Gulf Oil Corp.–Acquisition
Summary of the facts
o George Keller of the Standard Oil Company of California (Socal) is trying to figure out how much he wants to bid for Gulf Oil Corporation. Gulf will not consider bids below $70 per share, despite the last closing price per share being valued at $43.
o Between 1978 and 1982, Gulf doubled its exploration and development costs to increase its oil reserves. In 1983 Gulf began to significantly reduce exploration spending due to falling oil prices when Gulf management repurchased 30 million of its 195 million shares outstanding.
o Gulf Oil’s acquisition follows a recent takeover attempt by Boone Pickens, Jr. of Mesa Petroleum Company. He and a group of investors had issued $638 million and received about 9% of all outstanding Gulf shares. Pickens engaged in a proxy fight for control of the company, but Gulf executives fought Boone’s takeover when he made a partial takeover bid at $65 a share. Gulf then decided to liquidate the company on its own terms and contacted several firms to participate in the sale.
o The opportunity to improve was Keller’s main draw to Gulf and now he must decide if Gulf is worth $70 per share in the event of liquidation and how much he will bid for the company.
o What is Gulf Oil worth per share if the company is liquidated?
o Who are Socal’s competitors 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?
Major competitors in extracting 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 an offer of $65/share for 13.5 million shares, increasing Mesa’s ownership to 21.3%.
o As part of the reincorporation, they would have to borrow an amount that is a multiple of Mesa’s net worth in order to gain the majority required for 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 bid.
o The bid price is likely to be less than $75/share as a bid of $75 skyrockets the debt ratio, making it difficult to borrow more.
o Socal’s debt is only 14% (Figure 3) of total assets, and banks are willing to lend enough to allow bids into the $90 mark.
o Specialized in leveraged buyouts. Keller believes her offer is best because at the heart of her offer is preserving Gulf’s name, assets and jobs. Gulf will essentially continue until a longer term solution can be found.
Socal’s bid is based on how much the Gulf’s reserves are worth without further exploration. Gulf’s other assets and liabilities are included in Socal’s balance sheet.
Gulf Oil weighted average cost of capital
o Gulf’s WACC was set at 13.75% using the following assumptions:
o CAPM 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 on arithmetic mean from 1926 to 1995). Cost of Equity: 18.05%.
o Fair value of equity was determined by multiplying the number of shares outstanding by the 1982 share price of $30. This price was used as it is the non-inflated value before the takeover attempts pushed the price up. Market value of equity: $4,959 million, weighting: 68%.
o Debt value was determined using the book value of long-term debt of $2,291. Weight: 32%.
o Borrowing costs: 13.5% (given)
o Tax rate: 67% calculated as net profit before tax divided by income tax expense.
Review by Gulf Oil
Gulf’s value 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 forecast was made for the future from 1983, estimating oil production until all reserves were exhausted (Figure 2). Production in 1983 was 290 million barrels of composites and this was expected to remain constant through 1991 when the remaining 283 million barrels will be produced.
o Production costs have been held constant relative to production volume, including depreciation due to Gulf’s current unit of production method (production remains the same, therefore the depreciation amount remains the same).
o Because Gulf uses the LIFO method of accounting for inventories, it is assumed that new reserves will be expensed in the same year that they are discovered, and all other exploration costs, including geological and geophysical costs, as incurred be posted to income.
o As there will be no future exploration, the only expenses taken into account are the costs associated with producing to deplete the reserves.
o The price of oil should not increase for the next ten years and since inflation affects both the selling price of oil and the cost of production, it cancels out and has been negated in the cash flow analysis.
o Income minus expenses determined the cash flows for the years 1984-1991. Cash flows end in 1991 after all oil and gas reserves are liquidated. The derived cash flows only consider the liquidation of the oil and gas assets and do not consider the liquidation of other assets such as working capital or net worth. The cash flows were then discounted to net present value using Gulf’s cost of capital as the discount rate. Total cash flows to the completion of the liquidation, discounted at Gulf’s discount rate (WACC) of 13.75%, are $9,981 million.
Gulf’s corporate value
o The second component of Gulf’s value is enterprise value.
o Relevant to the valuation as Socal has no plans to sell Gulf assets other than its oil as part of the liquidation plan. Instead, Socal will leverage Gulf’s other assets.
o Socal may elect to return Gulf to going concern at any time during the liquidation process, all that is required is for Gulf to restart the exploration process.
o Value as a going concern was calculated by multiplying the number of shares outstanding by the 1982 stock price of $30. Value: $4,959 million.
o The 1982 share price was chosen because that is the value the market assigned before the takeover attempts drove the price up.
o When two companies merge, it is common for the buying company to overpay for the company being bought.
o As a result, the shareholders of the acquired company benefit from the overpayment and the shareholders of the acquiring company lose value.
o Socal’s responsibility is to its shareholders, not Gulf Oil’s shareholders.
o Socal has priced Gulf Oil in Liquidation at $90.39 per share. Payment in excess of this amount would result in a loss for Socal shareholders.
o The maximum bid amount per share was determined by calculating the value per share using Socal’s WACC, 16.20%. The resulting price was $85.72 per share.
1. This is the price per share that Socal cannot exceed in order to still realize profits from the merger as Socal’s WACC is 16.2% closer to what Socal expects to pay its shareholders.
o The minimum bid is usually determined by the price at which the stock is currently being sold, which would be $43 per share.
1. However, Gulf Oil will not accept an offer below $70 per share.
2. The addition of the competitor’s willingness to bid at least $75 per share also drives up the bid price.
o Socal averaged the maximum and minimum bid prices, resulting in an bid price of $80 per share.
Preserving the Value of Social
o If Socal buys Gulf at $80, it is based on the company’s liquidation value and not on a going concern basis. So if Socal operates Gulf as a going concern, its stock will be devalued by about half. Socal shareholders’ fears that management could take over Gulf and control the company as it’s only valued at its current $30 stock price.
o Post-acquisition, there will be high interest payments that could force management to improve performance and operational efficiencies. The use of leverage in acquisitions serves not only as a financing technique, but also as a tool, hopefully to force changes in managerial behavior.
o There are some strategies Socal could employ to reassure shareholders and other relevant parties that Socal is acquiring and utilizing Gulf at fair value.
o An agreement could be made at or before the time of the offer. It would specify Socal management’s future commitments and include their liquidation strategy and projected cash flows. Although management might respect the agreement, there is no real motivation to prevent them from implementing their own agenda.
o Management could be supervised by a senior manager; however, this is often a costly and ineffective process.
o Another way to keep shareholders safe, especially when monitoring is too expensive or difficult, is to align management’s interests with those of shareholders. For example, an increasingly common solution to the difficulties arising from the separation of ownership and management of public companies is to pay managers in part with shares and stock options in the company. This gives managers a strong incentive to act in the interests of owners by maximizing shareholder value. This is not a perfect solution as some managers have committed accounting fraud with many stock options in order to increase the value of those options long enough for them to exercise some of them, but to the detriment of their firm and their other shareholders.
o It would probably be most beneficial and least costly for Socal to align the concerns of its managers with those of shareholders by partially paying their managers in stock and stock options. This strategy comes with risks, but it will definitely incentivize management to liquidate Gulf Oil.
o Socal will bid on Gulf Oil as its cash flows show it is worth $90.39 in a liquidated state.
o Socal will bid $80 per share but will cap further bids at $85.72 as paying a higher price would be detrimental to Socal shareholders.