Kennecott copper corporaton case report
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KENNECOTT COPPER CORPORATION CASE REPORT
1. Analyze the economic rationale of the Carborundum acquisition. Under what conditions an acquisition would be expected to add to shareholder value in general? Do any of these reasons apply to Carborundum acquisition?
Prior to the consideration of Carborundum as an acquisition target, Kennecott, a copper company, pursued an acquisition of Peabody, a coal company, for $285 million in cash in 1968. There are two main rationales behind the acquisition of Peabody by Kennecott. First, to stabilize the high volatility in Kennecott’s profitability due to sharp changes in copper prices and increasing competition from copper producers in Chile, Zambia, Peru, and Zaire, LDCs whose reliance on copper exports for their foreign exchange earnings forces them to flood the world’s copper market in spite of times of low profitability. Secondly, Kennecott hoped to diversify its operations.
The acquisition of Peabody did not go as planned. The fact that the FTC intervened by filing an antitrust law against the Kennecott-Peabody transaction had led Kennecott to ultimately seek another target, Carborundum.
Since the FTC’s antitrust law required Kennecott to divest Peabody, Kennecott would receive cash or near-cash of $600 million from the Peabody sale. Kennecott’s 33.2 million common shares had a market value of about $900 million by the end of May 1977, $600 million from the Peabody sales. The large cash fall from the divestiture of Peabody and Kennecott’s problems of copper prices dropping sharply, world inventories at all-time highs, and their shares at severely depressed market prices made Kennecott a potential target for any acquisition-minded firm with roughly $300 million or more of available funds. According to Exhibit 3 of the case, as of December 31, 1976, 26 U.S. nonfinancial firms could have easily financed a takeover of Kennecott.
Kennecott’s use of Peabody’s proceeds was not limited to acquiring
Carborundum alone. Instead, Kennecott had a number of options at their disposal. First, invest additional capital in the copper business. Second, distribute the proceeds to shareholders in the form of special dividend or repurchase shares. Third, pay down some of its long-term debt.
Under the influence of Morgan Stanley’s advice that Kennecott may become over-committed to cooper, Kennecott decided to search for an acquisition target outside the copper industry and their initial focus on oil and gas and forest-products firms, presumably since their previous deal with an energy firm was met with governmental opposition, and thus the acquisition of Carborundum Company, a producer of abrasive products, arose.
Generally, shareholder value is created through the added tax shield of financing an acquisition with a large amount of debt, which lessens tax burdens and therefore indirectly increases profitability. Another source for shareholder value is the creation of synergy by consolidating management costs and complementing core strengths or creating vertical integration. Only the first of these two reasons is met in this case. The major incentive for the acquisition of Carborundum is the diversification of Kennecott’s products and services for Kennecott’s management. Shareholder’s should not be interested in having this diversification done for them, and should instead would want to diversify their portfolio themselves which offers much greater efficiency. Conglomerates tend to diversify losses when it is in the interest of the parent company, which does not create shareholder value. Clearly, the management of Kennecott seek the acquisition out of self-interest as not to become a takeover target, and to stabilize their cyclical business as previously attempted with Peabody Coal.
2. Kennecott’s management team determined, based on Exhibit 7, that the value of Carborundum to Kennecott would be about $70-$85 per share (page 7). Critically evaluate the methodology used to determine this value. As shown in Exhibit 7 of the case, the annual cash flow is calculated as the sum of the dividend to Kennecott and the tax shelter from plant write-up. The dividends to Kennecott equal to the difference between Carborundum’s net income after adjustment and the profit retention. The methodology
Kennecott’s management team used to determine the value of Carborundum to Kennecott was evaluated using an incorrect set of cash flows. First, it subtracted out the profit retention requirements needed to support Carborundum’s growth even though Kennecott would own the full equity in Carborundum, which is incorrect. Second, depending on the method used to value the company, the relevant set of cash flow is needed to be determined, either the free cash flow to the firm or the free cash flow to equity.
