IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
IN RE APPRAISAL OF DFC GLOBAL CONSOLIDATED
CORP. C.A. No. 10107-CB
MEMORANDUM OPINION
Date Submitted: April 28, 2016
Date Decided: July 8, 2016
Geoffrey C. Jarvis and Kimberly A. Evans, GRANT & EISENHOFER P.A.,
Wilmington, Delaware; Attorneys for Petitioners.
Raymond J. DiCamillo, Susan M. Hannigan and Rachel E. Horn, RICHARDS,
LAYTON & FINGER, P.A., Wilmington, Delaware; Meryl L. Young and Colin B.
Davis, GIBSON, DUNN & CRUTCHER LLP, Irvine, California; Attorneys for
Respondent DFC Global Corporation.
BOUCHARD, C.
In this appraisal action, former stockholders of DFC Global Corporation
(“DFC”) petitioned the Court to appraise the fair value of shares they held when
the company was sold to a private equity buyer, Lone Star Fund VIII (U.S.), L.P.
(“Lone Star”) for $9.50 per share in June 2014. Petitioners allege that DFC was
sold at a discount to its fair value during a period of regulatory uncertainty that
temporarily depressed the market value of the company. Using a discounted cash
flow model based on management’s most recent five-year projections, petitioners’
expert calculated a fair value of $17.90 per share. Respondent’s expert used a
discounted cash flow model and a multiples-based comparable companies analysis,
blending the two to calculate a much lower fair value of $7.94 per share.
Respondent also urges the Court to consider the transaction price of $9.50 per
share as the most reliable evidence of fair value.
Although this Court frequently defers to a transaction price that was the
product of an arm’s-length process and a robust bidding environment, that price is
reliable only when the market conditions leading to the transaction are conducive
to achieving a fair price. Similarly, a discounted cash flow model is only as
reliable as the financial projections used in it and its other underlying assumptions.
The transaction here was negotiated and consummated during a period of
significant company turmoil and regulatory uncertainty, calling into question the
reliability of the transaction price as well as management’s financial projections.
1
Thus, neither of these proposed metrics to value DFC stands out as being
inherently more reliable than the other.
In this opinion I conclude that the most reliable determinant of fair value of
DFC’s shares is a blend of three imperfect techniques: a discounted cash flow
model incorporating certain methodologies and assumptions each expert made and
some of my own, the comparable company analysis respondent’s expert
performed, and the transaction price. Giving each equal weight, I conclude that the
fair value of DFC’s shares when the transaction closed was $10.21 per share.
I. BACKGROUND
The facts recited in this opinion are my findings based on the stipulations of
the parties, documentary evidence, and testimony presented at trial. I accord the
evidence the weight and credibility I find it deserves.
A. The Parties
Respondent DFC is a Delaware corporation with headquarters in
Pennsylvania. DFC’s business focuses on alternative consumer financial services,
colloquially known as payday lending. DFC was publicly traded on the NASDAQ
exchange from 2005 until it was acquired by an indirect subsidiary of Lone Star in
a merger transaction (the “Transaction”).1
1
Stipulated Joint Pre-Trial Order (“PTO”) ¶¶ 1, 41-44.
2
Petitioners Muirfield Value Partners, LP, Candlewood Special Situations
Master Fund, Ltd., CWD OC 522 Master Fund, Ltd., Oasis Investments II Master
Fund Ltd., and Randolph Watkins Slifka were stockholders of DFC at the time of
the Transaction. Petitioners collectively hold 4,604,683 shares of DFC common
stock that are eligible for appraisal.2
B. DFC Faces Regulatory and Business Uncertainty
As of mid-2013, DFC was operating its payday lending business in ten
countries through more than 1,500 retail storefront locations and internet
platforms. 3 DFC faced significant competition in each of the countries in which it
operated, although the nature of the competition varied from market to market.4
DFC also was subject to regulations from different regulatory authorities across its
markets. 5 One of the key risks DFC faced was the potential for changes to those
regulations that could increase the cost of doing business or otherwise limit the
company’s opportunities.6
2
PTO ¶¶ 12, 19, 24, 25, 30, 35.
3
JX 295 at 4.
4
Id. at 17.
5
See id. at 18-22.
6
Id. at 24-26.
3
In the United States, for instance, the Consumer Financial Protection Bureau
began to supervise and regulate DFC. The company was unable to predict whether
and to what extent the Consumer Financial Protection Bureau would impose new
rules and regulations on it, which had the potential to adversely affect DFC’s
business in the United States. 7
In the United Kingdom, DFC faced an even greater amount of regulatory
uncertainty as a new regulator, the Financial Conduct Authority (the “FCA”),
prepared to take over regulation of the payday lending industry, effective April 1,
2014. 8 Before then, the Office of Fair Trading (the “OFT”) was DFC’s regulator
in the U.K.
In February 2012, the OFT began an in-depth review of some of the largest
firms in the payday lending business to assess compliance with the Consumer
Credit Act and the OFT’s “irresponsible lending guidance.”9 In November 2012,
the OFT issued debt collection guidance requiring payday lenders to make
disclosures to consumers regarding the use of continuous payment authority and to
avoid using continuous payment authority to collect money from customers who
7
Id. at 26.
8
JX 490 at 30.
9
PTO ¶ 64.
4
were believed to be experiencing financial hardship. 10 Continuous payment
authority is a mechanism by which lenders seek to automatically collect on loans
by continuously accessing customers’ checking accounts in order to withdraw
funds shortly after they appear in the account. 11
In March and April 2013, the OFT sent letters to each of DFC’s U.K.
businesses identifying deficiencies in their businesses and requiring corrective
action. 12 This regulatory environment imposed certain transitional difficulties on
DFC. In an earnings release on April 1, 2013, the company cut earnings guidance
for the fiscal year (ending June 30) from $2.35-$2.45 per share to $1.70-$1.80 per
share, noting that the transition period was causing liquidity problems for
consumers in the United Kingdom, resulting in heightened loan default rates. 13
In August 2013, DFC provided fiscal year 2014 adjusted EBITDA guidance
of $200-240 million, noting that it was providing adjusted EBITDA rather than
earnings per share until DFC had “clearer visibility as to the amount and timing of
these [regulatory] issues.”14 DFC announced that it expected to operate “at a
10
Id. ¶ 72.
11
See Trial Tr. (“Tr.”) 15-16 (Gavin), 412-13 (Kaminski); JX 565 at 4.
12
PTO ¶ 77.
13
Id. ¶ 79.
14
JX 290 at 8.
5
continuing competitive disadvantage in the United Kingdom until all industry
providers are required to operate consistently under the new regulatory
framework.” 15 The company also stated, on the other hand, that it was hopeful that
its market share would increase as some lenders began to face difficulties operating
within the stricter regulatory environment and exited the market. 16
In October 2013, the FCA issued a paper containing proposed new
regulations that DFC expected would be implemented on April 1, 2014, when the
FCA assumed its regulatory authority. 17 Among these proposals were stricter
affordability assessments that would be effective April 1, 2014, and limits to two
rollovers per loan and two continuous payment authority attempts, effective July 1,
2014. 18 Rollovers allow a borrower to defer repayment of a loan by paying
additional interest and fees. 19 Before the FCA issued its proposals, DFC had no
limit on the number of rollovers its retail business would allow. 20 On November
15
PTO ¶ 85.
16
Id.
17
Id. ¶ 89.
18
Id.
19
JX 587 at 76; JX 590 at 38.
20
JX 587 at 76-77. DFC’s online business was limited to six rollovers before principal
would need to begin being repaid. Id. at 77.
6
25, 2013, DFC also received notice that by the beginning of 2015, the U.K. would
implement a total cost of credit cap for the company’s products.
On January 30, 2014, DFC cut its adjusted EBITDA projections again,
lowering its fiscal year 2014 forecast from $200-240 million to $170-200 million,
noting the continued difficulties with the U.K. regulatory transition.21
In February 2014, the OFT sent DFC a letter expressing serious concerns
regarding DFC’s ability to meet the FCA’s impending new regulations.22 In
response, DFC implemented a two-rollover limit effective in late March 2014, and
clarified the enhancements to the company’s affordability assessments in April
2014. 23
The company believed that it had a good track record for navigating
regulatory change, giving it a potential advantage over its competitors, and that it
may be able to grow where others could not. 24 DFC had previously navigated a
period of significant regulatory change in Canada from about 2007 to 2010, during
which the Canadian provinces assumed regulatory authority from the federal
21
PTO ¶ 120.
22
Id. ¶ 130.
23
Id. ¶ 131.
24
Id. ¶¶ 207, 208, 211.
7
government. 25 That regulation ended up benefiting DFC as more aggressive
competitors were forced to scale back their operations, giving DFC a stronger
market position after the regulatory environment stabilized.26
Encouraged by its previous success in the Canadian regulatory overhaul,
DFC hoped to have a similar experience with the changing U.K. environment.
Both before and after the Transaction closed, DFC management thought that some
competitors might exit the market in light of the new regulatory regime, allowing
DFC to capture additional market share. 27 At the same time, DFC was aware that
modifying its U.K. lending practices to accommodate the impending regulations
put it at a disadvantage compared to competitors who did not adopt the new
regulations before they took effect.28 In contrast, some of the key Canadian
regulations had little impact on DFC’s business because they were rate-focused,
and DFC’s products already fell within the acceptable rate range. 29 It is against
this backdrop of regulatory uncertainty that the Transaction was negotiated.
25
Tr. 135-37 (Gavin); JX 409 at 21, 25.
26
See id.; Tr. 135-37 (Gavin); JX 587 at 66-67.
27
JX 309 at 23; Tr. 410-11, 470-74 (Kaminski). The competitor exits they hoped for did
not materialize. Tr. 436-37, 447 (Kaminski).
28
PTO ¶ 75.
29
JX 587 at 65-66; Tr. 400-01 (Kaminski), 514-15 (Barner), 139-40 (Kaminski)
(contrasting regulatory price points in Canada, which allowed DFC to operate profitably,
with price points in U.K., which did not). The U.K. also was the largest of DFC’s
8
C. Lone Star Acquires DFC
In April 2012, DFC engaged Houlihan Lokey Capital Inc. (“Houlihan”) to
investigate selling the company to a financial sponsor. This decision was inspired
in part by the regulatory uncertainty the company faced, in addition to the
company’s high leverage and questions regarding management succession.30
Houlihan contacted six sponsors and eventually engaged in discussions with J.C.
Flowers & Co. LLC and another sponsor, as well as an interested third party that
Houlihan had not contacted. 31 During the summer, the three potential buyers
conducted due diligence. In August 2012, one of the three lost interest in pursuing
a transaction. In October, J.C. Flowers and the other potential buyer also lost
interest. 32 Houlihan spent the next year reaching out to 35 more financial sponsors
and three potential strategic buyers. 33
In September 2013, DFC renewed discussions with J.C. Flowers and began
discussions with Crestview Partners about a possible joint transaction.34 In
markets, meaning the uncertain regulatory outcome would have a greater impact on the
business than was the case with Canada. Tr. 140 (Kaminski).
