The Gulf Oil Takeover

1
The Gulf Oil Takeover

• Summary Points
• Prof. Mike Vetsuypens
• SMU Cox School of Business

2
Gulf Oil Epilogue

• FINAL BIDDING VALUES
• Pickens 65.00 ARCO 72.00
  KKR 87.50 (noncash) SOCAL
  80.00
• Total SOCAL bid 13.2 billion
• PICKENS' PROFIT 760 million
• SOCAL/GULF DECISIONS AFTERWARDS
• Divested Assets 1 billion James Lee
  received a 13 million severance pay
• SOCAL cut its workforce by 25,000

3
Why hostile takeovers?

• The Market for Corporate Control a deviceto
  ensure that assets are deployed effectively
• Strategy/Finance/Capital Markets InteractDon't
  define strategy without consideringfinancial
  markets or YOU'LL PAY!
• "If you dont use your assets the best thatthey
  can be used, someone else will do itfor you"
  (T. Boone Pickens)

4
Technical issues

• Merger Analysis Should Use StandardFinancial
  Tools
• Key Elements of Capital Expenditure Analysis
  Cash Flows, Cash Flows, Cash Flows!
  Incremental After Tax Timing of Cash
  Flows matters Inflation be consistent
  Cost of Capital Sensitivity Analysis

5
Gulfs Cost of Capital

• Cost of Debt AA yield12.76, after tax6.38
• Cost of Equity CAPM
• Risk free rate12, Gulf equity beta1.15
• Equity Risk Premium 7
• -? Cost of Equity 121.15720.50
• Weighted Average Cost of Capital (WACCAT)
• CAPITAL COST MKT VALUE WEIGHT
  WEIGHTED COST
• Debt 6.38 2,646 29
  1.85
• Equity 20.50 6,612 71
  14.24
• 
  16.1 WACCAT

6
Takeover Strategy Points

• Market Value lt "Highest Best" Value
• With competitive bidding, target company leaves
  very little "on the table"
• Target shareholders get large premiums (15 to
  40)
• Bidder may overpay Winner's Curse
• Average Bidder returns gt 0, average Bidder
  returns lt0
• Combined returns on portfolios of buyer and
  targets gt0

7
Does MA create value for the bidder?

• A recent academic study of 12,023 MA deals
  between 1980 and 2001 finds industry-adjusted
  losses in the dollar value of acquiring firms
  around the merger announcement, but small
  percentage gains in stock returns (1.1).
• A significant amount of the lost economic value
  occurred in 87 large deals, mostly during the
  1998-2001 period.
• So a majority of small mergers create value for
  the buyers, but most recent large deals (done
  with bidder stock) destroy bidder value.

8
How do we know if bidders benefit from a merger?

• Test 1 Did the share price of the buyer rise?
• Fails to control for unrelated market/industry
  factors
• Test 2 Did the buyers stock returns exceed a
  benchmark?
• Over what time period should returns be
  calculated?
• Too much noise over long periods, announcement
  period best
• Test 3 Are bidder shareholders better off after
  the deal than they would have been had the deal
  not occurred?
• Ideal test, but difficult to carry out
• Example AOLs purchase of Time Warner

9
Some dubious Takeover Motives

• The target company is undervalued
• Do you trust the CEOs stock picking ability?
• Diworsification
• Cant shareholders diversify on their own?
• Butreducing unique risk to avoid distress costs
  is OK
• Redeploy surplus funds
• Will you waste excess cash on bad deals?
• Empire-building (size maximization)
• Mgmt salaries are a positive function of firm
  size!
• Illusion that growth for growths sake is
  desirable

10
The problem with Earnings growth targets

• GrowthInternal (core, organic) External
• Internal growth inflation real GDP expansion
• market share gains productivity gains
• External growth joint ventures, MA
• Core earnings growth in mature firms is LOW
• This often leads to frenzied MA deals
• shopping for more growth

11
Cosmetics vs. Fundamentals

• Growth in EPS is a poor measure of excellence
• Focuses on earnings instead of cash flows
• EPS is a backward-looking, one-period metric
• EPS ignores the cost of the equity capital needed
  to create it
• A negative NPV merger can increase EPS!
• A positive NPV merger may dilute current EPS
• May explain what happened at Enron, WorldCom
• Must focus on creating value for your
  shareholders
• Look at discounted cash flows
• Compare IRR against the cost of your capital
• Are you earning economic profits?

12
Valid merger reasons

• Economies of scale, cost reductions
• Consolidate ops, eliminate redundancies (net of
  integration costs), reduce competition (beware of
  antitrust laws)
• Vertical integration (but consider outsourcing!)
• Complementary resources, cross-selling
• Eliminating operational or governance problems

13
Which of these 2 deals is the better one for the
buyer?

• A
  B
• Pre-merger target value 10 billion
  40 billion
• Acquisition premium 30
  20
• Merger value gains 4 billion
  7 billion

14
Prime Directive for a good merger

• By themselves, neither the target pre-merger
  value, the acquisition premium, nor the merger
  synergies matter.
• What matters is that what you pay target value
  premium should be less than what you get target
  value synergies
• Dont say Were buying a great company with
  superb assets and people, with great growth
  prospects. This only makes sense if the target
  is undervalued. Is it? Or will you pay full
  price for these assets?

15
Form S-4 Registration Statement, 1/11/2006, p 32

• ConocoPhillips believes the merger (between
  COP and BR) joins two well-managed companies,
  providing strategic and financial benefits to
  stockholders of COP. COP expects the benefits to
  include
• Creation of a leading North American natural gas
  position comprised of high-quality, long-lived,
  low risk gas reserves with significant
  unconventional resource potential and enhanced
  production growth
• Enhanced business mix with a higher proportion of
  exploration and production assets, assets in OECD
  countries and North American natural gas
• Significant free cash flow and synergy benefits
  and
• Access to BRs talented and technically capable
  workforce

16
A merger checklist.

• 1 Explain the strategic rationale for the
  merger! Be explicit/realistic on how changes and
  synergies will be achieved within the target.
• 2 Know the walk-away price! Dont overpay for
  the synergies. No deal is worth doing at any
  price!
• 3 Perform due diligence understand what you
  are buying, including people.
• 4 Dont just do a deal because you have ample
  internal cash flows, or a high stock price.
• 5 Dont forget merger integration costs.
• 6 Beware of stock deals in hot MA markets

17
How can we create Corporate Discipline?

• Through Hostile MA activity
• Internally (Top Management compensation
• Board oversight)
• Through Competition in Product Markets
• Through increased Borrowings