Gulf Oil Corp.–Takeover
Summary of Facts
o George Keller of the Standard Oil Company of California (Socal) is trying to determine how much he wants to bid on Gulf Oil Corporation. Gulf will not consider bids below $70 per share even though their last closing price per share was valued at $43.
o Between 1978 and 1982, Gulf doubled its exploration and development expenses to increase their oil reserves. In 1983, Gulf began reducing exploration expenditures considerably due to declining oil prices as Gulf management repurchased 30 million of their 195 million shares outstanding.
o The Gulf Oil takeover was due to a recent takeover attempt by Boone Pickens, Jr. of Mesa Petroleum Company. He and a group of investors had spent $638 million and had obtained around 9% of all Gulf shares outstanding. Pickens engaged in a proxy fight for control of the company but Gulf executives fought Boone’s takeover as he followed up with a partial tender offer at $65 per share. Gulf then decided to liquidate on its own terms and contacted several firms to participate in this sale.
o The opportunity for improvement was Keller’s principal attraction to Gulf and now he has to decide whether Gulf, if liquidated, is worth $70 per share and how much he will bid on the company.
Problems
o What 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 bid on Gulf Oil?
o What can be done to prevent Socal from operating Gulf Oil as a going concern?
Competition
Major competitors for obtaining Gulf Oil include Mesa Oil, Kohlberg Kravis, ARCO, and, of course, Socal.
Mesa Oil:
o Currently holds 13.2% of Gulf’s stock at an average purchase price of $43.
o Borrowed $300 million against Mesa securities, and made an offer of $65/share for 13.5 million shares, which would increase Mesa’s holdings to 21.3%.
o Under the re-incorporation, they would have to borrow an amount many times the value of Mesa’s net worth to gain the majority needed to gain a seat on the board.
o Mesa is unlikely to raise that much capital. Regardless, Boone Pickens and his investor group will make a substantial profit if they sell their current shares to the winner of the bidding.
ARCO:
o Offer price is likely less than $75/share since a bid of $75 will send its debt proportion soaring, thus making it difficult to borrow anything more.
o Socal’s debt is only 14% (Exhibit 3) of total capital, and banks are willing to lend enough to make bids into the $90’s possible.
Kohlberg Kravis:
o Specializes in leveraged buyouts. Keller feels theirs is the bid to beat since the heart of their offer lies in the preservation of Gulf’s name, assets and jobs. Gulf will essentially be a going concern until a longer-term solution can be found.
Socal’s offer will be based on how much Gulf’s reserves are worth without further exploration. Gulf’s other assets and liabilities will be absorbed into Socal’s balance sheet.
Gulf Oil’s Weighted-Average Cost of Capital
o Gulf’s WACC was determined to be 13.75% using the following assumptions:
o CAPM used to calculate cost of equity using beta of 1.5, risk-free rate of 10% (1 year T-bond), market risk premium of 7% (Ibbotson Associates’ data of arithmetic mean from 1926 – 1995). Cost of equity: 18.05%.
o Market value of equity was determined by multiplying the number of shares outstanding by the 1982 share price of $30. This price was used because it is the un-inflated value before the price was driven up by the takeover attempts. Market value of equity: $4,959 million, weight: 68%.
o Value of debt was determined by using the book value of long-term debt, $2,291. Weight: 32%.
o Cost of debt: 13.5% (given)
o Tax rate: 67% calculated by net income before taxes divided by income tax expense.
Valuation of Gulf Oil
Gulf’s value is comprised of two components: the value of Gulf’s oil reserves and the value of the firm as a going concern.
o A projection was made going forward from 1983 estimating oil production until all of the reserves were depleted (Exhibit 2). Production in 1983 was 290 million composite barrels, and this was assumed to be constant until 1991 when the remaining 283 million barrels are produced.
o Production costs were held constant relative to the production amount, including depreciation due to the unit-of-production method currently used by Gulf (Production will be the same, so depreciation amount will be the same)
o Because Gulf uses the LIFO method to account for inventory, it is assumed that new reserves are expensed the same year that they are discovered and all other exploratory costs, including geological and geophysical costs are charged against income as incurred.
