Exam 5: Implementation: Search Through Closing: Phases 3 to 10 of the Acquisition Process

Integration planning is included in which of the following activities?

Case Study Short Essay Examination Questions The Anatomy of a Transaction: K2 Incorporated Acquires Fotoball USA Our story begins in the early 2000s. K2 is a sporting goods equipment manufacturer whose portfolio of brands includes Rawlings, Worth, Shakespeare, Pflueger, Stearns, K2, Ride, Olin, Morrow, Tubbs and Atlas. The company's diversified mix of products is used primarily in team and individual sports activities, and its primary customers are sporting goods retailers, many of which are not strongly capitalized. Historically, the firm has been able to achieve profitable growth by introducing new products into fast-growing markets. Most K2 products are manufactured in China, which helps ensure cost competitiveness but also potentially subjects the company to a variety of global uncertainties. K2's success depends on its ability to keep abreast of changes in taste and style and to offer competitive prices. The company's external analysis at the time showed that the most successful sporting goods suppliers will be those with the greatest resources, including both management talent and capital, the ability to produce or source high-quality, low-cost products and deliver them on a timely basis, and access to distribution channels with a broad array of products and brands. Management expected that large retailers would prefer to rely on fewer and larger sporting goods suppliers to help them manage the supply of products and the allocation of shelf space. The firm's primary customers are sporting goods retailers. Many of K2's smaller retailers and some larger retailers were not strongly capitalized. Adverse conditions in the sporting goods retail industry could adversely impact the ability of retailers to purchase K2 products. Secondary customers included individuals, both hobbyists as well as professionals. The firm had a few top competitors, but there were other large sporting goods suppliers with substantial brand recognition and financial resources with whom K2 did not compete. However, they could easily enter K2's currently served markets. In the company's secondary business, sports apparel, it did face stiff competition from some of these same suppliers, including Nike and Reebok. K2's internal analysis showed that the firm was susceptible to imitation, despite strong brand names, and that some potential competitors had substantially greater financial resources than K2. One key strength was the relationships K2 had built with collegiate and professional leagues and teams, not easily usurped. Larger competitors may have had the capacity to take some of these away, but K2 had so many that it could withstand the loss of one or two. The primary weakness of K2 was its relatively small size in comparison to major competitors. As a long-term, strategic objective, K2 set out to be number one in market share in the markets it served by becoming the low-cost supplier. To that end, K2 wanted to meet or exceed its corporate cost of capital of 15 percent; achieve sustained double-digit revenue growth, gross profit margins above 35 percent, and net profit margins in excess of 5 percent within five years; and reduce its debt-to-equity ratio to the industry average of 25 percent in the same period. The business strategy for meeting this objective was to become the low-cost supplier in new niche segments of the sporting goods and recreational markets. The firm would use its existing administrative and logistical infrastructure to support entry into these new segments, new distribution channels, and new product launches through existing distribution channels. Also, K2 planned to continue its aggressive cost cutting and expand its global sourcing to include low-cost countries other than China. All this required an implementation strategy. K2 decided to avoid product or market extension through partnering because of the potential for loss of control and for creating competitors once such agreements lapse. Rather, the strategy would build on the firm's great success, in recent years, acquiring and integrating smaller sporting goods companies with well-established brands and complementary distribution channels. To that end, M&A-related functional strategies were developed. A potential target for acquisition would be a company that holds many licenses with professional sports teams. Through its relationship with those teams, K2 could further promote its line of sporting gear and equipment. In addition, K2 planned to increase its R&D budget by 10 percent annually over five years to focus on developing equipment and apparel that could be offered to the customer base of firms it acquired during the period. Existing licensing agreements between a target firm and its partners could be enhanced to include the many products K2 now offers. If feasible, the sales force of a target firm would be merged with that of K2 to realize significant cost savings. K2 also thought through the issue of strategic controls. The company had incentive systems in place to motivate work towards implementing its business strategy. There were also monitoring systems to track the actual performance of the firm against the business plan. In its acquisition plan, K2's overarching financial objective was to earn at least its cost of capital. The plan's primary non-financial objective was to acquire a firm with well-established brands and complementary distribution channels. More specifically, K2 sought an acquisition with a successful franchise in the marketing and manufacturing of souvenir and promotional products that could be easily integrated into K2's current operations. The acquisition plan included an evaluation of resources and capabilities. K2 established that