Case Analysis

ABRY & F+W Publications

An investor performs due diligence on a targeted acquisition to understand and evaluate the business entity prior to closing the deal. It s like inspecting a house before closing. There are two types of due diligence: acquisition due diligence is what a buyer performs on a seller to evaluate a potential investment; internal due diligence is what company management does to run the business effectively. We re concerned with the former. From a technical standpoint, acquisition due diligence is defined as the analytic review and validation of business operations and financial position performed by a buyer to substantiate valuation, assess operational performance and identify misrepresentations. It s important that due diligence be planned, structured and focused on the key elements. Otherwise, the process can drift aimlessly wasting time and resources. Due diligence not done properly can also jeopardize positions of the investors in the funding vehicle like a PE firm. Private equity firm ABRY Partners faced the similar issue on account of acquisition Due Diligence. Following practices can be adopted to further improve upon the Acquisition Due diligence process: y y y y y Auditors independency should be checked and the audit reports should be analyzed for Qualified Comments. Probe deeply into the accounting system followed by company and check for potential red flags Check for Undisclosed liabilities and potential future liabilities Analyze the Contingent liabilities, their nature and quantum of commitments made by the entity Compliance with various laws and regulations applicable to the entity

Due Diligence alone is not sufficient; proper mechanism should be put in place to get a grip on the targets management if fraud is discovered later in future. Some of them could be paying in terms of combination of cash and stock, creation of escrow account, putting legal contracts in place etc. Private Equity firms should also address the principal - agent problem which may compel the fund managers to go for manipulations.

Philip Morris Companies and Kraft, Inc

Case Background:
The case discussion summaries about the hostile takeover bid by Philip Morris for Kraft Inc, in an attempt to improve their margins in the food business. The discussion related to this case is to highlight and understand the takeover defenses taken by the Target Company, against a hostile tile takeover bid.

Initial tender offer: $90 a share, the offer represented a 50% premium over the $60.125 closing price on 18th October 1988. Kraft Inc, refused the bid stating the bid undervaluing Kraft Inc. Finally, the market reacted in favor of the restructuring defenses of Kraft and Kraft s stock prices rise by over $10 to $102 and finally closed at $94 on October 27th 1988.

Philip Morris (Acquirer in the tender bid)

Phillip Morris has its business diversified across various non-related businesses. Their major profits came from its tobacco sales, mainly from Malboro, Bensen &hedges cigarettes business. However, the consumption of cigarettes has been declining from its peak in 1981 to 1988. Phillip Morris was pursuing the strategy of diversifying the business out of tobacco. That is why the acquisition of brewing division and also Food division from General Foods for $5.6 billion. However, these acquisitions have mixed results without resulting into very good results in terms of profit improvements. Hence they were in need of another acquisition which can revamp their food business and Kraft Inc came along as a good option with valuable potential synergies.

Kraft Inc (Target Company in the tender offer)

Earlier, Kraft s strategy was to focus on food, which they changed to all-food strategy in sharp contract. After the tender offer by Morris, Kraft has undergone various restructuring changes to make the takeover difficult for Phillip Morris. A few key restructuring changes can be highlighted as: y y y Share holders to receive a cash dividend of $84 and high yield debt valued at $14 Share holders would retain their highly leveraged equity portion interest Total restructuring package at $110 per share

To arrange the fund for the dividend plan, Kraft involved into the following restructuring plan: 1. Business Spin-off: They sold off their some business for cash proceed of about $1.2 billion after taxes 2. Improved their operating margins, by reducing their operating expenses 3. Indulge into $6.8 billion bank borrowing at 12% annual interest and rest $3 billion at higher rates ranging 12.5% to 14.75%

Stock market s response

Market welcomed the restructuring move by Kraft, and Kraft s share price rose by $10 per stock to $102. These restructuring changes were in fact one of the takeover defenses against the offered bid, to pitch for a higher bid from the acquirer.

This triggered other players to jump to this potential acquisition in the food industry and prompted for industry consolidation. Players like Kohlberg, Kravis and Roberts also entered the bidding for RJR Nabison.

