Gulf Oil Corp: acquisition
Summary of facts
o George Keller of Standard Oil Company of California (Socal) is trying to determine how much he wants to bid for Gulf Oil Corporation. Gulf will not consider offers below $ 70 per share even though its last closing price per share was valued at $ 43.
o Between 1978 and 1982, Gulf doubled its exploration and development expenses to increase its oil reserves. In 1983, Gulf began significantly reducing exploration spending due to falling oil prices when Gulf management repurchased 30 million of its 195 million outstanding shares.
o The acquisition of Gulf Oil was due to a recent acquisition attempt by Boone Pickens, Jr. of Mesa Petroleum Company. He and a group of investors had spent $ 638 million and obtained about 9% of all Gulf shares outstanding. Pickens engaged in a power struggle for control of the company, but Gulf executives opposed the Boone acquisition while he followed up with a partial public offering at $ 65 per share. Gulf then decided to liquidate on its own terms and contacted several companies to participate in this sale.
o The opportunity for improvement was Keller’s main attraction to Gulf and he now has to decide whether Gulf, if liquidated, is worth $ 70 per share and how much it will bid for the company.
o How much is Gulf Oil worth per share if the company is liquidated?
o Who is Socal’s competition and how are they a threat?
o What should Socal offer for Gulf Oil?
o What can be done to prevent Socal from operating Gulf Oil as a going concern?
The main competitors for Gulf Oil include Mesa Oil, Kohlberg Kravis, ARCO and, of course, Socal.
o Currently owns 13.2% of Gulf shares at an average purchase price of $ 43.
o Borrowed $ 300 million against Mesa securities and made a $ 65 / share offer for 13.5 million shares, which would increase Mesa’s holdings to 21.3%.
o Under reinstatement, they would have to borrow an amount many times greater than Mesa’s net worth to get the majority needed to get a seat on the board.
o Mesa is unlikely to raise that much capital. Regardless, Boone Pickens and his group of investors will make a substantial profit if they sell their current shares to the winner of the tender.
o The offer price is likely to be less than $ 75 / share, as a $ 75 offer will cause your debt ratio to rise, making it difficult to borrow anything else.
o Socal’s debt is only 14% (Exhibit 3) of the total capital, and the banks are willing to lend enough to make possible offers for the $ 90.
o Specializes in leveraged acquisitions. Keller feels that his is the best option, as the heart of his offering lies in the preservation of Gulf’s name, assets and works. The Gulf will essentially be a going concern until a longer-term solution can be found.
Socal’s offer will be based on the value of the Gulf reserves without further exploration. The other assets and liabilities of Gulf will be absorbed in Socal’s balance sheet.
Gulf Oil Weighted Average Cost of Capital
o The Gulf WACC was determined to be 13.75% using the following assumptions:
o CAPM used to calculate cost of capital using beta of 1.5, risk-free rate of 10% (1-year T bond), market risk premium of 7% (arithmetic mean data from Ibbotson Associates from 1926 to 1995) . Cost of share capital: 18.05%.
o The market value of the capital stock was determined by multiplying the number of shares outstanding by the 1982 share price of $ 30. This price was used because it is the non-inflated value before acquisition attempts caused the price to rise. . Market value of the shares: $ 4,959 million, weighting: 68%.
o The value of the debt was determined using the book value of the long-term debt, $ 2,291. Weight: 32%.
o Cost of debt: 13.5% (given)
o Tax rate: 67% calculated by the net profit before taxes divided by the income tax expense.
Gulf oil valuation
The value of Gulf is made up of two components: the value of Gulf’s oil reserves and the value of the company as a going concern.
o A projection was made starting in 1983 estimating oil production until all reserves are exhausted (Table 2). Production in 1983 was 290 million composite barrels, and it was assumed to be constant until 1991, when the remaining 283 million barrels are produced.
o Production costs were held constant relative to production quantity, including depreciation due to the unit of production method currently used by Gulf (production will be the same, so the depreciation amount will be the same)
o Because Gulf uses the LIFO method to account for inventory, new reserves are assumed to be expensed the same year they are discovered and all other exploration costs, including geological and geophysical costs, are charged against income as it is incurred.
o Since there will be no further exploration in the future, the only expenses that will be considered are the costs involved with producing to deplete reserves.
o The price of oil was not expected to increase in the next ten years, and since inflation affects both the sale price of oil and the cost of production, it is canceled and nullified in the cash flow analysis.
o Income minus expenses determined the cash flows for the years 1984-1991. Cash flows cease in 1991 after the liquidation of all oil and gas reserves. Derivative cash flows represent only the liquidation of oil and gas assets, and do not take into account the liquidation of other assets such as current assets or net property. The cash flows were then discounted at net present value using Gulf’s cost of capital as the discount rate. Total cash flows until settlement is complete, discounted by Gulf’s 13.75% discount rate (WACC), amount to $ 9,981 million.