after completion of a merger, the target's sourcing and manufacturing capabilities must be integrated with those of K2, which would also retain management, key employees, customers, distributors, vendors and other business partners of both companies. An evaluation of financial risk showed that borrowing under K2's existing $205 million revolving credit facility and under its $20 million term loan, as well as potential future financings, could substantially increase current leverage, which could - among other things - adversely affect the cost and availability of funds from commercial lenders and K2's ability to expand its business, market its products, and make needed infrastructure investments. If new shares of K2 stock were issued to pay for the target firm, K2 determined that its earnings per share could be diluted unless anticipated synergies were realized in a timely fashion. Moreover, overpaying for any firm could result in K2 failing to earn its cost of capital. Ultimately, management set some specific preferences: the target should be smaller than $100 million in market capitalization and should have positive cash flows, and it should be focused on the sports or outdoor activities market. The initial search, by K2's experienced acquisition team, would involve analyzing current competitors. The acquisition would be made through a stock purchase - and K2 chose to consider only friendly takeovers involving 100 percent of the target's stock - and the form of payment would be new K2 non-voting common stock. The target firm's current year P/E should not exceed 20. After an exhaustive search, K2 identified Fotoball USA as its most attractive target due to its size, predictable cash flows, complementary product offering, and many licenses with most of the major sports leagues and college teams. Fotoball USA represented a premier platform for expansion of K2's marketing capabilities because of its expertise in the industry and place as an industry leader in many sports and entertainment souvenir and promotional product categories. K2 believed the fit with the Rawlings division would make both companies stronger in the marketplace. Fotoball also had proven expertise in licensing programs, which would assist K2 in developing additional revenue sources for its portfolio of brands. In 2003, Fotoball had lost $3.2 million, so it was anticipated that they would be receptive to an acquisition proposal and that a stock-for-stock exchange offer would be very attractive to Fotoball shareholders because of the anticipated high earning growth rate of the combined firms. Negotiations ensued, and the stock-for-stock offer contained a significant premium, which was well received. Fotoball is a very young company and many of its investors were looking to make their profits through the growth of the stock. The offer would allow Fotoball shareholders to defer taxes until they decided to sell their stocks and be taxed at the capital gains rate. An earn-out was also included in the deal to give management incentives to run the company effectively and meet deadlines in a timely order. Valuations for both K2 and Fotoball reflected anticipated synergies due to economies of scale and scope, namely, reductions in selling expenses of approximately $1 million per year, in distribution expenses of approximately $500,000 per year, and in annual G&A expenses of approximately $470,000. The combined market value of the two firms was estimated at $909 million - an increase of $82.7 million over the sum of the standalone values of the two firms. Based on Fotoball's outstanding common stock of 3.6 million shares, and the stock price of $4.02 at that time, a minimum offer price was determined by multiplying the stock price by the number of shares outstanding. The minimum offer price was $14.5 million. Were K2 to concede 100 percent of the value of synergy to Fotoball, the value of the firm would be $97.2 million. However, sharing more than 45 percent of synergy with Fotoball would have caused a serious dilution of earnings. To determine the amount of synergy to share with Fotoball's shareholders, K2 looked at what portion of the combined firms revenues would be contributed by each of the players and then applied that proportion to the synergy. Since 96 percent of the projected combined firms revenues in fiscal year 2004 were expected to come from K2, only 4 percent of the synergy value was added to the minimum offer price to come up with an initial offer price of $17.8 million, or $4.94 per share. That represented a premium of 23 percent over the market value of Fotoball's stock at the time. The synergies and the Fotoball's relatively small size compared to K2 made it unlikely that the merger would endanger K2's credit worthiness or near-term profitability. Although the contribution to earnings would be relatively small, the addition of Fotoball would help diversify and smooth K2's revenue stream, which had been subject to seasonality in the past. Organizationally, the integration of Fotoball into K2 would be achieved by operating Fotoball as a wholly owned subsidiary of K2, with current Fotoball management remaining in place. All key employees would receive retention bonuses as a condition of closing. Integration teams consisting of employees from both firms were set to move expeditiously according to a schedule established prior to closing the deal. The objective would be to implement the best practices of both firms. On January 26, 2004, K2 Inc. completed the purchase of Fotoball USA in an all-stock transaction. Immediately after, senior K2 managers communicated (on-site, where possible) with Fotoball customers, suppliers, and employees to allay any immediate concerns. Discussion Questions: -What alternatives to M&As could K2 have employed to pursue its growth strategy? Why were the alternatives rejected?

