The Delaware Chancery Court’s decision related to PetSmart’s appraisal case provides boards and advisors with a blueprint for running a managed sales process.

August 23, 2017

In re Appraisal of PetSmart, Inc. is a case that highlights important valuation issues related to corporate merger and acquisition activity. PetSmart (the “company” or the “respondent”) was taken private in 2015 by a private equity firm, but a group of the company’s shareholders disputed the sale price. Through an appraisal proceeding, the Delaware Chancery Court (the “court”) found that the sales process was sufficient to support that the merger price was indicative of fair value. In addition, in its analysis of the competing expert testimony, the court determined that the discounted cash flow analysis used by the expert for former shareholders of PetSmart (the “petitioners”) was unreliable, largely due to the use of management’s unrealistic and unsupportable projections. In this case review, we examine the key factors behind the court’s decision and address how these considerations can benefit corporate boards and advisors.

Background

PetSmart is a pet-specialty retailer. Its business consists of providing pet products as well as pet services. PetSmart operates over 1,400 stores in the United States, Canada, and Puerto Rico. The industry in which PetSmart operates is concentrated, with the two largest players being PetSmart and its direct competitor, Petco Animal Supplies (“Petco”).

From 2000 through 2007, PetSmart was able to achieve better revenue growth than the overall retail industry. Two trends in particular helped PetSmart realize these growth levels: 1) the increase in the number of pets, and 2) the increasing amount of money that owners spent on their pets.

PetSmart’s growth started slowing, however, in 2012. With the subpar performance, the company had trouble accurately projecting its financial future. Coupled with management turnover, earnings misses sent PetSmart’s stock price downward. At this point, a potential transaction involving the company started to make sense. After much due diligence and discussion, two parties made final offers to buy PetSmart. Apollo Global Management and BC Partners came in with final offers of $81.50 per share and $83.00 per share, respectively. Ultimately, BC Partners acquired PetSmart for $83 per share on March 11, 2015 (the “merger”).

The petitioners declined the merger consideration and demanded appraisal for their shares. Specifically, the petitioners claimed that the merger price was unreliable for a variety of reasons and that the fair value of PetSmart should be determined via the application of a discounted cash flow (DCF) analysis. The petitioners contested that the true fair value of PetSmart, at the time of the merger, was $128.78 per share.

The respondent countered by suggesting the fair value of PetSmart was indeed the merger price because the merger was the result of a robust auction process which culminated in a transaction with an arm’s-length market participant. As explained in the court decision, “the vast delta between the valuations generated by the parties’ proffered methodologies raises red flags and suggests, perhaps, that neither is truly reflective of PetSmart’s fair value. The $4.5 billion that separates the parties certainly leaves much room for compromise.” 

Sales Process

As a result of PetSmart’s declining financial performance, PetSmart’s board of directors (the “board”) hired financial advisors and began a formal auction process in the late summer of 2014. PetSmart’s financial advisors reached out to 27 potential bidders. Of these potential bidders, three were strategic buyers, and the remainder were financial buyers. None of the strategic buyers elected to participate in the process. Of the 24 financial buyers, 15 signed nondisclosure agreements to move forward with the bidding process. During this initial phase, the board considered reaching out to Petco for a potential transaction. However, potential antitrust issues and the possibility of Petco, a direct competitor, obtaining PetSmart’s financial and strategic information proved to be too much of a risk for the board to pursue this option.

PetSmart set up an electronic data room as part of the auction process. It contained adequate information concerning the company’s financial results and certain relevant nonpublic information. PetSmart’s management also made presentations to certain bidders that signed nondisclosure agreements. By the end of October 2014, PetSmart received five preliminary bids that ranged from $65 to $85 per share. PetSmart’s stock price was $72.35 at the time. Of the five preliminary bids, four were over $80 per share. The board allowed these four bidders to conduct further due diligence, including access to more detailed information and additional meetings with management. On December 10, 2014, after further due diligence, PetSmart received new offers from the remaining bidders ranging from $78.00 to $80.70 per share. PetSmart’s financial advisors brought these new bids to the board. The board countered, requesting the bidders to submit their best and final offers. Two of the remaining bidders submitted final offers: Apollo at $81.50 per share and BC Partners at $83.00 per share.

The board met on December 13, 2014, to discuss the final offers from Apollo and BC Partners. The board also considered alternatives to a sale of the company during this meeting. After considering all options, the board decided to accept BC Partners’ $83.00 per share offer.

In assessing the strength of the auction process, the court considered whether, “the transactional process leading to the merger [was] fair, well-functioning, and free of structural impediments to achieving fair value for the company.”

Specifically, the court considered the following six questions in determining whether the auction process was sufficiently robust:

1. Were there restrictions on financing impeding the ability of bidders to bid as much as they may have otherwise been willing to pay?

The court found no evidence that suggested the unavailability of credit affected the amount any potential buyer was willing to offer for PetSmart.