30
Tr. 24 (Gavin).
31
PTO ¶¶ 65-68.
32
Id. ¶¶ 67-70.
33
Id. ¶ 71.
34
Id. ¶¶ 87-88.
9
October 2013, Lone Star also expressed potential interest in DFC. 35 Part of Lone
Star’s interest in the transaction related to the regulatory uncertainty. Lone Star
sought to take advantage of this uncertainty by buying DFC at this time, when its
performance was weak and outlook unclear. 36
In November 2013, DFC gave the three potential acquirers financial
projections prepared by DFC’s management.37 On December 12, 2013, DFC got
some bad news and some good news: Crestview was no longer interested in
pursuing a transaction, but Lone Star made a preliminary non-binding indication of
interest in acquiring DFC for $12.16 per share. 38 On December 17, J.C. Flowers
made its own non-binding indication at $13.50 per share. 39
On February 14, 2014, DFC’s board approved a set of revised projections
prepared by management, which they shared with J.C. Flowers and Lone Star.40
These projections lowered DFC’s projected earnings compared to the projections
approved in November. 41 On February 28, 2014, Lone Star offered to buy DFC for
35
Id. ¶ 91.
36
Tr. 533-37 (Barner).
37
PTO ¶ 108.
38
Id. ¶¶ 113-14.
39
Id. ¶ 117.
40
Id. ¶¶ 123-25.
41
Id. ¶¶ 108, 123.
10
$11.00 per share and requested a 45-day exclusivity period.42 To justify the
reduction in price from its original indication of interest, Lone Star explained that
the drop was due to the U.K. regulatory changes, the threat of increased U.S.
regulatory scrutiny, downward revisions to company projections, reduced
availability of acquisition financing, stock price volatility, and weak value in the
Canadian dollar. 43 On March 11, DFC entered into the requested exclusivity
agreement with Lone Star.44
On March 26, 2014, DFC provided Lone Star with DFC management’s
revised preliminary adjusted EBITDA forecast for fiscal year 2014, which had
dropped by $24 million compared to the February projections. 45 The next day,
Lone Star offered to buy DFC for $9.50 per share in cash, explaining this new drop
in price as taking into account, among other things, the further downward revisions
in company projections, another reduction in available acquisition financing,
continued regulatory changes in the U.K., and a class action suit against the
company that was disclosed in an 8-K filed on March 26, 2014. 46 Lone Star gave
42
Id. ¶ 132.
43
Id. ¶ 133.
44
Id. ¶ 140.
45
Id. ¶ 146.
46
Id. ¶¶ 147-48.
11
DFC 24 hours to accept the offer, but later extended that deadline to April 1,
2014. 47 After receiving Lone Star’s offer, Houlihan did not contact any other
financial sponsors or strategic buyers about a potential transaction.48
At the end of March, DFC approved another set of projections (the “March
Projections”) and directed management to share them with Lone Star. 49 Projected
earnings dropped compared to the February projections, although the decline was
less substantial than the decline from the November projections to the February
projections. 50 On April 1, DFC’s board approved the Transaction and entered into
a merger agreement with Lone Star.51 The next day, DFC announced the
Transaction and publicly cut its earnings outlook once again, reducing its 2014
fiscal year EBITDA projections from $170-200 million to $151-156 million. 52 The
Transaction closed on June 13, 2014.53
47
Id. ¶ 149.
48
Id. ¶ 152.
49
Id. ¶¶ 156, 160.
50
Id. ¶¶ 108, 123, 161.
51
Id. ¶¶ 172-73.
52
Id. ¶ 175.
53
Id. ¶ 5.
12
D. Procedural Posture
Between June 18 and October 1, 2014, petitioners filed petitions for
appraisal under 8 Del. C. § 262. 54 This Court consolidated their petitions on
October 9, 2014,55 and held a three-day trial in October 2015. Post-trial argument
was held on April 1, 2016, after which the parties provided further submissions.
II. LEGAL ANALYSIS
A. Legal Standard
Petitioners request appraisal of their shares of DFC under 8 Del. C. § 262.
“An action seeking appraisal is intended to provide shareholders who dissent from
a merger, on the basis of the inadequacy of the offering price, with a judicial
determination of the fair value of their shares.”56 Respondent has not disputed
petitioners’ eligibility for an appraisal of their shares.57
In an appraisal action, the Court will determine the fair value of the
dissenting stockholders’ shares “exclusive of any element of value arising from the
accomplishment or expectation of the merger or consolidation, together with
interest, if any, to be paid upon the amount determined to be the fair value. In
54
See Stipulation and Order for Consolidation and Appointment of Grant & Eisenhofer
P.A. as Lead Counsel at 2.
55
Id. at 5.
56
Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1142 (Del. 1989).
57
PTO ¶ 12.
13
determining such fair value, the Court shall take into account all relevant
factors.” 58 The appraisal excludes any value resulting from the merger itself
because its purpose is to compensate dissenting stockholders for what was taken
from them. 59 Consequently, the value of the stock must be appraised on a going
concern basis.60
In using “all relevant factors” to determine fair value, the Court has
significant discretion to use the valuation methods it deems appropriate, including
the parties’ proposed valuation frameworks, or one of the Court’s own making.61
This Court has relied on a number of different approaches, including comparable
company and transaction analyses, discounted cash flow analyses, and the price of
the relevant transaction if it was struck at arm’s length.62 “This Court may not
58
8 Del. C. § 262(h).
59
See Weinberger v. UOP, Inc., 457 A.2d 701, 713 (Del. 1983) (quoting Tri-Cont’l Corp.
v. Battye, 74 A.2d 71, 72 (Del. 1950)).
60
Huff Fund Inv. P’ship v. CKx, Inc., 2013 WL 5878807, at *8 (Del. Ch. Nov. 1, 2013),
aff’d, 2015 WL 631586 (Del. Feb. 12, 2015) (TABLE).
61
See In re Appraisal of Ancestry.com, Inc., 2015 WL 399726, at *15 (Del. Ch. Jan. 30,
2015).
62
See Laidler v. Hesco Bastion Envtl., Inc., 2014 WL 1877536, at *6 (Del. Ch. May 12,
2014) (compiling authorities). See also In re Lane v. Cancer Treatment Ctrs. of Am.,
Inc., 1994 WL 263558, at *2 (Del. Ch. May 25, 1994) (“[R]elevant factors to be
considered include assets, market value, earnings, future prospects, and any other
elements that affect the intrinsic or inherent value of a company’s stock.”) (quoting
Weinberger, 457 A.2d at 711) (internal quotation marks omitted).
14
adopt at the outset an ‘either-or’ approach, thereby accepting uncritically the
valuation of one party, as it is the Court’s duty to determine the core issue of fair
value on the appraisal date.”63 “In an appraisal proceeding, the burden to establish
fair value by a preponderance of the evidence rests on both the petitioner and the
respondent.”64
B. Overview of Valuation Methodologies
Petitioners and respondent submitted the reports of experts who performed
valuations of DFC. Kevin F. Dages, Executive Vice President of Compass
Lexecon, was petitioners’ expert. Daniel Beaulne, Managing Director of Duff &
Phelps, LLC, was respondent’s expert.
Dages relied solely on a discounted cash flow model for his valuation. He
also performed a multiples-based comparable company analysis but gave it no
weight in his valuation.65 Based on the discounted cash flow model alone, he
valued DFC at $17.90 per share.66
Beaulne used a discounted cash flow model, valuing the company at $7.81
per share, and a multiples-based comparable company analysis, valuing the
63
In re Appraisal of Metromedia Int’l Gp., Inc., 971 A.2d 893, 899-900 (Del. Ch. 2009).
64
Laidler, 2014 WL 1877536, at *6 (citing M.G. Bancorporation, Inc. v. Le Beau, 737
A.2d 513, 520 (Del. 1999)).
65
JX 596 (“Dages Report”) ¶¶ 99-105.
66
Id. ¶¶ 92, 117.
15
company at $8.07 per share. 67 He weighted each methodology equally (50-50) for
a final fair value of $7.94 per share. 68 Respondent further argues that the
transaction price of $9.50 is a reliable indicator of fair value, 69 a proposition
petitioners vigorously dispute.70
There is a wide gap of $10.09 per share between the experts’ discounted
cash flow valuations, a difference larger than the deal price itself. This sharp
divide is the result of many disagreements regarding the proper inputs and methods
to use in the discounted cash flow model. 71 I begin by analyzing the parties’
respective positions regarding the discounted cash flow model in order to
determine the inputs for the model I use. I then turn to consider respondent’s
multiples-based comparable company analysis and the transaction price.
67
JX 597 (“Beaulne Report”) at 64, 69.
68
Id. at 71.
69
Resp’t’s Post-Trial Br. 4-14.
70
Pet’rs’ Post-Trial Reply Br. 4-15.
71
Unfortunately, the existence of drastic differences between experts’ valuations is not an
uncommon issue. See In re Appraisal of Dell Inc., 2016 WL 3186538, at *45 (Del. Ch.
May 31, 2016) (expressing concern over the problem of significant valuation differences
between experts and citing study showing that respondents’ experts produced valuations
on average 22% below deal price, and petitioners’ experts produced valuations on
average 186% above deal price) (“Two highly distinguished scholars of valuation
science, applying similar valuation principles, thus generated opinions that differed by
126%, or approximately $28 billion. This is a recurring problem.”).
16
C. The Discounted Cash Flow Model
The experts have numerous points of disagreement regarding how to
construct a discounted cash flow valuation of DFC, but a few areas are largely
undisputed. I begin with those. Dages and Beaulne had somewhat different
approaches to the firm’s capital structure to be used in the discounted cash flow
model, with Beaulne using DFC’s current debt-to-capital ratio of 74% and Dages
using three different capital structure scenarios. Both experts note that
management did not have a target capital structure, and Dages agrees that
Beaulne’s use of a 74% ratio is reasonable. 72 Like Beaulne, rather than test
multiple scenarios, I will use a 74% debt-to-capital ratio.
Dages and Beaulne estimated the cost of debt using the yield to maturity of
DFC’s 2016 senior notes, 73 but Beaulne used a measurement date closer to (but
still before) the announcement of the Transaction. Beaulne criticizes Dages’ use of
a less recent measurement period,74 and Dages appears to agree that Beaulne’s
more recent figure is a reasonable choice. 75 I will therefore use Beaulne’s estimate
of 10.0% rather than Dages’ estimate of 9.1%.
72
JX 601 (“Dages Rebuttal”) ¶ 14.
73
Dages Report ¶ 72, Beaulne Report at 53-54.
74
JX 600 (“Beaulne Rebuttal”) at 11.
75
Dages Rebuttal ¶ 15 (describing cost of debt as one of the inputs on which the experts
could agree).
17
Dages and Beaulne agreed on the risk-free rate (3.14%) and the equity risk
premium (6.18%). 76 These metrics are reasonable, and I adopt them as well.
