©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston Chapter Increasing the Value of the Organization

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2 Multiple Approaches to Valuation are Illustrated by Case Examples Mergers in oil industry in the 1980s (Chevron-Gulf) Mergers in oil industry of the 1990s (Exxon-Mobil) Firm valuation through the stages in the life cycle Valuations in the Internet industry

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3 Oil Mergers of the Early 1980s (Chevron/Gulf) Transaction terms –Chevron won auction in March 1984 –Cash bid of $80 per share –Pretakeover activity price of Gulf was $39 –Premium was $41 or 105% –Gulf had million shares, total price was $13.2 billion — a gain of $6.8 billion –Transaction was taxable and treated as a purchase

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4 Valuation and Merger Analysis General Framework Nature of the industry Industry characteristics that drive mergers and potential synergies Historical value drivers Business economic analysis of the future for the industry and firms

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5 Projections of the value drivers for valuation firms Effects of the merger or rival competitive structure and strategies Antitrust and other regulatory aspects Implementation

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6 Exxon-Mobil Merger Characteristics of the oil industry –Basic characteristics Oil is a global market Strategically important for industrial, political, and military reasons Large costs required for environmental protection Impact of OPEC High degree of price instability

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7 –Setting for oil industry mergers in Price fluctuations — from $25 per barrel in 1996 to $9 per barrel by early 1999 to $24 per barrel in September 1999; $35 in early 2000; $26 in May 2000 Restructuring, investment in technology, and cost reduction –Oil industry characterized by cash flows in excess of positive NPV investment opportunities –Oil companies tried diversification in 1980s which resulted in declines in shareholder values

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8 Reasons for the Exxon-Mobil merger –Would extend presence in regions of the world with highest potential for future oil and gas discoveries and production –Stronger position to invest in large outlay programs with high prospective returns and risk –Complementary exploration and production operations in South America, Russia, Eastern Canada, Asia, and Africa –Near-term operating synergies in the amount of $2.8 billion

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9 Event analysis –Event date 0 was announcement date on 12/1/98 –Excess returns with respect to AMEX Oil Index –CAR for event window [-10,0] Mobil = 16.2% Exxon = 0.97% –CAR for event window [-10,+10] Mobil = 23.7% Exxon = 6.3% –Positive CARs consistent with calculation of $32 billion added value from the merger

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10 Antitrust issues –Herfindahl-Hirschman Index (H Index) measure H index for petroleum industry –1975, H index = 410 –1979, H index = 416 –1984, H index = 377 –1990, H index = 362 –1995, H index = 407 –1996, H index = 415 H index well under critical 1,000 level specified in regulatory Guidelines

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11 –Effects of major oil mergers on H index Major oil combinations –Total/Petrofina: increase index by 6.13 points to –Total Fina/Elf Aquitane: increase index by points to –BP/Amoco: increase index by points to –Exxon/Mobil: increase index by points to –BP Amoco/ARCO: increase index by 51.1 points to –If a Chevron/Texaco took place: increase index by points to Six mergers among top 23 petroleum companies in the world would result in a rise of H index from 389 to 599, well short of 1,000 critical level

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12 –Overall industry concentration measures are far below 1,000 threshold –Antitrust issues are not raised from an aggregate industry standpoint –Although individual oil companies are large, oil industry is also large ($1.5 trillion revenues) –Federal Trade Commission required Exxon- Mobil to sell off some wholesale distribution and retail marketing entities

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13 The Internet and Online Technologies Background –Revolutionary distribution vehicle –Global market –High growth rates

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14 –Financial characteristics High volatility in stock prices High stock prices relative to revenues because of high prospective growth rates Internet retailers can earn returns on invested capital comparable to traditional retailers with gross operating margins in the 5 to 10% range vs. 20 to 30% because of lower investment requirements –Use of M&As Proceeds and stocks from new Internet IPOs used for rapid series of acquisitions Aim is to achieve critical mass, market leadership, and name recognition

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15 Valuation approaches –Comparable companies approach Ratio of market to EBITDA may not work because of low or negative EBITDAs Ratio of market to book may be distorted because losses depress size of book values Ratio most widely used is market to revenues

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16 –DCF valuation Standard DCF methodology with multiple stages of revenue growth can explain valuation relationships observed for Internet companies Illustration of a 4-stage DCF valuation model –Stage 1 Losses in early years High revenue growth rate above 50% Negative operating margins Zero tax rate High cost of capital of 15%, reflecting high beta risks

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17 – Stage 2 Company has matured sufficiently to achieve profitability Period of favorable growth and high margins Growth rate drops to around 33% Operating margins rise to 30% Tax rate around 20% to reflect benefit of carryforward of tax losses in Stage 1 Cost of capital remains relatively high –Stage 3 Revenue growth decays until it reaches 3% Operating margin declines to 15% Combined corporate tax (federal and state) of 40% Cost of capital remains relatively high

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18 –Stage 4 Constant or no growth rate Operating margins decline further to 10% Tax rate and cost of capital at same level as in Stage 3 Variations in the value drivers can be made to reflect different scenarios High multiples of market to revenues observed in Internet companies reflect high growth and high profit margins achievable in early stages of new industries

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19 Calculating Growth Rates Discrete compound annual growth rate (d) –Geometric average based on the end points of the time series –Found by dividing the final year number (X n ) by the initial year figure (X 1 ), then taking the n-th root (for n number of years between initial and final number) –May be seriously flawed if end values are not representative of fluctuations in the time series of the variable