Now, which approach should one use to value a business?
The Delaware Chancery Court in Huff was asked to determine the fair value of shares. The case pitted well-known industry experts, Robert Reilly, of Willamette Management, against Jeffrey Cohen. Each presented different opinions as to fair value. The court decided that the merger price was the fair value. The opinion raises a number of questions including, implicitly, what is fair value, what role, if any, valuation professionals have in this type of case, and what are we, as valuation professionals, supposed to do in this type of statutory engagement?
Huff Investment Partnership v. CKx, Inc.
The issue before the Delaware Chancery Court was whether the arm’s-length price paid by a disinterested party for CKx, Inc. (“CKx”) was fair. The transaction in question is one that occurred in May 2011 when CKx merged with Apollo Global Management, LLC (“Apollo”). Petitioners opted for an appraisal rather than the cash-out price received in the sale of CKx.
By way of background, CKx was publicly traded on NASDAQ. It was formed by Robert Sillerman, a businessman with experience in managing and investing in media and entertainment companies, including radio, concert promotion, sports management, and television. Sillerman created CKx to own and manage iconic entertainment properties. CKx’s business strategy arose from the premise that the ever-increasing number of entertainment distribution channels—including computer, smartphone, tablet, and television—would lead to an ever-increasing demand for original content. Sillerman, who owned 20.6 percent of CKx’s equity, and the board believed that technology would lead to an ever-increasing demand for original content and that this would lead consumers to focus less on the distribution channel and more on the content they were interested in, thereby allowing content owners to reap increasing returns.
In pursuit of this strategy, CKx focused on acquiring the rights to iconic entertainment properties. As of 2010, CKx’s most significant assets were: (1) 19 Entertainment, which owned rights to the number-one- rated television show, American Idol, as well as a successful dance show, So You Think You Can Dance (“Dance”); and (2) Elvis Presley Enterprises, as well as some rights to Presley’s recorded music catalog; and (3) Muhammad Ali Enterprises, which owned the name, likeness, and image of the boxing champion. CKx owned other assets; however, American Idol accounted for 60-75 percent of CKx’s cash flow.
“I cannot employ a DCF analysis in this case for the same reason that the Court in Doff & Co. v. Travelocity.com declined to rely on a DCF analysis. There, as here, management had prepared a set of uncertain and therefore unreliable financial projections.”
CKx’s principal challenge was how to deal with the maturation of the American Idol franchise. From its peak in 2006 until the time of the merger in May 2011, American Idol had suffered five seasons of declining ratings. During that period, American Idol’s Nielsen ratings fell by almost 50 percent among the lucrative 18-to-49-year-old demographic. American Idol also faced increasing competition from other reality shows featuring musical competition. Particularly problematic in the summer of 2011 was the looming threat of the talent-competition show X Factor. X Factor was the brainchild of former American Idol “judge” and prominent personality, Simon Cowell. Cowell’s success with a show similar to X Factor in the United Kingdom suggested that this show could pose a serious threat to American Idol. The economic uncertainty was further compounded on account that that the contract between American Idol’s network distributor, Fox, and 19 Entertainment was expiring and negotiations were underway. These entities were negotiating over the licensing fees that Fox would pay for the right to broadcast the show. Negotiations were further complicated because Fox held a perpetual license to renew its exclusive contract to broadcast American Idol.
Between 2007 and 2010, CKx encountered a number of issues that affected its acquisition strategy; CKx attempted to address those concerns by publicly stating that it was not “for sale.” One month before the Apollo merger, CKx was involved in talks with Sharp Entertainment (“Sharp”), a television production company that focused on reality and event-based programming and was expected to generate about $11 million in operating income in 2011, roughly double its 2010 earnings. Sharp had produced several popular reality shows, including Travel Channel’s Man v. Food, the highest-rated program in the channel’s history. Sharp employed 160 people, most of whom were responsible for producing and editing the more than 30 television shows in the company’s portfolio.
CKx’s announcement prompted several private equity funds to approach it. CKx’s board met to consider the options and decided again to pursue a sale of the company. The board retained a financial advisor to run an auction among interested buyers and also to solicit interest from third parties. By mid-to-late April 2011, the financial advisor informed the board that Apollo and a third party—Party B—were the only bidders who had conducted any due diligence and that two other prospective financial bidders who had signed confidentiality agreements were no longer interested in conducting due diligence or pursuing the acquisition with CKx. To incentivize the financial advisor, CKx’s board modified the terms of the agreement so as to provide additional compensation if the merger price were to exceed $5.50 per share. Sillerman expressed support for the proposed transaction with Apollo. Ultimately, Apollo submitted a bid for $5.50 per share and Party B submitted a bid for $5.60 a share. Despite the marginally lower price, the board ultimately selected Apollo’s bid because Party B’s financing was uncertain.
The financial advisor opined that the transaction represented a fair price to CKx’s shareholers, after which the board approved the transaction.