o Since there will be no more exploration going forward, the only expenses that will be considered are the costs involved with production to deplete the reserves.
o The price of oil was not expected to rise in the next ten years, and since inflation affects both the selling price of oil and the cost of production, it cancels itself out and was negated in the cash flow analysis.
o Revenues minus expenses determined the cash flows for years 1984-1991. The cash flows cease in 1991 after all oil and gas reserves are liquidated. The cash flows derived account for the liquidation of the oil and gas assets only, and do not account for liquidating other assets such as current assets or net properties. The cash flows were then discounted by net present value using Gulf’s cost of capital as the discount rate. Total cash flows until liquidation is complete, discounted by Gulf’s 13.75% discount rate (WACC), come 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 utilize Gulf’s other assets.
o Socal can choose to turn Gulf back into a going concern at any time during the liquidation process, all that is needed is for Gulf to start exploration process again.
o Value as a going concern was calculated by multiplying the number of shares outstanding by the 1982 share price of $30. Value: $4,959 million.
o 1982 share price chosen because this is the value the market assigned before the price was driven up by the takeover attempts.
Bidding Strategy
o When two companies merge it is common practice for the purchasing company to overpay for the purchased firm.
o Results in the shareholders of the purchased company profiting from the over-payment, and the shareholders of the purchasing company losing value.
o Socal’s responsibility is to their shareholders, not the shareholders of Gulf Oil.
o Socal has determined the value of Gulf oil, in liquidation, to be $90.39 per share. To pay anything over this amount would result in a loss for Socal shareholders.
o Maximum bid amount 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 still obtain profit from the merger, because Socal’s WACC of 16.2% is closer to what Socal will expect to pay their shareholders.
o The minimum bid is usually determined by the price the stock is currently selling at, which would be $43 per share.
1. However, Gulf Oil will not accept a bid lower than $70 per share.
2. Also, the addition of the competitor’s willingness to bid at least $75 per share drives the winning bid price up.
o Socal took the average of the maximum and minimum bid prices, resulting in a bid price of $80 per share.
Maintaining Socal’s Value
o If Socal purchases Gulf at $80 it is based on the company’s liquidation value and not as a going concern. Therefore, if Socal operates Gulf as a going concern their stock will be devalued by approximately half. Socal stockholder’s fear that management might takeover Gulf and control the company as is which is only valued at its current stock price of $30.
o After the acquisition, there will be large interest payments that could force management to improve performance and operating efficiency. The use of debt in takeovers serves not only as a financing technique but as a tool to hopefully force changes in managerial behavior.
o There are a few strategies Socal could employ to ensure stockholders and other relevant parties that Socal will takeover and use Gulf at the appropriate value.
o A covenant could be executed on or before the time of the bid. It would specify the future obligations of Socal management and include their liquidation strategy and projected cash flows. Although management might respect the covenant, there is no real motivation to prevent them from implementing their own agenda.
o Management could be monitored by an executive; however, this is often costly and an ineffective process.
o Another way to ensure shareholders, especially when monitoring is too expensive or too difficult, is to make the interests of the management more like those of the stockholders. For instance, an increasingly common solution towards the difficulties arising from the separation of ownership and management of public companies is to pay managers partly with shares and share options in the company. This gives the managers a powerful incentive to act in the interests of the owners by maximizing shareholder value. This is not a perfect solution because some managers with lots of share options have engaged in accounting fraud in order to increase the value of those options long enough for them to cash some of them in, but to the detriment of their firm and its other shareholders.
o It would probably be the most beneficial and the least costly for Socal to align its managers concerns with that of the stockholders by paying their managers partly with shares and share options. There are risks associated with this strategy but it will definitely be an incentive for management to liquidate Gulf Oil.
Recommendation
o Socal will place a bid for Gulf Oil because its cash flows reveal that it is worth $90.39 in a liquidated state.
o Socal will bid $80 per share but limits further bidding to a ceiling of $85.72 because paying a higher price would hurt Socal’s shareholders.
