EFiled: May 26 2017 11:52AM EDT
Transaction ID 60650885
Case No. 10782-VCS
IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
:
IN RE APPRAISAL OF PETSMART, INC. : CONSOLIDATED
: C.A. No. 10782-VCS
MEMORANDUM OPINION
Date Submitted: February 27, 2017
Date Decided: May 26, 2017
Stuart M. Grant, Esquire, Nathan A. Cook, Esquire, Kimberly A. Evans, Esquire,
and Joseph L. Christensen, Esquire of Grant & Eisenhofer P.A., Wilmington,
Delaware, Attorneys for Petitioners.
Gregory P. Williams, Esquire, Brock E. Czeschin, Esquire, John D. Hendershot,
Esquire, Robert L. Burns, Esquire, Sarah A. Clark, Esquire, and Matthew D. Perri,
Esquire of Richards, Layton & Finger, P.A., Wilmington, Delaware, and
Theodore N. Mirvis, Esquire, Rachelle Silverberg, Esquire, Adam M. Gogolak,
Esquire, Adam D. Gold, Esquire, and Joshua J. Card, Esquire of Wachtell, Lipton,
Rosen & Katz, New York, New York, Attorneys for Respondent PetSmart, Inc.
SLIGHTS, Vice Chancellor
I would not be the first to observe that the trial of an appraisal case under the
Delaware General Corporation Law presents unique challenges to the judicial
factfinder.1 The petitioner bears a burden of proving the “fair value” of his shares;
the respondent bears a burden of proving the “fair value” of the petitioner’s shares;
and then the judge, as factfinder, assumes, in effect, a third burden to assign a
particular value “as the most reasonable [] in light of all of the relevant evidence and
based on considerations of fairness.”2 The role assigned to the trial judge in this
process independently to review “all relevant factors” that may inform the
determination of fair value, if not unique, is certainly unusual.3 It is unusual in the
sense that the judge is not bound by the positions on fair value espoused by either of
1
See In re Appraisal of Ancestry.com, Inc., 2015 WL 399726, at *2 (Del. Ch. Jan. 30,
2015); Albert H. Choi & Eric L. Talley, Appraising the “Merger Price” Appraisal Rule
(Virginia Law and Economics, Working Paper No. 2017-01, Jan. 18, 2017).
2
Cede & Co. v. Technicolor, Inc., 2003 WL 23700218, at *2 (Del. Ch. July 9, 2004), aff’d
in part, rev’d on other grounds, 884 A.2d 26 (Del. 2005).
3
8 Del. C. § 262(h). See Ancestry.com, 2015 WL 399726, at *1 (noting that the burdens
of proof imposed by Section 262 makes the job of the judge “particularly difficult” and
that the litigation structure imposed by the statute is “unusual”); Choi & Eric Talley, supra,
at 2 (noting that the appraisal statute presents a “particularly vexing challenge” for the trial
judge, inter alia, because it “allocates no explicit burden of proof and requires the court to
deliver a single number at the end of the process”) (emphasis in original).
1
the parties. Indeed, the trial court commits error if it simply chooses one party’s
position over the other without first assessing the relevant factors on its own.4
Yet it cannot be overlooked that the judge’s decision in an appraisal case
follows a trial––an honest-to-goodness, adversarial trial––where the parties are
incented to present their best case, grounded in competent evidence, and to subject
their adversary’s evidence to the discerning filter of cross-examination. The trial
court then reviews the evidence the parties have placed in the trial record and does
its best to “distill the truth.”5 In this regard, at least, the appraisal trial is no different
from any other trial. The court’s determination of “fair value,” while based on “all
relevant factors,” must still be tethered to the evidence presented at trial. The
appraisal statute is not a license for judicial freestyling beyond the trial record.
This appraisal action follows a going-private merger in which the public
stockholders of PetSmart, Inc. (“PetSmart,” the “Company” or the “Respondent”)
received $83 per share in cash from a private equity acquiror, BC Partners, Inc. (the
“Merger”). The Merger closed on March 11, 2015. Petitioners declined the Merger
consideration and demanded appraisal.
4
See Gonsalves v. Straight Arrow Publ’rs, Inc., 701 A.2d 357, 362 (Del. 1997) (holding
that the trial court’s decision to adopt one of the parties’ valuations of the company “hook-
line-and-sinker” without considering all relevant factors was “fatally flawed”).
5
See Finkelstein v. Liberty Digital, Inc., 2005 WL 1074364, at *24 n.56 (Del. Ch. Apr. 25,
2005).
2
The battle lines staked here rest on positions that are well-known to Delaware
courts, the academy and those who otherwise follow the evolving state of Delaware
appraisal litigation. The Respondent would have me determine fair value by
deferring to the price paid by a third-party purchaser in an arm’s-length transaction
after an allegedly robust pre-signing auction process. The Petitioners insist that
“deal price” is unreliable in this case for a variety of reasons and urge me to
determine fair value by employing a tried and true valuation methodology,
discounted cash flow (“DCF”). The experts engaged by the parties, both well
credentialed, sponsor these differing views with unwavering commitment. Indeed,
the parties are so certain of their respective positions on the fair value of PetSmart
at the time of the Merger that they insist I disregard the other’s proffered
methodology entirely. The result: Respondent values PetSmart at $83 per share;
Petitioners value the same firm at $128.78 per share.
In this post-trial opinion, I conclude that the evidence presented during trial
points in only one direction––Petitioners have failed to carry their burden of
persuasion that a DCF analysis provides a reliable measure of fair value in this case.
The management projections upon which Petitioners rely as the bedrock for their
DCF analysis are, at best, fanciful and I find no basis in the evidence to conclude
that a DCF analysis based on other projections of expected cash flows would yield
a result more reliable than the Merger consideration. Nor is there a foundation in
3
the evidence for concluding that some other valuation methodology might lead to a
reliable determination of fair value. On the other hand, I am satisfied Respondent
has carried its burden of demonstrating that the process leading to the Merger was
reasonably designed and properly implemented to attain the fair value of the
Company. Moreover, the evidence does not reveal any confounding factors that
would have caused the massive market failure, to the tune of $4.5 billion (a 45%
discrepancy), that Petitioners allege occurred here. Based on my review of all
relevant factors, as found in the evidence, I am satisfied that the deal price of $83
per share, “forged in the crucible of objective market reality,”6 is the best indicator
of the fair value of PetSmart as of the closing of the Merger.7
I. BACKGROUND
I recite the facts as I find them by a preponderance of the evidence after a
four-day trial beginning in October 2016. That evidence consisted of testimony from
seventeen witnesses (thirteen fact witnesses, some presented live and some by
deposition, and four live expert witnesses) along with over 2300 exhibits. To the
6
Van de Walle v. Unimation, Inc., 1991 WL 29303, at *17 (Del. Ch. Mar. 7, 1991).
7
To preserve its record, Respondent has asked me to decline to follow the now-settled
precedent of this Court that establishes the right of a petitioner to seek appraisal of shares
acquired after the record date by demonstrating that the number of shares held by the record
holder and not voted in favor of the merger exceeds the number of shares upon which
appraisal is sought. See In re Transkaryotic Ther., Inc., 2007 WL 1378345 (Del. Ch.
May 2, 2007). The issue is preserved but I decline to revisit this precedent.
4
extent I have relied upon evidence to which an objection was raised but not resolved
at trial, I will explain the bases for my decision to admit the evidence at the time I
first discuss it.
A. Parties and Relevant Non-Parties
Respondent, PetSmart, Inc., is a Delaware corporation with headquarters in
Phoenix, Arizona.8 It is one of the largest retailers of pet products and services in
North America.9 Prior to the Merger, PetSmart’s stock traded on NASDAQ.10 On
March 11, 2015, PetSmart was acquired by a consortium of funds advised by BC
Partners, Inc. and certain other investment firms for $83.00 cash per share
(the “Merger Price”) in a merger.11 In connection with this transaction, PetSmart
merged into Argos Merger Sub Inc., with PetSmart surviving as a wholly owned
subsidiary of Argos Holdings Inc.12
Petitioners are CF Skylos I LLC, CF Skylos II LLC, Third Point Reinsurance
(USA) Ltd., Third Point Reinsurance Company Ltd., Third Point Partners Qualified
L.P., Third Point Offshore Master Fund L.P., Third Point Partners L.P., Third Point
8
Stipulated Joint Pre-Trial Order ¶ 77 (“PTO”).
9
PTO ¶¶ 78, 116; JX 1336 at 23.
10
PTO ¶ 79.
11
PTO ¶ 1.
12
Id.
5
Ultra Master Fund L.P., Farallon Capital Partners, L.P., Farallon Capital AA
Investors, L.P., Farallon Capital (AM) Investors, L.P., Farallon Capital Institutional
Partners, L.P., Farallon Capital Institutional Partners II, L.P., Farallon Capital
Institutional Partners III, L.P., Farallon Capital Offshore Investors II, L.P., Noonday
Offshore, Inc., Muirfield Value Partners LP, HCN L.P., CAZ Halcyon Strategic
Opportunities Fund L.P., Halcyon Mount Bonnell Fund L.P., Merlin Partners, LP,
and AAMAF, LP (collectively, “Petitioners”).13 Petitioners were stockholders of
PetSmart as of the Merger date and collectively held 10,713,225 shares of PetSmart
common stock.14
B. The Company
Founded in 1987, PetSmart is a pet specialty retailer.15 Its business consists
of providing pet products, including consumables and hardgoods,16 as well as pet
services such as pet grooming and boarding.17 At the time of the Merger, PetSmart
operated 1,404 stores in the United States, Canada, and Puerto Rico and had annual
13
PTO ¶¶ 15–16, 19, 24–30, 36–44, 51, 55, 60–62, 64, 69–72.
14
PTO ¶¶ 15–16, 19, 24–30, 36–44, 51, 55, 60–62, 64, 69–72. Most of these shares were
acquired after the record date of January 29, 2015. See PTO ¶¶ 18, 31, 45, 53, 63, 71.
15
PTO ¶ 117.
16
Pet “consumables” include “pet food, pet treats and snacks, and pet litter products.”
JX 2307 (Weinsten-Opening) at 12. Pet “hardgoods” include “pet toys, apparel, collars,
leashes, grooming equipment, food bowls and pet beds.” Id.
17
PTO ¶ 78; JX 1336 at 23; JX 1477.
6
revenues of approximately $7 billion.18 The only other company in North America
that does what PetSmart does on the same scale is Petco Animal Supplies, Inc.
(“Petco”).19 PetSmart also faces competition from big box stores like Target and
WalMart, grocery stores like Kroger, smaller chain and independent pet stores and
online retailers like Amazon.20
C. PetSmart Experiences Strong Growth from 2000–2012
PetSmart experienced significant positive growth each year from 2000 to
2012.21 From 2000 to the onset of the financial crisis in 2007, PetSmart achieved
annual revenue growth of 8–13%, significantly outperforming the retail industry as
a whole.22 PetSmart’s annual revenue growth rate declined in 2008 and 2009 (falling
to 5% in 2009) during the peak of the financial crisis but soon rebounded, reaching
11% in 2012.23
PetSmart’s growth was driven in significant part by favorable dynamics in the
pet industry from 2000 to 2008 coupled with PetSmart’s rapid increase in new store
18
JX 1336 at 23.
19
PTO ¶ 118.
20
Trial Tr. 181:13–182:24 (Teffner).
21
JX 1697 (Metrick-Opening) at 15–16, Ex. 1A, Ex. 3; see Trial Tr. 177:1–7 (Teffner).
22
JX 1697 (Metrick-Opening) at 15–16, Ex. 1A, Ex. 3; see JX 1698 (Dages-Opening) at 3–
6; Trial Tr. 177:1–7 (Teffner).
23
JX 1697 (Metrick-Opening) at 15–16, Ex. 1A, Ex. 3.
7
openings.24 From 2000 to 2008, the pet industry benefitted from the convergence of
two industry-favorable trends: an increasing pet population in North America and
increasing spending per pet by North American pet owners due to the trend described
as pet “humanization.”25 The period from 2000 to 2008 also saw PetSmart more
than double the number of its stores, from 484 stores in 2000 to 1,004 stores at the
start of 2008.26 PetSmart’s store expansion was particularly rapid from 2004 to
2008, when PetSmart opened 518 new stores.27 As these new stores grew to their
full sales potential, PetSmart experienced a strong increase in its comparable store
sales growth from 2009 to 2012.28
24
JX 1698 (Dages-Opening) at 6–7; see Trial Tr. 177:8–178:11 (Teffner).
25
JX 1697 (Metrick-Opening) at 11–14; JX 1698 (Dages-Opening) at 3–4; Trial Tr. 177:8–
178:11 (Teffner); PTO ¶ 121. Pet “humanization” describes owners treating their pets as
members of the family. Id. This, in turn, prompts owners to seek out premium pet foods
and products of a quality they might buy for themselves or other family members.
PTO ¶ 122.
26
JX 1697 (Metrick-Opening) at Ex. 4.
27
Id.
28
JX 1697 (Metrick-Opening) at 16, 19; JX 2307 (Weinsten-Opening) at 56, Ex. 18;
JX 1698 (Dages-Opening) at 6. “Comparable stores sales growth” (or “comp”) is the
percentage growth in sales revenue period-over-period (e.g., year-over-year or quarter-
over-quarter) for a retailer’s existing stores, “excluding new [stores] during their first year,
remodeled [stores] and [stores] that have since closed.” JX 2307 (Weinsten-Opening)
at 15. Comparable store sales growth (as between two different time periods of equal
duration) is calculated by multiplying (1) the change period-over-period in the total number
of customer purchase transactions for existing stores by (2) the change period-over-period
in average dollars per consumer purchase transaction for those existing stores. Id. at 15–
8
D. PetSmart’s Performance Declines
PetSmart’s growth began to stall in 2012.29 Between Q1 2012 and Q4 2013,
PetSmart’s comparable store sales growth declined from 7.4% (in Q1 2012) to 1.4%
(in Q4 2013), and PetSmart’s overall sales growth exhibited a general downward
trend.30 During this same period, PetSmart found itself facing increasing
competition and other headwinds on multiple fronts.31 Along with this decline,
PetSmart struggled accurately to project its future performance, even quarter-by-
quarter. Indeed, management’s forecasts were often off by large margins.32
PetSmart also experienced substantial management turnover in 2013 and early
2014. In June 2013, PetSmart’s CEO and CFO both resigned.33 David Lenhardt,
who had previously served as PetSmart’s President and COO, became PetSmart’s
16. Comparable store sales growth is a metric that features prominently in the discussion
of PetSmart’s fair value.
29
JX 1697 (Metrick-Opening) at Ex. 1A.
30
Id. at 20, Fig. 4, Ex. 2.
31
Trial Tr. 183:5–186:17 (Teffner); Trial Tr. 396:23–397:18 (Gangwal).
32
See JX 1697 (Metrick-Opening) at 64–65, Fig. 11. See also Trial Tr. 1172:22–1178:4
(Weinsten) (describing PetSmart’s historical difficulties in meeting its near-term forecasts,
and how this affected his view of the reliability of the Management Projections because
“[i]t’s easier to forecast in the near term. It’s even easier forecasting in the near term when
you have actual results available that factor into the calculation. So projecting out over a
five-year period is significantly more difficult”).
33
JX 153 at 2; JX 137 at 4; PTO ¶¶ 101, 103.
9
new CEO, and Carrie Teffner joined PetSmart as its new CFO.34 PetSmart’s then-
President and COO, Joseph O’Leary, left the Company in April 2014.35
New management pushed initiatives that precipitated additional difficulties
for PetSmart. In particular, under Lenhardt’s direction, PetSmart implemented a
major “consumables reset” in early 2014 through which it increased store space for
exclusively distributed premium pet foods while reducing space for widely
distributed value pet foods.36 This consumables reset was intended to drive growth
in PetSmart’s sales and margins.37 As reflected in PetSmart’s disappointing Q1 2014
34
PTO ¶¶ 99–101, 103.
35
PTO ¶ 169.
36
PTO ¶ 135.
37
See Trial Tr. 246:20–23 (Teffner); JX 1684 (Lenhardt Dep.) 50:14–16, 51:20–52:7;
PTO ¶ 171. Petitioners object to the admission of Lenhardt’s deposition on hearsay and
related grounds. Pursuant to Court of Chancery Rule 32(a)(3)(B), deposition transcripts
may be used “by any party for any purpose” in lieu of live witness testimony when “that
witness is out of the State of Delaware, unless it appears that the absence of the witness
was procured by the party offering the deposition.” When Rule 32 applies to permit the
use of deposition testimony, “the Rules of Evidence are ‘applied as though the witness
were then present and testifying[,]’ . . . [such that] a party cannot raise evidentiary
objections to admissibility based on the fact that the testimony takes the form of a
deposition.” ACP Master, Ltd. v. Sprint Corp., 2017 WL 75851, at *3 (Del. Ch. Jan. 9,
2017). Rule 32 allows Respondents to offer Lenhardt’s deposition testimony as he is “out
of the state of Delaware” and there is no evidence that the Respondent procured his
absence. Importantly, procuring the absence of a witness from trial is different from “doing
nothing to facilitate presence,” even where potential witnesses are employed by one of the
parties to the trial. Carey v. Bahama Cruise Lines, 864 F.2d 201, 204 (1st Cir. 1998)
(quoting Houser v. Snap-On Tools Corp., 202 F. Supp. 181, 189 (D. Md. 1962)). To have
procured the absence for the purposes of Rule 32, the party must have “actively [taken]
steps to keep the deponent[] from setting foot in the court-room.” Carey, 864 F.2d at 204.
Respondent also demonstrated that the witness is “unavailable” pursuant to DRE 804(a)(5)
10
results, announced on May 21, 2014, the consumables reset failed.38 PetSmart’s
comparable store sales growth for Q1 2014 had declined to -0.6%, and its Q1 2014
net sales growth was only 1.1%.39
Following PetSmart’s announcement of its Q1 2014 results, PetSmart’s stock
price dropped 8% to $57.02.40 PetSmart’s Q1 2014 results, combined with the sharp
decline in its stock price, drew the ire of shareholders, including Longview Asset
Management LLC (“Longview”), then PetSmart’s largest stockholder. Longview
was not bashful in communicating its frustration with PetSmart’s lackluster
performance to both members of management and PetSmart’s board of directors (the
“Board”).41
E. PetSmart’s Board Begins to Explore Strategic Alternatives
At a meeting on June 18, 2014, the Board received reports on Longview’s
most recent communications and PetSmart’s poor results in Q1 2014.42 Morgan
& 804(b)(1). This reasoning applies with equal force to the use of the deposition testimony
of Christina Vance, Kim Smith and Michael Chang, all of whom were “out of the State of
Delaware” at the time of trial through no active involvement of the Respondent.
38
PTO ¶ 171.
39
Id.
40
Id.; JX 1623.
41
E.g., Trial Tr. 193:10–195:18 (Teffner); PTO ¶ 170.
42
PTO ¶¶ 176–78.
11
Stanley had been engaged to advise the Board regarding its options in the wake of
recent events and, at the June 18 meeting, it gave a presentation on PetSmart’s
valuation, capital structure and potential strategic alternatives.43
In anticipation of the June 2014 meeting, PetSmart had provided Morgan
Stanley with PetSmart’s strategic plan and a set of financial projections prepared by
PetSmart’s management (the “June 2014 Projections”). The June 2014 Projections
were “very high level,”44 created “specifically for Morgan Stanley,”45 and prepared
in “[r]elatively short order, in a matter of maybe not even a week”46 using
management’s general financial planning framework (the “fishbone” or “financial
framework”).47 These projections had not been approved by PetSmart’s Board and
43
PTO ¶¶ 176–80.
44
Trial Tr. 198:12 (Teffner).
45
Trial Tr. 197:17–18 (Teffner).
46
Trial Tr. 198:18–19 (Teffner).
