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Financial Analysis on an Oil Corporation Takeover
Gulf Oil Corp.–Takeover
Summary of the facts
o George Keller of Standard Oil Company of California (SoCal) is trying to decide how much to bid for Gulf Oil Corporation. Gulf will not consider bids lower than $70 per share even though their last closing price per share was $43.
o Between 1978 and 1982, the Gulf countries doubled their exploration and development spending to increase their oil reserves. In 1983, Gulf began to significantly reduce exploration costs as oil prices fell, with Gulf management repurchasing 30 million of its 195 million shares.
o The acquisition of Gulf Oil resulted from a recent takeover attempt by Boone Pickens Jr. of Mesa Petroleum Company. He and a group of investors spent $638 million and acquired about 9% of all Gulf shares outstanding. Pickens was engaged in a proxy battle for control of the company, but Gulf executives fought Boone’s takeover as he pursued a partial tender offer at $65 per share. Gulf then decided to liquidate on its own terms and approached several companies to participate in the sale.
o The opportunity for improvement was Keller’s main attraction to Gulf, and now he has to decide whether Gulf, if liquidated, is worth $70 per share and how much he will bid for the company.
o What is Gulf Oil’s price per share if the company is liquidated?
o Who is Socal’s competition and how are they a threat?
o What should Socal bid for Gulf Oil?
o What can be done to prevent Sokal from doing Gulf Oil work?
Major contenders for Gulf Oil include Mesa Oil, Kohlberg Kravis, ARCO, and of course SoCal.
o Gulf currently owns 13.2% of the stock at an average purchase price of $43.
o Borrowed $300 million on Mesa Securities and offered $65/share for 13.5 million shares, which would increase Mesa’s holding to 21.3%.
o Under re-incorporation, they would have to borrow several times Mesa’s net worth to get the majority needed to get a seat on the board.
o Mesa is unlikely to raise that much capital. Regardless, Boone Pickens and his investor group stand to make a handsome profit if they sell their existing shares to the winning bidder.
o The offer price is likely to be lower than $75/share because a $75 bid would increase its debt ratio, making it difficult to borrow any more.
o Socal’s debt is only 14% of total capital (Exhibit 3) and banks are willing to lend enough to bid on the possibility of $90.
o Specializes in leveraged buyouts. Keller believes his offer is central to preserving Gulf’s name, assets and jobs. Until a long-term solution is found, the Gulf will remain a concern.
Socal’s offer will be based on what the Gulf reserves are worth without further exploration. Gulf’s other assets and liabilities will be absorbed into Socal’s balance sheet.
Gulf Oil’s weighted-average cost of capital
o Gulf’s WACC was determined to be 13.75% using the following assumptions:
o CAPM is used to price equity using a beta of 1.5, risk free rate of 10% (1 year T-Bond), 7% market risk premium (Ibbotson Associates data of arithmetic mean from 1926 – 1995). Cost of Equity: 18.05%.
o The market value of equity was determined by multiplying the 1982 share price of $30 by the number of shares outstanding. This price was used because it is the uninflated value before takeover attempts increased the price. Market value of equity: $4,959 million, weight: 68%.
o Debt value was determined using the book value of long-term debt, $2,291. Weight: 32%.
o Cost of Loan: 13.5% (Given)
o Tax rate: 67% of net income before tax divided by income tax expense.
Valuation of Gulf Oil
Gulf’s value is made up of two factors: the value of Gulf’s oil reserves and the company’s value as a going concern.
o A projection was made of oil production from 1983 until all reserves were exhausted (Exhibit 2). Production in 1983 was 290 million composite barrels and this was assumed to be stable until 1991 when the remaining 283 million barrels were produced.
o Production costs were kept constant relative to production volume, including depreciation due to the unit method of production currently used by Gulf (production would be the same, so depreciation would be the same)
o Since Gulf uses the LIFO method for inventory, it is assumed that new reserves are expensed in the year they are discovered and all other exploration costs, including geological and geophysical costs, are charged to revenue.
o Since there will be no further exploration, costs associated with production will be considered to reduce reserves.
