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The Gulf Oil Takeover. Summary Points Prof. Mike Vetsuypens SMU Cox School of Business. Gulf Oil: Epilogue. FINAL BIDDING VALUES: Pickens $65.00 ARCO $72.00 KKR $87.50 (non–cash) SOCAL $80.00 Total SOCAL bid: $13.2 billion

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The Gulf Oil Takeover

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    1. The Gulf Oil Takeover Summary Points Prof. Mike Vetsuypens SMU Cox School of Business

    2. Gulf Oil: Epilogue • FINAL BIDDING VALUES: Pickens $65.00 ARCO $72.00 KKR $87.50 (non–cash) SOCAL $80.00 Total SOCAL bid: $13.2 billion • PICKENS' PROFIT: $760 million • SOCAL/GULF DECISIONS AFTERWARDS: Divested Assets: $1 billion James Lee received a $13 million severance pay SOCAL cut its workforce by 25,000 Professor Mike Vetsuypens

    3. Why hostile takeovers? • The Market for Corporate Control: a deviceto ensure that assets are deployed effectively • Strategy/Finance/Capital Markets Interact:Don't define strategy without consideringfinancial markets… or YOU'LL PAY! • "If you don’t use your assets the best thatthey can be used, someone else will do itfor you" (T. Boone Pickens) Professor Mike Vetsuypens

    4. Technical issues: • Merger Analysis Should Use StandardFinancial Tools • Key Elements of Capital Expenditure Analysis: Cash Flows, Cash Flows, Cash Flows! Incremental After Tax Timing of Cash Flows matters Inflation: be consistent Cost of Capital Sensitivity Analysis Professor Mike Vetsuypens

    5. Gulf’s Cost of Capital • Cost of Debt: AA yield=12.76%, after tax=6.38% • Cost of Equity: CAPM • Risk free rate=12%, Gulf equity beta=1.15 • Equity Risk Premium= 7% - Cost of Equity= 12+1.15*7=20.50% • Weighted Average Cost of Capital (WACCAT): CAPITAL% COSTMKT VALUEWEIGHTWEIGHTED COST Debt 6.38% 2,646 29% 1.85% Equity 20.50% 6,612 71% 14.24% 16.1% WACCAT Professor Mike Vetsuypens

    6. Takeover Strategy Points • Market Value < "Highest & Best" Value • With competitive bidding, target company leaves very little "on the table" • Target shareholders get large premiums (15% to 40%+) • Bidder may overpay: “Winner's Curse” • Average Bidder % returns > 0, average Bidder $ returns <0 • Combined returns on portfolios of buyer and targets >0 Professor Mike Vetsuypens

    7. Does M&A create value for the bidder? • A recent academic study of 12,023 M&A deals between 1980 and 2001 finds industry-adjusted losses in the dollar value of acquiring firms around the merger announcement, but small percentagegains in stock returns (+1.1%). • A significant amount of the lost economic value occurred in 87 large deals, mostly during the 1998-2001 period. • So a majority of small mergers create value for the buyers, but most recent large deals (done with bidder stock) destroy bidder value. Professor Mike Vetsuypens

    8. How do we know if bidders benefit from a merger? • Test #1: Did the share price of the buyer rise? • Fails to control for unrelated market/industry factors • Test #2: Did the buyer’s stock returns exceed a benchmark? • Over what time period should returns be calculated? • Too much noise over long periods, announcement period best • Test #3: Are bidder shareholders better off after the deal than they would have been had the deal not occurred? • Ideal test, but difficult to carry out • Example: AOL’s purchase of Time Warner Professor Mike Vetsuypens

    9. Some dubious Takeover Motives • The target company is undervalued • Do you trust the CEO’s stock picking ability? • “Diworsification” • Can’t shareholders diversify on their own? • But…reducing unique risk to avoid distress costs is OK • Redeploy surplus funds • Will you waste excess cash on bad deals? • Empire-building (size maximization) • Mgmt salaries are a positive function of firm size! • Illusion that growth for growth’s sake is desirable Professor Mike Vetsuypens

    10. The problem with Earnings growth targets • Growth=Internal (core, organic)+ External • Internal growth= inflation + real GDP expansion + market share gains + productivity gains • External growth= joint ventures, M&A • Core earnings growth in mature firms is LOW • This often leads to frenzied M&A deals: “shopping for more growth” Professor Mike Vetsuypens

    11. Cosmetics vs. Fundamentals • Growth in EPS is a poor measure of excellence: • Focuses on earnings instead of cash flows • EPS is a backward-looking, one-period metric • EPS ignores the cost of the equity capital needed to create it • A negative NPV merger can increase EPS! • A positive NPV merger may dilute current EPS • May explain what happened at Enron, WorldCom… • Must focus on creating value for your shareholders: • Look at discounted cash flows • Compare IRR against the cost of your capital • Are you earning economic profits? Professor Mike Vetsuypens

    12. Valid merger reasons • Economies of scale, cost reductions • Consolidate ops, eliminate redundancies (net of integration costs), reduce competition (beware of antitrust laws) • Vertical integration (but consider outsourcing!) • Complementary resources, cross-selling • Eliminating operational or governance problems Professor Mike Vetsuypens

    13. Which of these 2 deals is the better one for the buyer? A B Pre-merger target value $10 billion $40 billion Acquisition premium 30% 20% Merger value gains $4 billion $7 billion Professor Mike Vetsuypens

    14. Prime Directive for a good merger • By themselves, neither the target pre-merger value, the acquisition premium, nor the merger synergies matter. • What matters is that what you pay {target value + premium} should be less than what you get {target value + synergies} • Don’t say: “We’re buying a great company with superb assets and people, with great growth prospects”. This only makes sense if the target is undervalued. Is it? Or will you pay full price for these assets? Professor Mike Vetsuypens

    15. Form S-4 Registration Statement, 1/11/2006, p 32 ConocoPhillips believes the merger (between COP and BR) joins two well-managed companies, providing strategic and financial benefits to stockholders of COP. COP expects the benefits to include: • Creation of a leading North American natural gas position comprised of high-quality, long-lived, low risk gas reserves with significant unconventional resource potential and enhanced production growth; • Enhanced business mix with a higher proportion of exploration and production assets, assets in OECD countries and North American natural gas; • Significant free cash flow and synergy benefits; and • Access to BR’s talented and technically capable workforce Professor Mike Vetsuypens

    16. A merger checklist…. #1: Explain the strategic rationale for the merger! Be explicit/realistic on how changes and synergies will be achieved within the target. #2: Know the walk-away price! Don’t overpay for the synergies. No deal is worth doing at any price! #3: Perform due diligence: understand what you are buying, including people. #4: Don’t just do a deal because you have ample internal cash flows, or a high stock price. #5: Don’t forget merger integration costs. #6: Beware of stock deals in hot M&A markets Professor Mike Vetsuypens

    17. How can we create Corporate Discipline? • Through Hostile M&A activity • Internally (Top Management compensation + Board oversight) • Through Competition in Product Markets • Through increased Borrowings Professor Mike Vetsuypens