Tata Corus Deal

CORPORATE MERGERS & ACQUISITIONS: The Issue Of Shareholders’ Wealth Maximization Revisited

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

1

THE SCENARIO: TATA TAKES OVER CORUS IMMEDIATE IMPACT: TISCO SHARE PRICE GONE DOWN SUBSTANTIALLY: 11% BY ONE STROKE: ALTHOUGH BSE SENSEX THEN ROSE BY 18 POINTS.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

2

EV/ EBDIT multiple as paid to Corus : 9 times

EV/ EBDIT multiple of Tata Steel :

4.6 times

EV/EBDIT multiple Mittals paid to Arcelor: 5.8 times

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

3

Mr.Ratan Tata’s argument: price of steel companies will go up soon. It’s almost an echo of Hewlett-Packard’s the then CEO’s comment in 2001. But the research afterwards has proven otherwise.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

4

BUT WHAT’S THE MARKET INFORMATION? ICRA Industry Monitor: World steel consumption growth rates: 2006 : 8.9% 2007 : 5.2%( anticipated) 2010 : 4.2% (anticipated).

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

5

Then overproduction in steel is apprehended. And steel price is likely to fall.

Fear factor 1. a $50 in global steel price will result in $414 m loss from Corus acquisition

Fear factor 2. a $75 fall would lead the new firm to a loss of $846 m.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

6

Impact of the issue of $1.7 bn preferential issue to Tata Sons: • Addl debt on balance sheet

Rs.5802.5 crore

• Equity dilution

25.1%

• Net increase in PAT

Rs.374.3 crore

• But decrease in EPS

by 13.1%

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

7

• How to translate the low cost opportunity? A part of that lies in cheaper iron ore. But not allowed to export iron ore to Britain. • The issue of junk bonds might spoil Tata’s fund rising for greenfield expansion.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

8

REMINDER: CORPORATE SCANDALS THAT GAVE BIRTH TO Sarbanes-Oxley legislation. BUT SOX LEGISLATION HAS NOT ENSURED THAT THE BOARD OF DIRECTORS WOULD CERTAINLY RAISE THE pertinent QUESTIONS WITHOUT FAIL.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

9

CORUS SHAREHOLDERS ARE BENIFITTED.

WHAT ABOUT THE TISCO LOYALS?

WE HAVE TO WAIT AND SEE.

THE QUESTION REMAINS: HAVE THEY BEEN GIVEN THE TREATMENT ENOUGH WORTHY? Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

10

•WHAT DO WE EXPECT FROM A MERGER? •SYNERGIES- FINANCIAL AND OPERATING and/or OTHERWISE. •IN FACT, IT’S NOT ONLY THE EXPECTATION. IT SHOULD BE A PRECONDTION, NECESSARY AND ESSENTIAL. •SUCCESS STORIES ARE THERE TOO. •BUT WHO’LL BEAR THE BURDEN OF FAILURE? AND, THAT TOO, WHY?

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

11

A few words from Mr. Warren Buffet: “ In some mergers there truly are major synergies- though often the acquirer pays too much too obtain them- but at other times the cost and revenue benefits that are projected prove illusory. Of one thing, however, be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairy tales are the emperors told that they are naked.” Quoted from Annual Report, 1997, Berkshire Hathaway Inc

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

12

Buffet’s argument is fortified and vindicated by the efficient market school: M&A only repeats what the individual shareholders can do themselves.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

13

• THUS THE ADVANTAGES IN THE NAME OF SYNERGIES AND DIVERSIFICATION ARE NO MORE BASED ON SOLID GROUNDS. • WHAT’S MORE TRUE? •SHAREHOLDERS’ VALUE MAXIMIZATION EFFORTS; or, •AMBITION TO ACQUIRE THE CULT OF BEING COLOSSAL.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