47
Trial Tr. 197:21–198:9 (Teffner). Teffner testified that PetSmart’s management used
the financial framework to outline its expectations with respect to “revenue growth, how
much of that was comp, how much of that was new store growth . . . margin, profit, CAPX,
those type of things.” Trial Tr. 198:3–6 (Teffner); Trial Tr. 208:20–22, 209:20–210:12
(Teffner). See also JX 1674 (Vance Dep.) 42:2–12, 43:15–20 (“The format of [the
fishbone was] a single piece of paper that has some boxes on it that have little numbers on
it that say sales should grow three to four percent, margins should be flat, expenses should
grow, you know . . . three to four percent, something like that.”), 46:1–4 (“The [fishbone]
itself is not a plan. It’s a piece of paper that says here’s what we aspire to achieve, but it’s
not an individual plan.”).
12
were not intended to inform PetSmart’s business operations going forward.48 Rather,
the June 2014 Projections were prepared “to be in line with what the board would
have expected from the financial framework, but [also] to give them directional
guidance in terms of what the impact of leveraging up to do a significant share
buyback would do.”49
Having reviewed PetSmart’s strategic plan and the June 2014 Projections,
Morgan Stanley presented the following “preliminary conclusions” to PetSmart’s
Board at the June 2014 meeting: (1) “Based on management’s forecasts and
[PetSmart’s] recent share price decline, [PetSmart’s] stock appeared to be
undervalued”;50 (2) “PetSmart could optimize its capital structure and lower its cost
of capital by raising debt to accelerate its return of capital while still maintaining
strategic flexibility”;51 and (3) “Given [PetSmart’s] compelling cash flow and return
characteristics . . . , Morgan Stanley expected financial sponsors to be interested in
a take-private transaction [i.e., a leveraged buyout (“LBO”)].”52 Morgan Stanley’s
presentation to the Board also included a preliminary assessment of PetSmart’s value
48
Trial Tr. 198:20–199:1 (Teffner).
49
Trial Tr. 199:5–9 (Teffner).
50
PTO ¶ 179(c)(i).
51
PTO ¶ 179(c)(ii).
52
PTO ¶ 179(c)(iii).
13
based on a DCF analysis, which yielded a range of valuations for PetSmart of $100
per share (upside), $88 per share (base), and $77 per share (downside).53
Following Morgan Stanley’s presentation, the Board discussed a range of
possible strategic options, including: (1) adhering to management’s current strategic
and operating plans; (2) engaging in a significant leveraged recapitalization
(as described by Morgan Stanley); (3) pursuing an acquisition of Pet360, Inc.
(“Pet360”), an online pet business; (4) pursuing a strategic combination with Petco;
or (5) pursuing a sale of the Company to a financial buyer.54 At the end of the June
2014 meeting, the Board established an Ad Hoc Advisory Committee of non-
executive, independent directors: Gregory Josefowicz, Rakesh Gangwal, and
Thomas Stemberg.55 The Board established the Ad Hoc Committee to work with
management and PetSmart’s advisors to evaluate options that would increase
shareholder value (including a leveraged recapitalization) and to develop one or
more related proposals for consideration by the Board.56 One of the goals in forming
53
PTO ¶ 180.
54
PTO ¶ 178; Trial Tr. 400:12–16 (Gangwal).
55
PTO ¶ 181. The three members of the Ad Hoc Committee were each experienced board
members and former CEOs (Josefowicz was the former CEO of Borders, Gangwal was the
former CEO of US Airways, and Stemberg was the former CEO of Staples). JX 276 at
15–16.
56
PTO ¶ 182.
14
the Ad Hoc Committee was to relieve some of the pressure from PetSmart’s “young
management team” during the Company’s exploration of strategic alternatives since
management “was already under a lot of pressure to perform.”57
F. Activist Investor JANA Partners Discloses Stake in the Company and
Urges Sale
On July 3, 2014, JANA Partners LLC (“JANA”), an activist hedge fund,
disclosed in a Schedule 13D filing that it had acquired a 9.9% stake in PetSmart.58
JANA stated its view that PetSmart’s stock was undervalued and disclosed its
intention to push PetSmart to pursue strategic alternatives including a possible sale.59
Four days later, on July 7, 2014, Longview publicly disclosed a letter it had sent to
the Board in response to JANA’s filing that also encouraged the Board to pursue a
possible sale of the Company in addition to examining other strategic alternatives.60
On July 10, 2014, JANA representatives met in person with Lenhardt, Teffner,
and Josefowicz.61 At that meeting, JANA’s representatives criticized PetSmart’s
Board and management for pricing missteps, ineffective cost management, failure
57
Trial Tr. 402:16–403:9 (Gangwal).
58
PTO ¶ 188; JX 386.
59
PTO ¶ 188; JX 386 at 2–3.
60
PTO ¶ 190; JX 427; JX 403; Trial Tr. 462:14–15 (Gangwal).
61
PTO ¶ 192.
15
to capitalize on growth opportunities and failure to respond adequately to
competitors.62 In light of these failures, JANA’s view was that PetSmart’s only
solution was to sell the Company.63 That same day, Longview reiterated to PetSmart
its support for a possible sale of the Company.64
On July 11, 2014, the Board held a special meeting via telephone.65 During
the meeting, the Board received a report on recent shareholder communications from
JANA and Longview and, with management’s recommendation, authorized the
retention of J.P. Morgan Securities LLC (“JPM”) as PetSmart’s new financial
advisor.66 A team from JPM led by Anu Aiyengar presented JPM’s preliminary
analysis of PetSmart’s current situation and possible strategic alternatives.67 This
presentation included an overview of preliminary valuation perspectives, selected
capital alternatives and selected strategic alternatives such as a possible going-
62
See Trial Tr. 201:24–202:9 (Teffner); Trial Tr. 404:9–19 (Gangwal); JX 427 at 1–2;
JX 433.
63
See Trial Tr. 201:24–202:9 (Teffner); JX 427 at 2; JX 433.
64
PTO ¶ 193; JX 427 at 2; Trial Tr. 462:14–15 (Gangwal).
65
PTO ¶ 194.
66
PTO ¶¶ 191, 194–95; JX 427 at 4–5. According to the July 2014 meeting minutes, the
Board resolution authorizing JPM’s retention as PetSmart’s financial advisor provided that
the Ad Hoc Committee (1) was to determine the scope and terms of that retention; and
(2) then negotiate with JPM to reach the final terms of its engagement. JX 427 at 4–5.
67
JX 427 at PETS_APP00000314–315; Trial Tr. 882:20–22 (Aiyengar).
16
private transaction or the acquisition of Petco.68 JPM also discussed certain steps
that it would undertake to assist the Board in evaluating alternatives and making a
decision, which included: (1) reviewing and performing due diligence on PetSmart’s
business plan, which management had provided to JPM; (2) assessing trends in the
pet sector; (3) asking strategic questions about possible changes to PetSmart’s
business plan; (4) evaluating capital and structural changes that could be considered
in connection with that plan, as alternatives to a sale of the business; (5) considering
acquisition scenarios; (6) comparing the potential value to shareholders of executing
PetSmart’s business plan (including recommending possible modifications and
capital and structural changes) with the potential value to stockholders of a sale of
PetSmart, and (7) assessing which of these or other alternatives was more likely to
maximize shareholder value.69 While JANA had threatened a proxy fight if
PetSmart decided not to sell, the Board indicated to JPM that it was prepared to take
on that fight if it decided that a sale was not in the best interests of the Company. 70
68
PTO ¶ 196; Trial Tr. 204:17–21 (Teffner).
69
PTO ¶ 197; Trial Tr. 882:20–22 (Aiyengar); JX 372; JX 427 at 3.
70
Trial Tr. 405:8–406:1, 467:5–6 (Gangwal).
17
G. PetSmart’s Management Prepares Long-Term Projections
Following the July 11 meeting, PetSmart’s management began to prepare a
set of long-term projections at the direction of the Board (the “Base Case”).71 This
project was led principally by PetSmart CFO Carrie Teffner, Christina Vance,
PetSmart’s director of financial planning, and Kim Smith, PetSmart’s director of
treasury operations—with input from Lenhardt and several other executives.72
PetSmart did not prepare long-term projections in the ordinary course to
operate its business.73 Instead, PetSmart’s management would create a one-year
budget (or operating plan) which forecasted PetSmart’s quarterly performance for
the upcoming year.74 The budget formulation process began each summer with a
series of meetings over several days referred to within the Company as “Summer
Strategy.”75 During these meetings, PetSmart’s management discussed financial and
strategic priorities for the next fiscal year.76 Prior to each Summer Strategy, the
71
Trial Tr. 217:10–17, 229:2–6 (Teffner); JX 1674 (Vance Dep.) 105:18–112:8.
72
Trial Tr. 220:1–18, 221:22–222:1 (Teffner).
73
See Trial Tr. 209:4–6 (Teffner) (Q: “Did PetSmart senior management prepare long-term
projections to operate its business?” A: “No.”); Trial Tr. 211:8–14, 211:21–23 (Teffner).
74
PTO ¶ 433; Trial Tr. 206:21–209:3 (Teffner).
75
Trial Tr. 205:14–209:3 (Teffner); PTO ¶ 424.
76
Id. See also JX 149 (presentation slides from 2013 Summer Strategy “Lead Meeting 4”);
JX 150 (presentation slides from 2013 Summer Strategy business case prioritization
18
leaders of PetSmart’s different business segments would identify potential initiatives
for the upcoming fiscal year and, working with members of PetSmart’s finance
department, develop “business cases” around those initiatives.77 Each business case
for a proposed initiative would include certain financial forecasts.78 The business
segment leaders would then present their proposed business initiatives
(and business cases) to the Company’s senior management during the Summer
Strategy meetings.79 Management, in turn, would select (and approve) specific
initiatives for advancement in the upcoming fiscal year.80
Following Summer Strategy, PetSmart’s management would continue to
evaluate the approved initiatives through the fall and early winter to determine their
expected impact on PetSmart’s revenue and expenses.81 Typically, management
would then complete the one-year budget in February of the following calendar year,
meeting); JX 156 (presentation slides from 2013 Summer Strategy business case
prioritization review meeting).
77
Trial Tr. 205:16–206:5 (Teffner); PTO ¶ 425–27.
78
PTO ¶ 431. “While business cases [used] multiyear looks [i.e., projections] . . . , the
focus was really on Year 1 and what we were going to wind up putting in the budget for
the following year.” Trial Tr. 206:12–14 (Teffner).
79
Trial Tr. 206:6–10 (Teffner).
80
Trial Tr. 206:23–207:12 (Teffner).
81
Trial Tr. 206:23–207:17 (Teffner); PTO ¶ 434. PetSmart’s fiscal year runs from
February 1 to January 31. PTO ¶ 80.
19
present it to the Board in March of that year and the Board would approve it that
same month.82 Thereafter, before Q2, Q3 and Q4 of the fiscal year, management
would prepare reforecasts of PetSmart’s projected performance for the remaining
quarters.83 PetSmart used the one-year budgets and reforecasts “to run the business
and incentivize management.”84
Over time, Vance had developed a model to extrapolate the business cases
presented at Summer Strategy.85 She used her model to evaluate whether PetSmart
“would stay within [its] financial framework.”86 The model was not, however,
“presented to the board for approval . . . [and was not] considered a multiyear
projection that the business relied upon.”87 Rather, it “was more of an inherent
working tool for the planning department . . . .”88
PetSmart management confronted several challenges when the Board tasked
them with developing the long-term projections to be used by JPM and the Board in
82
PTO ¶¶ 434–35; Trial Tr. 207:18–208:3 (Teffner).
83
PTO ¶ 440.
84
Trial Tr. 211:18–19 (Teffner); PTO ¶¶ 438–42.
85
Trial Tr. 213:7–19 (Teffner); JX 1674 (Vance Dep.) 38:12–41:24.
86
Trial Tr. 213:12–13 (Teffner). See also JX 1674 (Vance Dep.) 38:12–42:12.
87
Trial Tr. 213:15–19 (Teffner).
88
Trial Tr. 213:16–17 (Teffner).
20
their evaluation of strategic alternatives. First and foremost, they had never prepared
long-term projections and the process of doing so was vastly different than the
process employed to prepare budgets for Summer Strategy.89 The business units
were unable to provide much input because they had never prepared and had never
been accountable for long-term projections.90 And then there was the time pressure.
The Board rushed management to prepare the Base Case “in the span of a few days”
after the Board meeting on July 11, 2014, so that the results could be presented at
the next Board meeting in August.91
During PetSmart’s 2014 Summer Strategy, management had “identified a
variety of initiatives that [management] thought would be go-forward initiatives to
help drive growth going forward.”92 Thus, in creating the Base Case, management
first sought “to build a base of what [they] believe[d] the comp would be for the
existing business before layering in [those] initiatives.”93 The finance team then
89
Trial Tr. 220:19–222:1 (Teffner).
90
Trial Tr. 220:22–221:19 (Teffner) (noting that in her past experience before joining
PetSmart the business units “really owned their own forecasts” but at PetSmart the
management in place did not “have experience putting multiyear projections together”
leaving “a small group of [senior management] to “try[] to validate with the business
instead of the other way around.”).
91
Trial Tr. 219:7–22 (Teffner); JX 426; JX 430; JX 448; JX 458; JX 583.
92
Trial Tr. 217:24–218:3 (Teffner).
93
Trial Tr. 218:4–16 (Teffner).
21
“layered onto [the “base” comp projections] what it thought the value of each of
the[] initiatives would be.”94 As part of this “layering” process, the finance team
sent its value assumptions to the relevant business segment leaders “to get an
affirmation that yes, that looks right . . . .”95 And, as Teffner explained, “that’s
essentially what drove the top line.”96
The Base Case forecast estimated revenues using three primary yardsticks:
(1) new store openings; (2) comparable stores sales growth; and (3) four initiatives
selected from the Summer Strategy.97 The Base Case is summarized below:98
94
Trial Tr. 218:20–22 (Teffner).
95
Trial Tr. 220:1–18 (Teffner).
96
Trial Tr. 218:22–23 (Teffner).
97
JX 586 at 7; JX 598.
98
JX 586 at 8.
22
The comparable store sales forecasts were ambitious and well above the
performance management had projected at Summer Strategy, including comparable
store sales growth.99 Specifically, the Base Case assumed the success of each of the
new revenue initiatives developed at Summer Strategy and projected comparable
store sales growth of 1.3% in 2015, 3.2% in 2016 and 3.3% increases each year
thereafter.100
The Base Case was not well received by the Board. Specifically, “when
[management] reviewed the base case comp assumptions with the ad hoc committee
of the board, [the committee], specifically . . . Stemberg, indicated that the comp
assumptions that [management] had put in the plan were not aggressive enough and
[management] needed to be far more aggressive, recognizing that potential buyers
looking at [PetSmart would] discount [management’s] plans themselves.”101
Accordingly, management went back to the drawing board and prepared the Base-
Plus Case, which is summarized below:102
99
Trial Tr. 233:22–234:19 (Teffner). Estimates coming out of Summer Strategy had shown
that, including the acquisition of Pet360 that was under consideration but excluding any
new initiatives, PetSmart’s comparable store sales growth for 2015 to 2017 would range
from 0.1% to 0.5%. JX 842 at 139.
100
JX 586 at 6; JX 842.
101
Trial Tr. 234:23–235:6 (Teffner).
102
JX 586 at 9.
23
The Base-Plus Case “assumed more aggressive delivery of performance
against the exact same initiatives that [management] had looked at in the Base
Case.”103 These projections also assumed comparable store sales growth that
exceeded similar projections in the Base Case.104 The take away from the Base-Plus
Case was that it depicted an even sharper turnaround of PetSmart’s recent
downward-trends than had been forecast previously.105
103
Trial Tr. 235:9–14 (Teffner).
104
Compare JX 586 at 8 (Base Case projections) with id. at 9 (Base-Plus Case projections).
105
See JX 1684 (Lenhardt Dep.) 275:14–21 (describing the projections as “a hockey stick
from negative to slightly positive to much more positive,” meaning that “there was a lot of
risk going forward to hitting these things”).
24
As with the Base Case, management prepared the Base-Plus Case “extremely
quickly.”106 During this same time frame, PetSmart’s management also prepared a
third set of projections—the “Growth Case.”107 The Growth Case started with the
Base-Plus Case projections and “assumed yet even [better] performance of the exact
same initiatives.”108 Unlike the Base Case and Base Plus Case, however, the Growth
Case was not prepared at the request of the Ad Hoc Committee.109 Rather, PetSmart
management prepared the Growth Case on its own initiative because it was not “sure
how far the ad hoc committee wanted [them] to go in terms of comp assumptions.”110
Management kept the Growth Case in their “back pocket” in case the Ad Hoc
Committee once again was displeased with their work on the Base Plus Case.111
H. The PetSmart Board Decides to Commence a Public Sale Process
PetSmart’s Board next met on August 13, 2014.112 At this meeting, JPM
presented a preliminary valuation summary for PetSmart and reviewed several
106
Trial Tr. 219:9–14 (Teffner).
107
Trial Tr. at 236:11–16 (Teffner).
108
Trial Tr. 236:15–16 (Teffner).
109
See Trial Tr. 237:5–12 (Teffner).
110
Trial Tr. 237:9–12 (Teffner).
111
Id.
112
PTO ¶¶ 198, 204–05.
25
strategic alternatives for the Company, including (1) continuing on a standalone
basis while engaging in a significant leveraged recapitalization; (2) exploring a sale
of the Company; and (3) exploring a strategic merger with another industry
participant.113 In connection with the third alternative, the Board focused on the
potential benefits and risks associated with inviting Petco to participate in an
exploratory sales process.114 The Board identified two “overwhelming,
overriding”115 risks associated with such an overture: (1) that Petco would not be
serious about acquiring PetSmart, but would feign interest in order to gain access to
confidential information about PetSmart’s business model, strengths and
weaknesses;116 and (2) that a Petco-PetSmart merger “would face pretty strong
[antitrust] headwinds . . . [so that] approval of th[e] transaction would be quite
difficult.”117 Given these concerns, the Board “was not very keen on engaging with
Petco” at that time.118
113
PTO ¶ 206.
114
Trial Tr. 414:12–416:24 (Gangwal).
115
Trial Tr. 415:14 (Gangwal).
116
Trial Tr. 415:9–10 (Gangwal).
117
Trial Tr. 415:15–17, 414:21–23 (Gangwal).
118
Trial Tr. 415:17–18 (Gangwal).
26
During the August 2014 meeting, PetSmart management and JPM provided
the Board with an overview of management’s standalone plan and the Base Case and
Base-Plus Case financial projections.119 The Board admonished management that
that Base Case and the Base-Plus Case were not aggressive enough because
PetSmart “needed to put [its] best foot forward in terms of the projections [it was]
putting forward to . . . potential buyers.”120 Teffner’s “take-away from the [August
2014 Meeting] was very much one that [management] needed to put [their] best foot
forward because potential buyers were going to discount [management’s]
assumptions and assume that [the Company was] putting more aggressive
assumptions forward.”121
At the conclusion of the August meeting, the Board determined that it would
publicly announce that PetSmart was exploring strategic alternatives including a
possible sale of the Company.122 Accordingly, on August 19, 2014, PetSmart issued
a press release to that effect, announcing that, based on a thorough, year-long
business review, the Board had determined to explore strategic alternatives for the
119
Trial Tr. 237:17–238:13 (Teffner). Management did not present the Growth Case at the
August 2014 Meeting. See Trial Tr. 237:5–12 (Teffner).
120
Trial Tr. 241:10–13 (Teffner).
121
Trial Tr. 242:22–243:2 (Teffner).
122
Trial Tr. 418:12–419:8 (Gangwal).
27
Company to maximize value for shareholders, including a possible sale of the
Company.123
Also on August 19, 2014, PetSmart issued a second press release announcing
PetSmart’s Q2 2014 results.124 Here, PetSmart announced that its comparable store
sales for Q2 2014 had declined to -0.5%, with comparable transactions declining to
2.6%.125 This press release also announced that the Company had entered into a
definitive merger agreement to acquire online retailer Pet360 for $130 million and
that the Company would be launching a broad cost reduction program and certain
other growth initiatives.126
I. PetSmart Management Formulates the Profit Improvement Plan and
Finalizes its Projections
Prior to the August 13, 2014 Board meeting, PetSmart had engaged two
consulting firms to analyze certain aspects of PetSmart’s business and identify cost-
savings opportunities.127 In May 2014, PetSmart engaged The Hackett Group to
identify cost cutting initiatives with respect to PetSmart’s Selling, General, and
123
PTO ¶ 213.
