Gulf

The Gulf Oil Takeover
Summary Points
Prof. Mike Vetsuypens
SMU Cox School of Business
Gulf Oil: Epilogue
FINAL BIDDING VALUES:

Pickens
ARCO
KKR
SOCAL
$65.00
$72.00
$87.50 (noncash)
$80.00
Total SOCAL bid:

PICKENS' PROFIT:
$13.2 billion
$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
Why hostile takeovers?
The Market for Corporate Control: a device

to ensure that assets are deployed effectively
Strategy/Finance/Capital Markets Interact:

Don't define strategy without considering
financial markets or YOU'LL PAY!
"If you dont use your assets the best that

they can be used, someone else will do it
for you" (T. Boone Pickens)
Technical issues:
Merger Analysis Should Use Standard

Financial 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
Gulfs 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 % COST
Debt
Equity
MKT VALUE
WEIGHT WEIGHTED COST
6.38%
2,646
29%
1.85%
20.50%
6,612
71%
14.24%
16.1% WACCAT
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
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 percentage
gains in stock returns (+1.1%).
A significant amount of the lost economic value
occurred in 87 large deals, mostly during the 19982001 period.
So a majority of small mergers create value for the
buyers, but most recent large deals (done with
bidder stock) destroy bidder value.
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 buyers 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: AOLs purchase of Time Warner
Some dubious Takeover Motives

The target company is undervalued
Do you trust the CEOs stock picking ability?
Diworsification
Cant shareholders diversify on their own?

Butreducing 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 growths sake is desirable
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
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?
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
Which of these 2 deals is the better one for the buyer?
A
Pre-merger target value
$10 billion
B
$40 billion
Acquisition premium
30%
20%
Merger value gains
$4 billion
$7 billion
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}
Dont say: Were 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?
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 BRs talented and technically capable workforce
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! Dont overpay for the
synergies. No deal is worth doing at any price!
#3: Perform due diligence: understand what you are
buying, including people.
#4: Dont just do a deal because you have ample
internal cash flows, or a high stock price.
#5: Dont forget merger integration costs.
#6: Beware of stock deals in hot M&A markets
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

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The Gulf Oil Takeover

Gulf Oil: Epilogue

FINAL BIDDING VALUES:

Total SOCAL bid:

SOCAL/GULF DECISIONS AFTERWARDS:

Why hostile takeovers?

The Market for Corporate Control: a device

Strategy/Finance/Capital Markets Interact:

"If you dont use your assets the best that

Merger Analysis Should Use Standard

Key Elements of Capital Expenditure Analysis:

Gulfs 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):

WEIGHT WEIGHTED COST

Takeover Strategy Points

Market Value < "Highest & Best" Value

With competitive bidding, target company leaves

Target shareholders get large premiums (15% to 40%+)

Bidder may overpay: Winner's Curse

Average Bidder % returns > 0, average Bidder $ returns

Combined returns on portfolios of buyer and targets >0

Does M&A create value for the bidder?

A recent academic study of 12,023 M&A deals

How do we know if bidders benefit from a merger?

Fails to control for unrelated market/industry factors

Test #2: Did the buyers stock returns exceed a benchmark?

Some dubious Takeover Motives

Do you trust the CEOs stock picking ability?

Cant shareholders diversify on their own?

Redeploy surplus funds

Will you waste excess cash on bad deals?

Empire-building (size maximization)

Mgmt salaries are a positive function of firm size!

The problem with

Cosmetics vs. Fundamentals

Focuses on earnings instead of cash flows

Must focus on creating value for your shareholders:

Look at discounted cash flows

Valid merger reasons

Consolidate ops, eliminate redundancies (net of integration

Vertical integration (but consider outsourcing!)

Which of these 2 deals is the better one for the buyer?

Merger value gains

Prime Directive for a good merger

By themselves, neither the target pre-merger value,

Form S-4 Registration Statement, 1/11/2006, p 32

#1: Explain the strategic rationale for the merger! Be

How can we create Corporate Discipline?

Through Hostile M&A activity

Internally (Top Management compensation

Through Competition in Product Markets

Through increased Borrowings

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