One board member dissented. Shortly thereafter, a class action lawsuit was brought challenging the Apollo transaction; this was settled for some additional disclosures and a slight modification of the termination fee.
There were a number of important issues before the court. One of the critical issues was whether the projections developed by management in connection with the expressions of interest from potential acquirers, “was a genuine prediction or a marketing ploy designed to produce a high bid from potential acquirers?” The assumptions included a belief that the revenues under the to-be-negotiated American Idol contract would increase by approximately $20 million each year. CKx’s CFO described the projection as “the more optimistic or most optimistic” possible outcome.
Petitioner’s expert witness, Robert Reilly (“Reilly”), utilized various approaches and methods in valuing CKx’s stock as of the merger date; he utilized the Discounted Cash Flow (DCF) Method and a Guideline Publicly Traded Company Method. Reilly concluded that the fair value of CKx’s shares was $11.02 per share. Respondent’s expert, Jeffrey Cohen (“Cohen”), conducted a DCF analysis in which he concluded that the value of CKx was $4.41 per share. The differences were largely due to the following factors:
Each expert used different figures in their five-year cash flow projections.
Cohen disregarded the forecasted $20 million increased in fixed licensing fees under the to-be-negotiated American Idol contract that was initially included in the management projections, instead assuming that the fees from Fox would grow at four percent per year for five years.
Reilly did not adjust the cash flows he used in his DCF analysis and relied wholly on the revenues forecast in the management projection.
Cohen and Reilly used different growth rates to calculate the terminal value in their DCF analyses.
Reilly used a long-term nominal growth rate of 4 percent.
Cohen used a long-term nominal growth rate of 0 percent.
Reilly and Cohen also used different estimates for CKx’s weighted average cost of capital, principally as a result of using different betas and size premia.
As for the guideline companies and transactions analyses, the court held that:
First, I will not rely on either of Reilly’s “guideline” analyses; the guideline publicly traded company analysis, or the guideline merged and acquired company analysis. ‘The true utility of a comparable company approach is dependent on the similarity between the company the court is valuing and companies used for comparison’. Here, the evidence is abundantly clear that the “guideline” companies used by Reilly are not truly comparable to CKx. In fact, Reilly admitted at trial that he found no companies he could describe as ‘comparable’ to CKx.
As for the DCF Approach, the court held that:
I cannot employ a DCF analysis in this case for the same reason that the Court in Doff & Co. v. Travelocity.com declined to rely on a DCF analysis. There, as here, management had prepared a set of uncertain and therefore unreliable financial projections. In Travelocity.com, the uncertainty of managements’ projections arose from inherent unpredictability of the financial performance of a travel and booking company in the aftermath of the terrorist attacks on September 11, 2001.… The unreliability of the revenue estimates, both including and excluding the $20 million estimate, is a serious impediment to creating a reliable DCF analysis.
Given the above, the court concluded that:
In the absence of comparable companies or transactions to guide a comparable companies analysis or a comparable transaction analysis, and without reliable projections to discount in a DCF analysis, I rely on the merger price as the best and most reliable indication of CKx’s value.
As for the precedential value of Golden Telecom. Inc. v. Global GT LP, 11 A.3d 214 (Del. 2010), the court held:
The Petitioner’s argue that the Supreme Court’s decision in Golden Telecom and this Court’s analysis of Golden Telecom in Merion Capital v. 3M Cogent stand for the proposition that merger price is now irrelevant in an appraisal context and that I am required to accord it no weight when determining fair value. However, I read those cases differently.
It is not clear if the case will be appealed. So, how should a valuation analyst proceed in this type of engagement? The case suggests that absent fiduciary or procedural irregularities, courts should hesitate to substitute their own appraisal and should not rely on expert appraisals where projections are uncertain.
The case is not satisfying and begs the question of why retain an expert appraiser when the price is the result of a process? What is the valuation expert supposed to do? What should legal counsel (for the petitioner) do in these instances? Isn’t uncertainty de rigueur in all types of cases, from the start-up to the “run of the mill” dissolution? Is it fair to assume the price reached following a process is the fair value? Is the Market Approach dead in the lower middle market? Is the DCF Approach dead in Delaware? There are more questions and few answers. That said, this is a case where I feel that the court should have reached a decision based on the competing scenarios, rather than assume the price offered is fair value. If the court has issues with the expert witnesses, then it should have said something, or, better yet, retained a third-party expert to prepare a separate valuation.
Roberto Castro, Esq., MST, MBA, CVA, CPVA, is a managing member of Wasatch Business Valuation & Litigation Support Services, LLC, www.wasatchbusval.com, and a Washington State attorney. Wasatch Business Valuation provides business valuation, term sheet analysis and exit planning services, and litigation support/economic damages analysis. His valuation advisory services and legal practice focuses on bankruptcy, estate and gift, succession planning, ERISA, healthcare, and M & A/transactional services. Roberto can be reached at either Roberto.Castro@wasatchbusval.com or RobertoC1@NACVA.com.
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