124
PTO ¶ 211.
125
Id.
126
PTO ¶ 212. The PetSmart-Pet360 merger closed on September 29, 2014, with a
purchase price of $131.5 million and a potential earnout of $30 million. PTO ¶ 221.
127
See PTO ¶¶ 366–70, 378; Trial Tr. 247:22–248:23 (Teffner).
28
Administrative expenses (specifically, a headcount reduction).128 And in May/June
2014, PetSmart engaged A.T. Kearny, Inc. to focus on cost cutting initiatives with
respect to certain of PetSmart’s indirect expenses.129
Shortly after the August 2014 Board meeting, with the assistance of its
consultants, PetSmart’s management undertook to formulate a large-scale cost-
savings plan at the Board’s direction.130 This plan came to be known as the “Profit
Improvement Plan” (or “PIP”).131 The PIP consisted of: (1) implementing a
headcount reduction;132 (2) engaging A.T. Kearny to develop a cost-savings plan
with respect to PetSmart’s cost of goods sold (“COGS”) expenses and certain of
PetSmart’s other indirect expenses such as spending on transportation, marketing,
supplies, real estate, packaging, and real estate services;133 and (3) engaging the
Peppers & Rogers Group to develop a cost-savings plan with respect to PetSmart’s
enterprise costs.134 Two weeks after the August 2014 Board meeting, Teffner sent
128
PTO ¶ 378; Trial Tr. 247:22–24 (Teffner).
129
Trial Tr. 248:5–7 (Teffner); PTO ¶ 370. PetSmart had previously entered into a Master
Provider Agreement with A.T. Kearney in August 2013. Id.
130
Trial Tr. 247:14–19 (Teffner); see PTO ¶ 366.
131
Trial Tr. 247:14–19 (Teffner); PTO ¶ 366.
132
Trial Tr. 248:14–17 (Teffner).
133
Trial Tr. 248:17–23 (Teffner); PTO ¶¶ 371–73.
134
PTO ¶ 375; Trial Tr. 248:24–249:7 (Teffner) (“We also brought in Peppers & Rogers[,]
and their work was [focused] around a Lean Six Sigma operational efficiency process, . . .
29
an email to the Board stating that management’s target for PIP cost savings was
“[approximately] $160M–$200M+ EBITDA improvement.”135 The final PIP
savings developed by the consultants, together with management, and presented to
the Board showed an expected range of $183–$283 million in EBITDA savings
annually.136
While management worked on developing the PIP, they also worked to
prepare an updated set of financial projections that would integrate the PIP
savings.137 Specifically, between August and October 2014, PetSmart management
prepared what would be their final revised set of financial projections for
presentation to the Board (the “Management Projections”).138 The Management
Projections started with the Base-Plus Case projections and layered on (1) greater
sales growth assumptions for the same proposed business initiatives, (2) new sales
growth expected from the Pet360 acquisition, and (3) cost savings associated with
to see if [PetSmart] had opportunity to reduce labor costs by operating more efficiently
than [it was] currently operating at the time.”). PetSmart engaged Peppers & Rogers to
perform this work on September 12, 2014. PTO ¶ 375.
135
JX 668 at 1.
136
JX 2021 at 375; Trial Tr. 338:22–339:1 (Teffner); PTO ¶ 232.
137
See Trial Tr. 247:22–249:8 (Teffner); PTO ¶¶ 223, 231.
138
PTO ¶¶ 223, 231.
30
the PIP.139 The forecasts for comparable store sales growth were significantly higher
than those set forth in both the Base and Base-Plus Cases. These new projections
also included more aggressive Net Sales, EBITDA, Earnings Per Share and Capex
numbers.140 They estimated that, through the PIP, PetSmart would achieve cost
savings totaling $120 million in 2015 and then $200 million for each of the
subsequent years laid out in the forecast.141 The Management Projections are
summarized below:142
Management Projections (FY2014-2019)
2014E 2015E 2016E 2017E 2018E 2019E
($ in millions)
Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20
Revenue $7,088 $7,456 $7,869 $8,331 $8,822 $9,329
EBITDA $958 $1,060 $1,223 $1,326 $1,422 $1,515
Net Income $432 $490 $588 $646 $700 $748
Capital
Expenditure $152 $150 $157 $167 $176 $187
FCF Before
Distributions $465 $571 $667 $684 $736 $786
139
PTO ¶ 223; Trial Tr. 254:16–255:6, 259:1–14 (Teffner).
140
Compare JX 807 at PETS_APP00000694 with JX 586 at PETS_APP00000438–39.
141
JX 1136 at 8; Trial Tr. 339:7–10 (Teffner).
142
PTO ¶ 231.
31
Once again, management designed its latest projections to be aggressive—
“bordering on being too aggressive.”143 Indeed, Vance went so far as to characterize
the Management Projections as approaching “insan[ity].”144 With that said, these
projections reflected an inexperienced management team’s best effort at estimating
how PetSmart would perform in the future if all of its performance and cost
initiatives paid off.145 And management made a point of “being very clear with
respect to the assumptions that they were making.”146
The record is clear that the Board exerted substantial pressure upon
management to prepare increasingly more aggressive and ultimately unrealistic
long-term projections. In this regard, Lenhardt and Teffner were told that their jobs
“depended” on it.147 And management heard the Board “loud and clear.”148 For its
part, JPM told PetSmart management that prospective buyers would likely view the
143
Trial Tr. 258:13–14, 258:18–20 (Teffner).
144
JX 758.
145
Trial Tr. 368:19–369:16 (Teffner). See also JX 1674 (Vance Dep.) 136:25–137:3.
146
Id.
147
JX 671 at PETS_APP00215455. See also JX 608; JX 668.
148
JX 673.
32
overly aggressive Management Projections skeptically,149 and that management best
be prepared to defend them when the sales process got underway.150
J. The Auction for PetSmart
While PetSmart management continued the back-and-forth with the Board
over its projections, JPM opened the auction process for PetSmart in earnest. JPM
spoke with 27 potential bidders following the announcement that PetSmart was
exploring a sale in August through early October.151 As among the potential bidders,
three were potential strategic partners that had been targeted by JPM and the
Board—Wal-Mart, Target, and Tractor Supply––and the rest were financial
sponsors.152 Ultimately, none of the strategics elected to participate in the process.153
Of the 24 private equity funds with whom JPM spoke, 15 signed nondisclosure
agreements and moved forward with the bidding process.154
149
Trial Tr. 256:11–13, 257:10–11 (Teffner).
150
JX 758; JX 753.
151
JX 1336 at 23; Trial Tr. 884:10–885:4, 886:10–18 (Aiyengar).
152
Trial Tr. 919:4–921:21 (Aiyengar).
153
Id.
154
JX 1336 at 23; JX 811 at PETS_APP00000578; Trial Tr. 887:18–888:5 (Aiyengar).
33
The Board held additional meetings with JPM on October 2 and 3, 2014, to
discuss, among other things, the risks and benefits of formally inviting Petco to bid
for the Company.155 Citing the risks it and JPM had previously identified, the Board
again decided that it was not in the Company’s best interests to pursue a transaction
with Petco.156 Of course, the Board was open to engaging with Petco if Petco
expressed a serious indication of interest.157
During the Board meetings on October 2 and 3, PetSmart’s management
updated the Board on their progress with the PIP, including their expectation that the
Company would achieve cost savings of $120 million in 2015 and $200 million in
2016.158 Management also presented the Management Projections to the Board.159
JPM’s reaction to this presentation was to reiterate that buyers would likely be
skeptical of PetSmart’s ability to achieve those results as potential bidders had
expressed concerns to JPM that well-documented trends in PetSmart’s performance
did not bode well for the future.160 Even so, the Board decided to use the
155
JX 803; JX 811.
156
JX 803 at PETS_APP00000557–58.
157
See Trial Tr. 417:13–418:1 (Gangwal); Trial Tr. 923:1–16 (Aiyengar).
158
JX 805 at PETS_APP00000609.
159
Id.
160
JX 803 at PETS_APP00000556.
34
Management Projections for the auction process,161 with the expectation that bidders
would give a “haircut” to the projections in any event.162
PetSmart’s electronic data room was opened to bidders after the October 3
Board meeting. It was well-stocked with comprehensive, nonpublic information
about PetSmart, including information about PetSmart’s financials, performance and
the PIP.163 PetSmart’s management also made presentations to the various potential
bidders who had signed nondisclosure agreements.164 Around this time, JPM
informed potential bidders that Longview would consider rolling over up to
7.5 million of its approximately 9 million shares in a sale of the Company.165
PetSmart received five preliminary bids by October 31, 2014: (1) $80–$85 per
share from Clayton, Dubilier & Rice (“CD&R”); (2) $81–$84 per share from Apollo
Global Management L.P. (“Apollo”); (3) $81–$83 per share from BC Partners;
(4) $70–$75 per share from KKR & Co. L.P. (“KKR”); and (5) $65 per share from
161
See PTO ¶¶ 315–17.
162
See Trial Tr. 234:23–235:8, 242:22–243:2, 256:11–17, 258:8–14 (Teffner); Trial
Tr. 421:4–422:3 (Gangwal); Trial Tr. 892:1–20 (Aiyengar).
163
Trial Tr. 263:3–265:13 (Teffner); JX 811 at PETS_APP00000580; JX 913 at
PETS_APP00000748; JX 1054 at PETS_APP00000907.
164
JX 913 at PETS_APP00000747; Trial Tr. 262:1–263:2 (Teffner).
165
JX 861.
35
Ares Management, L.P. and Canada Pension Plan Investment Board.166 The stock
price as of October 31 was $72.35, while the unaffected price, which JPM set as of
July 2, 2014, was $59.81.167 Some members of the Board were “surprised that the
numbers had come in that high.”168
As the auction progressed, the Board continued to consider alternatives to a
sale.169 In this regard, the Board pressed management to create a stronger standalone
plan for the Company.170 And the Ad Hoc Committee asked JPM to report on the
financing that would be available for a leveraged recapitalization of the Company
should the Board decide against a sale.171
The Board next reviewed the progress of the auction for PetSmart with its
advisors at a meeting on November 3.172 JPM reported on the initial indications of
interest it had received as well as feedback from parties who chose not bid. This
feedback largely reflected a view that PetSmart’s business had “significant execution
166
JX 913 at PETS_APP00000749.
167
Id.
168
Trial Tr. 430:3–4 (Gangwal).
169
See JX 666; JX 915; Trial Tr. 427:22–428:15 (Gangwal).
170
JX 666.
171
JX 915 at PETS_APP00000741–42.
172
JX 913.
36
risk” and that there was inadequate potential for upside growth.173 The Board
decided to allow the four bidders who bid $80 per share or higher (CD&R, Apollo,
BC Partners and KKR) to continue in the process.174 These remaining bidders
performed further due diligence, which included access to more detailed information
about PetSmart’s financials, the Management Projections and the PIP, and additional
meetings with management.175
PetSmart released its Q3 results on November 18, 2014.176 Comparable store
sales growth was stagnant and comparable transactions were down 2.4%.177
PetSmart also announced its progress on the PIP and its expectation that the plan
would be fully implemented by the end of fiscal year 2015, and reiterated its
expectation that the plan would result in a pre-tax cost savings of $120 million in
2015 and $200 million per year starting in 2016.178
173
JX 913 at PETS_APP00000752; Trial Tr. 898:11–899:11 (Aiyengar).
174
JX 1336 at 24. The Board later determined to allow CD&R and KKR to work together
based on the understanding that this would allow them to make a stronger bid. Id.; JX 953.
175
JX 1054 at PETS_APP0000903.
176
JX 984.
177
Id.
178
Id.
37
The Board met again on December 2 and 3 to consider whether to sell the
Company, remain independent or pursue a leveraged recapitalization.179 The Board
also reexamined the Management Projections, noting that it believed the PIP savings
were achievable but that it was skeptical about the Company’s ability to achieve the
projected top-line revenue and comparable store sales growth.180 The feedback
delivered to management was that the Board had a low level of confidence in
PetSmart’s ability to achieve the results forecasted in the Management
Projections.181
The Board’s skepticism centered largely around the projections of comparable
stores sales growth; “many in the board really did not believe” that these projections
were realistic.182 To understand PetSmart’s standalone value better, the Board
determined that it needed to “see additional sensitivity analyses, particularly around
top-line and same-store sales growth.”183 Accordingly, the Board directed JPM to
prepare sensitivities assuming a 2% comparable store sales growth.184 The requested
179
JX 1336 at 24; JX 1121; JX 1081 at PETS_APP00000759–61.
180
JX 1081 at PETS_APP00000760.
181
Trial Tr. 440:7–9 (Gangwal). See also Trial Tr. 432:13–433:14, 434:1–8, 436:13–19,
440:2–4 (Gangwal).
182
Trial Tr. 433:9–14 (Gangwal). See also Trial Tr. 433:12–13, 434:3, 436:14 (Gangwal).
183
JX 1081 at PETS_APP00000760.
184
Trial Tr. 434:4–8 (Gangwal); Trial Tr. 910:24–911:8 (Aiyengar). I will hereafter refer
to these adjustments to the Management Projections as the “JPM sensitivities.” This should
38
sensitivities were set at 2% because the Board had “a great amount of discomfort . . .
[about whether the 4% comparable store sales used in the Management Projections]
would be achievable, attainable or not.”185 Instead, the Board believed that
“2 percent looked more reasonable, and something that the management team more
than likely should be able to get to, if they executed a plan.”186
In the weeks leading up to the final bids, questions arose about whether the
financial sponsors would be able to obtain deal financing based on reports that the
Office of the Comptroller of the Currency (“OCC”) and Federal Reserve would
engage in “increased scrutiny . . . over LBO loans.”187 The OCC and Federal
Reserve had implemented restrictions on the amount of leverage that would be
allowed in deal financing and, in the days leading up to Thanksgiving 2014 (in the
not be interpreted, however, as a finding that the JPM sensitivities were undertaken on
JPM’s own initiative. As noted above, I am satisfied that the Board came up with the idea
of the 2% sensitivities and then directed its financial advisor to run the analysis. The JPM
sensitivities began with the Management Projections and then: (1) for Sensitivity #1
applied a higher discount rate; (2) for Sensitivity #2 made no changes to the new store
assumptions through FY19 but eliminated new stores thereafter; (3) for Sensitivity #3
assumed half the new stores through FY19 and eliminated new stores thereafter; and (4) for
Sensitivity #4 assumed no new stores after FY14. See JX 1336 at 35. Sensitivity #1 was
the only sensitivity not to make adjustments based on 2% comparable store sales growth.
Id. This sensitivity was not featured at trial, not addressed by the experts and will not be
included herein when referencing the JPM sensitivities.
185
Trial Tr. 436:14–19 (Gangwal).
186
Id.
187
JX 2044. See also JX 1414; JX 1618.
39
midst of the PetSmart auction), regulators indicated they would begin to enforce
these regulations more strictly than before.188 This led bidders to perceive that the
quantum of debt available to finance an acquisition of PetSmart had tightened.189
While there were initial concerns that this increased regulatory scrutiny may affect
the bids for PetSmart, the evidence reveals that those concerns abated after
Thanksgiving when it became clear that all of the bidders would have no difficulty
securing debt financing at the levels necessary to fund their bids for PetSmart at the
values they deemed appropriate.190
188
JX 1414 at 3; JX 2044.
189
See Trial Tr. 859:15–860:24 (Svider); JX 1104; JX 1084 (Svider characterizing the
financing restrictions as “[w]orse than during Lehman in some ways”). See also JX 1103;
JX 1109 at 5–6 (discussing BC Partners’ issues with debt financing); Trial Tr. 995:4–6
(Aiyengar) (discussing Apollo’s struggles to get its debt financing in order); JX 1296 at 182
(stating that KKR’s financing for the PetSmart deal had “apparently” collapsed).
190
See Trial Tr. 861:18–862:3 (Svider) (testifying that BC Partners was able to get all the
financing that it needed); Trial Tr. 916:16–918:3, 994:13–995:6 (Aiyengar) (testifying that
all other bidders were able to secure deal financing and that none were prevented from
reaching the levels needed to bid their desired price). The ability of the bidders to secure
adequate financing in spite of the enhanced regulation appears to be attributable, at least in
part, to PetSmart’s strong cash flow profile. See JX 1109 at BC00146204 (noting that BC
Partners was able to get seven “viable” financing proposals notwithstanding the increased
regulatory scrutiny due to the “high quality of the credit” of PetSmart); Trial Tr. 917:7–
918:10 (Aiyengar) (testifying that she had no reason to believe that any regulation of the
U.S. debt market negatively impacted the bidding for PetSmart, likely because of
PetSmart’s “pretty strong cash flow profile,” as she saw U.S. regulated banks participating
in diligence calls, whereas U.S. regulated banks typically will not participate in financing
when leverage levels are too high).
40
On December 10, PetSmart received new offers from the remaining
bidders.191 BC Partners made a binding offer of $80.70 per share.192 Apollo made
a binding offer of $80.35 per share.193 KKR and CD&R, working together, verbally
indicated they would not offer more than PetSmart’s current stock price, which was
approximately $78 per share.194 When JPM presented these offers to the Ad Hoc
Committee, the committee directed JPM to engage further with Apollo and
BC Partners to see if they would increase their bids.195 The Ad Hoc Committee also
decided on December 12 that it would allow Longview to join with BC Partners after
BC Partners “indicated that they may be able to offer [] a higher price with
Longview.”196
JPM returned to the bidders and directed them to submit their best and final
offers because the Board would soon be meeting to make a final decision whether to
sell the Company or go in a different direction. Specifically, JPM told bidders “if
191
JX 1336 at 25.
192
JX 1144.
193
JX 1134.
194
JX 1336 at 25.
195
Id.
196
JX 1142 at 1. See also PTO ¶¶ 288–89. Apollo had indicated that it was not interested
in partnering with Longview and that its price would be the same with or without
Longview’s participation. JX 1142 at 1; JX 1153 at PETS_APP00000944.
41
[they] had anything more in [their] pocket, now [was] the time to put it [in].”197
Apollo responded with an offer of $81.50 per share; BC Partners, with its
commitment from Longview in hand, offered $82.50 per share.198 With some
prodding, JPM was able to get BC Partners to increase its offer to $83 per share.199
Both parties made clear that these were their best and final offers.200
K. The Auction Concludes and the Board Recommends the BC Partners
Offer to Shareholders
The PetSmart Board met on December 13 to discuss the final offers from BC
Partners and Apollo and to consider strategic alternatives to a sale of the
Company.201 JPM made presentations to the Board on each of these alternatives,
including the possibility that the Board may have to engage in a proxy contest with
JANA.202 JPM also presented its valuation analysis under various scenarios
including a standalone valuation of PetSmart if the Board determined to terminate
197
Trial Tr. 907:5–12 (Aiyengar).
198
JX 1336 at 26.
199
Id.
200
JX 1153 at PETS_APP00000945; Trial Tr. 906:7–908:9 (Aiyengar).
201
JX 1156; JX 1157; JX 1153 at PETS_APP00000944–45. In fact, the night before this
meeting, PetSmart management worked to put together a press release that would announce
that the Company had decided to end the sales process. JX 1138.
202
JX 1149; JX 1153; JX 1155; JX 1158.
42
the auction.203 This standalone valuation focused on a DCF analysis based on the
Management Projections that resulted in a valuation for the Company of $78.25–
$106.25 per share.204 Understanding that the Board had little faith in the
Management Projections, JPM also presented the Board with the results of the
sensitivity analyses the Board had requested which resulted in a valuation range of
$65–$95.25 per share.205
As a part of its presentation, JPM delivered its fairness opinion with respect
to the BC Partners offer concluding that, as of that date, the Merger Price of $83 per
share in cash was fair from a financial point of view to the stockholders of the
Company.206 Petitioners point to several aspects of JPM’s fairness opinion they
contend reveal that JPM “manipulated [its] financial analysis” in order to get to a
place where it could recommend the BC Partners proposal.207 At the core of the
criticism is the contention that JPM “stretched” to reach a high weighted average
cost of capital (“WACC”) for PetSmart in order to deflate the DCF results.208 In this
203
JX 1158 at PETS_APP00001265–73; JX 1156 at PETS_APP00001129–31.