Case Study Short Essay Examination Questions McKesson HBOC Restates Revenue McKesson Corporation, the nation's largest drug wholesaler, acquired medical software provider HBO & Co. in a $14.1 billion stock deal in early 1999. The transaction was touted as having created the country's largest comprehensive health care services company. McKesson had annual sales of $18.1 billion in fiscal year 1998, and HBO & Co. had fiscal 1998 revenue of $1.2 billion. HBO & Co. makes information systems that include clinical, financial, billing, physician practice, and medical records software. Charles W. McCall, the chair, president, and chief executive of HBO & Co., was named the new chair of McKesson HBOC. As one of the decade's hottest stocks, it had soared 38-fold since early 1992. McKesson's first attempt to acquire HBO in mid-1998 collapsed following a news leak. However, McKesson's persistence culminated in a completed transaction in January 1999. In its haste, McKesson closed the deal even before an in-depth audit of HBO's books had been completed. In fact, the audit did not begin until after the close of the 1999 fiscal year. McKesson was so confident that its auditing firm, Deloitte & Touche, would not find anything that it released unaudited results that included the impact of HBO shortly after the close of the 1999 fiscal year on March 31, 1999. Within days, indications that contracts had been backdated began to surface. By May, McKesson hired forensic accountants skilled at reconstructing computer records. By early June, the accountants were able to reconstruct deleted computer files, which revealed a list of improperly recorded contracts. This evidence underscored HBO's efforts to deliberately accelerate revenues by backdating contracts that were not final. Moreover, HBO shipped software to customers that they had not ordered, while knowing that it would be returned. In doing so, they were able to boost reported earnings, the company's share price, and ultimately the purchase price paid by McKesson. In mid-July, 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 had fallen by 48% since late April when it first announced that it would have to restate earnings. McKesson's senior management had to contend with rebuilding McKesson's reputation, resolving more than 50 lawsuits, and attempting to recover $9.5 billion in market value lost since the need to restate earnings was first announced. When asked how such a thing could happen, McKesson spokespeople said they were intentionally kept from the due diligence process before the transaction closed. Despite not having adequate access to HBO's records, McKesson decided to close the transaction anyway. : -Describe the measurable and non-measurable damages to McKesson's shareholders resulting from HBO's fraudulent accounting activities.

In contacting large,publicly traded firms,it is usually preferable to make initial contact through an intermediary and at the highest level of the company possible.