Learning
y y y y A good business with consistently over the industry average makes a company exposed to potential to hostile takeover Restructuring the Company in terms of D/E, dividend payout plans. Raising debt at higher rates acts as effective takeover defenses against the tender offer Crown Jewel Defense: Selling off the performing assets ( Spin off ) of some of the businesses make the target more un-attractive Poison Pills: Offering stock holders, high yielding debt valued at $14, were acting as poison pills for the acquirer, as it made the liabilities more stringent for acquirer

Movie Discussion
Movie Background

Other People s Money

This movie is about Takeover defenses that companies adopt to prevent hostile or normal takeover by potential players. New England Cable and Wire Company, run by its promoter Mr. Jorgy, is a company manufacturing cable wires to find major application in Telecom sector. Mr. Garfield, promoter of an Equity Investment Firm, has significant interest in the company not just because he is an investor in company s shares but also because he finds it to be a potential target for takeover. The company s stock which was once at a high of $60 is currently trading in the market at $14 while he believes that fair value of the firm is much higher.

About the Company

New England Wire and Cable Company stated as a Financial Cancer by Mr. Garfield, is running into losses since its inception and is supported by 3 other profitable firms in the business. Mr. Garfield who has intentions to sell the firm in parts an pieces after acquiring it has conservatively valued the company at Rs 100 Million (including Land and other assets) and considering total shares of the company as 4 million shares makes a bid of $25 for acquiring a majority stake. But the owner of the company Mr. Jorgy is a conventionalist and is ignoring the interest of the shareholders when he is continuously warned by his manager and friend about the possible loss the company may face in the future.

Potential Risks for the Company

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Since the company is consistently running into losses investors are losing confidence in the owner and his potential Even after sharing the potential business ideas for the company in its annual general meeting with the shareholders, the stock doesn t rise showing lack of confidence in the plans The product being manufactured by the company faces significant risk of being obsolete in the coming future because of competition from Fibre Optics The company being in U.K does not enjoy any comparative advantage as compared to others in Taiwan or Japan The owner of the company is resistant to change, lacks vision for the company and is conventional on his ideas and tactics

Important Tactics adopted by the Company as Takeover Defenses

y y The corporate lawyer proposes Greenmail as a potential defense but even Garfield does not accept it as a useful tool because it may be harmful to all investors and not just him The company gets permission for a standstill agreement under which Mr. Garfield cannot buy more shares of the company but this is a weak form of defense and can be easily broken The lawyer tries to diverge Mr. Garfield by levying technical charges on him but he easily escapes out of them The company goes for share buyback by agreeing to buy all shares owned by Mr. Garfield for $20 per share but he doesn t agree to it The lawyer proposes to sell the loss making division New England Wire and Cable Company to Mr. Garfield through a swap deal (possible strategy of White Knight) but the owner doesn t agree to it because he does not want to sell the unit Mr. Jorgy s wife agrees to buy back the shares at cost plus 1 million dollars of the savings fund she owned in exchange for the shares owned by Mr. Garfield without any positive results The company has no mechanism of Golden Parachute,( which though a weak takeover defense) proved very harmful for the company because the manager of the company sold his valuable million shares to Mr. Garfield when he not assured of his future in the company

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Conclusions

In the wake of things, when none of the takeover defenses seemed to be working for the company, a tender offer was made by Mr. Garfield to acquire majority stake in the company and a general meeting of shareholders was convened followed by voting as a result of which Mr. Garfield won the stake he wanted to own

Learnings from the Movie

y As a manager, owner or promoter of firm it is important to have a vision for the company and should adopt new methodologies and technologies to add value to the company by disregarding conventional thinking Managers should respect the interests of the shareholders and take all steps in that direction even if it is at the cost of a merger or takeover Strategies like Standstill Agreement or Golden Parachutes are weak takeover defenses and do not bring any positive results to the table From the point of view of investors it is important to realize that managers understand the business better than outsiders and should trust the objectives of the managers to the extent their interests do not suffer. Investment can be short term or long term and depending upon the timeline investors should expect returns

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HP Compaq: Term Sheet Analysis

A term sheet is a bullet point document outlining the material terms and conditions of a business agreement. It comprehensibly lists down various terms & conditions of the deal structuring like y y y y y y Payment terms Ownership structure Price of the acquirer and target shares pre & post acquisition Accounting methods and tax implications Management board Shareholder voting details

We looked at various types of payment for e.g. cash, cash-stock deal in terms of how it affects the share prices post & pre acquisition. Another important point of discussion throughout the class was the significance of share exchange ratio and calculation of premiums given to acquire the target company. The exchange ratios by the way of premiums indicate the value of synergies expected from the deal. The synergies calculation helped us to indicate the amount of time required for the combined company to realize the synergies, to be considered for the deal to be a success.