204
Id.
205
JX 1158 at PETS_APP00001265–68; Trial Tr. 432:13–436:19 (Gangwal); Trial
Tr. 908:14–912:20 (Aiyengar).
206
JX 1153 at PETS_APP000945; PTO ¶ 293.
207
Pet’rs’ Post-Trial Br. 72.
208
Id. at 73.
43
regard, Petitioners select certain of JPM’s internal communications they contend
demonstrate that Aiyengar pushed her team to inflate PetSmart’s WACC into double
digits even though her team had determined that a much lower WACC was
appropriate.209
To be sure, there were discussions among the JPM deal team regarding
whether a double digit WACC could be defended.210 But the evidence also
demonstrates that JPM approached its work without preconceptions or designs to
reach a desired result.211 JPM made no secret of its approach to calculating WACC
and walked the Board through that analysis in detail.212 Petitioners may not agree
209
Id.
210
JX 847.
211
See JX 1680 (Gold Dep.) 47:24–48:2, 49:7–50:11; JX 1679 (Aiyengar Dep. Day 1)
327:16–330:6. I note that Aiyengar’s deposition testimony, proffered by Respondents,
along with the deposition testimony of other witnesses who testified at trial on
Respondent’s behalf, is admissible over Petitioners’ objection under either Court of
Chancery Rule 32(a)(4) or DRE 106. Court of Chancery Rule 32(a)(4) provides that “[i]f
only part of a deposition is offered in evidence by a party, an adverse party may require the
offeror to introduce any other part which ought in fairness to be considered with the part
introduced, and any party may introduce any other parts.” Delaware Rule of Evidence 106
provides that where a party introduces “a writing or recorded statement or part thereof . . . ,
an adverse party may require him at that time to introduce any other part or any other
writing or recorded statement which ought in fairness to be considered contemporaneously
with it.” After an analysis of the deposition testimony proffered by the Respondents in
response to Petitioners’ Post-Trial Brief, I find that each instance where Respondent cites
to the deposition testimony of Teffner, Svider, Aiyengar and Weinstein fits under the
“completeness” doctrine codified in Court of Chancery Rule 32(a)(3)(B) and DRE 106,
and is therefore admissible.
212
JX 1086 at JPM00000203; JX 1158 at PETS_APP00001282.
44
with that approach but there is simply no credible evidence that JPM set out to
manipulate its analysis to support a fairness opinion.213
Petitioners also criticize JPM for utilizing the so-called “Barra beta,” which
Petitioners (and others) describe as a “‘black box’ form of forward-looking beta”
that is difficult, if not impossible, to verify.214 Contrary to Petitioners’
characterization of JPM’s process, however, the evidence reveals that, in addition to
considering Barra’s forward-looking beta, JPM considered “Barra predicted, Barra
historical, as well as relevered beta.”215
Petitioners next criticize JPM for “artificially inflat[ing]” the betas it applied
by “arbitrarily” selecting PetSmart’s peer group and then selecting the betas of
companies in the lowest quartile of that group even though PetSmart had historically
213
JX 605; JX 1086; JX 1158.
214
JX 1679 (Aiyengar Dep. Day 1) 253:5–8; JX 79. “Barra is a company owned by MSCI,
Inc., that provides investment decision-making tools, including market indices and a beta
service.” In re Appraisal of DFC Global Corp., 2016 WL 3753123, at *8 n.89 (Del. Ch.
July 8, 2016). See JX 1698 (Dages-Opening) 40–42 (“Barra betas are rarely used by
academics to justify their beta estimates. I am unaware of any academic evidence that
Barra beta estimates are superior predictors of a stock’s future beta than are historical
estimates such as Bloomberg. Another problem with Barra betas is that they cannot be
unlevered and relevered to reflect the appropriate target capital structure. Therefore, a
peer-based beta derived from Barra betas can potentially reflect the risk of a capital
structure that is different than the operative capital structure of the company being valued.
. . . In addition, a commonly referenced valuation textbook cautions the use of Barra betas
because they are not replicable. I understand that, for those same reasons, Barra betas have
yet to be accepted by the Delaware Chancery Court.”) (citations omitted).
See JX 1158 (JPM’s slide deck reflecting its WACC analysis relied upon Barra predicted
215
and historical betas); Trial Tr. 947:23–948:1 (Aiyengar).
45
traded at a premium to its peers.216 Here again, Petitioners’ criticism recounts only
a portion of the evidence. First, the criticism glosses over the fact that PetSmart was
a niche retailer with only one true peer (Petco). Moreover, the complete evidentiary
picture reveals that, after conducting a “very detailed benchmarking analysis,” JPM
looked to the betas of companies that had “operating and financial statistics” that it
could meaningfully correlate with PetSmart’s operations, “numbers and
projections.”217
While one can debate the results JPM reached, and can speculate whether JPM
would have arrived at the same place had it utilized different inputs in its valuation
analysis,218 there is no credible basis to debate whether JPM skewed its analysis to
push the Board to accept the BC Partners offer. The JPM analysis was thorough and
the results were objectively rendered.219
216
Pet’rs’ Post-Trial Br. 72.
217
JX 1682 (Aiyengar Dep. Day 2) at 412:9–413:15. See also JX 1682 (Aiyengar Dep.
Day 2) at 122:15–24, 243:8–245:1, 288:7–24, 320:3–10, 341:21–342:21, 673:24–675:10;
JX 534; JX 538.
218
Trial Tr. 958:21–959:10 (Aiyengar) (agreeing that had JPM utilized a lower WACC it
could not have rendered its fairness opinion).
219
I also find no basis to accept Petitioners’ contention that JPM labored under disabling
conflicts. Pet’rs’ Post-Trial Br. 74. JPM’s previous work with Petco was disclosed to the
PetSmart Board and, if anything, it was deemed as a benefit not a conflict. Trial Tr.
203:21–204:6 (Teffner). JPM’s prior relationships with potential private equity buyers,
including those that actively participated in the process, was correctly deemed by the Board
to be a “fact of business life.” See In re Dollar Thrifty S’holder Litig., 14 A.3d 573, 582
(Del. Ch. 2010) (noting that it is “one of the facts of business life that most of the top, if
not all, banks have relationships with the major private equity firms.”); Trial Tr. 484:22–
46
Aiyengar shared her view during the December 13 Board meeting that the
PetSmart auction had been “a robust auction process, where anybody who had an
interest in this company had the opportunity to engage with the company and see
whether they wanted to buy the company.”220 The Board then weighed the $83 per
share offered by BC Partners generated by this process against the Company’s
prospects if it remained standalone.221 In its deliberations, the Board considered the
aggressiveness of the Management Projections, which it felt were heavily dependent
on a number of factors breaking the Company’s way all of which were subject to
much speculation and volatility.222 After weighing all options, the Board decided to
take the $83 per share offered by BC Partners, as this was a “certainty,” rather than
confront the “risk of trying to get something more than $83 if [PetSmart] were a
23 (Gangwal) (testifying that he “knew that [JPM] would have many, many” relationships
with private equity firms). Nor is there a basis in the evidence to find that JPM misled the
Board regarding potential conflicts. See Pet’rs’ Post-Trial Br. 75. The evidence to which
Petitioners refer in support of this contention, JX 1251, upon careful reading, says no such
thing.
220
Trial Tr. 925:12–15.
221
See JX 1336 at 27; Trial Tr. 439:4–441:9 (Gangwal).
222
JX 1336 at 27 (In considering the achievability of the Management Projections, the
Board considered, inter alia, “the risks associated with executing on [PetSmart’s] business
plans, including that [PetSmart’s] business plans and Profit Improvement Plan [were]
based, in part, on projections . . . dependent on a number of variables, including economic
growth, same-store-sales growth, ability to execute on store expansion plans, and overall
business performance that are difficult to project and are subject to a high level of
uncertainty and volatility.”).
47
stand-alone.”223 This decision reflected the Board’s pessimism that management
would be able to deliver on their plans and its view that such efforts likely would not
yield more than the $83 per share that had been achieved through the sales process.224
The Board unanimously voted to approve and recommend the Merger with
BC Partners at the conclusion of the December 13 meeting.225 It announced the
transaction and signed the Merger Agreement the following day.226
The $83 per share was $1.50 higher than what the next highest bidder, Apollo,
had offered. Indeed, Apollo told JPM after the process concluded that it “never
would have paid that price” for PetSmart.227 Several financial analysts also were
surprised and impressed by the price achieved in the auction.228 While PetSmart was
covered by more than a dozen securities analysts, the consensus price target for
223
Trial Tr. 440:23–441:2 (Gangwal). See also JX 1336 at 26–27 (proxy statement
summarizing the Board’s reasons for recommending the merger to stockholders).
224
Trial Tr. 439:16–441:9 (Gangwal).
225
JX 1336 at 26.
226
Id.
227
Trial Tr. 908:9 (Aiyengar). I have considered this hearsay testimony only as evidence
of the state of mind of the declarants, not for the truth of the matter asserted. DRE 803(3).
228
JX 1188; JX 1187; JX 1185. In addition to DRE 803(3), these analyst reports are
admissible under DRE 703 as they were relied upon by Professor Metrick in formulating
his opinion and are “of a type” of information “reasonably relied upon by experts” in the
valuation field. They have “help[ed] the [Court] understand [the] expert’s thought process
and determine what weight to give [the] expert’s opinion.” Towerview LLC v. Cox Radio,
Inc., 2013 WL 3316186, at *2 (Del. Ch. June 28, 2013) (applying DRE 703).
48
PetSmart in the year preceding the Merger, even after the PIP was disclosed, never
exceeded $75 per share.229
PetSmart’s definitive proxy statement, filed with the SEC on February 2, 2015
(the “Proxy”), disclosed the Management Projections as well as the JPM
sensitivities.230 When introducing the projections, the Proxy disclosed that the
Company had not historically prepared long-term projections in the ordinary course
of its business and that it was “wary” of doing so.231 The Board wanted stockholders
to have the Management Projections because they had been utilized by the Board,
JPM, and the bidders.232 But the Proxy made clear that the Board was cautioning
stockholders not to place undue reliance on the projections.233 With regard to the
JPM sensitivities, the Proxy disclosed that these had been prepared by JPM “to assist
229
See JX 1703 (Metrick-Rebuttal) at 71. See also JX 1697 (Metrick-Opening) at Ex. 8
(providing monthly summary of analyst price targets for PetSmart stock from January 2012
to March 2015).
230
JX 1336 at 35–36, 38–39.
231
Id. at 37–38.
232
Id. The Proxy “included a summary of [the Management Projections] . . . to give
stockholders access to certain nonpublic information provided to [the PetSmart Board] and
J.P. Morgan for purposes of considering and evaluating the Company’s strategic and
financial alternatives, including the merger.” Id.
233
Id. at 38 (“Readers . . . are cautioned not to place undue reliance on the [projections
found in the Proxy].”). See also Trial Tr. 324:7–15 (Teffner) (“The proxy had disclaimer
statements in there with respect to projections . . . to explain that these are projections” and
therefore speculative.).
49
the board in assessing the potential downside risks that could arise from reasonable
deviations in the assumptions underlying the [Management] Projections.”234
After the announcement of the transaction, and the disclosure of the
Management Projections in the Proxy, no topping bids emerged and no further
inquiries about PetSmart surfaced before the Merger closed.235 The stockholder vote
on March 6, 2015, overwhelmingly favored the Merger; 99.3% of voting shares of
PetSmart voted in favor of the transaction, representing 77.4% of the 99,455,151
outstanding common shares.236 The Merger closed on March 11, 2015.237
L. BC Partners Creates its Plan for PetSmart
As one would expect, BC Partners formulated a plan to turnaround PetSmart
throughout the auction process so it could hit the ground running should it win the
bid. It engaged Michael Massey, the former CEO of Collective Brands, former
President of Payless, Inc. and current director of Office Depot, to provide counsel as
it pursued its goal (as reported to investors) of making a significant retail
234
JX 1336 at 39.
235
See Trial Tr. 926:5–7 (Aiyengar) (“[T]here was nobody who called after the deal was
announced really, other than to say congratulations for getting such a good price.”).
236
PTO ¶¶ 3–4; JX 1496.
237
PTO ¶ 5.
50
acquisition.238 When looking at PetSmart, Massey believed the Company lacked a
clear strategy or understanding of its customers, meaning it was ripe for a
turnaround.239 BC Partners also believed that PetSmart had been “undermanaged,”
but that these management problems had been masked historically by “the strength
of underlying market growth” in the pet specialty industry.240 BC Partners’ strategic
hypothesis was that PetSmart’s performance slowed when the underlying growth
trends in the pet specialty industry slowed. It posited that PetSmart could be revived
with a new management team, headed by Massey, who would implement a series of
new revenue and cost initiatives.241
In performing its due diligence, BC Partners engaged Boston Consulting
Group to speak to PetSmart’s vendors on its behalf.242 It also spoke directly to
several former PetSmart executives and consultants.243 With this information in
hand, BC Partners was confident that the Management Projections were not
238
See JX 779; JX 931.
239
JX 779; Trial Tr. 1011:6–23 (Massey).
240
JX 1060 at BC00105547.
241
JX 1060 at BC00105547–49, 560, 617–21; Trial Tr. 739:9–742:1 (Svider).
242
Trial. Tr. 833:15–838:16 (Svider).
243
Trial Tr. 827:4–833:4, 838:21–841:2 (Svider).
51
achievable, at least not with PetSmart’s current management in place.244 Therefore,
when evaluating PetSmart, BC Partners developed its own “BCP Case.”245 The BCP
Case projected lower total revenues, year-over-year total sales growth and fewer new
store openings from 2014 to 2019.246 These projections were included in the equity
syndication memo that BC Partners sent to potential investors.247 BC Partners told
its potential investors that its case was conservative, with room for significant
upside.248
Massey also created his own set of projections based on his plans for running
PetSmart (the “Massey Case”), which included the implementation of his proposed
cost and revenue initiatives which he hoped would help drive up EBITDA.249
Massey told BC Partners’ equity investors that these projections were conservative
and that he was very confident they could be achieved.250 The projected cash flows
244
Trial Tr. 746:9–15 (Svider).
245
Id.
246
Compare JX 1060 at BC0010552 with JX 807 at PETS_APP00000692–94.
247
JX 1065 at 80.
248
JX 1065 at 83.
249
JX 1060 at BC00105546; JX 1132; Trial Tr. 739:9–740:11 (Svider).
250
JX 1238 at 29, 48; Trial Tr. 1125:8–1127:23 (Massey).
52
from the Massey Case were higher than those in the Management Projections by
$192 million.251
BC Partners also prepared the “Bank Case” with the help of PetSmart’s
management after the signing of the Merger Agreement252 in order to solicit debt
financing for the transaction253 and present to ratings agencies so they could rate the
bonds BC Partners would issue in connection with the transaction.254 The Bank Case
was designed to be conservative; it assumed, for instance, that PetSmart would have
no new store openings in later years.255
M. PetSmart’s Performance in the Period Leading Up To The Stockholder
Vote and Post-Closing
Beginning in December of 2014, preliminary estimates suggested that
PetSmart was outperforming the forecasts in the Management Projections for items
such as comparable store sales, comparable transactions and earnings per share.256
251
Trial Tr. 526:14–19 (Dages).
252
PTO ¶ 309; Trial Tr. 360:22–361:15 (Teffner).
253
PTO ¶ 311; Trial Tr. 362:9–16 (Teffner).
254
PTO ¶ 309; Trial Tr. 363:17–20 (Teffner). “Bank Case” is a term of art in the LBO
industry to describe projections meant to reflect a company’s post-acquisition capacity to
service its debt. They are heavy on cash flows and light on growth. Trial Tr. 692:3–15
(Dages).
255
Trial Tr. 639:2–8 (Dages); Trial Tr. 373:14–18 (Teffner).
256
JX 1280; JX 1411 at 17.
53
When PetSmart released its Q4 2014 results on March 4, 2015––seven days before
the close of the transaction––it revealed that its operating income EBIT beat its
projections by 5.4%.257 PetSmart also adjusted its non-GAAP adjusted diluted
earnings per share estimate up to $1.43, exceeding its guidance and the $1.28 per
share achieved for the prior year period.258 PetSmart’s comparable store sales grew
from -.05% in Q2 2014, to flat in Q3 2014, to +2.6% in Q4 2014.259 Revenue
similarly grew from 1.4% in Q2 2014, to 2.6% in Q3 2014, to 6% in Q4 2014.260
The Merger Agreement was signed in the middle of Q4 2014, and Lenhardt,
Teffner and Gangwal all testified that PetSmart’s favorable Q4 performance did not
change their views about the long-term prospects of the Company.261 Indeed, in
Q1 2015 (the quarter in which the Merger closed), PetSmart’s comparable store sales
growth dropped to 1.7%,262 and remained below 2% throughout 2015.263
257
JX 1350 at 12.
258
JX 1447; Trial Tr. 1385:21–23 (Metrick).
259
JX 630; JX 983; JX 1476.
260
Id.
261
Trial Tr. 272:18–274:19 (Teffner); Trial Tr. 447:4–11 (Gangwal); JX 1684 (Lenhardt
Dep.) 63:10–65:19, 331:21–332:25.
262
JX 1598 at PETS_APP00842050.
263
Id.; JX 1619 at PETS_APP00820988; JX 1656 at PETS_APP00821452. See also Trial
Tr. 1057:6–9 (Massey).
54
After the closing of the Merger, Lenhardt resigned and Massey became
PetSmart’s new President and CEO.264 Massey quickly installed a new management
team, changed PetSmart’s organizational structure and created a new strategy for
PetSmart based on his own revenue and cost initiatives.265 While Massey used the
Management Projections solely for purposes of management compensation,266 his
team created a new set of multi-year projections in July 2015.267
In 2015, PetSmart achieved $7.2 billion in total sales and $982.1 million in
EBITDA.268 PetSmart’s comparable store sales growth, however, came in at 0.9%,
missing the projected 1.5% growth forecast in the Management Projections by
264
JX 1508.
265
Trial Tr. 741:19–742:19 (Svider); Trial Tr. 1051:15–1055:13 (Massey). These new
initiatives were informed by updated reports from PetSmart’s consultants who identified
for Massey additional savings they believed could be achieved. See Trial Tr. 348:16–350:6
(Teffner); JX 2022 at 5; JX 1286 at 18; PTO ¶ 388–393. See also JX 1286 at 7; Trial Tr.
342:24–346:16 (Teffner); JX 1684 (Lenhardt Dep.) 324:14–23.
266
Trial Tr. 750:2–5, 750:14–22 (Svider).
267
JX 1590 at PETS_APP00821375.
268
JX 1656 at PETS_APP00821450–51, 57. I appreciate that PetSmart’s post-closing
performance is not relevant when assessing the Company’s operational reality at the point
of valuation––the date the merger closed. Cede & Co. v. Technicolor, Inc., 758 A.2d 485,
499 (Del. 2000). Petitioners argue, however, that PetSmart’s post-closing performance is
probative of the reliability of the management projections. I have considered this post-
merger evidence for this limited purpose. See id. (holding that a court may consider post-
merger evidence to the extent it relates to the validity of projections prepared prior to the
merger).
55
40%.269 According to Massey, in 2016 year-to-date, the comparable store sales
growth was -0.2%, in comparison to the projected growth in the Management
Projections.270 The Company’s EBITDA, however, exceeded the 2015 Management
Projections by $200 million by the end of FY 2015.271 In February 2016, PetSmart
was able to issue a dividend of $800 million which constituted a 38% return on
invested capital.272
N. Procedural Posture
Petitioners seek appraisal for 10,713,225 shares of common stock of
PetSmart, 9,541,372 of which were acquired after the record date of the Merger.273
Six appraisal petitions were filed on March 12 and 13, 2015, and all were
consolidated by order dated April 30, 2015.274 A trial was held October 31 to
November 3, 2016. I heard post-trial oral argument on February 28, 2017, following
post-trial briefing.