14

NO, I don’t propose the doomsday for M&A. It’s a reality. Despite all arguments in its favor and/or against, M&A has come to stay. Our purpose is to see through the euphoria, sometimes created by the media, to see beyond corporate jingoism. The objective is simple: to ensure the maximization and protection of shareholders’ wealth since that’s the goal of management. That’s the acid test of every managerial decision.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

15

Year 2001. Hewlett-Packard took over Compaq in September. Corporate announcement was made on 3rd September. HP stock price dropped down by 20%. The explanation offered by the then HP CEO Carly Fiorina : thing shouldn’t be judged on the basis of such shortterm price movement. May or may not be. But let’s have a look at the results of the survey taken up by Mark Sirower and Sumit Sahni in response to that comment. And, astonishingly the results speak exactly the otherwise. SURVEY SPAN:1995-2001 SAMPLE SIZE: 302 DEALS AVERAGE MARKET CAP: ACQUIERER’S- $ 14.2 bn TARGET’S

- $ 5.5 bn

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

16

OBSERVATIONS: 1. On average acquirer underperformed than its peers in the industry to the extent of -4% or more. 2. Over 60% of cases, market responded negatively to the announcements of takeover for the acquiring company. 3. For the acquiring firms with negative reaction, things hardly changed after a year in 75% of cases. 4. For the firms with initial positive reactions continued to perform the same even after a year. Dr. Manipadma Datta,Professor of fianance, 5. Negative performers paid moreIMT, premium Ghaziabad to the target firms than the positive performers.( QUITE INTERESTING!)

17

6. However, at the macro level, the target’s shareholders’ gain have compensated, and at times, more than compensated the loss done to the shareholders of the acquiring firms. 7. Selling corporates were the biggest beneficiaries.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

18

ARE THESE RESULTS ANY INDICATION AS TO THE MARKET’S FEAR THAT • THE ACQUIRING FIRM WONT BE ABLE TO MAINTAIN ITS TREND OF SUCCESS? • THE PREMIA PAID TO THE SELLING FIRMS ARE BALLOONED UP?

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

19

It has also been observed that the cash or part cash deals were more positively accepted by the market than the deals done on stock swapping only. This is perhaps providing us a with an explanation to the questionwhat makes markets so skeptical? Cash richness was taken to be a positive financial virtue by the market.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

20

• MARKET IS CONCERNED ABOUT THE SHAREHOLDERS’ VALUE AT RISK(S-VAR) • S-VAR = ( PREMIUM PAID TO THE SEELING FIRM/ MARKET VALUE OF THE ACQUIRING FIRM) • A LESSON FOR MANAGERS: MARKET REWARDS THE FIRMS GOING FOR CASH DEALS IN THE FORM OF REDUCED S-VAR FOR THE FIRM. Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

21

• THE CRUX OF THE MATTER LIES IN HAVING A MATCH BETWEEN SYNERGIES AND PREMIUM PAID. • SO, PREMIUM ≤ VALUE OF THE SYNERGY • OTHERWISE, BE READY TO SUFFER. • SINCE VALUE OF SYNERGIES IS DIFFICULT TO ASCERTAIN TO PRECISELY, BETTER TO PLAY CONSERVATIVE.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

22

THUS WHAT APPEAR MOST IMPORTANT ARE • APPROPRIATE VALUATION OF FIRMS; • SWAP RATIO DETERMINATION.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

23

MOST COMMONLY USED VALUATION TECHNIQUES 1. Discounted future earnings 2. Capitalization of earnings 3. Comparable multiples; and, 4. Assets oriented approaches like fair value, book value, liquidation value etc.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

24

My Prescription: FCF and/or EVA

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

25

FREE CASH FLOW VALUATION MODEL Cost of Capital (WACC)

E D WACC = K e * + Kd * (1 − t ) * . D+E D+E Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

26

Thus the value of the firm

∞ FCFt FCF1 FCF2 Value = + + ... = ∑ 2 t (1 + wacc) (1 + wacc) ( 1 + wacc ) t =1

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

27

Value of Company = Present value of cash flows during the explicit forecasting period + Present Value of Cash flows beyond the explicit forecasting period (terminal value) Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

