Exam 5: Implementation: Search Through Closing: Phases 310 of the Acquisition Process

Loan covenants are promises made by the borrower that certain acts will be performed and others will be avoided.

Confidentiality agreements often cover both the buyer and the seller, since both are likely to be exchanging confidential information, although for different reasons.

Only acquiring firms perform due diligence.

Closing is included in which of the following activities?

Shrewd sellers often negotiate a break-up clause in an agreement of purchase and sale requiring the buyer to pay the seller an amount at least equal to the seller's cost associated with the transaction.

First Union Buys Wachovia Bank: A Merger of Equals? First Union announced on April 17, 2001, that an agreement had been reached to acquire Wachovia Corporation for about $13 billion in stock, thus uniting two fiercely independent rivals. With total assets of about $324 billion, the combination created the fourth largest bank in the United States behind Citigroup, Bank of America, and J.P. Morgan Chase. The merger also represents the joining of two banks with vastly different corporate cultures. Because both banks have substantial overlapping operations and branches in many southeastern U.S. cities, the combined banks are expected to be able to add to earnings in the first 2 years following closing. Wachovia, which is much smaller than First Union, agreed to the merger for only a small 6% premium. The deal is being structured as a merger of equals. That is a rare step given that the merger of equals’ framework usually is used when two companies are similar in size and market capitalization. L. M. Baker, chair and CEO of Wachovia, will be chair of the new bank and G. Kennedy Thompson, First Union’s chair and CEO, will be CEO and president. The name Wachovia will survive. Of the other top executives, six will be from First Union and four from Wachovia. The board of directors will be evenly split, with nine coming form each bank. Wachovia shareholders own about 27% of the combined companies and received a special one-time dividend of $.48 per share because First Union recently had slashed its dividend. To discourage a breakup, First Union and Wachovia used a fairly common mechanism called a “cross option,” which gives each bank the right to buy a 19.9% stake in the other using cash, stock, and other property including such assets as distressed loans, real estate, or less appealing assets. (At less than 20% ownership, neither bank would have to show the investment on its balance sheet for financial reporting purposes.) Thus, the bank exercising the option would not only be able to get a stake in the merged bank but also would be able to unload its least attractive assets. A hostile bidder would have to deal with the idea that another big bank owned a chunk of the stock and that it might be saddled with unattractive assets. The deal structure also involved an unusual fee if First Union and Wachovia parted ways. Each bank is entitled to 6% of the $13 billion merger value, or about $780 million in cash and stock. The 6% is about twice the standard breakup fee. The cross-option and 6% fee were intended to discourage other last-minute suitors from making a bid for Wachovia. According to a First Union filing with the Securities and Exchange Commission, Wachovia rebuffed an overture from an unidentified bank just 24 hours before accepting First Union’s offer. Analysts identified the bank as SunTrust Bank. SunTrust had been long considered a likely buyer of Wachovia after having pursued Wachovia unsuccessfully in late 2000. Wachovia’s board dismissed the offer as not being in the best interests of the Wachovia’s shareholders. The transaction brings together two regional banking franchises. In the mid-1980s, First Union was much smaller than Wachovia. That was to change quickly, however. In the late 1980s and early 1990s, First Union went on an acquisition spree that made it much larger and better known than Wachovia. Under the direction of now-retired CEO Edward Crutchfield, First Union bought 90 banks. Mr. Crutchfield became known in banking circles as “fast Eddie.” However, acquisitions of the Money Store and CoreStates Financial Corporation hurt bank earnings in late 1990s, causing First Union’s stock to fall from $60 to less than $30 in 1999. First Union had paid $19.8 billion for CoreStates Financial in 1998 and then had trouble integrating the acquisition. Customers left in droves. Ill, Mr. Crutchfield resigned in 2000 and was replaced by G. Kennedy Thompson. He immediately took action to close the Money Store operation and exited the credit card business, resulting in a charge to earnings of $2.8 billion and the layoff of 2300 in 2000. In contrast, Wachovia assiduously avoided buying up its competitors and its top executives frequently expressed shock at the premiums that were being paid for rival banks. Wachovia had a reputation as a cautious lender. Whereas big banks like First Union did stumble mightily from acquisitions, Wachovia also suffered during the 1990s. Although Wachovia did acquire several small banks in Virginia and Florida in the mid-1990s, it remained a mid-tier player at a time when the size and scope of its bigger competitors put it at a sharp cost disadvantage. This was especially true with respect to credit cards and mortgages, which require the economies of scale associated with large operations. Moreover, Wachovia remained locked in the Southeast. Consequently, it was unable to diversify its portfolio geographically to minimize the effects of different regional growth rates across the United States. In the past, big bank deals prompted a rash of buying of bank stocks, as investors bet on the next takeover in the banking sector. Banks such as First Union, Bank of America (formerly NationsBank), and Bank One acquired midsize regional banks at lofty premiums, expanding their franchises. They rationalized these premiums by noting the need for economies of scale and bigger branch networks. Many midsize banks that were obvious targets refused to sell themselves without receiving premiums bigger than previous transactions. However, things have changed. Back in 1995 buyers of banks paid 1.94 times book value and 13.1 times after-tax earnings. By 1997, these multiples rose to 3.4 times book value and 22.2 times after-tax earnings. However, by 2000, buyers paid far less, averaging 2.3 times book value and 16.3 times earnings. First Union paid 2.47 times book value and 15.7 times after-tax earnings. The declining bank premiums reflect the declining demand for banks. Most of the big acquirers of the 1990s (e.g., Wells Fargo, Bank of America, and Bank One) now feel that they have reached an appropriate size. Banking went through a wave of consolidation in the late 1990s, but many of the deals did not turn out well for the acquirers’ shareholders. Consequently, most buyers were unwilling to pay much of a premium for regional banks unless they had some unique characteristics. The First Union–Wachovia deal is remarkable in that it showed how banks that were considered prized entities in the late 1990s could barely command any premium at all by early 2001. -What integration challenges do you believe these two banks will encounter as they attempt to consolidate operations?

