IN STATUTORY MERGER APPRAISAL PROCEEDING, CHANCERY COURT DECLINES USE OF THE DISCOUNTED CASH FLOW ANALYSIS TO DETERMINE FAIR VALUE AND UPHOLDS DEAL PRICE AS BEST INDICATOR OF FAIR VALUE
By Annette Becker and Rikiya Thomas
In In Re Appraisal of PetSmart, Inc., C.A. No. 10782-VCS (Del. Ch. May 26, 2017), the Delaware Court of Chancery confirmed in a statutory appraisal proceeding that the fair value of the shares of common stock of PetSmart, Inc. (“PetSmart” or the “Respondent”) at the time of its going-private merger transaction was the deal price of $83 per share. The Court reached this conclusion after thoroughly examining and ultimately rejecting the use of the discounted cash flow (“DCF”) analysis to determine fair value as proposed by a group of plaintiff former stockholders of PetSmart (the “Petitioners”).
After experiencing a decline in performance results over a period of several fiscal quarters and receiving communications from displeased stockholders, the board of directors of PetSmart (the “Board”) retained financial advisor, J.P. Morgan Securities LLC (“JPM”), to advise the Board of as to valuation, capital structure, and possible strategic alternatives. After consideration of JPM’s analysis, the Board ultimately decided that it was in the best interest of PetSmart and its stockholders to commence an auction process to sell PetSmart. JPM spoke with 27 potential bidders, including three strategic partners. Of the 27 potential bidders, five private equity funds placed bids. The highest bidder, BC Partners, Inc. (“BC Partners”), offered $83 per share which was $1.50 per share higher than the next highest bidder’s offer. The Board unanimously approved and recommended to its stockholders that PetSmart consummate the going-private merger transaction with BC Partners (the “Merger”). The parties signed the Merger Agreement in December 2014, and the stockholders voted in favor of the Merger in March 2015. The Merger closed on March 11, 2015.
The Petitioners holding 10.7 million shares (9.5 million of which were acquired after the transaction was announced) of PetSmart common stock declined the Merger consideration and sought a statutory appraisal proceeding pursuant to Section 262 of the Delaware General Corporation Law. During the four-day trial, the Petitioners offered evidence contesting that the valuation of PetSmart was significantly lower than expected and that the DCF analysis should have been used to determine the fair value of PetSmart which would have resulted in a valuation of $128.78 per share. To the contrary, the Respondent asserted that the deal price was the best indicator to determine the fair value of PetSmart at the time of the Merger. Both sides presented analyses provided by their respective projections and valuation experts.
In its opinion, the Court explained that both parties must prove their respective valuations by a preponderance of the evidence and if neither party was able to do so the Court would use its independent judgment to determine fair value and taking into consideration “all relevant factors.” The Court acknowledged the vastly different valuations presented by the parties and narrowed examination of the competing positions down to three issues.
First, the Court examined whether the transaction process leading to the Merger was “fair, well-functioning and free of structural impediments” to achieve a deal price indicative of the fair value of PetSmart. The Court noted that in order for the market value (i.e. deal price) to be considered a fair value of a company, such market value must be the product of a fair sales process and also a well-functioning market. The Court found that while the transaction process employed to facilitate the sale of PetSmart was not perfect, it was close enough to produce a reliable indicator of PetSmart’s fair value. In its findings, the Court noted that PetSmart explored all of its strategic options, pursued the sale in an open auction which welcomed “the whole universe of potential bidders”, had not rushed the sale process by prematurely accepting an offer and had received a deal price at a 39% premium. The Court refuted the Petitioners’ argument that there was a lack of strategic bidders by citing that the auction process was open to all bidders, and despite JPM’s effort to entice potential strategic bidders, none expressed a firm interest. The Court also rejected the Petitioners’ argument that the deal price was stale at the time of closing. It noted that despite the Q4 2014 favorable results received during the interim period between signing and closing, such results were not indicative of a long-term trend which would have affected PetSmart’s going concern value at the time of the Merger.
The Court then addressed whether the DCF analyses proffered by the parties’ experts would produce a reliable indicator of the fair value of PetSmart. The Court held that the key to a reliable DCF analysis is the availability of reliable projections of future expected cash flows prepared by management in the ordinary course of business. The Court determined that such projections used in the DCF analyses provided by the Petitioners’ experts were unreliable for a number of reasons. The notable reasons for rejecting the projections included: (1) management had no experience preparing long-term projections, (2) the projections were not prepared by management in the ordinary course of business, but instead were prepared to aid in the auction process and (3) the short-term projections prepared by management frequently missed the mark. The Court ultimately rejected Petitioners’ argument that the DCF analysis was the proper indicator to assess the fair value of PetSmart due to unreliability of the projections used.
Lastly, the Court examined whether there was a basis to make adjustments to the projections or to alter inputs used by the parties’ experts to arrive at a more reliable analysis. The Court declined to construct its own valuation after citing there were no reliable projections and no basis to alter the inputs used by the experts. The Court further cited the similarities of the DCF models constructed by the parties’ experts despite their different projections and alterations.
The Court ultimately held that the deal price of $83 per share was the best indicator of the fair value of PetSmart at the time of the Merger. The Court further stated that it found no reason to deviate from the deal price given the Petitioners’ flawed, post-hoc valuation and found no evidence to reach a fair value somewhere between the values offered by the parties.