FOOL ON THE HILL
Did Your Company Sell Too Low?

In the past few months, shareholders of three companies have watched as their managements agreed to sell their companies for what seemed like bargain prices. In one case, the acquisition price was below the current share price. What really happens in a merger negotiation? How are these prices determined? Bill Mann describes some of the components that go into the price of an acquisition.

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By Bill Mann (TMF Otter)
November 22, 2002

In the past few months, a few mergers have either been proposed or consummated that left more than a few outside shareholders scratching their heads. To wit:

  • Last week, embattled credit card and lending company Household International (NYSE: HI) agreed to be acquired by U.K.-based mega-bank HSBC (NYSE: HBC) for $13 billion in stock, or about $30.04 per share. This represented a 35% premium over the previous day's closing price, but is well below prices at which the stock traded even earlier this year (less than half the company's annual high).

  • CTB International Group, a farm equipment maker, chose to be acquired by Berkshire Hathaway (NYSE: BRK.A) for $140 million, or $12.75 per share, in an all-cash deal that closed at a discount to the closing price on the day of the acquisition. CTB claimed that the deal would give it greater access to capital markets.

  • Meridian Medical Technologies (Nasdaq: MTEC) agreed in October to a takeover by King Pharmaceuticals (NYSE: KG) for $247 million, or $44.50 per share. The deal represented a premium to Meridian's stock price of about 16%. But Meridian, a company featured this year in The Motley Fool Select, seemed poised to capture substantial new business as a result of medical requirements consistent with enactment of homeland defense statutes in the U.S.

All three of these deals seemed odd to outside shareholders because the companies appeared to have sold out so cheaply. In particular, the CTB deal must have been bitter to disenfranchised shareowners, as they would receive cash and thus would not see any further potential benefits of the deal accrue to them unless they bought Berkshire Hathaway shares with their proceeds. (Hint: There are worse things one could do with one's money.)

But even the most shareholder-friendly company is under no obligation to reveal its true reason for agreeing to be acquired, nor will it disclose much detail on how it came about agreeing upon a price. As such, outside shareholders are left to work out their own values, and these are generally based either on the share price or on some multiple of book value. Both of these measures are sadly derivative and insufficient for merger and acquisition purposes, the equivalent of trying to catch mosquitoes using a chain link fence.

Not every deal, even the ones above, is necessarily part of "the big screw" of outside minority shareholders. We can't see everything. Here are some things that our measures are likely to miss.

1. Shareowners may be oblivious to some real risks. Household International, in particular, is facing big questions about its business. It was charged by the FTC as a predatory lender and had agreed recently to change its business practices. How would this have altered its business? What did the quality of its loan book look like? What was its cost of capital going to be? We don't know.

Its management could have been facing a big precipice had this deal not been made, an outcome not altogether improbable following the collapse of subprime lenders Providian (NYSE: PVN), AmeriCredit (NYSE: ACF), and others. One Wall Street Journal editorial actually said that HSBC may not have bought Household at the top, but rather at the bottom. Selling now may have saved shareholders at Household from some real pain in the future.

2. Selling companies must justify the price. They're called "fairness opinions," and the target company will nearly always get one done to provide a third-party opinion that its selling price offers fair compensation to shareholders.

In the CTB deal, in part because it sold below the stock market's valuation of the company, management did not get just one fairness opinion, but three. This process puts a true value on a company's assets and intellectual property, earnings power, and other components. No, they don't just use "book value," which is an accounting construct. A 75-year-old factory might be valued on a company's books at zero, but if it is still fully operational, then its tangible value is somewhat north of that.

A read of a recent expos� in Hong Kong by David Webb shows what really happens when a company's majority shareholder tries to get away with in environments where fairness opinions are not exactly prized.

3. Operational benefits may be more important. Household International may have needed to raise as much as $39 billion next year to shore up its operations; this would have been a tough feat as its credit spreads yawned ever wider, a sure sign that the market smells real trouble.

HSBC solves the access to the credit market with its own liquidity, as well as its own significantly higher credit rating. The cost of not going with an HSBC may have been too great. Similarly, Meridian Medical, though it has a good core business with its autoinjectors, might have seen King Pharmaceuticals' significantly larger sales and marketing arm as offering it the best chance to spread its technology in a hurry. And CTB made no bones about its desire to gain access to capital at Berkshire's AAA rates. Its cost of capital is dramatically reduced as a result. Again, cold comfort to the old CTB shareowners looking at their $12.75 in cash.

4. This might have been the least/worst option. Companies approach other companies all the time to discuss a merger or acquisition. In most cases, we will not hear about it. Particularly when a company's stock has dropped considerably, management may feel that it is at risk of being the target of a predatory acquirer, or may have even been approached by a company.

In CTB's case, for example, an outside investor owned more than 40% of the company, and so even management may have been relatively helpless to stop a takeover if the investor supported it. As such, companies that are under threat may seek the arms of a more suitable company for merger. In such cases, acquiring companies are not likely to be charitable in negotiating the price for the transaction -- they know that the company to be acquired is under pressure.

5. What's in it for me? Of course, we cannot simply say that all reasons for a merger are good, or that they are in the best interest of the shareholders. In many cases, the executives of the buying -- and particularly the selling -- companies will have financial incentives for getting the deal done, often in the millions of dollars. These same executives may be looking also at the transaction as a liquidity event, allowing them an exit strategy from the company. This is cynical reasoning, as it places the needs of the executives over those of the shareowners.

A case in point was the recent merger between Hewlett-Packard (NYSE: HPQ) and Compaq. Michael Capellas, then CEO of Compaq, had built in significant success rewards for completing the merger, as did Carly Fiorina at HP. Scant months after the merger, Mr. Capellas announced he was leaving the company and resurfaced as the new CEO of WorldCom. Never mind that both he and Ms. Fiorina sold the merger on the basis that they would share leadership over the combined company.

The truth is that with mergers you're never going to know everything. In every situation, company executives will claim that the transaction is in the shareowners' best interest. Even if the price of the deal seems low to outsiders, this may very well be true. But in cases such as the HP merger, it is only after the fact that one can see that some of the representations given by the managements of both companies were at best cynically given. It seems that Walter Hewlett was correct in his decision to fight the merger tooth and nail.

From my point of view, if an executive team sells out its shareowners in a merger, perhaps it actually did those shareowners a favor, hosing them all at once, rather than little by little over long periods of time.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann's fantasy hockey team is actually losing to a team called "Booger Pie." Bill owns shares of Berkshire Hathaway. He is the managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas you won't find anywhere else. The Motley Fool has a disclosure policy.