Turning to the disputed inputs, which are numerous, the primary areas of
disagreement concern various factors used to calculate DFC’s weighted average
cost of capital (“WACC”), namely beta, the method of unlevering and relevering
beta, the appropriate size premium, and the tax rate. The experts also disagree over
certain adjustments to the company’s projected cash flows, including changes to
net working capital and adjustments to account for stock-based compensation
expenses. Finally, the experts disagree over whether to use a two-stage model or a
three-stage model for calculating DFC’s value. I address these issues below.
1. Beta
“Market or systematic risk is measured . . . by beta. Beta is a function of
the expected relationship between the return on an individual security . . . and the
return on the market.” 77 Beta is used together with the equity risk premium to
estimate the expected risk premium for the subject company as a component of its
cost of capital.78 A relatively small change in beta can substantially affect the
WACC and, consequently, the outcome of a discounted cash flow model.
76
Dages Report ¶¶ 75, 79; Beaulne Report Ex. II.
77
Shannon P. Pratt & Roger J. Grabowski, Cost of Capital: Applications and Examples
203 (5th ed. 2014) [hereinafter Cost of Capital].
78
Cost of Capital at 202-03.
18
Although determining beta is an important exercise, it can be a quite theoretical
one. The experts’ theories diverge significantly on this metric, leading to markedly
different valuations.
Dages estimated DFC’s beta using two years of weekly stock returns for
DFC and nine peer companies relative to a market index.79 Bloomberg L.P. is
Dages’ source for these estimates. 80 Dages used raw beta, as opposed to smoothed
beta. 81 Using these companies, Dages estimated three betas that he uses in
calculating his WACC: one based on DFC’s observed beta, one based on all nine
peer companies, and one based on the six of his nine peer companies that are based
in the United States.82
Beaulne estimated beta using two different methodologies and took the
midpoint of the two. 83 Beaulne used the betas of six peer companies, all of which
were included in Dages’ peer group. 84 Unlike Dages, he did not use the historical
79
Dages Report ¶ 76, Ex. 3 (listing nine peer companies that are shaded, indicating
inclusion in beta estimate).
80
Id. ¶ 76.
81
Dages Report ¶ 77, Ex. 10. I explain the difference in my analysis below.
82
Id. ¶¶ 76-77, Ex. 10. Dages did not average these beta groups, but instead used them to
construct a beta range and select betas within that range for his various capital structure
scenarios. See Dages Report Ex. 11.
83
Beaulne Report at 56.
84
Id. at 55-56, 66.
19
beta of DFC itself in addition to his selected peers. 85 His first method used
Bloomberg weekly beta for a five-year period, in contrast to Dages’ two-year
period. Beaulne used smoothed beta, rather than raw beta.86 Smoothed beta
adjusts the historical (raw) beta by taking an average of the historical beta,
weighted two-thirds, and the market beta of 1.0, weighted one-third.87
Consequently, this smoothed beta will be higher than raw beta for relatively stable
companies with a raw beta below 1.0, but will be lower than raw beta for more
volatile companies with a raw beta above 1.0. The purpose of this adjustment is to
create a forward-looking estimated beta from the historical beta, based on the
assumptions that a company’s beta will revert to the market average and that an
estimate of 1.0 is superior to an unreliable beta estimate. 88
Beaulne’s second methodology was to use the betas provided by Barra 89 as
of May 31, 2014. Barra calculates predicted, forward-looking betas using a
proprietary model designed to measure a firm’s sensitivity to changes in the
85
Tr. 706 (Beaulne).
86
Beaulne Report at 56-57.
87
Id.
88
See Cost of Capital at 211.
89
Barra is a company owned by MSCI Inc. that provides global investment decision-
making tools, including market indices and a beta service. Beaulne Report at 56; Tr. 596
(Beaulne).
20
industry or the market. 90 The model still relies on historical baseline information,
but makes adjustments based on various factors in order to determine the forward-
looking beta figure. 91 Beaulne used Barra betas that were benchmarked against a
global index.92
To summarize, the main points of contention between the experts regarding
beta are: (1) whether to include Barra beta or only use Bloomberg beta; (2) which
companies to include in the beta estimate; (3) whether to use a two-year or a five-
year historical period; and (4) whether to use raw beta or smoothed beta. I address
these in turn.
a. Barra Beta
Dages criticizes Beaulne’s use of Barra beta for half of his beta estimation,
while Beaulne criticizes Dages for omitting Barra beta. Beaulne’s criticism is
primarily that different methods of calculating beta can produce very different
results, and thus by implication, using multiple beta methodologies will improve
the robustness of the estimate. 93
90
Beaulne Report at 56; Cost of Capital at 217.
91
Tr. 595-97 (Beaulne).
92
Beaulne Report at 56.
93
See Beaulne Rebuttal at 7.
21
Dages criticizes the use of Barra betas because they derive from a
proprietary model and cannot be replicated. 94 Dages opines that, without the
ability to replicate or reverse engineer Barra betas, one cannot properly determine
whether they should be included in the beta estimate or whether they deserve to be
given the same weight as the Bloomberg betas.95 Beaulne contends that Barra is
not quite such a black box. For one thing, he notes that he could have paid Barra a
substantial price to see each factor in the Barra model if he had wished to receive
this information.96 Presumably, this would have allowed him to see the value and
weighting of each factor and truly understand each beta figure. In addition, at
Beaulne’s request, Barra gave Beaulne the replications of their formulas for the
peer group betas Beaulne relied upon in this case. 97 Beaulne also opined that his
firm has performed quality checks using the beta replications in the past,98 but
admitted that it has not performed any analysis on the predictive value of Barra
betas in general. 99
94
Dages Rebuttal ¶ 18.
95
Tr. 254, 319-20 (Dages).
96
Tr. 598 (Beaulne).
97
Tr. 599-600 (Beaulne).
98
Tr. 599 (Beaulne).
99
Tr. 704 (Beaulne), 770-71 (Dages). See also Tr. 601-02 (Beaulne) (admitting that there
is no authoritative literature analyzing predictive power of Barra beta).
22
In this case, Dages’ concerns regarding the proprietary nature of Barra betas
are persuasive. In Golden Telecom, this Court expressed similar concerns when it
rejected the use of Barra beta because Barra did not publicly disclose the weight of
each factor used in its proprietary model, did not explain the changes in different
versions of the model, and because the expert who relied upon it did not fully
understand all details of the model. 100 The Court emphasized that it was not
rejecting the use of Barra beta in all cases, but noted that a record of how Barra
beta works and why it is superior would be a necessary prerequisite to its adoption
in other appraisal cases. 101 This Court has subsequently approved the use of Barra
beta in another case,102 but heeding the warnings laid out by Golden Telecom is
more appropriate in the present context.
Here, as in Golden Telecom, I am not convinced that Beaulne fully
understood the details underlying the peer companies’ Barra betas or why they
differed from those companies’ Bloomberg betas. It did not appear that he could
recreate the Barra betas he used.103 Although Barra replicated its betas for him in
100
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).
101
Id. at 521.
102
IQ Hldgs., Inc. v. Am. Commercial Lines Inc., 2013 WL 4056207, at *4 (Del. Ch.
Mar. 18, 2013) (using Barra beta while noting that it fell at the midpoint of expert’s other
beta estimates), aff’d, 80 A.3d 959 (Del. 2013) (TABLE).
103
Tr. 695-96 (Beaulne).
23
this case, when questioned about the betas for one of his comparable companies,
Beaulne was unable to explain why the company’s Barra beta was significantly
higher than its Bloomberg beta.104 Perhaps most problematic, neither Beaulne nor
any published research has demonstrated the predictive effectiveness of Barra
betas.105 Consequently, I have very little information guiding whether to rely on
Barra betas in constructing a valuation of DFC. There is no benefit to using a
second beta methodology without confidence in the methodology itself. Unlike
Beaulne, I am not confident that Barra betas are sufficiently reliable to warrant a
50% weighting, a value that Beaulne seems to have chosen arbitrarily, or to
warrant any weighting in this case. Thus, although they may have use in other
cases, I reject the use of Barra betas here, and will use only Bloomberg betas.
b. Beta Peer Group
The experts used different peer groups of companies to compute their
respective estimates of beta. Beaulne used six companies in his analysis. Dages
used nine companies, including the same six that Beaulne used.106
104
Tr. 701-03 (Beaulne).
105
See supra note 99.
106
The six peer companies in common are: Cash America International, Inc., Cash
Converters International Limited, EZCORP, Inc., First Cash Financial Services Inc.,
International Personal Finance Plc, and World Acceptance Corp. Dages Report Ex. 10;
Beaulne Report Ex. II.
24
Each of the six companies both experts used was comparable to DFC, as
evidenced by the experts’ agreement on them and by their use in peer group
analyses that six different firms (including DFC itself, Lone Star, and Houlihan)
used to evaluate DFC for various reasons from April 2013 to June 2014.107 Four of
these peer companies were used by all six firms in their analyses. 108
Dages selected three additional peers: Provident Financial plc, Springleaf
Holdings, Inc., and Credit Acceptance Corporation.109 These three peers were only
selected as comparable companies in one or two of the analyses described above.
Respondent criticizes these peers as incomparable to DFC. Dages conceded some
of these differences at trial. One of Provident Financial’s primary products is
credit cards, but DFC does not have a credit card business.110 Springleaf offers life
insurance products, unlike DFC. 111 Credit Acceptance specializes in automobile
financing programs to car dealers. 112 The only firm to select Credit Acceptance as
a comparable company (KPMG) used it only to compare it to one minor line of
107
Dages Report Ex. 3. The other three firms were KPMG, ICR, and Hudson Americas.
108
Id.
109
Id. Ex. 10.
110
Id. Ex. 4; Tr. 371 (Dages).
111
Dages Report Ex. 4; Tr. 371 (Dages). See also Tr. 641 (Beaulne) (opining that
Springleaf was in several businesses that were fundamentally different from DFC’s).
112
Dages Report Ex. 4.
25
DFC’s business representing a small percentage of revenue for purposes of an
impairment analysis. 113 These companies differ meaningfully from DFC and are
not appropriate comparisons in my view. Beaulne’s selection of six peers, all of
which Dages also selected, is the more appropriate group, which I will use.
Apart from the disagreement over the three additional companies Dages
used in his peer group, Dages criticizes Beaulne for failing to incorporate or even
consider DFC’s own beta in his analysis. The experts agree that using a peer group
tends to be preferable to using only DFC’s beta, because using a single company’s
beta exposes the estimate to measurement error and idiosyncrasies.114 But Dages
assessed DFC’s beta alongside the peer group’s betas in order to select the
appropriate beta,115 while Beaulne disregarded it. 116
I agree that using DFC’s beta in isolation would expose the discounted cash
flow model to measurement error. At the same time, the most comparable
company to DFC is DFC itself, and in my view it is appropriate to factor DFC’s
beta into the analysis, a proposition that Dages supports and Beaulne did not rebut.
113
Tr. 370 (Dages), 641 (Beaulne).
114
Tr. 318-19 (Dages), 593 (Beaulne), 708-09 (Beaulne). At trial, Dages also
commented that he was sufficiently comfortable with DFC’s standalone beta that he
would be willing to use it in isolation. Tr. 764-67 (Dages).