2. Did the lack of strategic buyers leave PetSmart at the mercy of financial sponsors and their leveraged buyout models?

The court noted that, while it was true only financial buyers offered bids for PetSmart, the board’s financial advisor made every effort to attract strategic buyers. In addition, the court found that the financial buyers that did make bids had every incentive to put their best offer on the table. Finally, the court noted that the petitioners’ assertion that financial buyers’ use of a leveraged buyout model will rarely, if ever, produce fair value lacked merit. The court stated that, “while it is true that private equity firms construct their bids with desired returns in mind, it does not follow that a private equity firm’s final offer at the end of a robust and competitive auction process cannot ultimately be the best indicator of fair value for the company.”

3. Was PetSmart forced into the sales process at a low point in its performance by agitated stockholders?

The court found no credible support for this claim. The court noted that by the time an activist shareholder purchased its stake in PetSmart in July 2014, the board had already begun the process of reviewing strategic alternatives with its financial advisors. Furthermore, the board took its time with the sales process through December 2014 and was ready to pursue other strategic alternatives had the final offer not been sufficient.

4. Was the board ill-informed?

The court found no credible support for this claim.

5. Were PetSmart’s financial advisors conflicted?

The petitioners contended that the board’s financial advisor was conflicted due to previous relationships with the private equity bidders and one of the board members. However, the board’s financial advisor was a large, well-known institutional bank. The court found that this advisor would naturally have had relationships with private equity bidders given its size and stature in the mergers and acquisitions industry.

6. Was the transaction price stale by the valuation date?

The court found this argument to be speculative. The petitioners argued that the merger price was stale given the amount of time that passed between signing and closing. While PetSmart experienced some favorable financial results in the short term, the court was not convinced that this was indicative of a long-term trend. 

Based on the foregoing, the court found that the merger price was a reliable indicator of fair value. The court noted that the merger price was the “result of a ‘proper transactional process’ comprised of a robust presigning auction in which adequately informed bidders were given every incentive to make their best offer in the midst of a ‘well-functioning market.’” 

Within its decision, the court essentially lays out a blueprint with the factors it considers in determining whether a sales process leads to a merger price that is indicative of fair value. Corporate boards and financial advisors would be wise to consider this guidance when conducting a sales process that could be challenged by a disgruntled shareholder or an appraisal arbitrage investor.

Management Projections

As part of its assessment of fair value, the court also analyzed the validity of the petitioners’ expert’s DCF method. A DCF method is a multiple-period discounting model in which the value of a company is determined based on the present value of its projected future cash flows. Specifically, the court analyzed whether, at the time of the merger, there were “reliable projections of future expected cash flows, preferably derived from contemporaneous management projections prepared in the ordinary course of business.”

The court found that, in PetSmart’s normal course of business, management did not prepare long-term projections to operate the business, but typically prepared only one-year budgets. PetSmart used the one-year budgets and subsequent reforecasts to run the business and incentivize management. When management was tasked with preparing long-term projections for the auction process, the management team and the business units were unable to provide much input because they had never prepared long-term projections. Furthermore, there were significant time constraints placed on the management team to develop the projections, as the board rushed management to prepare long-term projections in the span of a few days.

Similar to analyzing the strength of the auction process, the court considered several key questions when determining whether management’s projections prepared during the auction process were reliable inputs into a DCF analysis.

Specifically, the court considered the following questions:

1. Did management have a history of creating long-term projections?

As noted above, PetSmart’s management team did not have a history of creating long-term projections. The court noted that PetSmart’s forecasting practice was limited to creating annual budgets that were nothing like the five-year projections management prepared for the auction process. In addition, the senior management of PetSmart was relatively new at the time the sales projections were created. Finally, the company prepared the long-term projections under extreme time constraints. 

2. Did management have success in achieving its historical projections?

The court found that even PetSmart’s short-term projections did not accurately predict the company’s performance historically.

3. Were the projections used for the auction process created in the ordinary course of business?

Given that management did not typically create long-term projections, the projections created as part of the sales process were not part of the ordinary course of business, but instead were created solely for use in the process of marketing the company for sale.

4. Was management unduly influenced by outside parties when creating the long-term projections?

The court found that the board influenced management to create aggressive and extra-optimistic projections because the board knew that whatever was put forth would be discounted by potential buyers. 

Based on the foregoing, the court found that the management projections prepared during the auction process were not reliable indications of future performance. Thus, the court determined that the petitioners’ expert’s model itself was unreliable, stating that “any DCF analysis that relies upon the management projections … would produce ‘meaningless’ results.” 

Similar to the court’s decision related to the auction process, the court essentially lays out a blueprint with the factors it considers in determining whether projections prepared by management are reasonable to rely upon in a valuation analysis. Corporate board and financial advisors would be wise to consider this guidance when developing financial projections and preparing valuations to be used in an auction process. 

Guidance for Boards and Advisors

The court’s decision in this case provides useful insights with respect to the factors it considers in determining whether a merger price is indicative of fair value and whether the projections prepared by management are reliable. As previously stated, corporate boards and financial advisors would be well-advised to be aware of this guidance and consider the recommended policies and procedures when contemplating sales processes.

Stout regularly researches Delaware Chancery Court cases and provides expert analysis on significant matters. We examine the background behind a case as well as the court’s proceedings leading up to a decision. We also consider key takeaways for professionals who might find themselves in related situations.