269
Id.
270
Trial Tr. 1057:6–9 (Massey).
271
Trial Tr. 1119:16–20 (Massey); JX 1643 at 4; JX 1637 at 2.
272
JX 1637 at 2; PTO ¶ 352; JX 1627 at 6.
273
PTO ¶¶ 15–16, 18, 24–29, 31, 36–43, 45, 51, 53, 60–61, 63, 69–71.
274
PTO ¶¶ 6–7.
56
Petitioners and Respondent both presented two experts at trial: one to address
the reliability of the Management Projections and the other to address the fair value
of PetSmart at the time of the Merger. I summarize their opinions briefly below.
1. The “Projections” Experts
Mark A. Cohen served as Petitioners’ retail expert.275 He focused on the
credibility of the Management Projections and the outlook of PetSmart’s business
going forward.276 Based on his analysis of the pet retail industry and PetSmart’s
prior performance, Cohen believes that PetSmart hit a “speed bump” just prior to the
initiation of the sales process from which the Company would have rebounded.
According to Cohen, PetSmart was not facing long-term growth issues.277 He also
opined that the Management Projections were created in line with industry standards
and were reliable estimates of the Company’s future cash flows.278
275
JX 1692 (Cohen-Opening) at 1–3, App. 8–9.
276
Cohen holds a B.S. in Electrical Engineering as well as a M.B.A. from Columbia
University. He has an extensive history working in the retail industry, having worked for
Abraham & Strauss, Gap Stores, Lord & Taylor, Mervyns Stores, Federated Department
Stores, Bradlees Inc. and Sears Roebuck & Co. He served as Chairman and CEO of Sears
Canada Inc. from 2001 to 2004. Since 2005, he has served as the Director of Retail Studies
and Adjunct Professor of Retailing at Columbia University’s Business School, maintains
an independent consulting practice, and serves as a contributor for several news outlets.
JX 1692 (Cohen-Opening) at 1–3.
277
See JX 1692 (Cohen-Opening) at 28, 30, 33, 35–37.
278
Id. at 38 (“PetSmart’s 5-year financial projections were reasonably and reliably prepared
in a manner consistent with industry standards.”).
57
Mark Weinsten was retained by Respondent to provide an expert opinion on
the Management Projections and related business plans created by the PetSmart
management during the sales process.279 Weinstein opined that the Management
Projections were overly aggressive, overly optimistic and wholly unreliable.280 In
support of this opinion, he pointed to the facts that PetSmart’s management was
newly installed when they were directed to create the projections, they had no
experience in creating long-term projections of future cash flows and they could not
look to past examples of projections within PetSmart for guidance since PetSmart
historically did not create long-term projections.281 In those instances where
management attempted to forecast future performance, even for quarterly forecasts,
the Company regularly would underperform.282
279
Weinsten holds a B.S. in economics from Carnegie-Mellon University and an M.B.A.
from the Wharton School at the University of Pennsylvania. He is a Managing Director in
the Corporate Finance Group at Berkeley Research Group, a global strategic advisory firm.
His practice focuses on turnarounds and restructurings, and he specializes in serving in
interim executive positions during transition phases. Prior to joining Berkeley Research
Group, Weinsten served as Senior Managing Director in the Corporate Finance &
Restructuring practice of FTI Consulting, Inc. JX 2307 (Weinsten-Opening) at 1–6,
App. A.
280
See id. at 6–7.
281
Id.
282
Id. at 42 (“Starting in 2013 through first half of 2014, Management had underperformed
its quarterly forecasts––even short-term forecasts). See also id. at 43, Ex. 15.
58
According to Weinsten, the Management Projections were all the more
sketchy given that they were prepared largely as top down forecasts, an approach
not consistent with industry best practices, and were prepared specifically for a sales
process with Board pressure to be more and more aggressive.283 He also found
specific areas of concern regarding the achievability of the forecasts, which included
the comparable store sales growth projections and the ability of management
successfully to execute on its overall business plans.284
2. The Valuation Experts
Petitioners’ valuation expert was Kevin Dages.285 Dages determined that a
DCF analysis based on the Management Projections is the most reliable indicator of
283
Id. “Top down is driven by management and starts with overarching goals, such as 3%
revenue growth and 10% gross margin expansion, which are then pushed down to targets
and quotas that are assigned down to employees. Bottoms up planning starts with teams
of employees who develop plans for initiatives to improve the business, which are then
passed on to management for review and approval and the aggregate result of all initiatives
drives the overall company goals and targets. . . . [B]ottoms up planning typically yields
more realistic and reliable results as it involves detailed planning by the people who will
be responsible for executing on the initiatives.” Id. at 45.
284
Id. at 53 (“[I]t would have been difficult for Management to achieve the turnaround in
comparable store sales growth reflected in the [Management Projections.]”); id. at 84 (“The
ability to execute a plan hinges upon three critical components—people, processes and
tools. At the time of development of the [Management Projections], PetSmart faced
challenges with respect to all three components.”).
285
Dages is well-known to this Court. He holds a B.B.A. in accounting from the University
of Notre Dame and is a Certified Public Accountant. He is an Executive Vice President of
Compass Lexecon, a consulting firm specializing in the application of economics to legal
and regulatory issues. JX 1698 (Dages-Opening) at 1.
59
the fair value of the Company. Based on his DCF analysis, Dages concluded that
the fair value of PetSmart’s common stock as of the date of the Merger was $128.78
per share.286 Dages relied upon the Management Projections in all respects for his
DCF analysis based upon Cohen’s opinion that the projections “were reasonably and
reliably prepared in a manner consistent with industry standards,” as well as his own
opinion that the Management Projections “represent the most reasonable set of
projections [available] as to PetSmart’s future performance.”287 Dages also
acknowledged, however, that “once [he] signed onto the opinion of where the fair
value is . . . based on these projections,” he was, “at the end of the day,” tied to the
projections.288 On the other hand, Dages recognized that if the Court finds that the
Management Projections are not reliable, then it should not rely on his DCF
286
In his DCF analysis, Dages used a perpetual growth rate of 2.25%, a WACC of 7.75%
and a required investment in the terminal period of $47 million. JX 1698 (Dages-Opening)
at 32–33; JX 1704 (Dages-Rebuttal) at Ex. 6D.
287
JX 1698 (Dages-Opening) at 25–26. Dages noted, however, that “I’m not a retail guy
so I didn’t start with this is absolutely the right set of projections to go with, because I—
you know, that’s not my expertise.” JX 1712 (Dages Dep.) 157:6–11.
288
JX 1712 (Dages Dep.) 155:20–157:22 (Dages further explained that the Management
Projections were “the best set of projections for me to start with and to examine
sensitivities, and to then . . . reach an opinion about fair value, and since the opinion on fair
value is based on this set of projections, then yes, I believe I’m wed to [the] answer [that
the Management Projections are the best estimate of PetSmart’s future performance]. . . .
If my opinion was based on the 80 percent PIP scenario, then I think I would be telling you
that the 80 percent PIP scenario is the best estimate of performance.”).
60
valuation because that analysis assumed the accuracy of those projections.289 Stated
differently, “[g]arbage in, garbage out.”290
Dages performed a WACC-based DCF analysis in which he discounted the
Company’s free cash flows back to present value using the Company’s weighted
average cost of capital and then subtracted the value of the Company’s debt to
determine the value of its equity.291 He also ran the BCP Case, Massey Case and
Bank Case through his DCF model—which, notably, all produced higher values than
the DCF based on the Management Projections.292 In Petitioners’ rebuttal case at
trial, Dages presented a new DCF analysis he ran during trial based on the JPM
sensitivities.293 This exercise yielded a value ranging from $102.82 to $112.90 per
share.294
289
Trial T7r. 624:14–19 (Dages).
290
Trial Tr. 624:6–13 (Dages).
291
JX 1697 (Metrick-Opening) at 107.
292
See Trial Tr. 554:6–556:21 (Dages). Using the BCP Case, Dages came up with a value
of $137.00 per share. Pet’rs’ DX1 at 66. With the Massey Case, Dages arrived at a value
of $138.87 per share. Id. The Bank Case produced a value of $138.04 per share. Id.
293
Trial Tr. 1412:9–17 (Dages).
294
Trial Tr. 1413:7–1420:12 (Dages); Pet’rs’ DX2 at 1; Pet’rs’ DX3 at 1; Pet’rs’ DX4 at 1.
61
Dages rejected the $83 per share deal price as a reliable indicator of fair value
for three main reasons.295 First, he believed the Merger Price was stale due to the
three-month lag between the signing and closing of the deal.296 Second, he believed
“the Board did not receive accurate or reliable valuation advice from J.P. Morgan”
because JPM’s DCF analysis was “results-driven” and biased.297 Finally, he found
that the Merger Price was depressed due to the exclusion of Petco, the most logical
strategic buyer, from the PetSmart auction, resulting in the participation of only
financial bidders.298
Respondent’s valuation expert was Andrew Metrick.299 According to
Metrick, the Merger Price of $83 per share, achieved after a well-run active auction,
is the most reliable indicator of PetSmart’s fair value at the time of the Merger.300
While he acknowledged that DCF is considered by many to be the “gold standard”
295
See JX 1704 (Dages-Rebuttal) at 3.
296
Id. at 6.
297
Id. at 10.
298
Id. at 14–23.
299
Metrick is also no stranger to this Court. He holds a Ph.D. and A.M. from Harvard
University and a M.A. and B.A. from Yale University. He is currently the Michael H.
Jordan Professor of Finance and Management at the Yale School of Management. Prior to
that, he was on the faculty at the Wharton School at the University of Pennsylvania and at
Harvard University, and served as Senior Economist and Chief Economist for the Council
of Economic Advisers in Washington, D.C. JX 1697 (Metrick-Opening) at 2.
300
Trial Tr. 1244:14–1245:23 (Metrick).
62
of valuation tools, Metrick found that DCF was misleading here since the primary
data input, the Management Projections, were entirely unreliable.301 He explained
that, for the purposes of a DCF analysis, “one must use the ‘expected’ (as opposed
to ‘hoped for’) future cash flows of the business.”302 Based on his review of the
evidence, Metrick opined that the Management Projections were unreliable because
they were prepared specifically for the sale process (not in the ordinary course of
business) by inexperienced management who were pushed to be overly optimistic.303
Nevertheless, for the sake of completeness, Metrick did perform a DCF
analysis, but not with the Management Projections. Instead, he utilized his own
adjustments to the revenue forecasts, starting with the JPM sensitivities.304 He did
not believe that PetSmart could achieve the $200 million in cost savings from the
PIP indefinitely into the future, as projected by management, so he adjusted the
projected PIP savings to decline linearly beginning three years after the savings are
assumed to be fully realized, with only $59 million remaining in the terminal
period.305
301
Trial Tr. 1241:3–17, 1244:14–1245:8 (Metrick).
302
JX 1697 (Metrick-Opening) at 60.
303
Id. at 101–02.
304
Id. at 102.
305
Id. at 103.
63
After adjusting the Management Projections, Metrick created an APV-based
DCF model that discounts the Company’s free cash flows by the Company’s
unlevered cost of equity, adds the benefits of a tax shield obtained from the
Company’s debt, and then subtracts the value of the debt to determine the
Company’s equity value.306 Metrick’s DCF analysis resulted in a fair value of
$81.44 per share. According to Metrick, his DCF valuation simply corroborates the
most reliable indicator of PetSmart’s fair value—the $83 per share Merger Price that
followed a “deal process where (1) the sale [was] well publicized, (2) there [were]
multiple bidders and a large number of interested parties, and (3) the incentives of
the Board and management [were] aligned with those of the stockholders.”307
Metrick asserts that his opinion regarding the fair value of PetSmart at the
Merger Price is bolstered by the following confirmatory analyses: (1) his DCF
analysis resulting in a value of $81.44 per share; (2) the fact that “[a]t no point prior
to PetSmart’s acquisition did its shares trade at or above $83 per share”; (3) the fact
that “[a]t no point prior to the consummation of the transaction did analysts’ average
price target of PetSmart exceed $83 per share”; (4) a “valuation of PetSmart based
on the trading multiples of comparable companies ranges from $70 to $112, with a
306
Id. at 107–08. In his DCF analysis, Metrick used a 2% terminal growth rate, a WACC
of 6.35% and a required investment in the terminal period of $222 million. Id. at 117–18,
Ex. 21, Ex. 23.
307
Id. at 142.
64
value below $91 (the median) [being] more appropriate based on PetSmart’s
operating metrics relative to the peers”; (5) a “valuation of PetSmart based on the
recent acquisition of Petco is $69”; and (6) a “valuation of PetSmart based on prior
transactions involving retailers ranges from $59 to $74.”308
After trial, Metrick submitted a supplemental report to respond to Dages’s
DCF analysis based on the JPM sensitivities.309 He determined that Dages’s
valuations corresponding to the sensitivities “are inflated significantly due to (i) an
assumption that PetSmart has no fixed costs, meaning margins are unchanged as
revenue declines in moving from the [Management Projections] to [the JPM
sensitivities], and (ii) [the] failure to adjust the discount rate to reflect the lease
treatment embedded in the cash flows.”310 Correcting for these errors, Metrick
derived valuations from the JPM sensitivities ranging from $82.79 to $86.96.311
The driving difference in the valuations produced by Dages and Metrick can
be traced most directly to the different projections of expected cash flows on which
they rely.312 Unlike many appraisal cases litigated in this court, the inputs utilized
308
Id.
309
JX 2315 (Metrick-Supplemental).
310
Id. at 2.
311
Id.
312
See Trial Tr. 1272:2–5 (Metrick) (“In this particular case, Mr. Dages and I approached
it in a broadly similar way and ended up with discount rates that were fairly similar.”);
65
by the valuation experts involved here are relatively close. But there are differences.
Metrick capitalized all of PetSmart’s current leases, 313 while Dages maintained the
characterization of the leases from PetSmart’s financial statements.314 The experts
agreed, however, that as long as the leases are treated consistently throughout the
valuation analysis, the manner in which the leases are characterized should not affect
the valuation substantially.315 The other large difference between the two models is
the terminal investment required.316 Metrick used a model out of a McKinsey & Co.
JX 1704 (Dages-Rebuttal) at 4 (“Assuming the Court agrees that PetSmart’s Management
Projections are the appropriate basis for a fair value calculation, the range of expert
opinions of fair value based on a DCF analysis would be $128.78 to $133.94 per share,
with the $133.84 per share DCF value resulting from Professor Metrick’s WACC and
terminal period growth assumptions and the lower $128.78 per share DCF value coming
from [Dages’s] analysis.”); JX 2028 (Metrick Dep.) 639:11–14 (“Q. But if I put the
[Management Projections] through your model and his model, if we use the same models,
we are going to come very, very close; correct? A. That is correct.”). See also JX 1704
(Dages-Rebuttal) at 23 (“The heart of any free cash flow-based valuation analysis—either
a WACC-based DCF or an APV-based DCF model – is the underlying financial forecast.”).
I note that while Dages uses a WACC-based DCF and Metrick uses an APV-based DCF,
if the analyses are performed correctly, both models should yield substantially the same
result. Trial Tr. 1274:9–15 (Metrick); JX 1704 (Dages-Rebuttal) at App. A ¶ 1. The two
experts are also “in general agreement regarding the appropriate levered beta,” though
Dages derives his beta estimate from PetSmart’s historical data and peer betas while
Metrick combined the historical beta for PetSmart with an industry average. JX 1703
(Metrick-Rebuttal) at 34.
313
Trial Tr. 1303:8–1304:3 (Metrick); Trial Tr. 636:6–15 (Dages).
314
Trial Tr. 1371:24–1372:5 (Metrick); Trial Tr. 636:6–15 (Dages).
315
See JX 2028 (Metrick Dep.) 639:5–10.
316
See Trial Tr. 1302:16–20 (Metrick) (“But that essentially—this boils down the
difference. On the DCF, we have a lot of things that are the same, but ultimately we
66
textbook to calculate the amount of investment necessary at the terminal period to
support the projected growth during the terminal period, arriving at an investment
rate of 28.6% in the terminal period.317 This results in a required investment of $222
million.318 Dages adopted the required terminal investment found in the
Management Projections of $47 million.319
II. ANALYSIS
Petitioners and Respondent present two vastly different valuations of
PetSmart as of the date of the Merger based on two binary views of the most reliable
means by which to determine fair value––deal price versus a discounted cash flow
analysis. The vast delta between the valuations generated by the parties’ proffered
methodologies raises red flags and suggests, perhaps, that neither is truly reflective
of PetSmart’s fair value. As the Court undertakes to discharge its duty (or burden)
independently to determine fair value, therefore, the temptation to strike a balance
between the competing positions is undeniable. The $4.5 billion that separates the
parties certainly leaves much room for compromise. But the unique structure of the
disagree about what the right model is for this company in the long-run and what will
happen to their returns.”).
317
Trial Tr. 1305:20–1307:21 (Metrick).
318
Trial Tr. 1367:15–1369:4 (Metrick).
319
Trial Tr. 572:22–574:10 (Dages); JX 1704 (Dages-Rebuttal) at Ex. 6D.
67
appraisal proceeding should not obscure the reality that the process is adversarial;
the parties have presented evidence; and the Court’s fact-finding and decision-
making must be evidence based. Nor should the Court jump to the conclusion that
both parties’ valuations are off the mark simply because their positions on fair value
are so incredibly divergent. Rather, the Court’s first task, as I see it, is to drill down
on the parties’ positions to see if they are grounded in the evidence and in sound
methodology. That assessment will take the Court a long way down the road of
fulfilling its function to appraise the fair value of the shares of PetSmart. Only then
can the Court discern the extent to which further valuation analyses may be required.
A proper examination of the parties’ competing positions reduces to the
following questions: (1) was the transactional process leading to the Merger fair,
well-functioning and free of structural impediments to achieving fair value for the
Company; (2) are the requisite foundations for the proper performance of a DCF
analysis sufficiently reliable to produce a trustworthy indicator of fair value; and
(3) is there an evidentiary basis in the trial record for the Court to depart from the
two proffered methodologies for determining fair value by constructing its own
valuation structure? I take up these questions below. But first I address the statutory
framework within which the Court must operate.
68
A. The Legal Standard for Appraisal
This action for appraisal is governed by the Delaware appraisal statute, which
directs that the Court
Appraise the shares, determining their fair value exclusive of any
element of value arising from the accomplishment or expectation of the
merger or consolidation, together with a fair rate of interest, if any, to
be paid upon the amount determined to be the fair value. In determining
such fair value, the Court shall take into account all relevant factors.320
The purpose of an appraisal action is to “provide equitable relief for shareholders
dissenting from a merger on grounds of inadequacy of the offering price.”321 The
court’s prescribed task is to determine the fair value of the dissenters’ shareholdings
as of the date of the merger.322
Appraisal is not subject to “structured and mechanistic procedure.”323 It is
“by design, a flexible process.”324 Accordingly, there are no presumptions in
320
8 Del. C. § 262(h).
321
Cede & Co. v. Technicolor, Inc., 684 A.2d 289, 296 (Del. 1996).
322
Id.
323
Weinberger v. UOP, Inc., 457 A.2d 701, 713 (Del. 1983).
324
Golden Telecom, Inc. v. Global GT LP, 11 A.3d 214, 218 (Del. 2010) (declining to
adopt a rule requiring this Court to defer to the deal price in appraisal proceedings). See
also id. (reiterating that appraisal is designed to be a flexible process and “declin[ing] to
adopt a rule that binds public companies to previously prepared company specific data in
appraisal proceedings,” noting that the statute provides this Court with “significant
discretion”).
69
Delaware appraisal law that favor one valuation approach over another.325 Instead,
the fair value determination, by statutory design and mandate, must take into account
“all relevant factors.”326 Every company is different; every merger is different.327
These differences are enriched with “relevant factors” that must be accounted for in
the search for fair value.
In the unique design of statutory appraisal, “[b]oth parties ‘have the burden of
proving their respective valuation positions by a preponderance of the evidence.’”328
325
See Union Ill. 1995 Inv. Ltd. P’ship v. Union Fin. Gp., Ltd., 847 A.2d 340, 356–57 (Del.