115
Tr. 764-67 (Dages).
116
Tr. 706-07 (Beaulne).
26
The simplest way to do so is by adding it as a seventh beta in the peer analysis.
Although commentary on this approach is somewhat sparse, constructing a beta
that blends the company’s beta with a peer group’s betas finds some support in
financial literature 117 and this Court’s precedent.118
In the Golden Telecom case, this Court supported the theory in two ways.
First, the Court used as a peer group an index of NASDAQ-traded
telecommunications companies, which the Court noted included the subject
company itself. Second, and more importantly, the Court’s final beta was a blend
of the Company’s observed beta, weighted 2/3, and the industry peer group’s beta,
weighted 1/3.119 By adding DFC as a seventh “peer” in the beta calculation, I am
essentially performing the same exercise, albeit with a smaller peer group and a
more modest weight applied to the subject company than in Golden Telecom, to
arrive at a final beta weighted 14% (1/7) to DFC’s beta and 86% (6/7) to the peer
group’s betas. Because DFC’s own observed beta is a meaningful input alongside
117
See Robert W. Holthausen & Mark E. Zmijewski, Corporate Valuation: Theory,
Evidence & Practice 308 (1st ed. 2014) (discussing the Vasicek Adjusted Beta Method,
which provides a blend between the subject company’s beta and a peer group or industry
beta, weighted by standard error); id. at 309, 334 (providing and explaining beta
calculation exercises that involve averaging betas of peer companies and the subject
company).
118
See Golden Telecom, 993 A.2d at 523.
119
Id. at 523-24.
27
the betas of its peers, I consider this weighting preferable to the 0% weighting DFC
would receive in the peer-only analysis.120 I therefore use DFC and its six peers to
estimate DFC’s beta.
c. Measurement Period
In selecting their betas, Beaulne used a five-year measurement period and
Dages used a two-year period. A five-year period is the most common for
measuring beta and generally results in a more accurate measurement, although
two-year periods are used in certain circumstances.121
At trial, Dages opined that he used the two-year measurement period to
capture the regulatory uncertainty in the market.122 Beaulne contended that shorter
periods are used when a fundamental change in business operations occurs, not
when an industry is continuously going through regulatory change. 123 Beaulne’s
account better matches that of authoritative literature, which lists reasons for a
shorter period such as a major acquisition or divestiture, financial distress, or
120
Adding DFC to the beta analysis reduces DFC’s estimated beta, because DFC’s
unlevered beta is on the low end of its peer group, although its levered beta is high as a
result of the agreed capital structure, consisting of 74% debt. See Appendix B.
121
Cost of Capital at 208; James R. Hitchner, Financial Valuation: Applications and
Models 256 (3d ed. 2011). A related decision is how frequently to sample beta, with a
monthly basis being the most common. Cost of Capital at 208. Here, both experts used
weekly sampling, as do I.
122
Tr. 255 (Dages).
123
Tr. 594-95 (Beaulne).
28
cancellation of a significant contract.124 In my opinion, a five-year measurement
period is conducive to a more accurate beta estimate in this case.
d. Beta Smoothing
Dages used raw betas while Beaulne used smoothed betas. The beta
smoothing technique Beaulne used adjusts historical raw beta to a forward-looking
beta estimate by averaging the historical estimate, weighted two-thirds, with the
market beta of 1.0, weighted by one-third.125 This practice attempts to capture the
tendency of betas to revert over time to the market mean of 1.0, a tendency Dages
acknowledged at trial. 126 This practice also recognizes that, when beta estimates
are unreliable, an estimate of 1.0 can be a superior estimate. 127 In light of my
decision not to use Barra betas, which are also forward-looking, I believe it is
appropriate to adjust historical betas to a forward-looking estimate for purposes of
constructing a forward-looking WACC, even if the smoothing methodology
appears somewhat crude.
124
Cost of Capital at 208. See also Tim Koller, Marc Goedhart & David Wessels,
Valuation: Measuring and Managing the Value of Companies 247 (5th ed. 2010) (noting
that long estimation period may be inappropriate when analysis of the five-year historical
chart shows changes in corporate strategy or capital structure that could render prior data
irrelevant).
125
Cost of Capital at 211; Tr. 595 (Beaulne) (describing use of smoothed beta to generate
a forward-looking estimate).
126
Cost of Capital at 211; Tr. 332 (Dages).
127
Cost of Capital at 211.
29
*****
To summarize, the beta calculation I will use consists of Bloomberg five-
year smoothed betas for the six peer companies the two experts agreed on and for
DFC itself. I will use the average of this peer group and will not use Barra
betas.128
2. Beta Unlevering Method
Published betas “for publicly traded stocks typically reflect the leverage of
each respective company,” which means that these betas incorporate both business
risk and capital structure risk.129 All else being equal, the equity of companies
with higher levels of debt is generally riskier than that of companies with lower
levels of debt. 130 In order to properly apply the betas of peer companies to a
subject company, those companies’ betas must be adjusted to account for the
differences between the capital structures of the peer companies and of the subject
company. 131 This is accomplished in a few steps: first, unlevering the betas of the
peer group companies to their theoretical values as if the companies had no debt,
128
To put this conclusion in perspective, I note that both experts acknowledged that the
difference between the two-year and the five-year period and between using smoothed
and raw Bloomberg betas was of minor importance in this case. Tr. 710-12 (Beaulne);
Dages Rebuttal ¶ 19.
129
Cost of Capital at 243.
130
Id. at 243.
131
Id. at 244; Tr. 185-87 (Dages).
30
thereby removing capital structure risk and leaving only business risk; second,
estimating the subject company’s unlevered beta in light of the peer group’s
unlevered betas (for instance, by taking the average); and third, relevering that beta
to reflect the amount of debt present in the subject company’s capital structure and
the resulting capital structure risk.132
Beaulne and Dages used different formulas for unlevering the betas of
DFC’s peer group. Dages unlevered beta using the Fernández formula, which
accounts for the beta of the company’s debt,133 while Beaulne used the Hamada
formula, which does not. 134 Unsurprisingly, each expert contends that the other’s
chosen methodology is inferior.
The Hamada formula is generally accepted and commonly used for
unlevering and relevering equity betas.135 Dages concedes that the Hamada
formula is frequently used, especially compared to the Fernández formula.136
Nonetheless, a leading authority has cautioned that its use is generally inconsistent
132
Cost of Capital at 244.
133
Dages Report Ex. 10; Dages Rebuttal ¶ 22; Cost of Capital at 255-56.
134
Beaulne Report Ex. II; Beaulne Rebuttal at 5-6; Cost of Capital at 247-48.
135
Beaulne Rebuttal at 5. See also Cost of Capital at 247 (noting that Hamada formulas
are commonly cited); Tr. 644 (Beaulne). The Hamada formulas are listed in Appendix B.
136
Tr. 187, 256, 332, 783 (Dages).
31
with capital structure theory and practice, recommending that practitioners instead
use one of several other formulas, including the Fernández formula.137
The Fernández formula, however, is not commonly used in estimating a
public company’s weighted average cost of capital. 138 At trial, Beaulne opined that
he had never seen anyone use it to unlever and relever betas despite the fact that
the concept has been around for a long time, and that the formula had not been
peer-reviewed. 139 As mentioned above, however, at least one persuasive authority
has suggested that the Fernández formula is more appropriate than the Hamada
formula.
The Fernández formula attributes some of the risk inherent in beta to a
company’s debt, lowering the beta of its equity. 140 To properly use the Fernández
formula, a practitioner must estimate the beta of the company’s debt, based on
fluctuations in the debt’s market price.141 Here, instead of using debt betas for
each individual company, Dages used the same debt beta of 0.31 for all the peer
companies, based on a regression of the two-year returns of a high-yield corporate
137
Cost of Capital at 266.
138
Beaulne Rebuttal at 5.
139
Tr. 643-44 (Beaulne).
140
Tr. 187-88 (Dages).
141
Cost of Capital at 219-23.
32
bond ETF against the S&P 500 index. 142 Beaulne criticizes Dages’ failure to use
individual debt betas estimated for each company. 143 Alternately, when observed
debt betas are unavailable, a practitioner can estimate an individual company’s
debt beta by creating a synthetic credit rating for that company. 144 Dages did not
do this either. 145
The Fernández formula has merits that may warrant its use in an appropriate
case. But here, the limits in available data, namely the lack of observed or even
estimated debt betas for each individual company in the peer group, negate the
benefit that the formula could provide. Beaulne opined that it is more appropriate
to use the Hamada formula than to use the Fernández formula based on a debt
index without measuring each company’s debt betas, which could lead to skewed
results.146 I agree. No method is ideal. But, in my view, it is more appropriate in
this case to use the Hamada formula, which is widely accepted, readily understood,
and not subject to dispute about whether it is properly calculated, even if it is
arguably an imperfect tool.
142
Dages Report ¶ 77 n.168; Tr. 333-34 (Dages).
143
Beaulne Rebuttal at 6.
144
Tr. 336-38 (Dages); see also Cost of Capital 220-21 (providing table of beta estimates
based on credit ratings, which Dages also did not use).
145
Tr. 338 (Dages).
146
Tr. 646-47, 748 (Beaulne).
33
3. Size Premium
A size premium is an adjustment to a company’s estimated cost of capital to
reflect risks stemming from the size of the company, following the general theory
that smaller companies tend to be riskier than larger ones.147 Both experts applied
size premiums in calculating DFC’s weighted average cost of capital. 148 They
disagree, however, on the magnitude of that premium.
Dages calculated his size premium based on DFC’s equity market
capitalization on April 1, 2014, the day before the announcement of the
Transaction. He used this market capitalization to determine the decile in the Duff
& Phelps 2014 Valuation Handbook into which DFC would fall.149 DFC’s market
capitalization of $346 million as of April 1 placed it within the 9th decile ($340
million to $633 million). According to the Valuation Handbook, that decile
corresponds to a size premium of 2.81%, which Dages used.150
Beaulne took a more complicated approach using two sources of size
premiums: (1) the 2014 Duff & Phelps Valuation Handbook, which Dages used,
and (2) the Duff & Phelps Risk Premium Report. He chose the midpoint of the
147
Cost of Capital at 301, 308.
148
Beaulne Report at 58-59; Dages Report ¶¶ 80-81.
149
Id. ¶¶ 80-81.
150
Id.; Duff & Phelps, 2014 Valuation Handbook: Guide to Cost of Capital Appendix 3
[hereinafter Valuation Handbook].
34
two size premiums he selected from these sources (3.87% and 4.60%) to reach his
final size premium of 4.24%. 151
As explained below, I disagree with Beaulne’s use of the Risk Premium
Report and I come to a different conclusion than both of the experts on which size
premium to use from the Valuation Handbook based on some of the considerations
to which Beaulne testified. In my opinion, the appropriate size premium to use in
calculating the WACC is 3.52%.