The screening process represents a refinement of the search process and commonly utilizes which of the following as selection criteria

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

Total consideration is a legal term referring to the composition of the purchase price paid by the buyer for the target firm.It may consist of which of the following:

Case Study Short Essay Examination Questions McKesson HBOC Restates Revenue McKesson Corporation, the nation's largest drug wholesaler, acquired medical software provider HBO & Co. in a $14.1 billion stock deal in early 1999. The transaction was touted as having created the country's largest comprehensive health care services company. McKesson had annual sales of $18.1 billion in fiscal year 1998, and HBO & Co. had fiscal 1998 revenue of $1.2 billion. HBO & Co. makes information systems that include clinical, financial, billing, physician practice, and medical records software. Charles W. McCall, the chair, president, and chief executive of HBO & Co., was named the new chair of McKesson HBOC. As one of the decade's hottest stocks, it had soared 38-fold since early 1992. McKesson's first attempt to acquire HBO in mid-1998 collapsed following a news leak. However, McKesson's persistence culminated in a completed transaction in January 1999. In its haste, McKesson closed the deal even before an in-depth audit of HBO's books had been completed. In fact, the audit did not begin until after the close of the 1999 fiscal year. McKesson was so confident that its auditing firm, Deloitte & Touche, would not find anything that it released unaudited results that included the impact of HBO shortly after the close of the 1999 fiscal year on March 31, 1999. Within days, indications that contracts had been backdated began to surface. By May, McKesson hired forensic accountants skilled at reconstructing computer records. By early June, the accountants were able to reconstruct deleted computer files, which revealed a list of improperly recorded contracts. This evidence underscored HBO's efforts to deliberately accelerate revenues by backdating contracts that were not final. Moreover, HBO shipped software to customers that they had not ordered, while knowing that it would be returned. In doing so, they were able to boost reported earnings, the company's share price, and ultimately the purchase price paid by McKesson. In mid-July, 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 had fallen by 48% since late April when it first announced that it would have to restate earnings. McKesson's senior management had to contend with rebuilding McKesson's reputation, resolving more than 50 lawsuits, and attempting to recover $9.5 billion in market value lost since the need to restate earnings was first announced. When asked how such a thing could happen, McKesson spokespeople said they were intentionally kept from the due diligence process before the transaction closed. Despite not having adequate access to HBO's records, McKesson decided to close the transaction anyway. : -Why do you think McKesson may have been in such a hurry to acquire HBO without completing an appropriate due diligence?

The signing of a letter of intent usually precludes the target firm from suing the potential acquiring company if the acquirer eventually withdraws its initial offer.

Which of the following is generally not true of integration planning?

Case Study Short Essay Examination Questions Case Study: Sleepless in Philadelphia Closings can take on a somewhat surreal atmosphere. In one transaction valued at $20 million, the buyer intended to finance the transaction with $10 million in secured bank loans, a $5 million loan from the seller, and $5 million in equity. However, the equity was to be provided by wealthy individual investors (i.e., "angel" investors) in amounts of $100,000 each. The closing took place in Philadelphia around a long conference room table in the law offices of the firm hired by the buyer, with lawyers and business people representing the buyer, the seller, and several banks reviewing the final documents. Throughout the day and late into the evening, wealthy investors (some in chauffeur-driven limousines) and their attorneys would stop by to provide cashiers' checks, mostly in $100,000 amounts, and to sign the appropriate legal documents. The sheer number of people involved created an almost circus-like environment. Because of the lateness of the hour, it was not possible to deposit the checks on the same day. The next morning a briefcase full of cashiers' checks was taken to the local bank. Discussion Question: -What do you think are the major challenges faced by the buyer in financing small transactions transaction in this manner?

The number of selection criteria should be as extensive as possible to ensure that all factors relevant to the firm's decision-making process are considered.

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

Case Study Short Essay Examination Questions 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. : -Speculate on why Wachovia's management rebuffed the offer from SunTrust Banks with the ambiguous statement that it was not in the best interests of Wachovia's shareholders?

Each of the following is true about the acquisition search process except for

Which of the following is generally not true of a financing contingency?

All of the following are true of buyer due diligence except for

There is no need for the seller to perform due diligence on its own operations to ensure that its representations and warranties in the definitive agreement are accurate.

All of the following statements are true about letters of intent except for

The actual purchase price paid for a target firm is determined doing the negotiation process and is often quite different from the initial offer price stipulated in a letter of intent.