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In Shareholder Appraisal Action, Court Adjusts Price per Share Valuation

In re Appraisal of DFC Global Corp.
No. 10107-CB (Del. Ch. July 8, 2016). Court of Chancery of the State of Delaware
by Matthew S. Sarna, Summer Associate
Semmes, Bowen & Semmes (www.semmes.com)

Available at: http://courts.delaware.gov/Opinions/Download.aspx?id=243400

In In re Appraisal of DFC Global Corp., C.A. No. 10107-CB (Del. Ch. July 8, 2016), the Delaware Chancery Court adjusted the fair value DFC Global Corp.’s (“DFC”) shares from $9.50 per share to $10.21 per share in response to Petitioner shareholders’ appraisal action under 8 Del. C. § 262.

DFC is a Delaware corporation operating in the alternative consumer financial services industry (payday lending). It operates in ten (10) countries with 1,500 retail locations and internet platforms. Consequently, DFC faced consistent turbulence from an ever-changing international regulatory landscape, causing a steady decline in DFC’s projected earnings and adjusted EBITA. In April 2012, DFC engaged Houlihan Lokey Capital Inc. (“Houlihan”) to investigate the sale of DFC to a financial sponsor. After reaching out to more than 35 financial sponsors and several potential strategic buyers, in October 2013, Lone Star expressed potential interest. After several rounds of negotiations, including a downgrade in Lone Star’s offer, DFC’s board approved the transaction and entered into a merger agreement with Lone Star for $9.50 per share. Subsequently, Petitioners filed for appraisal under 8 Del. C. § 262, seeking a judicial determination of the fair value of their shares. See Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1142 (Del. 1989).

At trial, both parties presented their valuation experts; Petitioners’ expert, Kevin F. Dages of Compass Lexecon (“Dages”) and DFC’s expert, Daniel Beaulne of Duff & Phelps, LLC (“Beaulne”) employed varying valuation techniques to arrive at the “fair” valuations of $17.90 and $7.81 per share, respectively. In their conclusions, Dages and Beaulne disagreed over the following: (1) Dages relied solely on a discounted cash flow model for his valuation, while Beaulne used a discounted cash flow model and a multiples-based comparable company analysis, weighing each equally; (2) various factors used to calculate DFC’s weighted average cost of capital (“WACC”), including beta, the method of unlevering and relevering beta, the appropriate size premium, and the tax rate; (3) changes to net working capital; (4) adjustments to account for stock-based compensation expenses; and (5) whether to use a two (2) or three (3) stage model for calculating DFC’s value.

The Court first examined the experts’ dispute over the appropriate beta. Dages and Beaulne disagreed over whether to include Barra beta or only use Bloomberg beta, which companies should be included in the beta estimate, whether to use a two (2) or five (5) year historical period, and whether to use raw beta or smoothed beta.

In accordance with Golden Telecom, the Court first determined that it was inappropriate to include Barra betas in DFC’s discounted cash flow analysis. This decision was grounded by a lack of published authority on Barra betas’ predictive effectiveness. See Global GT LP v. Golden Telecom, Inc., 993 A.2d 497, 520 (Del. Ch. 2010) (Strine, V.C.), aff’d, 11 A.3d 214 (Del. 2010). Next, the Court found that Beaulne’s selection of six (6) peer companies’ betas was appropriate, as opposed to Dages’ nine (9), three (3) of which were not closely related to DFC’s business. Additionally, the Court concluded that a five (5) year measurement period for measuring DFC’s beta was more conducive to an accurate beta estimate, given that shorter periods are more commonly utilized to reflect a company’s beta during times of major acquisitions, divestitures, etc. Finally, the Court sided with Beaulne in his usage of smoothed betas, which adjust historical raw betas to forward-looking beta estimates by averaging the historical estimate, weighted two-thirds, with the market beta of 1.0, weighted one-third.

Moving on to its examination of unlevering and relevering beta, the Court elaborated upon the experts’ two (2) differing formulas: the Fernández formula, which accounts for the beta of the company’s debt, and the Hamada formula, which does not. While noting that no method is ideal, the Court determined that the Hamada formula, as more widely accepted, readily understood, and not subject in this case to a calculative dispute, was appropriate.