For the first part of his methodology, Beaulne selected a different size
premium from the Valuation Handbook than Dages because Beaulne used a
microcap value for the combined 9th and 10th deciles, which cover companies
with a market capitalization in a wide range, from about $2.4 million to $632.8
million. 152 Beaulne opined that this approach was appropriate because DFC’s
market capitalization fell close to the edge of the 9th decile and would have fallen
into the 10th if its market capitalization was just two percent lower.153 In his
opinion, falling into the lower decile was a realistic possibility because of
discouraging financial results issued on April 2, 2014, the same day the transaction
was announced. Although April 1 was the last unaffected trading day, Beaulne
151
Beaulne Report at 58-59.
152
Id. at 58; Valuation Handbook Appendix 3.
153
Beaulne Rebuttal at 10.
35
viewed the negative financial developments disclosed on April 2 as part of the
company’s intrinsic value, justifying some blending of the two deciles.154
Beaulne also justified his selection of the combined 9th and 10th deciles on
the theory that, because the valuation for which the size premium is being selected
is supposed to be based on an independent discounted cash flow analysis, that form
of valuation should determine the appropriate size decile, rather than a company’s
market capitalization, which is based on stock price. According to Beaulne, this
leads to a “circularity issue because you can . . . predetermine which decile you fall
into based on your selection.”155 Beaulne claimed to have avoided this issue by
choosing a size premium based on a broader category incorporating both deciles.
Constructing a valuation based on an iterative methodology, and selecting a
size premium based on that valuation, appears to be a practice suited for companies
that are not publicly traded. Practitioners are advised to use an iterative process for
closely held companies because, in the absence of a publicly known market
capitalization, the analyst does not know the value of the company until she has
completed the valuation.156 In Sunbelt, this Court recognized the circularity
154
Id. at 10-11; Tr. 648 (Beaulne).
155
Tr. 613 (Beaulne).
156
See Cost of Capital at 1204.
36
problem inherent in valuing companies with unknown market capitalizations.157
The fact that market value is the key input in determining a private company’s size
premium is problematic, particularly when the company falls close to the border
between two size premium measures, because the size premium then affects the
valuation of the company. 158 Acknowledging the need to address this
methodological problem, the Court in Sunbelt selected a size premium for the two
valuation deciles that the company appeared to straddle, thus avoiding the need to
choose one decile over the other.159 Beaulne took the same approach by using the
microcap category covering both the ninth and tenth deciles, with a resulting size
premium of 3.87%.
Beaulne’s methodology overlooks the key difference in this case: the
market capitalization of DFC was not unknown, because DFC was a public
company. In other words, it is not necessary to attempt to artificially derive an
approximation of DFC’s market value because the actual market value of DFC was
known. Beaulne’s argument against using market value to construct a fundamental
value thus misses the point here. The size premium is indeed an input into the
157
In re Sunbelt Beverage Corp. S’holder Litig., 2010 WL 26539, at *11 (Del. Ch. Jan. 5,
2010), as revised (Feb. 15, 2010) (discussing circularity problem in context of a private
company).
158
Id. at *11-12.
159
Id. at *12.
37
Court’s calculation of fundamental value—it affects the cost of capital used in the
discounted cash flow model, thereby affecting the valuation. But the size premium
itself is calculated using market value, when available, as it is here.160 That the
size premium is being used in a fundamental valuation does not affect how the size
premium itself is calculated.
That said, I agree with Beaulne that the market value of DFC on April 1,
2014 was missing an important piece of information. On April 2, just one day
later, DFC announced reduced earnings guidance at the same time that it
announced the Transaction. 161 The reduction was significant, moving from the
previous quarter’s guidance of $170-200 million in 2014 adjusted EBITDA to
$151-156 million.162 Beaulne opines that it is inappropriate to use the market
value as of April 1, 2014 because that value did not reflect the negative impact of
the reduced earnings guidance. 163
160
See Cost of Capital at 308 (noting that size premium decile tables are constructed
based on market capitalization); id. at 327 (noting that size measures are based on market
value and that iterative process or alternate studies can be used when valuing a nonpublic
business or division); id. at 302 (noting that market value of equity is the traditional
measure of size, although not the only possible measure); id. at 1204-05.
161
PTO ¶ 175.
162
Id. ¶¶ 120, 175.
163
Beaulne Rebuttal at 10-11.
38
April 1 must be used in selecting the size premium because it was the last
unaffected trading date before the Transaction, and therefore properly excluded the
effect of the Transaction. Nonetheless, I agree with Beaulne that the reduced
financial projections were part of DFC’s value as of that date but had not yet been
realized in the market. As discussed above, my chosen methodology for
calculating DFC’s size premium does not use intrinsic value but rather uses market
capitalization. Therefore, although I do not need to estimate DFC’s intrinsic value
for this calculation, the impending earnings announcement undoubtedly would
have affected DFC’s market capitalization, which is the relevant metric for
selecting the size premium. It is impossible to know exactly how much the market
would have reacted to the reduction in projected earnings, because the stock price
that day also was affected by the announcement of the Transaction. But common
sense suggests, and Dages concedes, that the market would have reacted negatively
because the earnings reduction was meaningful. 164
If DFC had been resting comfortably within one of the deciles, perhaps no
adjustment would be warranted. But in this case, DFC rested on a knife’s edge
between the 9th and 10th deciles. A decline of less than $7 million (about 2%) in
market capitalization would have caused the company to drop into the 10th
164
Tr. 344-46 (Dages).
39
decile.165 It is very likely in my view that, all else equal, the announced drop in
projected earnings would have caused such a decline in DFC’s unaffected stock
price. As such, the most reasonable inference is that DFC’s market capitalization
would have fallen into the 10th decile despite having been in the 9th the previous
day.
The 10th decile is broken into subdeciles because the complete decile
reaches from market capitalizations as large as $338.8 million to as small as $2.4
million. The size premium varies widely depending on the subdecile, ranging from
3.52% to 12.12%. 166 The 10w subdecile contains market capitalizations from
$250.7 million to $338.8 million and carries a 3.52% size premium. 167 DFC’s
market capitalization was $346 million on April 1. In my view, it is reasonable to
assume that the market’s reaction to the earnings reduction alone, excluding its
reaction to the Transaction, would have pushed DFC into the 10w subdecile.168 In
light of the market’s probable reaction to DFC’s earnings guidance, the 10w
subdecile is the most reasonable category in my view, and I adopt its size premium
of 3.52%.
165
Beaulne Rebuttal at 10-11.
166
Valuation Handbook Appendix 3.
167
Id.
168
A loss in market capitalization anywhere from about $7 million to $95 million would
have had this result.
40
As noted above, Beaulne also employed a second size premium metric of
4.60% based on the Duff & Phelps Risk Premium Report. This methodology
constructs a size premium based on a number of relevant company metrics
including average net income, assets, sales, number of employees, and others.169
Beaulne opines that it is helpful to use this measurement in addition to the
Valuation Handbook because it captures other meaningful aspects of company size
besides market capitalization,170 which is not always perfectly correlated with
company size. 171
Dages opines that Beaulne erred by using the Risk Premium Report because
the size premium in that report does not apply to financial services firms.172
Indeed, Duff & Phelps admonishes practitioners not to use the Risk Premium
Report for valuing financial services companies, because some of the inputs into
the Risk Premium Report are difficult to apply to that sector, potentially leading to
skewed results.173 Specifically, the methodology should not be applied to
companies with a Standard Industrial Classification (“SIC”) code beginning with a
169
Beaulne Report at 59.
170
Id.
171
Beaulne Rebuttal at 9.
172
Dages Rebuttal ¶ 24.
173
Valuation Handbook 7-4.
41
“6,” which includes finance, insurance, and real estate firms. 174 DFC’s SIC Code
begins with a “6.” 175
Beaulne argues that it was appropriate to use the Risk Premium Report
despite these warnings because DFC is different from most other financial services
companies with SIC Codes beginning with a 6. For instance, DFC has lower
leverage than other financial services companies, and most of DFC’s peers do not
have SIC Codes beginning with 6.176 DFC may differ from the “typical” financial
services firm, if there is such a thing, so perhaps using the Risk Premium Report
would not cause a dire outcome. Nonetheless, the modest benefit of adding a
second size premium metric is not warranted in my view given the methodology’s
clear parameters and warnings. Consequently, I decline to use a second size
premium metric, and will use the premium of 3.52% derived from the 10w
subdecile of the Valuation Handbook.
4. Tax Rate
Beaulne and Dages used different tax rates in their WACC calculations.177
Dages used a tax rate of 32%, the rate that DFC management provided Houlihan to
174
Id.
175
Tr. 622 (Beaulne).
176
Tr. 622-26 (Beaulne).
177
For clarity, this section addresses the tax rate used in the calculation of DFC’s WACC
and in the calculation of its relevered beta. The tax rates used in the cash flow
42
calculate the WACC in its fairness opinion.178 Rather than use management’s
assumptions, Beaulne calculated a rate based on the weighted average of tax rates
in the jurisdictions in which DFC was borrowing as of the closing date,179
excluding certain convertible notes that contained an equity component. 180 The
experts disagree over how DFC deducts taxes from jurisdiction to jurisdiction.181
Respondent points out that DFC may only deduct interest in the jurisdictions
in which the debt is issued, but does not address petitioners’ other point, which
seems to be that weighting the tax rate on the principal of the debt alone, without
regard for the amount of interest paid on that debt, may result in an inaccurate
weighted tax rate.182 This is because the weighted average outstanding debt in
each jurisdiction may not correspond to the weighted average amount of interest
paid, since a small outstanding debt with a high interest rate could generate a
relatively higher tax shield than a larger outstanding debt with a low interest rate.
projections, which the parties do not dispute, are management estimates that vary with
each year of the forecast period. See Appendix A; JX 455 at 24.
178
Dages Report ¶ 73. See also Tr. 217 (Dages) (discussing 32% tax rate as agreed tax
rate given to Houlihan for calculating cost of capital).
179
Beaulne Report at 54.
180
Tr. 589-91 (Beaulne).
181
Tr. 267-68 (Dages).
182
Pet’rs’ Post-Trial Br. at 45.
43
These disputes over the minute details of calculating a custom estimated tax
rate underscore the merits of Dages’ approach, which relies on management’s
seemingly reasonable estimated tax rate, just as the experts’ discounted cash flow
models rely on management’s other estimated financial projections. Considering
the disagreement surrounding the appropriate actual tax rate based on DFC’s debts
as of April 1, 2014, not to mention the uncertainty regarding the tax rates in the
jurisdictions of the company’s future obligations, management’s estimate of a 32%
effective tax rate is the most reliable figure to use for this input.
*****
Using the inputs described above, I calculate DFC’s weighted average cost
of capital to be 10.72%, 183 a result coincidentally located roughly in the middle of
Dages’ and Beaulne’s respective calculations of 9.5% and 12.4%, each of which
the other expert argues is an extreme figure. I now turn to the other disputed
figures in the experts’ discounted cash flow models.
5. Net Working Capital and Excess Cash
Another factor about which the experts disagree is the appropriate level of
net working capital. Dages used the balance sheet projection that management
provided and that Houlihan used in its fairness opinion, as he did with the other
183
The details of the WACC calculation are contained in Appendix B. See also Dages
Report ¶¶ 70, 74 (listing formulas for WACC).