Gulf’s value as a going concern
o The second component of Gulf’s value is its value as a going concern.
o Relevant to the valuation because Socal does not plan to sell any of Gulf’s assets other than its oil under the liquidation plan. Instead, Socal will use other Gulf assets.
o Socal may elect to convert Gulf back to a going concern at any time during the liquidation process, all that is needed is for Gulf to begin the exploration process again.
o The value as a going concern was calculated by multiplying the number of outstanding shares by the 1982 share price of $ 30. Value: $ 4,959 million.
o 1982 share price chosen because it is the value that the market assigned before the acquisition attempts caused the price to rise.
o When two companies merge, it is common practice for the purchasing company to overpay for the purchased company.
o Results in the shareholders of the purchased company benefiting from the overpayment and the shareholders of the acquiring company losing value.
o Socal’s responsibility is to its shareholders, not to Gulf Oil shareholders.
o Socal has determined that the value of Gulf oil, in liquidation, is $ 90.39 per share. Paying anything above this amount would mean a loss to Socal shareholders.
o The maximum amount of offer per share was determined by finding the value per share with Socal’s WACC, 16.20%. The resulting price was $ 85.72 per share.
1. This is the price per share that Socal must not exceed to continue to profit from the merger, because Socal’s WACC of 16.2% is closer to what Socal expects to pay its shareholders.
o The minimum offer is generally determined by the price at which the stock is currently selling, which would be $ 43 per share.
1. However, Gulf Oil will not accept an offer of less than $ 70 per share.
2. Additionally, the addition of the competitor’s willingness to bid at least $ 75 per share increases the price of the winning bid.
o Socal took the average of the maximum and minimum bid prices, resulting in a bid price of $ 80 per share.
Maintaining the value of Socal
o If Socal buys Gulf at $ 80, it is based on the liquidation value of the business and not as a going concern. Therefore, if Socal operates Gulf as a going concern, its shares will devalue by about half. Socal shareholders fear that management will take over Gulf and control the company as it is, which is only valued at its current share price of $ 30.
o After the acquisition, there will be large interest payments that could force management to improve performance and operational efficiency. The use of debt in acquisitions serves not only as a financing technique, but also as a tool to force changes in managerial behavior.
o There are some strategies that Socal could employ to ensure that shareholders and other relevant parties take ownership of Socal and use Gulf at appropriate value.
o An agreement could be executed at the time of the tender or before. It would specify the future obligations of Socal’s management and include its liquidation strategy and projected cash flows. Although management can respect the pact, there is no real motivation to prevent them from implementing their own agenda.
o Management could be supervised by an executive; however, this is often a costly and ineffective process.
o Another way to reassure shareholders, especially when monitoring is too expensive or too difficult, is to make the interests of management more closely resemble those of shareholders. For example, an increasingly common solution to the difficulties that arise from the ownership and management of public companies is to pay managers in part with shares and stock options in the company. This gives managers a powerful incentive to act in the interests of owners by maximizing shareholder value. This is not a perfect solution because some managers with many stock options have engaged in accounting fraud to increase the value of those options long enough for them to cash out some of them, but to the detriment of their company and their other shareholders. .
o It would probably be the most beneficial and least costly thing for Socal to align the concerns of its managers with those of shareholders by paying its managers in part with shares and stock options. There are risks associated with this strategy, but it will definitely be an incentive for management to liquidate Gulf Oil.
o Socal will bid for Gulf Oil because its cash flows reveal that it is worth $ 90.39 in a liquidated statement.
o Socal will bid $ 80 per share, but limits additional bids to a cap of $ 85.72 because paying a higher price would hurt Socal shareholders.