The Court next looked to the dispute over which size premium to employ in the discounted cash flow analysis. Following the theory that smaller companies tend to be riskier than larger companies, size premiums are utilized as an adjustment to a company’s estimated cost of capital. Several handbooks exist to place companies of differing market caps into deciles, each with corresponding size premiums. Dages calculated his size premium based on DFC’s market cap on the day prior to the announcement of the transaction, utilizing the Duff & Phelps 2014 Valuation Handbook. Conversely, Beaulne utilized two sources of size premiums and chose the midpoint of the two. In an expansive discussion on whether DFC’s market cap would have sharply dipped upon the announcement of its declining projected earnings and the appropriate method for using Risk Premium Reports, the Court declined to use Beaulne’s second metric, and resolved to use a 3.52% size premium derived from the 10w subdecile of the Duff & Phelps Valuation Handbook. Additionally, the Court determined that Dages’ reliance on Houlihan’s estimate of a 32% effective tax rate was the most reliable figure as opposed to Beaulne’s debt-based weighted tax rate.

Applying each of the determined variables, the Court concluded DFC’s WACC to be 10.72%, roughly in the middle of Dages’ and Beaulne’s calculations.

Moving out of its WACC calculation, the Court analyzed the dispute over the appropriate figure for net working capital and excess cash. In the Court’s view, DFC’s June 2014 cash balance, estimated in its March projections was the appropriate metric. It estimated DFC’s cash closest to the closing of the transaction. Accordingly, the Court accepted Dages’ operating cash requirements and excess cash level figure of $51.5 million.

Next, the Court disagreed with Dages’ usage of a three (3) stage model for valuing the future cash flows of DFC beyond management’s projected period. The Court declined to add a third stage by extrapolating new data from already imperfect projections. In terms of the appropriate perpetuity growth rate, the Court explained that the Gordon growth model, which inputs the terminal year’s cash flow, the perpetuity growth rate, and the cost of capital, was most commonly used by the Court. See, e.g., Merion Capital, L.P. v. 3M Cogent, Inc., 2013 WL 3793896, at * 23 (Del. Ch. July 8, 2013). As such, the Court resolved to utilize a two-stage Gordon growth model with a 3.1% perpetuity growth rate.

In its last analysis of the disputed discounted cash flow calculation variables, the Court examined the dispute over what adjustment should have been made to DFC’s free cash flows to account for its stock-based compensation packages. Despite noting prior Court decisions, which deducted the full amount of accounting expenses for stock-based options, even though it likely overstated the impact of cash earnings, see Merion Capital LP v. BMC Software, Inc. 2015 WL 6164771, at *10, *13 (Del. Ch. Oct. 21, 2015), the Court sided with Dages’ estimation, based on historical cash expenses, as the more reasonable approach.

Inputting all of the above mention variables into its discounted cash flow formula, the Court came to calculate the fair value of DFC’s shares at the time of the transaction as $13.07 per share. Rather than relying solely on a discounted cash flow analysis however, the Court deemed it appropriate to equally weigh a multiples-based comparable company analysis and the transaction price as an indicator of fair value for DFC’s shares.

In its analysis of the experts’ multiples-based comparable company valuation method, the Court reasoned that Beaulne had used the more reasonable methodology in his analysis by selecting appropriate peer companies, using correct multiples, and basing his analysis on the median of the peer group’s value, rather than at a differing percentile. Accordingly, the Court adopted Beaulne’s methodology and his valuation of $8.07 per share.

The final input that the Court considered was the actual price of the transaction, $9.50 per share. As this transaction was negotiated at arm’s-length, “forged in the crucible of objective market reality,” the Court determined that the deal price could fairly be used as a measure of DFC’s value. See Van de Walle v. Unimation, Inc., 1991 WL 29303, at *17 (Del. Ch. Mar. 7, 1991).

As stated above, the Court deemed it appropriate to weigh all three (3) of these valuation methods equally. Accordingly, the Court took the discounted cash flow valuation of $13.07 per share, the multiples-based valuation of $8.07 per share, and the deal price of $9.50 per share, and concluded that the fair value of DFC at the time of the transaction was $10.21 per share.