44
financial projections.184 In contrast, Beaulne estimated the net working capital at
the end of each year as a percentage of total revenue, which came to 52 percent,
and projected the company’s net working capital based on that figure.185
As a general matter, petitioners and respondent both used the March
Projections as the foundation for their discounted cash flow analyses, and do not
appear to dispute that the March Projections are the appropriate figures to use.186
Consequently, the decision to independently calculate one balance sheet item, net
working capital, rather than to use management’s projections, seems unusual.
Beaulne explains that his measurement method is the most common one based on
authoritative finance literature.187 Beaulne’s decision to recalibrate net working
capital based on historical trends is not warranted here, however, considering that
the March Projections have been the focal point of the discounted cash flow
analyses. Put differently, there is no compelling reason to reject the March
Projections regarding this figure while adhering to them regarding others.
Using his adjusted working capital projections, Beaulne surmised that DFC
had a working capital deficit when the Transaction closed and therefore had no
184
Dages Rebuttal ¶ 44.
185
Id. ¶¶ 43-44; Beaulne Report at 49-52; Tr. 584-85, 682 (Beaulne).
186
Beaulne Report at 40; Dages Report ¶ 59.
187
Beaulne Report at 50; Resp’t’s Pretrial Br. at 56-57.
45
excess cash on its balance sheet.188 Because I reject Beaulne’s recalibration of
working capital, I also reject his assessment that DFC had no excess cash on that
basis.
Dages used a different approach to calculate excess cash. He began with
DFC’s balance sheet cash as of its March 31, 2014 10-Q, which amounted to
$236.9 million. 189 He then subtracted $150 million of operating cash requirements
as estimated by Houlihan, with a resulting excess cash level of $86.9 million.190
Respondent criticizes Dages for using the actual March 31, 2014 cash balance to
estimate excess cash upon closing of the Transaction in June. Respondent argues
that using either the June 2014 cash balance as forecasted in the March Projections
or DFC’s actual June 2014 cash balance would have been timelier and more
appropriate. 191 Dages responds that he used the March 31 actual cash balance to be
consistent with Houlihan but admitted that the June figures also could have been
used.192
188
Beaulne Report at 63-64.
189
JX 498 at 3.
190
Dages Report ¶ 92.
191
Resp’t’s Pretrial Br. at 57.
192
JX 602 at 229-30.
46
In my view, the June 2014 cash balance estimated in the March Projections
should have been used instead of the actual March figure, because it estimates
DFC’s cash at a point closer to the closing of the Transaction and because it is
more consistent with the model’s reliance on the March Projections. 193 Using the
projected June 2014 cash balance rather than the actual March balance reduces the
level of excess cash from $86.9 million to $51.5 million. Although respondent
contends that Houlihan’s estimate of required operating cash was likely
understated and points to deposition testimony suggesting as much, respondent
provides no evidence quantifying a better number. I therefore adopt Houlihan’s
operating cash requirements and the excess cash level of $51.5 million.
6. Two-Stage or Three-Stage Model
The experts took different approaches to valuing the future cash flows of the
company beyond management’s projection period. Beaulne used a two-stage
model, with the first stage based on management’s projections for the period of
2014-2017, and the second stage being a terminal value calculated using the
convergence formula beginning in 2018. Dages used a three-stage model. Stage
one was based on management’s projections for 2014-2018. Stage two used
Dages’ own projections for 2019 through 2023, which he calculated by applying a
193
Resp’t’s Post-Trial Br. 55; JX 444 at 2 (noting operating cash projection of $201.5
million). See also Tr. 367 (Dages) (admitting that, absent changes to business, using
more recent figure is preferable).
47
linear decline to step the growth rate down (1.8% per year) from management’s
projection of 11.7% in 2018 to the perpetuity growth rate of 2.7% in 2023.194 His
third stage is a terminal value calculated using the Gordon growth model and a
2.7% perpetuity growth rate. Dages also proposed in the alternative a two-stage
model with a 3.1% perpetuity growth rate.195
Beaulne criticizes Dages’ three-stage model for adding five years of new
data beyond management’s projections using linear extrapolation. He opines that
this ten-year period is an unusually long forecast window, that management’s
projections were already prone to uncertainty, and that Dages’ five-year
extrapolation of these projections is speculative.196 Dages contends that his three-
stage model is the best valuation method, but does not otherwise dispute Beaulne’s
use of a two-stage model and the convergence formula, which Dages opines
implies a perpetuity growth rate of 4.5%.197
Given the uncertainty regarding management’s projections, I question the
reliability of Dages’ linear extrapolation of five years of additional projections. I
agree with Beaulne’s opinion that it is more appropriate to rely on management’s
194
Dages Report ¶¶ 91-92.
195
Dages Report Ex. 16.
196
Beaulne Rebuttal at 16-18.
197
Dages Rebuttal ¶¶ 46-47, 53-54; Pet’rs’ Post-Trial Br. 50.
48
projection period and then to estimate a terminal value as accurately as possible.
The fact that the growth rate drops off somewhat sharply from the projection
period to the terminal period is not ideal but not necessarily problematic, as this
Court has recognized. 198 Thus, in this case a two-stage model is preferable to a
three-stage model that attempts to create a third stage by extrapolating new data
from already imperfect projections.
I turn next to the question of how to select an appropriate perpetuity growth
rate. Dages used a perpetuity growth rate of 3.1% in his alternate two-stage
version of his model, which appears in line with market theory and this Court’s
precedents. This Court often selects a perpetuity growth rate based on a reasonable
premium to inflation.199 Dages compiled inflation expectations around the time of
the closing of the Transaction from a number of sources, including government
forecasts, and noted a median inflation rate of 2.31%. 200 Dages also notes that
some financial economists view the risk-free rate as the ceiling for a stable, long-
term growth rate.201 In this case, that suggested ceiling is the 3.14% risk-free rate
198
See Owen v. Cannon, 2015 WL 3819204, at *26 (Del. Ch. June 17, 2015); S. Muoio &
Co. LLC v. Hallmark Entm’t Invs. Co., 2011 WL 863007, at *21 (Del. Ch. Mar. 9, 2011).
199
See Owen v. Cannon, 2015 WL 3819204, at *26 (“There also is considerable
precedent in Delaware for adopting a terminal growth rate that is a premium, such as 100
basis points, over inflation.”).
200
Dages Report ¶ 65.
201
Id.
49
both experts agreed on.202 Thus, the 3.1% rate that Dages used in his alternative
two-stage model 203 represents a reasonable premium of 79 basis points over
inflation, and falls just under the suggested ceiling represented by the 3.14% risk-
free rate.
In contrast, Beaulne calculated his stage-two terminal value using the
convergence model. The convergence formula is based on the theory that, in the
long-term, the return on investment in highly competitive industries will converge
to the cost of capital as competition eliminates the opportunity to earn excess
returns.204 As noted above, Dages opined that Beaulne’s convergence formula
implies a 4.5% perpetuity growth rate, which Dages admits is at the high end of the
reasonable range of long-term growth rates.205 In my view, 4.5% is an
inappropriately high perpetuity growth rate in this case. Although one suggested
ceiling for a company’s perpetuity growth rate is nominal GDP, which Dages
estimated as ranging from 4.5% to 4.8%, 206 economists have cautioned (as noted
above) that the long-term growth rate should not be greater than the risk-free rate.
202
See supra Part II.C.
203
Dages Report ¶ 96, Ex. 16.
204
See Hitchner, supra note 121, at 152-53; Tr. 627-28 (Beaulne).
205
Dages Rebuttal ¶¶ 46-47.
206
Dages Report ¶ 64-65.
50
The 4.5% perpetuity growth rate implied by Beaulne’s convergence model is 136
basis points above that ceiling and represents an unusually large premium of 219
basis points above inflation.207 Considering the significant regulatory risks that
may affect the long-term viability of DFC’s business model, such a premium over
inflation is not appropriate in my view. 208
Because the perpetuity growth rate is not an input in the convergence
formula, I cannot simply pick a more reasonable rate to use in that model. In
contrast, the Gordon growth model’s inputs are the terminal year’s cash flow, the
perpetuity growth rate, and the cost of capital. 209 The Gordon growth model is
207
See, e.g., Owen v. Cannon, 2015 WL 3819204, at *25-26 (adopting premium of 100
basis points above inflation); Towerview LLC v. Cox Radio, Inc., 2013 WL 3316186, at
*26-27 (Del. Ch. June 28, 2013) (using growth rate 25 basis points above the low end of
inflation forecast); Del. Open MRI Radiology Assocs., P.A. v. Kessler, 898 A.2d 290,
334, 337 (Del. Ch. 2006) (applying growth rate 100 basis points above inflation); Gholl v.
eMachines, Inc., 2004 WL 2847865, at *13 (Del. Ch. Nov. 24, 2004) (applying
perpetuity growth rate 100-200 basis points above inflation), aff’d, 875 A.2d 632 (Del.
2005) (TABLE); Cede & Co. v. JRC Acquisition Corp., 2004 WL 286963, at *6 (Del. Ch.
Feb. 10, 2004) (applying growth rate 100 basis points above inflation). See also In re
Rural/Metro Corp. S’holders Litig., 102 A.3d 205, 226 (Del. Ch. 2014) (choosing
perpetuity growth rate falling “comfortably between” inflation rate and nominal GDP
growth rate, at 160 basis point premium to inflation), aff’d sub nom. RBC Capital
Markets, LLC v. Jervis, 129 A.3d 816, 868 (Del. 2015).
208
See JRC Acquisition Corp., 2004 WL 286963, at *6 (adopting growth rate only 100
basis points above inflation due to evidence of declining tobacco market).
209
See Cost of Capital at 41.
51
commonly used in this Court. 210 Because it is widely accepted and allows me to
select an appropriate perpetuity growth rate, I use a two-stage Gordon growth
model and a perpetuity growth rate of 3.1% to calculate DFC’s value.
7. Stock-Based Compensation
The experts agree that some adjustment to DFC’s free cash flows must be
made to account for stock-based compensation in the form of options and restricted
stock units, but they disagree over how to make such an adjustment. Dages
presents four different scenarios, each of which he acknowledges is an “imperfect
measure” of the impact the future exercise of stock-based compensation will have
on DFC’s free cash flows. 211 The scenario he considers most reliable, which he
uses in his discounted cash flow, replaces management’s projected stock-based
compensation expenses with the average historical net cash outflow for such
compensation, as a percentage of revenues, further adjusted to reflect tax
benefits. 212 Beaulne uses the stock-based compensation expenses projected in the
210
See, e.g., Merion Capital, L.P. v. 3M Cogent, Inc., 2013 WL 3793896, at *23 (Del.
Ch. July 8, 2013); Golden Telecom, 993 A.2d at 511; Crescent/Mach I P’ship, L.P. v.
Turner, 2007 WL 2801387, at *14 (Del. Ch. May 2, 2007).
211
Dages Report ¶¶ 89-90.