o Oil prices are not expected to increase over the next ten years, and since inflation affects both the selling price of oil and production costs, it cancels itself and is rejected in the cash flow analysis.
o Revenues minus expenses determine the cash flows for the years 1984-1991. The cash flow stopped in 1991 when all oil and gas reserves were exhausted. The cash flow derivative only accounts for the liquidation of oil and gas assets and does not account for the liquidation of other assets such as current assets or net assets. Cash flows were discounted through net present value using Gulf’s cost of capital as the discount rate. The total cash flow until liquidation is completed, at Gulf’s 13.75% discount rate (WACC), comes to $9,981 million.
Gulf value as a caste concern
o Another factor in Gulf’s value is its value as a concern.
o Appraisal-related because Socal has no plans to sell any Gulf assets other than oil under the liquidation plan. Instead, SoCal will use Gulf’s other assets.
o Socal may choose to convert Gulf back into a going concern at any time during the liquidation process, requiring Gulf to begin the exploration process again.
o Value as a going concern was calculated by multiplying the 1982 share price of $30 by the number of shares outstanding. Value: $4,959 million.
o The 1982 share price was chosen because this value is the market value before takeover attempts increased.
o When two firms merge, it is common for the acquiring firm to overpay for the acquired firm.
o Shareholders of the acquired company gain from the overpayment and shareholders of the acquiring company lose value.
o Socal’s responsibility is to its shareholders, not to Gulf Oil’s shareholders.
o Socal values Gulf Oil in liquidation at $90.39 per share. Any payment above this amount will result in a loss to the social stakeholders.
o Maximum bid amount per share was determined by finding value per share with Socal’s WACC, 16.20%. The resulting price was $85.72 per share.
1. This is the price per share that Socal should not exceed in order to make a profit from the merger, as Socal’s WACC of 16.2% is closer to what Socal would expect to pay its shareholders.
o The minimum bid is usually determined by the price at which the stock is currently selling, which would be $43 per share.
1. However, Gulf Oil will not accept a bid lower than $70 per share.
2. Also, adding a competitor’s willingness to bid at least $75 per share increases the price of the winning bid.
o Socal averaged the maximum and minimum bid prices, resulting in a bid price of $80 per share.
Maintaining social value
o If Socal buys Gulf at $80, that is based on the liquidation value of the company and not as a going concern. Therefore, if Socal were to operate Gulf as a going concern, their stock would be undervalued by roughly half. Social stockholder fears that management will take over Gulf and take control of a company that is only valued at its current stock price of $30.
o After acquisition, there will be large interest payments which may force management to improve performance and efficiency. The use of debt in takeovers is not only a financing technique but also a tool to induce change in managerial behavior.
o Socal may use certain strategies to ensure that Socal will take over and use Gulf at a fair value to stockholders and other related parties.
o The contract may be executed at or before the time of bidding. It will specify the future liabilities of the social management and include their liquidation strategy and projected cash flows. Even if management respects the contract, there is no real incentive to prevent them from implementing their own agenda.
o Management can be supervised by executive officers; However, this is often an expensive and ineffective process.
o Another way of assuring shareholders, especially when monitoring is too expensive or too difficult, is to align management’s interests with those of stockholders. For example, an increasingly common solution to the problems arising from the separation of ownership and management of public companies is to pay managers partly with shares and stock options in the company. This gives managers a powerful incentive to act in the interests of owners by maximizing shareholder value. This is not a perfect solution because some managers who own too many stock options have engaged in accounting fraud so that they can hold some of them in order to increase the value of those options, but to the detriment of their firm and other shareholders. .
o It would be most profitable and least costly for Socal to align its managers with stockholders’ concerns by partially paying them with shares and stock options. There are risks associated with this strategy but it will certainly be an incentive for management to eliminate Gulf Oil.
o Socal will bid for Gulf Oil because its cash flows show it is worth $90.39 in the liquidated state.
o Socal will bid $80 per share but limits further bids to a ceiling of $85.72 because a higher price would hurt Socal’s shareholders.
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