Ch. 2003) (“As I perceive it, I am free to consider all non-speculative elements of value,
provided that I honor the fair value definition articulated by the Delaware Supreme Court.
. . . I am empowered to come up with a valuation, drawing on what I reasonably conclude
is the most reliable evidence of value in the record.”).
326
8 Del. C. § 262(h).
327
See Merion Capital L.P. v. Lender Processing Servs., Inc., 2016 WL 7324170, at *16
(Del. Ch. Dec. 16, 2016) (recognizing that “[t]he relevant factors can vary from case to
case depending on the nature of the company, the overarching market dynamics, and the
areas on which the parties focus. . . . An argument may carry the day in a particular case
if counsel advance it skillfully and present persuasive evidence to support it. The same
argument may not prevail in another case if the proponents fail to generate a similarly
persuasive level of probative evidence or if the opponents respond effectively.”).
328
Highfields Capital, Ltd. v. AXA Fin., Inc., 939 A.2d 34, 42 (Del. Ch. 2007) (quoting
M.G. Bancorp., Inc. v. Le Beau, 737 A.2d 513, 520 (Del. 1999)). See also Lender
Processing, 2016 WL 7324170, at *12 (“Each party also bears the burden of proving the
constituent elements of its valuation position by a preponderance of the evidence, including
the propriety of a particular method, modification, discount, or premium. If both parties
fail to meet the preponderance standard on the ultimate question of fair value, the Court is
required under the statute to make its own determination.”) (quoting Jesse A. Finkelstein
& John D. Hendershot, Appraisal Rights in Mergers & Consolidations, 38–5th C.P.S.
§§ IV(H)(3), at A-89 to A-90 (BNA)).
70
If neither party carries this burden, however, “the court must then use its own
independent judgment to determine fair value.”329
B. Did the Auction for PetSmart Yield Fair Value?
“The concept of fair value under Delaware law is not equivalent to the
economic concept of fair market value.”330 It is, rather, “a jurisprudential concept
that draws more from judicial writings than from the appraisal statute itself.”331 The
focus of the fair value calculation is on “the value of the company as a going concern,
rather than its value to a third party as an acquisition.”332 Even so, in certain cases,
based on the evidence presented, the fair market value for a company may be the
best and most reliable indicator of fair value.333 But this will only be so where the
evidence reveals a market value “forged in the crucible of objective market
329
Taylor v. American Specialty Retailing Gp., Inc., 2003 WL 21753752, at *2 (Del. Ch.
July 25, 2003).
330
Lender Processing, 2016 WL 7324170, at *13 (quoting Finkelstein, 2005 WL 1074364,
at *12).
331
Del. Open MRI Radiology Assoc., P.A. v. Kessler, 898 A.2d 290, 310 (Del. Ch. 2006).
332
M.P.M. Enters., Inc. v. Gilbert, 731 A.2d 790, 795 (Del. 1999).
333
See, e.g., Lender Processing, 2016 WL 7324170, at *33; Merion Capital LP v. BMC
Software, Inc., 2015 WL 6164771, at *18 (Del. Ch. Oct. 21, 2015); LongPath Capital, LLC
v. Ramtron Intern. Corp., 2015 WL 4540443, at *24 (Del. Ch. June 30, 2015); Merlin P’rs
LP v. AutoInfo, Inc., 2015 WL 2069417, at *11 (Del. Ch. Apr. 30, 2015); Ancestry.com,
2015 WL 399726, at *24; Huff Fund Inv. P’ship v. CKx, Inc., 2013 WL 5878807, at *15
(Del. Ch. Nov. 1, 2013), aff’d, 2015 WL 631586 (Del. Feb. 12, 2015) (TABLE); Union
Ill., 847 A.2d at 364.
71
reality,”334 meaning that it was the “the product of not only a fair sales process, but
also of a well-functioning market.”335
After years of striving for it, Vince Lombardi finally arrived at the
understanding that perfection in human endeavors is not attainable.336 Even in the
best case, a process to facilitate the sale of a company, constructed as it must be by
the humans that manage the company and their human advisors, will not be
perfect.337 For the reasons I explain below, I am satisfied that the process employed
to facilitate the sale of PetSmart, while not perfect, came close enough to perfection
to produce a reliable indicator of PetSmart’s fair value.338
334
Unimation, Inc., 1991 WL 29303, at *17.
335
DFC, 2016 WL 3753123, at *21. See also Lender Processing, 2016 WL 7324170, at
*16 (collecting cases).
336
Chuck Carlson, Game of My Life: 25 Stories of Packer Football (Sports Pub. 2004)
(quoting Coach Lombardi as opening his first Packers team meeting in 1959, after twenty
years of coaching, by saying: “Gentleman, we are going to relentlessly chase perfection,
knowing full well we will not catch it, because nothing is perfect”).
337
See AutoInfo, 2015 WL 2069417, at *14 (observing that no “real-world sales process”
will live up to “a perfect, theoretical model”).
338
Lender Processing identifies a number of structural factors that may be relevant when
determining whether the merger consideration was a reliable indicator of the company’s
fair value including “meaningful competition among multiple bidders during the pre-
signing phase,” the availability of “adequate and reliable information” to participants in the
auction, the “absence of any explicit or implicit collusion,” and “the lack of a topping bid.”
2016 WL 7324170, at *16–26. Of course, the court also recognized that the relevant
considerations will be deal and company specific and that the court’s focus will be
sharpened by the arguments offered by counsel. Id. at *16. My analysis of the reliability
72
With guidance from Morgan Stanley, PetSmart’s Board began the process of
exploring strategic alternatives because the Company’s “stock had taken [a] very
significant decline from historical levels,” the Company “was unhappy,” and
“[s]hareholders were speaking up. . . .”339 When the Board ultimately decided to
pursue a sale, it engaged another reputable investment bank, JPM, and created an Ad
Hoc Committee of experienced independent directors to oversee the process. From
the outset, the Board’s orientation was to view a sale of the Company not as an
inevitable outcome, but rather as one of several strategic alternatives that also
included remaining standalone while pursuing new revenue and cost saving
initiatives or pursuing a significant leveraged recapitalization.340 If the price
achieved in the auction was unsatisfactory, the Board was prepared to walk away
from that process and pursue other alternatives.341 And if the more active among the
Company’s stockholders were unhappy with the decision the Board ultimately made,
the Board was ready to deal with the consequences of that reaction, including to take
of deal price as a product of the efficacy of the sales process necessarily has been shaped
by the arguments of counsel and the evidence they chose to present at trial.
339
Trial Tr. 398:22–399:7 (Gangwal).
340
JX 337; JX 339; Trial Tr. 400:7–16 (Gangwal).
341
Trial Tr. 427:7–430:12, 439:11 (Gangwal).
73
on a proxy fight if necessary.342 It was in this environment that the auction for
PetSmart was conducted.
In August of 2014, PetSmart announced to the world that it was pursuing
strategic alternatives including a sale, so the whole universe of potential bidders was
put on notice.343 The Board did not rush the sale; it did not receive final bids and
make its final decision to sell the Company until December 2014. By the time the
gavel fell, JPM had contacted 27 potential bidders, including the three potential
strategic partners it considered most likely to be interested in acquiring PetSmart’s
niche business. In this regard, I note that the Board considered inviting the most
likely strategic partner, Petco, into the process, but made the reasoned decision that,
without a firm indication of interest from Petco, the risks of providing PetSmart’s
most direct competitor with unfettered access to PetSmart’s well-stocked data room
outweighed any potential reward. Nevertheless, the evidence revealed that the
Board held the door open for Petco to join the auction if it expressed serious interest
in making a bid. It never did.
Fifteen parties signed nondisclosure agreements and engaged in due diligence.
PetSmart management made in-person presentations to thirteen suitors. Thereafter,
342
See Trial Tr. 405:8–406:2 (Gangwal).
343
Trial Tr. 418:24–419:8 (Gangwal). See also PTO ¶ 219.
74
JPM received indications of interest from five bid groups. Two of those bidders
joined forces so that three bid groups proceeded into the next round of bidding.
Those three bid groups then engaged in further due diligence, receiving constant
updates regarding PetSmart’s financials and operations (including the progress of
the PIP) and further presentations from PetSmart management.344 There was no
credible evidence presented that management, the Ad Hoc Committee, the Board or
JPM colluded with or otherwise favored any bidder during the entirety of the
process.345
When JPM directed the final-round bidders to submit “their best and final”
offers, KKR/CD&R advised JPM they could not offer more than PetSmart’s then-
current trading price of approximately $78 per share.346 Apollo then submitted a
final bid of $81.50 per share. BC Partners submitted a bid of $83 per share, after
JPM prodded it to bid against its own initial final bid of $82.50 per share.
BC Partners’ offer of $83 per share was higher than PetSmart stock had ever traded
and reflected a premium of 39% over its unaffected stock price. With this bid in
hand, the Board met on December 13, 2014, and carefully considered its strategic
344
JX 984; JX 910 at PETS_APP00177993; JX 936; JX 934; JX 1200.
345
See Global GT LP v. Golden Telecom, Inc. (Golden Telecom I), 993 A.2d 497, 507
(Del. Ch.), aff’d, 11 A.3d 214 (Del. 2010) (“an arms-length merger price resulting from an
effective market check is entitled to great weight in an appraisal.”).
346
Trial Tr. 907:5–12 (Aiyengar).
75
options with the assistance of its financial and legal advisors. Only after engaging
in an analysis of all options did the Board conclude that accepting the $83 per share
offer provided the best opportunity to maximize value for PetSmart stockholders.347
The Proxy issued by PetSmart in advance of the stockholder vote on the
Merger included the Management Projections. Even though the Board cautioned
stockholders against relying too heavily upon these projections,348 they were there
nonetheless for any stockholder to run its own DCF analysis, just as Petitioners have
done.349 PetSmart also announced its Q4 2014 results which revealed at least some
positive recent trends in PetSmart’s performance. Despite these disclosures,
between the announcement that BC Partners would acquire PetSmart and the
closing, no topping bidder stepped forward. When the time came to vote, PetSmart’s
fully-informed stockholders overwhelmingly approved the Merger.
In the wake of this well-constructed and fairly implemented auction process,
Petitioners are left to nitpick at the details and to invent certain prevailing market
dynamics that they now claim acted as impediments to PetSmart realizing fair value
in the Merger. Specifically, Petitioners point to the following confounders that
347
Trial Tr. 439:11 (Gangwal) (The Board, in determining whether to accept BC Partners’
offer of $83 per share “[was] looking at greater value if [it] could [get it].”). See also Trial
Tr. 439:4–441:9 (Gangwal).
348
JX 1336 at 38; Trial Tr. 324:7–15 (Teffner).
349
See Pet’rs’ Post-Trial Br. 53–54.
76
render deal price unreliable in this case: (1) restrictions on financing impeded the
ability of bidders to bid as much as they might have otherwise been willing to pay;
(2) the lack of strategic bidders left PetSmart at the mercy of financial sponsors and
their “LBO models”; (3) PetSmart was forced into the sales process at a low point
in its performance by the agitations of JANA; (4) the Board was ill-informed,
(5) JPM was conflicted; and (6) the transaction price was stale by the valuation date.
I address each in turn.
First, as for the contention that a seized credit market restricted the bids, the
credible evidence says otherwise. While JPM had concerns in the late fall of 2014
that the credit markets may not allow the private equity bidders to attain the
financing necessary to fully fund their bids, these concerns abated soon after
Thanksgiving and prior to the submission of final bids. The record is devoid of any
evidence that unavailable credit actually affected the amount any bidder was willing
to offer for PetSmart. Both Aiyengar and Svider confirmed that in their testimony
and I believe them.350
Second, while it is true that only financial sponsors submitted bids for the
Company, the evidence is clear that JPM made every effort to entice potential
strategic bidders and none were interested. Indeed, the Board would have been
350
Trial Tr. 755:6–757:6 (Svider); Trial Tr. 917:4–918:10 (Aiyengar).
77
receptive to a deal with Petco if only it would have expressed a serious indication of
interest. Importantly, the evidence reveals that the private equity bidders did not
know who they were bidding against and whether or not they were competing with
strategic bidders.351 They had every incentive to put their best offer on the table.
Petitioners advance the argument that the “LBO model” will rarely if ever
produce fair value because the model is built to allow the funds to realize a certain
internal rate of return that will always leave some portion of the company’s going
concern value unrealized. Taken to its logical conclusion, of course, Petitioners’
position would suggest that all private equity bidders employing the same model
(assuming they strive for the same IRR as Petitioners contend they do) should have
bid the same amount for PetSmart. This, of course, did not happen––as shown by
the spread between KKR and CD&R’s final verbal bid at $78 per share and
BC Partners’ winning bid at $83 per share. And while it is true that private equity
firms construct their bids with desired returns in mind, it does not follow that a
private equity firm’s final offer at the end of a robust and competitive auction cannot
ultimately be the best indicator of fair value for the company.352
351
Cf. Lender Processing, 2016 WL 7324170, at *18 (observing that “if bidders perceive
a sale process to be relatively open, then a credible threat of competition can be as effective
as actual competition”).
352
See, e.g., Lender Processing, 2016 WL 7324170, at *26–29 (relying on the merger price
in a sale to a private equity buyer); BMC, 2015 WL 6164771, at *18 (determining that the
deal price was the most reliable indicator of fair value in case involving sale to a group of
private equity buyers); AutoInfo, 2015 WL 2069417, at *12 (same); Ancestry.com, 2015
78
Third, the notion that the Board was forced to sell after the emergence of an
activist shareholder finds no credible support in the evidence. By the time JANA
arrived on the scene in July 2014, PetSmart’s Board had already begun the process
of reviewing strategic alternatives with Morgan Stanley. Thereafter, PetSmart took
its time with the sales process, not signing the Merger Agreement with BC Partners
until December 2014. Indeed, the evidence reveals that all strategic alternatives
were on the table in December 2014 and that the Board did not decide to sell until
JPM was able to coax the final offer of $83 per share from BC Partners (actually
causing it to bid against itself). Had the auction not generated an offer that the Board
deemed too good to pass up, I am satisfied that the Board was ready to pursue other
WL 399726, at *23–24 (same); CKx, 2013 WL 5878807, at *13 (same). I note that the
LBO model and DCF model both rely upon the same expected cash flows. The LBO
model, however, is risk adjusted to account for post-transaction leverage. It follows, then,
that the higher rate of return sought by bidders employing an LBO model will be offset by
the fact that most of the purchase price is financed with debt which, in turn, creates a higher
return on equity. Moreover, companies with a history of lagging performance may be
valued more by financial bidders with a plan to turn around the company than strategic
bidders who might be less inclined to take on that risk. Stated more simply, there are two
sides to the “LBO model” argument. JX 1697 (Metrick-Opening) at 49–56; Trial
Tr. 1277:4–1281:22 (Metrick). While there may be some intuitive appeal to Petitioners’
argument that the requisite IRR embedded in the LBO model will drive lower valuations,
the evidence in this trial record did not support that argument or demonstrate that this
dynamic was in play during the auction for PetSmart. Accord Alexander S. Gorbenko &
Andrey Malenko, Strategic and Financial Bidders in Takeover Auctions, 69 J. Fin. 2513,
2514–16, 2532 (2014) (conducting an analysis of values paid by strategic and financial
bidders and concluding that both, on average, pay more than the company’s value under
current management and that, in the case of 22.4% of the targets within the sample, those
targets, all “mature, poorly performing companies,” were “valued more by an average
financial bidder than by an average strategic bidder”).
79
initiatives as a standalone company and to defend itself in a proxy contest against
JANA and others if necessary.353
Fourth, Petitioners’ argument that the Board was ill-informed is premised
largely on the exploitation of director Gangwal’s inability to recall at trial (nearly
three years after the fact) certain details regarding PetSmart’s PIP initiative. It is a
stretch to point to a witnesses’ lack of recall at trial regarding the details of a cost-
savings initiative as evidence that the entire PetSmart Board was ill-informed
regarding the sales process. This is especially so given that Gangwal was able to
testify extensively regarding the Board’s consideration of strategic alternatives, the
sales process and the Board’s deliberations during this period.354 Petitioners also
argue that the Board was ill-informed because it did not receive advice regarding the
valuation of the Company if it remained standalone, but this is contradicted by the
353
See Trial Tr. 405:8–406:2, 427:7–430:12, 439:11 (Gangwal). Nor does the evidence
suggest that PetSmart was sold at a time of market or internal uncertainty. The market
trends confronting PetSmart had been in place for some time and the Company’s struggles
were not of recent origin. See, e.g., Resp’t’s RX-6 (displaying PetSmart’s historical
comparative store sales growth beginning Q1 2011, showing that comparable store sales
growth declined continually from Q1 2012 through Q1 2014 and then continued to slide in
2015 after a minor uptick Q4 2014). See also JX 2307 (Weinsten-Opening) at 16–26
(describing the challenges facing PetSmart in the period leading up to the Merger). This
is not a case like DFC, where the company was confronting acute regulatory uncertainty
at the time it was sold. 2016 WL 3753123, at *22. PetSmart’s Board was able to weigh
the Company’s options on a clear day and make the decision it believed was in the best
interest of the Company and its stockholders.
354
See, e.g., Trial Tr. 410:10–20, 418:20–419:8, 437:2–441:9 (Gangwal).
80
evidence adduced at trial, including (but not limited to) JPM’s presentation at the
December 13 Board meeting.355
Fifth, as previously noted, the “conflicts” Petitioners rely upon to impugn the
results of the sales process are hardly striking and, in any event, were fully disclosed
to the Board and the Ad Hoc Committee. For example, Petitioners argue that JPM
did not adequately disclose its previous relationships with potential private equity
bidders. As Gangwal testified, however, as a large institutional bank, the Board
knew and was not at all surprised that JPM naturally had ties to the large private
equity funds interested in bidding on the Company. 356 While Petitioners contend
that JPM did not disclose, and was hindered by, conflicts due to its involvement with
the initial public offering that Petco pursued in the fall of 2015, the only record
355
See Trial Tr. 908:14–910:23 (Aiyengar) (“[V]aluation was presented to the board at
multiple different times here. I don’t remember all the dates. But starting from—from the
time the plan was finalized in September, I think most of the other board presentations . . .
had some sort of valuation discussion.”). See also JX 1158.
356
See In re Inergy LP, 2010 WL 4273197, at *14 (Del. Ch. Oct. 29, 2010) (holding that
financial advisor’s “prior dealings” with counterparty to the proposed transaction “d[id]
not show that [the transaction committee’s] decision to retain [that advisor] . . . was
unreasonable”); Emerald P’rs v. Berlin, 2001 WL 115340, at *7 n.17 (Del. Ch. Feb. 7)
(rejecting argument that target banker’s work for the buyer created a conflict of interest),
vacated on other grounds, 787 A.2d 85 (Del. 2001); Maric Capital Master Fund, Ltd. v.
Plato Learning, Inc., C.A. No. 5402-VCS, at *87–88 (Del. Ch. May 13, 2010)
(TRANSCRIPT) (noting that the presence of a conflict “doesn’t mean that [the advisor]
can’t be the banker. . . . I’d rather have some of the best bankers with their conflicts
disclosed than some of the worst bankers who don’t have any conflicts”); Dollar Thrifty,
14 A.3d at 582 (noting that a company’s investment bankers working with private equity
bidders prior to a sales process was “one of the facts of business life”).
81
evidence on this conflict shows that JPM did not pitch this project, much less get
retained to work on it, until months after the PetSmart Merger closed.357 Petitioners
also point to JPM’s prior relationship with Gangwal due to its involvement in taking
his airline public, but I can discern no basis to characterize this relationship as a
conflict or to conclude that it would have affected the advice JPM rendered to the
PetSmart Board or its work in running the PetSmart auction.