28

FREE CASH FLOW CHART NET SALES +OTHER INCOME= LESS: TOTAL OPERATING EXPENSES:

TOTAL OPERATING INCOME •Raw materials •Wages •Salaries •Non-depreciation manufacturing expenses •Selling & distribution overheads •Administration overheads •Depreciation •Other operating expenses =NET OPERATING PROFIT

NET PERATING PROFIT * (1- Tax Rate) =NET OPERATING PROFIT ADJ USTED FOR TAX (NOPAT) ADD BACK: DEPRECIATION LESS: INVESTMENT ELEMENTS

=GROSS CASH FLOW •Net increase in Capex •Increase in Working Capital •Increase in other operating assets, if any. =FREE CASH FLOW

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

29

EVA Operating Invested Capital or OIC

Operating invested capital consists of all the operating assets, which the firm uses to generate NOPAT. It includes the fixed assets, the working capital, and other operating assets. If for example, we classify investments as an operating activity, then investments will also be included as part of operating invested capital. Similarly, capital work in progress is not used to generate the NOPAT and hence must not be included in the operating invested capital.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

30

Return on Operating Invested Capital

NOPATt ROIC = Operating Invested Capitalt −1

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

31

EVA = Operating Invested Capital * (ROIC – WACC)

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

32

Value= OIC+ PV (EVA)

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

33

SWAP ISSUE- points to ponder • per share offer price : market price per share of the acquiring firm • what’s obvious is that even the worst performer demands a higher price when negotiating for being takeover; • hard and conscious negotiation is a safeguard; • to see whether and how much the shares are under/over valued; • to prevent as far as practicable the possible dilution in EPS in the merged firm; • PE Ratio paid ≤ PE Ratio of the acquiring firm. This may be considered to be the limit. Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

34

A few Cautions: • In case no synergy is expected, swap should ponder over MPS of A/ MPS of T • But in case, it’s expected, the discounting should be done with care • If the maximum swap ratio that is acceptable to the promoter is lower than the maximum swap ratio that is acceptable to the other shareholders, then it is possible that the promoter will reject some of the mergers, which are in the interests of most of the shareholders. • It is also possible that the maximum swap ratio acceptable to all the shareholders is less than that is acceptable to the promoter. As we will discuss later, it is possible that in some cases, the promoter may go ahead with such mergers.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

35

Net Acquisition Value = V AT−[V A+V T ] –P T −E A V AT = COMBINED VALUE OF A and T V A = A’s MEASURE OF ITS OWN VALUE V T = MARKET VALUE OF THE SHARES OF T P T= PREMIUM PAID FOR T SHARES E A = EXPENSES FOR THE ACQUISITION PROCESS Reorganizing the equation, we get: NAV= [V AT−(V A+V T) ] –(P T +E A) This means, [V AT−(V A+V T) ] ≥ (P T +E A). Otherwise, it would mean that the bidding firm as overpaid

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

36

Operating Synergy: • Economies/ Diseconomies of Scale. • Spreading / Overspreading overhead. • Economies / Diseconomies of scope Financial Synergy • Risk of cash flows may decrease, particularly when cash flow streams of are not perfectly correlated. • Higgins and Schall: Debt coinsurance effect. If the income streams of both the firms are perfectly positively correlated, one of them could face the conditions of bankruptcy. • But which one, that may not be so easy to predict. Debt holders gain at the cost of equity holders. • Bankruptcy cost may be lowered. Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

37

DIVERSIFICATION • Related and unrelated diversifications • Diversification to enter more profitable industries • Financial benefit of diversification is there provided, Covariance between the earnings of the merging firms is negative; or, Cov E A, E T < 0 • Procycle and counter-cycle firm. • Benefits of conglomerates.

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

38

Thank you all!!

Dr. Manipadma Datta,Professor of fianance, IMT, Ghaziabad

39