The purchase price may be fixed at the time of closing, subject to future adjustment, or it may be contingent on future performance of the target business.

The first step in establishing a search plan for potential acquisition or merger targets is to identify the primary screening or selection criteria.

More and more firms are identifying potential target companies on their own without the use of investment bankers.

Confidentiality agreements usually also cover publicly available information on the potential acquirer and target firms.

is pre-closing integration planning important?

Exxon Mobil’s (Exxon) Unrelenting Pursuit of Natural Gas Believing the world will be dependent on carbon-based energy for many decades, Exxon continues to pursue aggressively amassing new natural gas and oil reserves. This strategy is consistent with its core energy extraction, refining, and distribution skills. As the world’s largest energy company, Exxon must make big bets on new reserves of unconventional gas and oil to increase future earnings. _____________________________________________________________________________________ Exxon has always had a reputation for taking the long view. By necessity, energy companies cannot respond to short-term gyrations in energy prices, given the long lead time required to discover and develop new energy sources. While energy prices will continue to fluctuate, Exxon is betting that the world will remain dependent on oil and gas for decades to come and that new technology will facilitate accessing so-called unconventional energy sources. During the last several years, Exxon continued its headlong rush into accumulating shale gas and oil properties that began in earnest in 2009 with the acquisition of natural gas exploration company XTO Energy. While natural gas prices have remained well below their 2008 level, Exxon used the expertise of the former XTO Energy personnel, who are among the most experienced in the industry in extracting oil and gas from shale rock, to identify the most attractive sites globally for future shale development. In 2010, Exxon acquired Ellora Energy Inc., which was active in the Haynesville shale fields in Texas and Louisiana, for $700 million and properties in Arkansas’s Fayetteville shale fields from PetroHawk Energy Corp. In 2011, Exxon bought TWP Inc. and Phillips Resources, which were active in the Marcellus shale basin, for a combined $1.7 billion. Exxon is betting that these properties will become valuable when natural gas prices again rise. By mid-2011, Exxon Mobil had added more than 70 trillion cubic feet of unconventional gas and liquid reserves since the XTO deal in late 2009 through acquisitions and new discoveries. Exxon is now the largest natural gas producer in the United States. The sheer size of the XTO acquisition in 2009 represented a remarkable departure for a firm that had not made a major acquisition during the previous 10 years. Following a series of unsuccessful acquisitions during the late 1970s and early 1980s, the firm seemed to have developed a phobia about acquisitions. Rather than make big acquisitions, Exxon started buying back its stock, purchasing more than $16 billion worth between 1983 and 1990, and spending about $1 billion annually on oil and gas properties and some small acquisitions. Exxon Mobil Corporation stated publicly in its 2009 annual report that it was committed to being the world’s premier petroleum and petrochemical company and that the firm’s primary focus in the coming decades would likely remain on its core businesses of oil and gas exploration and production, refining, and chemicals. According to the firm, there appears to be “a pretty bright future” for drilling in previously untapped shale energy properties—as a result of technological advances in horizontal drilling and hydraulic fracturing. No energy source currently solves the challenge of meeting growing energy needs while reducing CO2 emissions. Traditionally, energy companies have extracted natural gas by drilling vertical wells into pockets of methane that are often trapped above oil deposits. Energy companies now drill horizontal wells and fracture them with high-pressure water, a practice known as “fracking.” That technique has enabled energy firms to release natural gas trapped in the vast shale oil fields in the United States as well as to recover gas and oil from fields previously thought to have been depleted. The natural gas and oil recovered in this manner are often referred to as “unconventional energy resources.” In an effort to bolster its position in the development of unconventional natural gas and oil, Exxon announced on December 14, 2009, that it had reached an agreement to buy XTO Energy in an all-stock deal valued at $31 billion. The deal also included Exxon’s assumption of $10 billion in XTO’s current debt. This represented a 25% premium to XTO shareholders at the time of the announcement. XTO shares jumped 15% to $47.86, while Exxon’s fell by 4.3% to $69.69. The deal values XTO’s natural gas reserves at $2.96 per thousand cubic feet of proven reserves, in line with recent deals and about one-half of the NYMEX natural gas futures price at that time. Known as a wildcat or independent energy producer, the 23-year-old XTO competed aggressively with other independent drillers in the natural gas business, which had boomed with the onset of horizontal drilling and well fracturing to extract energy from older oil fields. However, independent energy producers like XTO typically lack the financial resources required to unlock unconventional gas reserves, unlike the large multinational energy firms like Exxon. The geographic overlap between the proven reserves of the two firms was significant, with both Exxon and XTO having a presence in Colorado, Louisiana, Texas, North Dakota, Pennsylvania, New York, Ohio, and Arkansas. The two firms’ combined proven reserves are the equivalent of 45 trillion cubic feet of gas and include shale gas, coal bed methane, and shale oil. These reserves also complement Exxon’s U.S. and international holdings. Exxon is the global leader in oil and gas extraction. Given its size, it is difficult to achieve rapid future earnings growth organically through reinvestment of free cash flow. Consequently, megafirms such as Exxon often turn to large acquisitions to offer their shareholders significant future earnings growth. Given the long lead time required to add to proven reserves and the huge capital requirements to do so, energy companies by necessity must have exceedingly long-term planning and investment horizons. Acquiring XTO is a bet on the future of natural gas. Moreover, XTO has substantial technical expertise in recovering unconventional natural gas resources, which complement Exxon’s global resource base, advanced R&D, proven operational capabilities, global scale, and financial capacity. In the five-year period ending in 2010, the U.S. Energy Information Administration (EIA) estimates that the U.S. total proven natural gas reserves increased by 40% to about 300 trillion cubic feet, or the equivalent of 50 billion barrels of oil. Unconventional natural gas is projected by the EIA to meet most of the nation’s domestic natural gas demand by 2030, representing a substantial change in the overall energy consumption pattern in the United States. At current consumption rates, the nation can count on natural gas for at least a century. In addition to its abundance, natural gas is the cleanest burning of the fossil fuels. A sizeable purchase price premium, the opportunity to share in any upside appreciation in Exxon’s share price, and the tax-free nature of the transaction convinced XTO shareholders to approve the deal. Exxon’s commitment to manage XTO on a stand-alone basis as a wholly owned subsidiary in which a number of former XTO managers would be retained garnered senior management support. By keeping XTO largely intact in Fort Worth, Texas, Exxon was able to minimize differences due to Exxon Mobil’s and XTO’s dissimilar corporate cultures. -What do you think Exxon Mobil believes are its core skills? Based on your answer to this question, would you characterize this transaction as a related or unrelated acquisition?