Finally, the argument that the Merger Price was stale by the time of closing is
at best speculative. Mergers are consummated after the consideration is set. That
temporal separation, however, does not in and of itself suggest that the merger
consideration does not accurately reflect the company’s going concern value as of
the closing date.358 Here, Petitioners would have me conclude that the Merger Price
was stale because, in the gap between signing and closing, PetSmart’s fortunes took
a miraculous turn for the better. While the record indicates that the Company did
enjoy some favorable results in Q4 2014, such as an uptick in comparable store sales
growth, I am not convinced that these short-term improvements were indicative of a
long-term trend. In fact, all testimony at trial was to the contrary—the Board, as
well as Teffner, believed that the Q4 results were temporary and provided no basis
357
JX 1679 (Aiyengar Dep. Day 1) 29:5–9.
358
See Union Ill., 847 A.2d at 358.
82
to alter their view of the Company’s long-term prospects.359 These perceptions were
born out in Q1 2015 (when the Merger closed) during which PetSmart’s comparable
store sales dropped to 1.7%.360 At year end, PetSmart reported comparable store
sales growth of 0.9%, a 40% miss from the Management Projections in just the first
projection year.361
Respondent has carried its burden of demonstrating that the Merger Price of
$83 per share was the result of a “proper transactional process”362 comprised of a
robust pre-signing auction in which adequately informed bidders were given every
incentive to make their best offer in the midst of a “well-functioning market.”363
359
See, e.g., Trial Tr. 447:4–7 (Gangwal) (Q. “And did [PetSmart’s] performance in the
fourth quarter [of 2014], did that in any way affect your view of the long-term value of the
company?” A. “No.”); Trial Tr. 273:24–24 (Teffner) (Q. “Did [PetSmart’s Q4 2014] results
change your view of the long-term prospects of the company?” A. “No.” Q. “Why not?”
A. “Because it was one quarter.”). Petitioners contend that PetSmart’s Q4 2014 results
were released too close to the closing of the Merger for potential bidders to digest them.
This ignores the fact that bidders were constantly updated regarding PetSmart’s
performance, so they received information about PetSmart’s Q4 performance in real time
well before the market. See, e.g., JX 1090; Trial Tr. 263:7–20 (Teffner); Trial Tr. 735:17–
737:21 (Svider).
360
JX 1598 at PETS_APP00842050.
361
JX 1656 at PETS_APP00821450–51, 57.
362
Ramtron, 2015 WL 4540443, at *21.
363
DFC, 2016 WL 3753123, at *21.
83
Under these circumstances, I am satisfied that the deal price is a reliable indicator of
fair value.364
C. Can a DCF Analysis that Relies Upon the Any of the Projections In the
Record Produce a Reliable Indicator of Fair Value?
My determination that the $83 per share Merger Price is a reliable indicator
of fair value does not end the inquiry. To discharge my statutory obligation to
consider “all relevant factors,” it is necessary that I consider the reliability of the
other valuations of PetSmart in the trial record.365
Petitioners peg DCF as the “gold standard” of valuation tools.366 To be sure,
that is precisely how Metrick has described it.367 This court, likewise, has turned to
a DCF analysis in the appraisal context to determine fair value and, in certain
circumstances, has deemed the results of a DCF analysis to be the only reliable
364
BMC, 2015 WL 6164771, at *11 (observing that the court may rely upon “the merger
price itself as evidence of fair value, so long as the process leading to the transaction is
reliable indicator of value and any merger-specific value in that price is excluded.”). I note
that there is no need or basis to adjust the Merger Price in recognition of either positive or
negative synergies associated with the combination of PetSmart and BC Partners since the
buyer here “was a financial buyer rather than a strategic acquirer,” DFC, 2016
WL 3753123, at *20 n.230, and there was no evidence presented that synergies unique to
private equity sponsors were present here. See Lawrence A. Hamermesh & Michael L.
Wachter, Rationalizing Appraisal Standards in Compulsory Buyouts, 50 B.C. L. Rev.
1021, 1050 (2009) (discussing synergies financial buyers may have with target firms
arising from other companies in their portfolio and reduced agency costs).
365
Gonsalves, 701 A.2d at 362.
366
Pet’rs’ Post-Trial Br. at 14.
367
JX 1714 (Metrick Dep.) 245:17-19; Trial Tr. 1317:10–21 (Metrick); JX 63 at 14.
84
indicator of fair value.368 Even though I am confident that the deal price in this case
is a reliable indicator of fair value, I have approached the DCF valuations performed
by the parties’ experts with an open mind.369
A proper DCF analysis follows a well-defined sequence:
First, one estimates the values of future cash flows for a discrete period,
based, where possible, on contemporaneous management projections.
Then, the value of the entity attributable to cash flows expected after
the end of the discrete period must be estimated to produce a so-called
terminal value, preferably [by] using a perpetual growth model.
Finally, the value of the cash flows for the discrete period and the
terminal value must be discounted back using the capital asset pricing
model or ‘CAPM.’370
The first key to a reliable DCF analysis is the availability of reliable projections of
future expected cash flows, preferably derived from contemporaneous management
projections prepared in the ordinary course of business.371 As this court has
determined time and again, if the “data inputs used in the model are not reliable,”
368
See, e.g., Owen v. Cannon, 2015 WL 3819204, at *29 (Del. Ch. June 17, 2015); Golden
Telecom I, 993 A.2d at 499.
369
I note that both valuation experts agree that no other valuation methodology (e.g.,
comparable company or comparable transaction analyses) would make sense here,
particularly given the rather unique nature of PetSmart’s retail business. See JX 1698
(Dages-Opening) at 73; JX 1697 (Metrick-Opening) at 142. I agree and will not discuss
these methodologies further.
370
Andaloro v. PFPC Worldwide, Inc., 2005 WL 2045640, at *9 (Del. Ch. Aug. 19, 2005)
(citation omitted).
371
See Merion Capital, L.P. v. 3M Cogent, Inc., 2013 WL 3793896, at *11 (Del. Ch. July 8,
2013); Ramtron, 2015 WL 4540443, at *10. See also JX 1697 (Metrick-Opening) at 106–
07; JX 1698 (Dages-Opening) at 23–24.
85
then the results of the analysis likewise will lack reliability.372 And, as the experts
in this case both agree, to be reliable, management’s projections should reflect the
“expected cash flows” of the company, not merely results that are “hoped for.”373
1. The Projections
Petitioners like the Management Projections and maintain they are reliable
indicators of PetSmart’s future performance. Respondent, on the other hand, finds
itself in the presumably uncomfortable position of having to argue that its own
projections cannot be trusted as a basis for predicting expected cash flows and,
therefore, cannot provide a sound foundation for a DCF analysis. While I appreciate
that the parties’ disagreement with respect to the reliability of the Management
Projections presents a question of fact that must be answered by the evidence in this
case, I take guidance from other instances where this court has examined the
reliability of projections used for the purposes of appraisal. Specifically, this court
has deemed projections unreliable where “the company’s use of such projections
was unprecedented, where the projections were created in anticipation of litigation,
372
Ramtron, 2015 WL 4540443, at *10. See also id. at *18 (stating that where there are
no “reliable five-year projections, any values generated by a DCF analysis are
meaningless”); CKx, 2013 WL 5878807, at *11 (noting that “methods of valuation,
including a discounted cash flow analysis, are only as good as the inputs to the model”);
Andaloro, 2005 WL 2045640, at *9 (noting that this court may give a DCF analysis great
weight in an appraisal proceeding “when it may be used responsibly”). Dages agrees. Trial
Tr. 624:6–13 (Dages) (“Garbage in; garbage out.”).
373
See Trial Tr. 621:2–8 (Dages); Trial Tr. 1240:18–23 (Metrick).
86
where the projections were created for the purpose of obtaining benefits outside the
company’s ordinary course of business,”374 where the projections were inconsistent
with a corporation’s recent performance,375 or where the company had a poor history
of meeting its projections.376
The Management Projections upon which Petitioners rely are saddled with
nearly all of these telltale indicators of unreliability: (1) PetSmart management did
not have a history of creating and, therefore, had virtually no experience with, long-
term projections; (2) even management’s short term projections frequently missed
the mark; (3) the Management Projections were not created in the ordinary course
of business but rather for use in the auction process; and (4) management engaged
in the process of creating all of the auction-related projections in the midst of intense
pressure from the Board to be aggressive, with the expectation that the projections
would be discounted by potential bidders. As explained below, each of these factors
undermine the credibility of Dages’s DCF results.
First, PetSmart had not historically created five-year projections prior to the
creation of the auction-related projections (including the Management Projections).
374
CKx, 2013 WL 5878807, at *9.
See In re Nine Sys. Corp. S’holders Litig., 2014 WL 4383127, at *41 (Del. Ch. Sept. 4,
375
2014) (citing Kahn v. Household Acq. Corp., 591 A.2d 166, 175 (Del. 1991)).
376
Nine Sys., 2014 WL 4383127, at *42.
87
PetSmart’s forecasting practice was limited to the creation of annual budgets in
connection with the Summer Strategy meetings. These budgets were nothing like
the five-year projections management was directed to prepare when the Board
decided to explore a sale of the Company. The Summer Strategy budgets were one-
year forecasts prepared to support particular proposed initiatives with the
anticipation that they would be revised throughout the year as events unfolded.377
While Vance made her own long-term projections based on the annual budgets
created as a part of Summer Strategy, her model was never presented to or relied
upon by PetSmart’s management or Board.378
The Board’s request that management shift from preparing one-year budgets
to five-year cash flow projections was made all the more difficult by the fact that
PetSmart’s senior management were new to their jobs. Teffner, who was leading
the effort, had only been in her job for about a year; Lenhardt had only taken on the
role of CEO in June 2013. And, of course, the projections were rush jobs; the Board
377
Trial Tr. 208:4–209:3 (Teffner). See also Trial Tr. 34:1–23 (Cohen) (Petitioners’ retail
expert testifying that retail operates on a one-year cycle, so that creating detailed
projections beyond one-year made little sense).
378
Trial Tr. 213:7–19 (Teffner) (explaining that Vance’s model “was not presented to
management, was not presented to the board for approval; [instead it] was more of an
inherent working tool for the planning department, but it wasn’t considered a multiyear
projection that the business relied upon”).
88
wanted the work product in a matter of weeks to ready the Company for the sales
process.379
Second, while management had no history of preparing long-term projections,
it did have a history of preparing short-term forecasts that did not accurately predict
Company performance.380 As demonstrated in the following chart produced in
Metrick’s opening expert report, even PetSmart’s reforecasts were often off by large
margins:381
FY13 FY14
Q1 Q2 Q3 Q4 FY Q1 Q2
F1 3.80% 3.90% 4.10% 4.30% 4.00% 1.50% 2.90%
F2 3.70% 4.00% 4.90% 4.10% 0.80%
F3 4.00% 4.90% 4.00%
F4 3.50%
Actual 3.50% 3.40% 2.70% 1.20% 2.70% -0.60% -0.50%
Actual - F1 -0.30% -0.50% -1.40% -3.10% -1.30% -2.10% -3.40%
Actual – F2 -0.30% -1.30% -3.70% -1.40% -1.30%
Third, the evidence reveals that management did not believe that the
projections they were preparing actually offered reliable predictions of future
379
Trial Tr. 219:9–22, 229:2–13, 236:8–16 (Teffner).
380
See Ramtron, 2015 WL 4540443, at *11 (discounting the reliability of management
projections since their ability to be accurate forecasters “more than two quarters out was
quite poor” and noting that “management’s lack of success in accurately projecting future
revenue in the past provides another reason to doubt the reliability of the Management
Projections”); AutoInfo, 2015 WL 2069417, at *8 (finding it significant in its assessment
of the reliability of management projections that “[m]anagement itself had no confidence
in its ability to forecast”).
381
JX 1697 (Metrick-Opening) at 65, Fig. 11.
89
performance. They were told to “put their best foot forward” and that is precisely
what they did.382 This, of course, is no surprise since they were told by the Board
that their jobs depended on it.383
Finally, the evidence makes clear that the Management Projections were
created specifically to aid PetSmart in its pursuit of strategic alternatives, including
a sale of the Company. To fulfill this purpose, the projections were created to be
aggressive and extra-optimistic about the future of the Company.384 In fact, the
Management Projections projected a reversal of several downward trends, including
with regard to the important metric of comparable store sales growth estimates.385
As Teffner, Gangwal and Aiyengar testified at trial, the projections were designed
to be aggressive because the Board (and JPM) were convinced that potential bidders
would discount whatever projections were put in front of them. This makes perfect
382
Trial Tr. 368:14–16 (Teffner) (“[The Management Projections were] our best foot
forward to potential buyers around the performance of the company, given the
initiatives.”). See also Trial Tr. 242:10–243:2, 256:7–17, 260:5–261:10, 268:9–269:5,
270:1–11, 370:19–23 (Teffner).
383
JX 671 at PETS_APP00215455.
384
JX 1674 (Vance Dep.) 135:5–137:3.
385
JX 1684 (Lenhardt Dep.) 275:14–21. See also JX 2307 (Weinsten-Opening) at Ex. 8
n.52.
90
sense when projections are being prepared not in the ordinary course but to facilitate
a sale of the Company.386
Petitioners argue that management knew where to draw the line between
reliable and unreliable projections as evidenced by management’s decision not to
share the super-aggressive “Growth Case” with the Board. According to Petitioners,
the fact that management was willing to provide the Management Projections to the
Board reveals that management stood behind them and that they can trusted as a
reliable input for a DCF analysis. I disagree. The Management Projections were the
product of aggressive prodding by the Board for more optimistic forecasts and
everyone involved in their creation knew that. Indeed, when the time came for the
Board to look to JPM for valuation guidance, the Board directed JPM to run only
downside sensitivities on the Management Projections.387
Petitioners next argue that the reliability of the Management Projections is
bolstered by the Company’s performance after the Merger Agreement was signed
and post-closing. Here again, I disagree. To hear Petitioners tell it, PetSmart’s post-
signing performance was nothing short of a turnaround miracle.388 The trial record
386
It should also be noted that management’s projections were “top down” rather than
“bottom up” projections, which is contrary to best practices. JX 2307 (Weinsten-Opening)
at 6–7.
387
Trial Tr. 434:16–436:19 (Gangwal).
388
Specifically, Petitioners contend, “PetSmart outperformed the projections immediately,
with that outperformance accelerating from signing through, and well after, closing.”
91
says otherwise. PetSmart’s success, both post-signing and post-closing was and has
been mixed. It is true that PetSmart’s EBITDA exceeded the Management
Projections for 2015 and that PetSmart was able to issue a $800 million dividend by
year end. It is also true, however, that in both 2015 and 2016 (as of the date of trial),
PetSmart’s comparable store sales growth was massively underperforming the
numbers forecast in the Management Projections.389 Hardly a turnaround miracle.
Petitioners point to the PIP and argue that no matter the “aggressiveness” of
the Management Projections, they must be considered in the context of the “cushion”
provided by the substantial estimated cost savings PetSmart would realize from this
initiative. In this regard, Petitioners point out that while PetSmart repeatedly
reported that it would achieve $200 million in cost savings annually from the PIP,
various internal documents set the actual estimates between $183–$283 million.390
Pet’rs’ Post-Trial Br. 44. See also id. at 47 (“PetSmart’s post-closing performance . . .
blew the Management Projections out of the water.”).
389
Petitioners argue that Respondent is unduly “fixated” on the comparable store sales
growth. See id. at 48–53. However, the PetSmart financial model was premised largely
on this important growth metric. Indeed, management appeased the PetSmart Board’s
desire to make the projections for the sale process more aggressive by increasing the
comparable store sales growth from the Base to the Base-Plus Cases to the final
Management Projections. See JX 598 at PETS_APP00611653, 656; JX 798 (Comp_Trend
tab). Suffice it to say, I am satisfied that “comp” is an important metric to measure
performance and growth. In any event, whether or not the comparable store sales growth
is important for the long-term prospects of the Company, as the parties dispute, based upon
the evidence adduced at trial, this metric was indisputably central to the creation of the
Management Projections and therefore directly indicative of their reliability.
390
Trial Tr. 338:22–339:10 (Teffner).
92
The suggestion is that the extra $83 million was a cushion to offset any undue
optimism in the Management Projections. Petitioners make too much of the range
of PIP savings identified at various times by management. When the rubber hit the
road, and management was pressed to provide optimistic but arguably achievable
forecasts of PIP savings, management determined that, in their best estimate, $200
million was what was actually achievable.391 The PIP was layered into the
Management Projections and I see no basis in the evidence to conclude that some
additional phantom savings were ready to be mined out of PetSmart beyond those
already accounted for.392
For all of these reasons, I find that the Management Projections are not reliable
statements of PetSmart’s expected cash flows. Any DCF analysis that relies upon
the Management Projections, therefore, would produce “meaningless” results.393
391
Trial Tr. 339:23–340:11 (Teffner). Petitioners also point to other cost-savings proposals
created by consultants estimating even greater savings, arguing that the consultants found
an additional $473–$685 million in cost savings. Pet’rs’ Post-Trial Br. 32. There is no
evidence that PetSmart management ever thought these pitches from the paid consultants
were actually achievable. For his part, Massey explicitly rejected the consultants’ pitches
as providing any meaningful input for a valuation of PetSmart because they were nothing
more than “ideas.” Trial Tr. 1105:1–5, 1106:5–1107:1 (Massey).
392
JX 807 at PETS_APP00000690; JX 728.
393
CKx, 2013 WL 5878807, at *9 (“[W]ithout reliable five-year projections, any values
generated by a DCF analysis are meaningless.”). See also id. at *11 n.113 (“If I were to
apply a DCF analysis in this matter, by choosing between speculative revenue estimates . . .
I would simply lend a faux-mathematic precision to a patently speculative enterprise: I
would become, to use Twain’s memorable locution, no better than a hair-ball oracle.”);
Ramtron, 2015 WL 4540443, at *18 (determining that there were no reliable five-year
93
Even though I have determined that the Management Projections cannot
support a meaningful DCF analysis, I must consider the possibility that a reliable
valuation of PetSmart nevertheless can be constructed from other evidence in the
record. In addition to the Management Projections, Dages has looked to other
projections—namely the BCP Case, the Massey Case, and the Bank Case—as
foundations for alternative DCF analyses.394 And on the final day of trial, Dages
presented rebuttal testimony regarding a new DCF analysis he had performed based
on the JPM sensitivities.
Metrick initially declined to run of any these projections through his DCF
model. Instead, he created his own forecasts for PetSmart by adjusting the
Management Projections, based on the 2% comparable store sales growth
assumption adopted in the JPM sensitivities, and then further adjusting to account
for the eventual decline of the PIP savings he believed would be realized further into
the forecast. As the last word from the valuation experts, however, Metrick
projections in the record, and therefore declining to rely upon a DCF analysis); Doft & Co.
v. Travelocity.com Inc., 2004 WL 1152338, at *7 (Del. Ch. May 20, 2004) (declining to
use a DCF analysis to value a company where the record did not contain any reasonably
reliable contemporaneous projections of the company’s future cash flows, rendering “a
DCF analysis of marginal utility as a valuation technique”).
394
To be clear, Dages performed a DCF analysis with Management Projections and the
Bank Case in his initial report. JX 1698 (Dages-Opening) at 59, 65. He prepared his DCF
on the BCP Case and the Massey Case in advance of his direct testimony at trial. Trial Tr.
554:7–556:21, 603:1–4 (Dages).
94
responded post-trial to Dages’ last-minute DCF analysis by pointing out its
shortcomings and running his own analysis on the unadjusted JPM sensitivities. The
questions remain whether any of these projections represent the expected future cash
flows of the Company and whether any DCF based on these projections can be
trusted as a reliable indicator of PetSmart’s fair value at the time of the Merger.
When faced with unreliable contemporaneous management projections, this
court has adopted other contemporaneous projections as a basis for a DCF analysis
where it is satisfied that those projections provide a reliable estimate of the
company’s future cash flows.395 But the projections must be contemporaneous,
meaning they must reflect the “operative reality” of the Company at the time of the
Merger.396 A DCF analysis does not work in the appraisal context when the
projections reflect the “operative reality” of the company in the hands of the
acquirer.397 With this in mind, it is easy to see why none of the projections prepared
395
See, e.g., AutoInfo, 2015 WL 2069417, at *15.
396
Highfields Capital, 939 A.2d at 42 (“The corporation subject to valuation is viewed as
a going concern based upon the operative reality of the company at the time of the merger.