212
Id. ¶ 89.
52
management model, deducting that amount from free cash flows, which he asserts
is a common practice. 213
In previous cases, this Court has opined that some adjustment must be made
for stock-based compensation but lamented the unavailability of an accurate
method for making such an adjustment. In both BMC and Ancestry.com, this Court
noted that deducting the full amount of accounting expense for stock-based
compensation from cash flows likely overstated the impact on cash earnings, but
nonetheless adopted that method because the opposing expert in each case had not
provided a better method for estimating cash impact. 214
In contrast to those cases, Dages offers a reasonable means of estimating the
impact of future stock-based compensation on cash flows by extrapolating
historical cash expense into future years. Although Beaulne opines that stock-
based compensation expense is already calculated using fair value measures,215 he
overlooks the distinction between a fair value accounting expense and an impact
213
Beaulne Report at 48.
214
See Merion Capital LP v. BMC Software, Inc., 2015 WL 6164771, at *10, *13 (Del.
Ch. Oct. 21, 2015) (adopting use of full accounting expense as cash impact because other
expert’s method did not incorporate effect of expected future stock-based compensation),
judgment entered, 2015 WL 6737350 (Del. Ch. Nov. 3, 2015); In re Appraisal of
Ancestry.com, 2015 WL 399726, at *22 (adopting method deducting non-cash stock
expense from EBIT because, while method was imperfect, opposing expert offered no
reliable alternative).
215
Beaulne Rebuttal at 26.
53
on cash flows. Consequently, subtracting the accounting expense for all stock-
based compensation from projected cash earnings, a crucial input in a discounted
cash flow model, was inappropriate. Although it may not be possible to perfectly
estimate the future cash impact of stock-based compensation, in this case Dages’
estimate based on historical cash expense is the most reasonable approach.
Respondent criticizes the fact that Dages’ method is novel and that it risks
understating cash expense if, for example, the company’s stock price were to rise
significantly after options were granted. 216 But the risk of inaccuracy is inherent in
any attempt to project future expenses. In my view, the hypothetical risk that
Dages’ method could lead to an understated cash expense is less problematic than
the much likelier possibility that treating the full accounting expense as a cash
outlay would overstate cash expense. I therefore adopt Dages’ method.217
*****
Using the inputs and methodologies described above, I have constructed a
discounted cash flow model that estimates the fair value of DFC’s shares as of the
216
Resp’t’s Post-Trial Br. 56-57.
217
I also adopt Dages’ calculation of total shares outstanding, which adds shares for
exercisable options and restricted stock units, adjusted for the Court’s lower valuation
compared to his. Based on his tables and the Court’s valuation, approximately 39.5
million shares would be outstanding.
54
date of the Transaction to be $13.07 per share. 218 The model is summarized in
Appendix A.
D. Multiples-Based Comparable Company Analysis
Dages did not rely on a multiples-based valuation, instead placing all weight
on his discounted cash flow valuation. 219 He opined that multiples-based
valuations do not necessarily reflect the intrinsic value of an enterprise, do not
allow the inclusion of company-specific operating characteristics, and do not fully
account for long-term growth potential.220 With admirable thoroughness, Dages
performed a multiples-based valuation despite giving it no weight in his analysis.
He used the same peer group of nine companies that he used to estimate DFC’s
beta for his WACC. 221
Beaulne performed a multiples-based valuation using the same peer group of
six companies that he used to calculate beta. For the same reasons discussed above
that I found Beaulne’s peer group acceptable for calculating beta and the additional
three companies Dages identified to be inapt comparisons, I find that the peer
218
See Appendix A.
219
Dages Report ¶ 100.
220
Id. ¶¶ 100-102.
221
Id. ¶ 103. Using the 75th percentile of the peer group, Dages estimated a valuation
between $11.38 and $15.65 per share based on the 2014 and 2015 estimated EBITDA
from the March projections, and $26.95 per share based on the last twelve months’
EBITDA. Id. ¶¶ 103-04.
55
group Beaune has identified provides an appropriate set of comparable
companies.222
To perform his valuation, Beaulne used the median of three multiples:
market value of invested capital over 2014 estimated EBITDA, market value of
invested capital over estimated 2015 EBITDA, and market value of invested
capital over last twelve months’ EBITDA. 223 Averaging the valuations implied by
these three metrics, Beaulne calculated a value of $8.07 per share. 224
Dages contends that Beaulne erroneously chose to use the median peer
group value of each multiple rather than the 75th percentile, which Dages viewed
as more appropriate considering DFC’s long-term projected growth and
profitability. 225 But DFC ranked below the 50th percentile of the peer group in
several (though not all) key financial metrics. 226 Dages admitted, furthermore, that
222
See supra Part II.C.1.b.
223
Beaulne Report at 67.
224
Id. at 69. Beaulne also performed a multiples-based valuation using guideline merged
and acquired companies, with a resulting valuation of $7.69 per share, but did not give
this method any weight. Id. at 69-70.
225
Dages Rebuttal ¶ 51.
226
Dages Report Ex. 5.
56
using the median or 50th percentile is a more common benchmark, and that this
was the only valuation he could recall in which he used the 75th percentile.227
In my view, Beaulne used a reasonable methodology in his multiples-based
analysis by selecting a suitable peer group, using correct multiples, and basing his
analysis on the median rather than another percentile. For these reasons, I will
adopt Beaulne’s comparable company methodology and its valuation of $8.07 per
share. 228 This leaves the question of how much weight to give it in relation to the
other valuation methodologies. I address that question below.
E. Deal Price
The third and final valuation input I will consider is the price of the
Transaction: $9.50 per share. The parties heatedly dispute whether the transaction
price is an appropriate indicator of fair value in this case. The merger price in an
arm’s-length transaction that was subjected to a robust market check is a strong
227
Tr. 379-80 (Dages).
228
Dages also criticized certain financial adjustments Beaulne made in the comparable
company analysis, namely the subtraction of stock-based compensation expenses. Dages
Rebuttal ¶ 50. Unlike in the case of his discounted cash flow analysis, Dages did not
opine on whether or why stock-based compensation should or should not be adjusted in
the comparable company analysis, nor did he provide a superior methodology that would
adjust for stock-based compensation expense more appropriately. See supra Part II.C.7.
He also noted that he was not certain whether or not his own data source adjusted for
stock-based compensation in the peer companies. Dages Report ¶ 103 n.213. I therefore
adopt Beaulne’s approach.
57
indication of fair value in an appraisal proceeding as a general matter, 229 and this
Court has attributed 100% weight to the market price in certain circumstances.230
The advantage of an arm’s-length transaction price as a reliable indicator of
fair value is that it is “forged in the crucible of objective market reality (as
distinguished from the unavoidably subjective thought process of a valuation
expert) . . . .” 231 This insight is particularly apt here, where the subjective thought
processes of two well-credentialed valuation veterans have led to chasmic
differences in their estimated fair values, despite their using similar methodologies
and the same baseline set of financial projections. By the same token, the market
229
See Golden Telecom, 993 A.2d at 507 (“It is, of course, true that an arms-length
merger price resulting from an effective market check is entitled to great weight in an
appraisal.”); Highfields Capital, Ltd. v. AXA Fin., Inc., 939 A.2d 34, 42 (Del. Ch. 2007)
(when transaction is product of arm’s-length process without structural impediments, the
“reviewing court should give substantial evidentiary weight to the merger price as an
indicator of fair value”); Union Ill. 1995 Inv. Ltd. P’ship v. Union Fin. Gp., Ltd., 847
A.2d 340, 358-59 (Del. Ch. 2004) (Strine, V.C.) (finding merger price resulting from a
competitive and fair auction to be a superior valuation technique to discounted cash
flow).
230
See, e.g., LongPath Capital, LLC v. Ramtron Int’l Corp., 2015 WL 4540443, at *20,
25 (Del. Ch. June 30, 2015) (citing authorities and giving 100% weight to transaction
price, minus synergies); CKx, 2013 WL 5878807, at *13 (giving 100% weight to deal
price and instructing parties to confer regarding adjustments for synergies); Huff Fund
Inv. P’ship v. CKx, Inc., 2014 WL 2042797, at *4, *8 (Del. Ch. May 19, 2014) (declining
in subsequent opinion to make any adjustments to deal price, including for synergies),
aff’d, 2015 WL 631586 (Del. Feb. 12, 2015) (TABLE); Union Ill., 847 A.2d at 364
(awarding merger price, net of synergies). In this case, I am unconcerned with adjusting
for synergies because Lone Star was a financial buyer rather than a strategic acquirer.
231
Van de Walle v. Unimation, Inc., 1991 WL 29303, at *17 (Del. Ch. Mar. 7, 1991).
58
price is informative of fair value only when it is the product of not only a fair sale
process, but also of a well-functioning market.
In my view, the deal price is an appropriate factor to consider in this case.
DFC was purchased by a third-party buyer in an arm’s-length sale. The sale
process leading to the Transaction lasted approximately two years and involved
DFC’s advisor reaching out to dozens of financial sponsors as well as several
potential strategic buyers. 232 The deal did not involve the potential conflicts of
interest inherent in a management buyout or negotiations to retain existing
management—indeed, Lone Star took the opposite approach, replacing most key
executives. 233 These circumstances provide me a reasonable level of confidence
that the deal price can fairly be used as one measure of DFC’s value.
*****
Having established and analyzed the three most reliable measures of DFC’s
value, I now turn to weighing them in order to formulate a fair appraisal value.
F. Weighing the Inputs to Estimate Fair Value
This Court has relied from time to time on multiple valuation techniques to
determine fair value, giving greater weight to the more reliable methodologies in a
232
See supra Part I.C.
233
Tr. 553-54 (Barner).
59
particular case.234 As explained above, three inputs merit consideration in
calculating DFC’s fair value: the result of my discounted cash flow analysis,
which incorporates certain aspects of each expert’s discounted cash flow model
and some of my own assumptions; Beaulne’s multiples-based comparable
company analysis; and the transaction price.
Each of these valuation methods suffers from different limitations that arise
out of the same source: the tumultuous environment in the time period leading up
to DFC’s sale. As described above, at the time of its sale, DFC was navigating
turbulent regulatory waters that imposed considerable uncertainty on the
company’s future profitability, and even its viability. 235 Some of its competitors
faced similar challenges. The potential outcome could have been dire, leaving
DFC unable to operate its fundamental businesses, or could have been very
positive, leaving DFC’s competitors crippled and allowing DFC to gain market
dominance. Importantly, DFC was unable to chart its own course; its fate rested
234
See, e.g., Andaloro v. PFPC Worldwide, Inc., 2005 WL 2045640, at *20 (Del. Ch.
Aug. 19, 2005) (attributing 75% weight to discounted cash flow because management
projections were reliable, and 25% weight to comparable company analysis because of
good peer group and benefit of additional insight provided by the approach); Hanover
Direct, Inc. S’holders Litig., 2010 WL 3959399, at *2-3 (Del. Ch. Sept. 24, 2010)
(adopting valuation of expert who applied multiple valuation techniques, noting that
Court has more confidence in the accuracy of multiple valuation methods when the
results support each other, and criticizing other expert’s use of only one technique rather
than a blend of valuation methods).
