documented arguments to weight her DCF analysis at 70%, even though her income approach conclusion of value differed dramatically from the result of two market approach analyses?
This is what happened in this ten-day bench trial in federal court (N.D. Tex.). which focused on focused the enterprise value of a directories business when Verizon spun it off in November 2006. The newly formed directory business lasted two years on the New York Stock Exchange, before filing for Chapter 11 bankruptcy in early 2009. At the time of the spinoff, there was significant investor interest in directories companies because of their high and stable cash flow, but while stand-alone directories companies traded at as much as 10 times EBITDA, Verizon’s was trading at only 5 to 5.5 times EBITDA.
Market analyses support a value of between $10 and $15 billion. The appraiser (a CPA, a certified insolvency and restructuring accountant, a credentialed business valuator, also holding licenses from the Financial Industry Regulatory Authority (FINRA)) recognized available market data, and agreed with it—specifically:
- Morgan Stanley, Citibank, and Goldman Sachs had all done their own valuations as of the spin-off date, and all came up with numbers between $11 and $14.4 billion.
- In November 2005, the Verizon board received a “strategic update” that indicated a valuation range from $10.5 billion to $15 billion resulting from a discounted cash flow (DCF) analysis.
- The appraiser's own "market multiple" approach, using the same five directories companies and multiples that the investment bank Houlihan Lokey had used when it performed a valuation analysis for a solvency opinion for the subject in fall 2006, found a value ranging from $11.7 billion to $13.2 billion.
- Under the comparable transaction method, she again drew on 17 company transactions Houlihan Lokey had used for its solvency opinion, arriving at a value range from $13.4 billion to $15.8 billion.
The appraiser had many reasons to doubt these market-based conclusions, however. For instance:
- an internal "downside case" DCF Verizon document from summer 2005 suggested a value of only $6.5 billion (though the in-house analyst subsequently “refined” that number to “was what it was when the transaction was completed,” that is, $12.8 billion).
- Verizon’s directories business performed worse than the market multiple comparables, she said. Also, the selected companies were not truly comparable: only one was, like the spin-off, an incumbent print company doing business in the U.S. And, the company had significant tax benefits not available to the subject.
- The tax structure of the spin-off prevented the subject from accessing the transactions market, she believed, rendering that the 17 comparable transactions in the second Houlihan Lokey inappropriate.
- Verizon’s and the subject’s SEC filings indicated declining revenues from 2001 through 2006 and industry analysts projected future revenue declines in the incumbent print business.
- And, most importantly, Verizon had only provided some of their EBITDA analyses to private-side investors, leading public investors and others to overvalue the equity. She asserted that Verizon had not disclosed the significant differences in EBITDA margins from the incumbent print and electronic businesses; concealed the steady annual declines in revenue in specific northeastern urban markets; and failed to disclose consistent missed management projections, as well as a consulting group’s pessimistic forecast about the future of the directories business. Verizon’s misrepresentations and omissions led investors to inflate the subject’s equity value by at least $4 billion, she argued, dismissing the standard stock price market value metric.
For the DCF valuation, she made three different calculations based on three different projections of the subject company’s free cash flow for the projection period. For one projection she adjusted a “base case” projection that Verizon had prepared in 2006; for a second, she used a stress-test projection Houlihan Lokey had made before presenting its solvency opinion; and for a third projection, she used a mathematical extrapolation of the trend of the actual historical performance of Verizon’s directory business from 2003 to 2006. She derived her terminal growth rate from the Gordon Growth Model, assuming an annual rate of EBITDA decline in perpetuity.
She determined a discount rate of 9.75% using the standard “Weighted Average Cost of Capital” (WACC) formula, which she applied to the three sets of projected cash flow in the projection period and the terminal value. Moreover, she applied a 2% company-specific risk premium in calculating the company’s cost of equity. As a result, the overall discount rate was 1% higher than it would have been without the premium. The adjustment was appropriate given certain disadvantages that were specific to the subject, she explained, including its operating in lower-growth, highly-competitive urban markets, lagging behind competitors in terms of performance, having inexperienced management, and facing restrictions in the strategic and financial options it could pursue because of the TSA.
She concluded that the value ranged from $5.4 billion to $6.3 billion and that the midpoint—$5.85 billion—most accurately reflected the enterprise value under the DCF.
The weighted calculations produced a value range from $7.5 billion to $8.8 billion whose midpoint— $8.15 billion—was the enterprise value the day of the transaction, she concluded; this meant the company was insolvent after including its spin-off debt.
The defendants’ rebuttal expert focused most of his critique on his counterpart’s DCF analysis:
- It was “incorrect” to use a purely historical average for a projection, as she did in her third projection.
- It also was inappropriate to use the Houlihan Lokey stress-test projection, because that originally was for a sensitivity analysis, not for the purpose of valuation.
- The analysis made inappropriate adjustments to Verizon’s base case projections, which were already more conservative than industry reports suggested.
- To assume an annual rate of EBITDA decline in perpetuity (for the terminal value calculation) was “commercially unreasonable und inappropriate in a DCF valuation” since most analysts would assume that management would take drastic steps to assure such steep declines did not occur.
- The capital structure the analyst assumed was too equity rich (at 56%), and the company specific risk (at 2%) “double counted” since the plaintiff’s expert already had assumed “drastically” lower cash flows than contemporaneous analysts.
The result? Not good for the plaintiff. The court found the defendants’ valuation expert convincing. “For nearly every step of the DCF analysis, [the plaintiff’s expert] selected inputs that forced [the company’s] value lower,” it said, producing a valuation “that is low in the extreme and that implied an incredibly low trading multiple for [the subject].”
It further agreed that numerous instances of double counting “infected” the DCF analysis and the expert’s overall conclusions. She not only applied an unjustified company-specific risk premium, but also weighted the market multiple method at 15%, ostensibly because the companies Houlihan Lokey had selected were not sufficiently comparable. But the bank, in its earlier analysis, had already applied a multiple discount to account for any dissimilarity.
The plaintiff’s expert’s valuation under the DCF method “produced an extreme outlier even within her own analysis,” the court stated. But rather than disregard or assign low weight to this valuation, she did the opposite: assign low weight to the consistent valuations. Consequently, the court dismissed the valuation. Relying on market evidence, the court found that the value “implied by trading on the NYSE was “at least $12 billion,” and that the spin-off was solvent at inception.