This value must be reached regardless of the synergies obtained from the consummation
of the merger, and cannot include speculative elements of value arising from the merger’s
accomplishment or expectation.”) (internal quotation marks and citations omitted).
397
Id. See also Cede & Co. v. JRC Acq. Corp., 2004 WL 286963, at *7 (Del. Ch. Feb. 10,
2004) (rejecting one party’s valuation expert’s attempt to use the debt incurred in the
merger as a justification for his debt-to-equity ratio in his DCF analysis because nothing
relating to the merger itself “can be included as an element of value”).
95
outside of PetSmart can produce a reliable DCF result. Each reflect various
scenarios of how PetSmart would be run under BC Partners’ management with a
variety of different assumptions. The BCP Case and the Massey Case both were
designed with the idea that PetSmart would be run as a private, rather than a public
company, with new management, new initiatives and Massey at the helm.398 While
BC Partners believed that Massey might be able to turn PetSmart around, it had no
such confidence in PetSmart’s current management.399 Given BC Partners’ plan to
overhaul PetSmart management and its lack of faith in the current management, it
398
Trial Tr. 741:19–742:22 (Svider) (describing the complete management turnover that
BC Partners believed was necessary at PetSmart, as “it was our view that in order to turn
this business around, you needed to implement very profound changes to the management
team” so that once the Merger closed, BC Partners “basically changed not only the whole
top management, but you know, pretty much the whole management of the company”).
See also JX 1236 at BC00043779–93 (detailing Massey’s loyalty, store associate behavior,
product optimization, product expansion, marketing and merchandising, net price, supply
chain and freight, consumable vendors negotiations, Asia sourcing, field payroll, overhead,
occupancy cost and other operating, general and administrative initiatives); Trial
Tr. 1027:7–11; 1030:8–1045:3 (Massey) (describing his proposed initiatives and how they
differed from current management’s initiatives); Trial Tr. 1041:23–1042:12 (Massey)
(stating that, after a meeting where they discussed current management’s progress on its
initiatives, “I had a lot of concern. Many of the initiatives didn’t seem to have much
backing them up. And what was really concerning were the—a number of the senior
managers really couldn’t articulate how they were going to execute these things. Some
could, and some did a very good job. But some of the most important ones in
merchandising and marketing, we had walked away with a lot of concerns”); Trial
Tr. 1048:3–22 (Massey) (describing his worries about the achievability of his plan leading
up to the consummation of the Merger because “I had serious doubts about relying on the
people, a number of the people. There were a lot of good people, but there [were] other
people I was very concerned about. And I knew I would have to make a tremendous
amount of change”).
399
Id. See also JX 1676 (Svider Dep.) 38:6–9, 145:14–23.
96
strains credulity to argue that the cases BC Partners created showed expected cash
flows if PetSmart were to continue operating as a going concern sans Merger.
The Bank Case prepared by BC Partners fares no better. The assumptions
upon which those projections are based resemble nothing of PetSmart’s operative
reality. To reiterate, the Bank Case was created for BC Partners to present to
potential lenders, not in the ordinary course of business, with the purpose of showing
that “if things get tough . . . you can run the business for cash.”400 It assumed that
the Company would cut capital expenditures in its efforts to preserve cash with the
implicit understanding that this approach would stymie long-term growth.401 Simply
stated, the Bank Case did not reliably state expected cash flows because that was not
its purpose.
Having determined that the Management Projections, the BCP Case, the
Massey Case and the Bank Case are not reliable statements of PetSmart’s expected
future cash flows, it should come as no surprise that I reject outright the DCF
analyses Dages performed using those projections as foundation.402 They are
patently not reliable indicators of fair value.
400
Trial Tr. 743:21–746:4 (Svider) (describing the purpose of a bank case).
401
Id.
402
Ramtron, 2015 WL 4540443, at *18 (holding that a DCF analysis built on unreliable
projections is “meaningless”).
97
That leaves the possibility of undertaking some adjustments to the
Management Projections to bring them in line with the Company’s expected cash
flows as a means to supply reliable data for a DCF analysis. Both parties have
submitted a DCF analysis based on the JPM sensitivities.403 Metrick has gone a step
further by making further adjustments to the JPM sensitivities to account for his view
that the PIP savings will not be sustainable indefinitely. 404 Even though Dages
appears to have referred to the JPM sensitivities as an afterthought, his DCF based
on those projections is in the record and must be addressed.
The Board requested that JPM run sensitivities based on 2% comparable store
sales growth because it had “a great amount of discomfort” with the 4% comparable
store sales growth utilized in the Management Projections, and thought that
“2 percent looked more achievable.” 405 Given the pressure the Board had placed
upon management to prepare increasingly aggressive projections, it is reasonable
that the Board would seek to gain a more realistic understanding of PetSmart’s
expected cash flows and its going concern value as the hour approached for the
Board to make impactful decisions about PetSmart’s future. While the evidence is
403
Trial Tr. 1411:23–1429:18 (Dages); JX 1697 (Metrick-Opening) at 108–09; JX 2315
(Metrick-Supplemental) at 1.
404
JX 1697 (Metrick-Opening) at 103.
405
Trial Tr. 436:13–19 (Gangwal).
98
a bit light with respect to the bases for the 2% adjustment in comparable store sales
growth selected by the Board, I take comfort that the adjustment was conceived by
an informed, experienced Board and then analyzed carefully by an informed,
experienced banker. It is also not lost on me that the JPM sensitivities are the only
projections utilized, in some form at least, by both of the valuation experts engaged
by the parties. They bear sufficient indicia of reliability to justify further
consideration of the valuations based on the data contained therein.
2. The Expert Valuations Based on the JPM Sensitivities
Dages performed his rebuttal DCF on the JPM sensitivities to respond to
testimony from Aiyengar and Gangwal to the effect that the Board directed JPM to
make adjustments to the Management Projections that would cause them to reflect
more accurately PetSmart’s future performance.406 For this analysis, Dages took the
cash flows from the JPM sensitivities and ran them through a DCF analysis applying
the inputs derived from both his and Metrick’s prior DCF analyses––the discount
rate (or WACC), the perpetual growth rate and the terminal investment.407 First, he
applied his perpetual growth rate of 2.25%, WACC of 7.75% and terminal
406
Trial Tr. 1412:9–1414:19 (Dages).
407
Trial Tr. 1415:19–1416:5, 1416:15–21 (Dages).
99
investment of $41 million.408 Across the three JPM sensitivities, this resulted in a
value ranging from $102.82 to $112.90 per share.409
Dages then ran a DCF analysis using the inputs he attributed to Metrick “based
on [the] exhibits” Metrick utilized during his trial testimony––a perpetual growth
rate of 2.0% and WACC of 6.35%.410 Dages calculated the terminal investment for
each of the sensitivities using the same formula that Metrick had used for each
sensitivity during his testimony.411 Across the JPM sensitivities, this resulted in a
value ranging from $108.13 to $118.88 per share.412
Metrick had already seized on the import of the JPM sensitivities in his initial
report.413 He adjusted the Management Projections to reflect the 2% comparable
store sales growth estimate for years after FY15.414 He further adjusted the
Management Projections, which assumed that PetSmart would achieve the cost
408
Pet’rs’ DX 2 at 2; Pet’rs’ DX 3 at 2; Pet’rs’ DX 4 at 2.
409
Id.
410
Trial Tr. 1413:19–1414:3 (Dages); Pet’rs’ DX 2 at 3; Pet’rs’ DX 3 at 3; Pet’rs’ DX 4
at 3.
411
Trial Tr. 1417:6–17, 1420:2–12 (Dages); Pet’rs DX 2 at 3; Pet’rs’ DX 3 at 3; Pet’rs’
DX 4 at 3. Dages used real rates in this method, whereas Metrick had used nominal rates.
Trial Tr. 1413:4–6.
412
Pet’rs’ DX 2 at 3; Pet’rs’ DX 3 at 3; Pet’rs’ DX 4 at 3.
413
JX 1697 (Metrick-Opening) at 102.
414
Id. at 102–03.
100
savings envisioned by the PIP infinitely, to account for his view “that the cost
savings EBITDA improvements will decline beginning in FY19, three years after
the savings are assumed to be fully realized in FY16.”415 He then incorporated his
assumption that “the annual savings will decline linearly to the Base Case Amount
($59 million) by the terminal period, which begins in FY25.”416
The projected decreases in PIP savings represented Metrick’s best attempts to
estimate how long and to what extent PetSmart would retain the projected
benefits.417 He based his opinion that PetSmart would not realize the PIP savings
infinitely on “economic theory, market response to the PIP, and industry experience
related to cost reduction programs.”418 Of particular relevance was a McKinsey &
Co. study that found 90% of 230 S&P 500 firms that had engaged in cost-savings
strategies between 1999 and 2003 had failed to sustain the lower cost savings beyond
three years.419 Additionally, Metrick believed that increasingly strong competition
415
Id. at 103.
416
Id.
417
Trial Tr. 1403:4–21 (Metrick).
418
JX 1697 (Metrick-Opening) at 103.
419
JX 24 at 108–11. This is also consistent with Weinsten’s experiences. Trial Tr. 1206:9–
19 (Weinsten).
101
from other pet retailers––i.e., Petco––would cause the cost savings to erode over
time.420
Metrick returned to the JPM sensitivities when he responded to Dages’s
rebuttal DCF valuations.421 He ran his own DCF analysis on the JPM sensitivities
(without adjustments) to reveal the errors in Dages’s DCF on those same
projections.422 Metrick found two principal faults with Dages’s rebuttal DCF. First,
he took Dages to task for using the improper discount rates. In this regard, he began
with the premise that “[t]o value the cash flows properly, the discount rate must
reflect the assumed capital structure, which in turn depends on how leases are treated
in the cash flows.”423 According to Metrick, the discount rates Dages utilized are
not consistent with the capital structure assumed in his analysis. Specifically, Dages
treated the leases as operating leases (as reflected in the JPM sensitivities), which
420
JX 1697 (Metrick-Opening) at 94–95.
421
JX 2315 (Metrick-Supplemental) at 1. I note for clarity that the JPM sensitivities are the
cash flows from JPM’s valuation model, and therefore distinct from the adjustments that
Metrick made to the Management Projections to reflect his view of the expected cash flows
for the DCF he performed in his initial report. See id. at 3.
422
Id. at 2. Metrick focused on Sensitivity #2 “for simplicity” because, given the
assumptions in Sensitivity #3 and Sensitivity #4 regarding new store growth, his DCF
analysis on Sensitivity #2 would result in a higher valuation for PetSmart. Id. at 1. Since
the differences across the sensitivities are assumptions regarding new store growth,
Metrick’s criticisms of Dages’ DCF analysis would apply equally to all three sensitivities
he analyzed. Id.
423
Id. at 5.
102
results in a capital structure with no debt (and 100% equity).424 And yet the WACC
utilized by Dages, pulled from his initial report, is based on a capital structure of 8%
debt and 92% equity.425 Similarly, the WACC Dages attributed to Metrick in his
rebuttal DCF was based on Metrick’s assumption of a capital structure of 31% debt
and 69% equity.426 Given the very different capital structure assumed in the JPM
sensitivities, Metrick opines that Dages should have used a WACC of 8.17% based
on his own beta and equity risk premium, not 7.75%.427 The proper WACC based
on Metrick’s assumptions should have been 7.7%, not 6.35%.428
Metrick’s second criticism of Dages focuses on his use of income projections
that “assume that all of PetSmart’s costs are completely variable, rising or falling in
proportion to sales, so profit margins do not change” even though the JPM
sensitivities (based on the Management Projections) include specific fixed expense
line items that will not vary with declining sales.429 To adjust for this, Metrick took
424
Id. at 6.
425
Id.; JX 1698 (Dages-Opening) at 58, Ex. 21. See also id. at 33 (noting that a company’s
WACC is “based on the company’s expected or target capital structure, that is, the relative
proportion of debt and equity ownership”).
426
JX 2315 (Metrick-Supplemental) at 6.
427
Id.
428
Id.
Id. at 6–7 (citing JX 1723 at row 128 of ‘Financial Build’ tab; JX 1697 (Metrick-
429
Opening) at 109).
103
the fixed costs he found in the Management Projections and treated “all other costs
as variable in implementing the 2% comparable store sales growth assumption.”430
Metrick then ran a DCF based upon JPM Sensitivity #2, which assumes that
PetSmart will open new stores according to current management plans through 2019
and will have no new store growth thereafter.431 In this DCF model, he used his
terminal investment formula to calculate the required investment in the terminal
period using a 2.0% perpetual growth rate.432 Applying his adjusted Dages WACC
of 8.17% (as adjusted to reflect the capital structure assumed by the cash flows),
Metrick then performed a DCF using the cash flows found in Sensitivity #2 resulting
in a valuation of $82.79 per share.433 Using his own adjusted WACC of 7.77%,
Metrick’s DCF analysis using Sensitivity #2 results in a valuation of $86.96 per
share.434
As explained above, I have found the JPM sensitivities to be the most reliable
projections in the record before me – the question now is what to do with the various
430
Id. at 7.
431
Id. at 1; JX 1336 at 35.
432
JX 2315 (Metrick-Supplemental) at 7–8, 8 n.18; JX 1697 (Metrick-Opening) at 115–
117. Both Dages and Metrick chose inflation for the perpetual growth rate; they just chose
two different rates of inflation. Trial Tr. 537:4–10 (Dages).
433
JX 2315 (Metrick-Supplemental) at 8. See also id. at 6 n.14, Ex. 4.
434
Id. at 8. See also id. at 6 n.15, Ex. 3.
104
DCF analyses constructed by the experts based upon these projections. While I
agree with Metrick’s criticism of any projection that extends the PIP cost savings
out indefinitely into the future, I find no support in the evidence for the specific
adjustments that he makes to the PIP cost savings in his initial report. The theory is
sound, and I agree that it is not reasonable to assume that the PIP savings will
continue at $200 million annually through the terminal period, but there is
insufficient evidence in the record to allow me to assess when the PIP cost savings
will begin to fade and at what levels. Therefore, I am not persuaded that Metrick’s
initial DCF valuation, based on his adjustments to the Management Projections,
offers a reliable indicator of fair value.435
This leads me to the experts’ competing analyses based on the JPM
sensitivities. I agree with Metrick’s criticism of the rebuttal DCF analysis Dages
presented at trial—the WACC must accurately reflect the capital structure indicated
by the cash flows, and the costs should accurately reflect the fixed costs. I am also
convinced that Metrick’s formula for calculating the required amount of investment
to support the terminal growth rate is proper, as it is supported by economic theory,
finance literature and even testimony that Dages offered to this court in a prior
435
To be fair, Metrick performed his DCF as a fallback. His showcase opinion is that the
Merger Price of $83 per share reflects fair value and that DCF is not a reliable indicator of
value in this case. Trial Tr. 1268:21–1269:8 (Metrick).
105
case.436 Metrick’s formula demonstrates that PetSmart’s return on invested capital
will converge towards its cost of capital, a theory this court has repeatedly cited with
approval.437 In contrast, and in contrast to his past practice, Dages merely adopted
the terminal investment from the Management Projections, which would imply that
PetSmart would permanently see returns on capital far above its cost of capital.438
That premise is not credible, at least not to me.
I also find Sensitivity #2 to be the most reliable of the three JPM sensitivities,
as this reflects the current management plan for new store sales growth.
Accordingly, I am satisfied that the DCF analysis performed by Metrick in his
supplemental report is the most reliable DCF that can be performed with the data
available. As noted, this analysis reveals a valuation of PetSmart ranging from
436
JX 2315 (Metrick-Supplemental) at 7–8, 8 n.18; JX 1697 (Metrick-Opening) at 115–
117; JX 1233 at 29–31; JX 1691; Trial Tr. 714:10–21 (Dages).
437
See, e.g., In re John Q. Hammons Hotels Inc. S’holder Litig., 2011 WL 227634, at *4
n.16 (Del. Ch. Jan. 14, 2011) (stating that the convergence model is “a reflection of the
widely-accepted assumption that for companies in highly competitive industries with no
competitive advantages, value-creating investment opportunities will be exhausted over a
discrete forecast period, and beyond that point, any additional growth will be value-
neutral” leading to the “return on new investment in perpetuity [converging] to the
company’s cost of capital”); Cede & Co. v. Technicolor, Inc., 1990 WL 161084, at *26
(Del. Ch. Oct. 19, 1990), consolidated with Cinerama, Inc. v. Technicolor, Inc., 1991
WL 111134 (Del. Ch. June 24, 1991), and aff’d in part and rev’d in part on other grounds,
634 A.2d 345 (Del. 1993) (discussing that “profits above the cost of capital in an industry
will attract competitors, who will over some time period drive returns down to the point at
which returns equal the cost of capital”).
438
Trial Tr. 572:22–574:10 (Dages); Trial Tr. 1299:3–1302:24 (Metrick); JX 1691.
106
$82.79 to $86.96 per share (depending upon whether one applies the adjusted Dages
WACC or the adjusted Metrick WACC). Given my lack of confidence in the
Management Projections underlying the JPM sensitivities, however, I am not
inclined to adjust my view that the fair value of PetSmart at the time of the Merger
is best reflected in the $83 per share Merger Price. The DCF analyses performed by
Metrick on the JPM Sensitivity #2 are, however, confirmatory.
D. Does the Evidence Provide a Basis for Alternative DCF Analyses?
As a final step in discharging my duty to consider “all relevant factors,” I have
looked to the record to determine if there is any basis to make further adjustments to
the projections or to alter the inputs used by the experts to arrive at a more reliable
DCF analysis. I am satisfied that no such basis exists. The JPM sensitivities
provided the most reliable evidence in the record of the actual, expected future cash
flows of the Company. And while they are not perfect, I find nothing in the evidence
that would allow me credibly to adjust these projections further. Nor do I find a
basis to alter the experts’ inputs. The DCF models they constructed were not that
dissimilar. Where they differed, I found Metrick’s explanations for his approach, in
this case, to be credible. I see no reason to alter the work he performed.
I have considered all relevant factors. I state my final decision below.
107
III. CONCLUSION
Accepting Petitioners’ contention that the fair value of PetSmart was
$128.78 per share would be tantamount to declaring that a massive market failure
occurred here that caused PetSmart to leave nearly $4.5 billion on the table. In the
wake of a robust pre-signing auction among informed, motivated bidders, and in the
absence of any evidence that market conditions impeded the auction, I can find no
basis to accept Petitioners’ flawed, post-hoc valuation and ignore the deal price. Nor
can I find a path in the evidence to reach a fair value somewhere between the values
proffered by the parties. And so I “defer” to deal price, not to restore balance after
some perceived disruption in the doctrinal Force, but because that is what the
evidence presented in this case requires.439
439
I cannot help but observe, however, that reliance upon the deal price as a reliable
indicator of fair value in this case, where the paid experts have offered such wildly different
opinions on the subject, does project a certain elegance that is very appealing. In an arm’s-
length transaction like the one here, the buyer and seller are both incented to value the
company as accurately as they can knowing that “they [will be] penalized in the
marketplace” for failing to do so. See Daniel R. Fischel, Market Evidence in Corporate
Law, 69 U. Chi. L. Rev. 941, 943 (2002). “Paid experts in litigation who testify about
values derived from analyzing comparables or discounting future cash flows to present
value, [on the other hand], have very different incentives.” Id. Given this dynamic,
Delaware courts must remain mindful that “the DCF method is [] subject to manipulation
and guesswork [and that] the valuation results that it generates in the setting of a litigation
[can be] volatile. . . .” William T. Allen, Securities Markets as Social Products: The Pretty
Efficient Capital Market Hypothesis, 28 J. Corp. L. 551, 560 (2003). The Merger Price,
negotiated at arm’s-length, in real time, after a well-run pre-signing auction that takes place
in the midst of a fully functioning market, is not burdened by such litigation-driven
confounding influences.
108
For the foregoing reasons, I have found the fair value of PetSmart shares at
the date of the closing of the Merger to be $83 per share. The legal rate of interest,
compounded quarterly, shall accrue from the date of closing to the date of payment.
The parties should confer and submit an implementing order within ten days.
109
In Re Appraisal of PetSmart, Inc.
Combined Opinion