235
See supra Part I.B.
60
largely in the hands of the multiple regulatory bodies that governed it. Even by the
time the transaction closed in June 2014, DFC’s regulatory circumstances were
still fluid.236
This uncertainty impacted DFC’s financial projections. As discussed above,
DFC repeatedly adjusted its projections downward, cutting its fiscal year 2014
adjusted EBITDA forecast from $200-240 million to $151-156 million in the span
of a few months, while noting that regulatory uncertainty made it impractical to
project earnings per share. 237 This series of adjustments calls into question the
reliability of DFC’s financial projections at the time, and necessarily reduces one’s
confidence in the March Projections upon which the experts’ discounted cash flow
models and my own are based. 238 Consequently, although a discounted cash flow
analysis may deserve significant emphasis or sole reliance in cases where the Court
has more confidence in the reliability of the underlying projections than in the
236
Tr. 439 (Kaminski).
237
See supra Parts I.B-C.
238
See Tr. 502-03 (Barner) (discussing Lone Star’s concern over management’s ability to
forecast accurately). Although Lone Star prepared its own set of projections with higher
revenue and EBITDA than the March Projections, PTO ¶¶ 184-85, those projections
reflect Lone Star’s planned initiatives for the company after the acquisition, and thus do
not represent its fair value for appraisal purposes. Tr. 496-97 (Barner). In addition, the
fact that the financials show a potential recovery does not mitigate the problem with the
March Projections, namely that they were unreliable and subject to change. A forecasted
significant recovery could still be unreliable, undermining confidence in the discounted
cash flow model.
61
transaction price, 239 I do not believe it merits a disproportionate weighting in this
case.
This same uncertainty inherent in the projections underlying the discounted
cash flow analysis was present in the sale process. Although the sale process
extended over a significant period of time and appeared to be robust, DFC’s
performance also appeared to be in a trough, with future performance depending
on the outcome of regulatory decision-making that was largely out of the
company’s control. Lone Star was aware of DFC’s trough performance and
uncertain outlook—these attributes were at the core of Lone Star’s investment
thesis to obtain assets with potential upside at a favorable price. 240 To the extent
Lone Star understood DFC’s unique position and potential value but the market of
other potential bidders did not, then the transaction price would not necessarily be
a reliable indicator of DFC’s intrinsic value. 241 Lone Star’s status as a financial
239
See In re Appraisal of Dell, 2016 WL 3186538, at *51 (attributing 100% weight to
discounted cash flow model due to unreliability of market pricing stemming from
imperfect sale process).
240
See Tr. 533-37 (Barner); JX 428 at 16 (noting that Lone Star saw DFC as an
opportunity to acquire an excellent global platform at a trough and to purchase it during a
period of regulatory uncertainty before a recovery to historical EBITDA margins).
241
This commentary should not be construed as an opinion on the propriety of Lone
Star’s investment strategy or bidding process, as Lone Star’s conduct is not on trial in this
appraisal action. Rather, the circumstances through which Lone Star purchased DFC are
relevant to assessing whether the transaction was the product of a robust competitive
bidding process with potential buyers who understood DFC’s intrinsic value.
62
sponsor, moreover, focused its attention on achieving a certain internal rate of
return and on reaching a deal within its financing constraints, rather than on DFC’s
fair value. 242 For instance, one of the reasons Lone Star reduced its offer to $9.50
was that its available financing for the transaction had fallen by another $100
million (to a total reduction of $300 million) due to DFC’s additional reductions in
projected EBITDA. 243
The 45-day exclusivity period Lone Star negotiated in March 2014 and the
short (six-day) window Lone Star afforded for considering its reduced offer of
$9.50 may have negatively affected the sale process.244 These events do not
undermine my level of confidence in the robustness of the market for DFC,
however, because they occurred at the end of what had been an extended (almost
two-year) sale process and because any of the potential buyers who had expressed
interest in buying DFC at a higher price could have renewed their interest after the
transaction was announced in April, particularly given that the termination fee was
reasonable and bifurcated to allow for a reduced fee in the event of a superior
proposal.245 Despite the fact that $9.50 was significantly lower than J.C. Flowers’
242
Dages Report ¶¶ 114-16.
243
PTO ¶ 148; Tr. 552 (Barner).
244
PTO ¶¶ 147, 151-54. Lone Star originally offered only 24 hours to accept, but later
extended the acceptance period so that it ran from March 27 to April 1. Id. ¶ 149.
245
JX 463 Ex 2.1 §§ 7.1(d)(iii), 7.3(b); Tr. 63 (Gavin).
63
previous indication of interest at $13.50, neither J.C. Flowers nor any other
potential buyer expressed any interest in competing with Lone Star’s offer of
$9.50.
The uncertainty surrounding DFC’s financial projections also affects the
reliability of the multiples-based valuation, because this valuation relies on two
years of management’s projected EBITDA. 246 Nonetheless, the multiples-based
valuation may be less prone to long-term uncertainty compared to the discounted
cash flow model, because it relies only on projections through 2015 rather than
2018, and because one third of the valuation relies on historical EBITDA data. In
addition, because it relies on the multiples of several peer companies, it is less
susceptible to the firm-specific issues that could hinder a competitive bidding
environment and reduce the reliability of market price as an indicator of fair value.
Consequently, although the multiples-based approach may be less frequently relied
upon than market price or a discounted cash flow valuation, I find it to be a
valuable source of information in this case.
In sum, all three metrics suffer from various limitations but, in my view,
each of them still provides meaningful insight into DFC’s value, and all three of
them fall within a reasonable range. In light of the uncertainties and other
considerations described above, I conclude that the proper valuation of DFC is to
246
See supra Part II.D.
64
weight each of these three metrics equally. Weighing at one-third each the
discounted cash flow valuation of $13.07 per share, the multiples-based valuation
of $8.07 per share, and the transaction price of $9.50 per share, I conclude that the
fair value of DFC at the time of the Transaction was $10.21 per share.
III. CONCLUSION
Petitioners are entitled to the fair value on the closing date of $10.21 per
share and to interest accruing from June 13, 2014, at the rate of 5% over the
Federal Reserve discount rate from time to time, compounded quarterly. 247 The
parties are instructed to confer and submit a final judgment within five business
days in accordance with this opinion.
247
8 Del. C. § 262(h).
65
Appendix A
Discounted Cash Flow Analysis
(in millions)
Fiscal Year Ending June 30
2014P 2015P 2016P 2017P 2018P Terminal
EBITDA1 $143.3 $165.4 $214.9 $269.5 $329.4
Less: Depreciation and Amortization (44.8) (45.1) (46.4) (46.6) (46.6)
Plus: Adjustment for SBC Accounting/Cash Difference2 5.6 6.4 6.8 7.0
EBIT $98.5 $125.9 $174.9 $229.7 $289.8
Tax Rate 42.3% 35.9% 32.1% 30.7%
Less: Income Tax (53.3) (62.8) (73.7) (89.0)
Unlevered Net Income $72.7 $112.1 $156.0 $200.8
Plus: Depreciation & Amortization 45.1 46.4 46.6 46.6
Less: Capital Expenditures (35.8) (42.6) (44.1) (45.7)
Less: Changes in Working Capital3 (48.8) (54.5) (69.8) (71.6)
Unlevered Free Cash Flow 4 $2.1 $33.2 $61.4 $88.7 $130.1 $ 1,761
Present Value of Distributable Cash Flows
WACC 10.72% 10.72% 10.72% 10.72% 10.72% 10.72%
Discount Period (mid-year convention) 0.02 0.55 1.55 2.55 3.55 3.55
Present Value Factor 1.00 0.95 0.85 0.77 0.70 0.70
Present Value of Distributable Cash Flows $2.1 $31.4 $52.4 $68.4 $90.7 $1,226.6
Enterprise Value
PV of Distributable Cash Flows (2014-2018) $244.9 Discount Rate 10.72%
PV of Residual Cash Flows $1,226.6 Perpetuity Growth Rate 3.10%
Cash and Equivalents $51.5 Valuation Date 13-Jun-14
Enterprise Value $1,523.0
Add: PV of Net Operating Loss Balance5 $38.1
Less: Debt $1,044.4
Equity Value $516.74
Shares Outstanding6 39.53
Value Per Share $13.07
1
Based on Beaulne's adjusted EBITDA, which includes full accounting SBC expense. Financial projections use Beaulne's model.
2
Adds back difference between full accounting SBC expense and Dages' estimated SBC cash expense.
3
Uses Beaulne's model but removes his adjustments to working capital based on 52.0% fixed rate assumption.
4
2014 unlevered cash flow based on Dages' calculation of prorated cash flow from June 13 until June 30.
5
Based on Beaulne's NOL model, adjusted for 10.72% discount rate.
6
Approximates adjusted shares outstanding using Dages' model and a $13 exercise price.
Appendix B
WACC Calculation
5Y Smoothed Total Debt Market Val of Equity/Capital Debt/Capital Effective Tax Hamada
Peer Group Company Bloomberg Beta ($000's) Equity ($000's) Ratio Ratio Rate Unlevered Beta
Cash America International, Inc. 0.9765 630,256 1,224,887 66.03% 33.97% 35.00% 0.7317
Cash Converters International Limited 0.8909 104,513 431,082 80.49% 19.51% 30.00% 0.7616
EZCORP, Inc. 1.1050 229,121 668,900 74.49% 25.51% 35.00% 0.9038
First Cash Financial Services Inc. 0.8951 200,000 1,551,881 88.58% 11.42% 35.00% 0.8259
International Personal Finance Plc 1.8789 664,292 2,435,081 78.57% 21.43% 21.00% 1.5458
World Acceptance Corp. 0.9972 505,500 761,218 60.09% 39.91% 38.25% 0.7072
DFC Global Corp. 1.1833 26.00% 74.00% 32.00% 0.4031
Peer Group & DFC Average Unlevered Beta: 0.8399
DFC Relevered Beta: 2.4653
Hamada Unlevered Beta = (Levered Beta) / (1 + (1-T)(Wd/We))
Hamada Relevered Beta = Unlevered Beta * (1+(1-T)(Wd/We))
Input Value Notes
Risk-free Rate (Rf) 3.14% 20-year Total Constant Maturity Treasury Yield
Beta (β) 2.4653 Avg. of 6 peers and DFC, relevered for DFC
Equity Risk Premium (ERP) 6.18% Duff & Phelps Supply-Side Equity Risk Premium
Size Premium (SP) 3.52% Duff & Phelps Size Premium, Subdecile 10w
Tax Rate (T) 32.00% Management Assumption
Debt/Capital (Wd) 74.00% Capital structure at close
Equity/Capital (We) 26.00% Capital structure at close
Cost of Equity (Ke) 21.90% Ke = Rf + (β * ERP) + SP
Cost of Debt (Kd) 10.00% 2016 Senior Note YTM
WACC 10.72% WACC = (We * Ke) + (Wd * (Kd * (1 – T)))