The Cash Impact of Product Warranties Reliable Appliances, a leading manufacturer of washing machines and dryers, acquired a marginal competitor, Quality-Built, which had been losing money during the last several years. To help minimize losses, Quality-Built reduced its quality-control expenditures and began to purchase cheaper parts. Quality-Built knew that this would hurt business in the long run, but it was more focused on improving its current financial performance to increase the firm’s prospects for eventual sale. Reliable Appliances saw an acquisition of the competitor as a way of obtaining market share quickly at a time when Quality-Built’s market value was the lowest in 3 years. The sale was completed quickly at a very small premium to the current market price. Quality-Built had been selling its appliances with a standard industry 3-year warranty. Claims for the types of appliances sold tended to increase gradually as the appliance aged. Quality-Built’s warranty claims’ history was in line with the industry experience and did not appear to be a cause for alarm. Not surprisingly, in view of Quality-Built’s cutback in quality-control practices and downgrading of purchased parts, warranty claims began to escalate sharply within 12 months of Reliable Appliances’s acquisition of Quality-Built. Over the next several years, Reliable Appliances paid out $15 million in warranty claims. The intangible damage may have been much higher because Reliable Appliances’s reputation had been damaged in the marketplace. -Should Reliable Appliances have been able to anticipate this problem from its due diligence of Quality-Built? Explain how this might have been accomplished.

In a rush to complete its purchase of health software producer HBO, McKesson did not perform adequate due diligence but rather relied on representations and warranties in the agreement of sale and purchase. Within six months following closing, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5 million for the past 3 fiscal years to correct for accounting irregularities. The company's stock fell by 48 percent. Assume HBO's financial statements had been declared to be in accordance with GAAP, would McKesson have been justified in believing that HBO's revenue and profit figures were 100 percent accurate?

The actual price paid by the buyer for the target firm is determined when

All of the following are true about a confidentiality agreement except for

Confidentiality agreements are rarely required when target and acquiring firms exchange information.

There is no substitute for performing a complete due diligence on the target firm.

So-called permanent financing for an acquisition usually consists of long-term unsecured debt.

Find a transaction currently in the news. Speculate as to what criteria the buyer may have employed to identify the target company as an attractive takeover candidate. Be specific.