To arrive to the correct set of cash flows to use for the most basic valuation method (the WACC), Kennecott should take net income and add back tax adjusted interest expenses, depreciation and goodwill amortization, and subtract increases in net working capital and capital expenditures. Without adjusting the net income to obtain the free cash flows, the value of Carborundum to Kennecott could justified $70-$85 per share. Multiplying the per share price of $85 by the 8 million shares outstanding, Carborundum would be worth $680 million. This figures is identical to the cash flows calculated under Exhibit 7 of the case, discounted at a discount rate of 10%, which comes out to $679 million.
It could be argued that Kennecott’s management team had an incentive to use a favorable valuation methodology to raise the valuation of Carborundum in order to convince its board and to avoid shareholder opposition to offering a higher price than what we have more conservatively calculated in question 3. Just as the First Boston report noted, “the Board’s legal responsibility was to exercise reasonable business judgment in the best interests of the Corporation and its continuing body of shareholders and that the Board was not required to act in accordance with the special interests of particular shareholders, such as those seeking short-term market profits, i.e. those who might prefer the partial liquidation of the Corporation’s earnings base or its takeover by another, “ the valuation methodology used by Kennecott’s management appears not to have been in the interest of its profit-oriented shareholders (page 9).
3. Use the information given in Exhibit 7 to determine the value of Carborundum to Kennecott using the Flow-to-Equity Method. Assume that the
market risk premium (ErM – rf) equals 8.3%. Let’s assume we will use the Flow-to-Equity method to value the company, thus we would need to calculate the free cash flow to equity. Since Exhibit 7 of the case explicitly provides the net income, the correct approach to derive from net income to free cash flow to equity is by adding depreciation and goodwill amortization, net borrowings and tax-loss carry forwards, and subtracting increases in working capital and capital expenditures.
After calculating the free cash flow to equity, we would need to calculate the appropriate discount rate to discount the cash flow. Since we are using the flow-to-equity method, we would need to discount the cash flows using the equity required rate of return. We will employ the CAPM formula re = rf + β*(rm – rf) for this purpose.
With the beta of equity of 1.16 given in Equity 5 of the case, the risk free rate of 5.60% given in Exhibit 5 of the case as the 90-day T-Bill rate, and the market risk premium assuming to be 8.30%, we can insert the equity beta into the CAPM formula to calculate the equity required rate of return as shown below:
re = 0.056 + 1.16*0.083 = 0.1523
the equity required rate of return computes to 0.1523 or 15.23%.
Before we can discount the cash flows, we need to determine the terminal value. Exhibit 7 of the case uses the multiple method to value the terminal value. However, we decided to use the constant growth perpetuity method to calculate the terminal value using a growth rate projected by the increase in working capital. We assume this growth rate to be 9%.
After outlining major assumptions we used in modeling Carborundum, the value of Carborundum to Kennecott is $478.4 million or $58.3 per share. Clearly this price per share is much lower than the price Kennecott agreed to pay of Carborundum, which is $66 per share or $541 million.
Further, we employed a sensitivity analysis to analyze the value of Carborundum had some assumptions were changed. Exhibit 2 shows the sensitivity analysis results. It shows that the price per share of $66 can only be justified with a higher growth rate and a less risky equity beta which is more of an aggressive approach.
4. Why is management pursuing the acquisition? As an outside director of the board, how would you argue and vote on the resolution to tender for Carborundum?
Kennecott had received a large sum of cash from the divestiture of Peabody Kennecott’s use of Peabody’s proceeds was not limited to acquiring Carborundum alone. Instead, Kennecott had a number of options at their disposal. First, invest additional capital in the copper business. Second, distribute the proceeds to shareholders in the form of special dividend or repurchase shares which was trading below the book value of the company. Third, pay down some of its long-term debt.
Kennecott decided to diversify their company’s asset by investing in another business to protect the company from fluctuations in the copper market. In our opinion, Kennecott’s decision to pursue Carborundum’s acquisition is a form of empire building.
As an outside director of the board, we believe that the Carborundum’s acquisition was a bad decision. As we have previously calculated, a tender offer of $66 for Carborundum was not justified. Based on our assumptions, any price offer above $58 per share would dilute the shareholders’ shares since our valuation shows that Carborundum was only worth $478 million instead of $541. The fact that the $66 tender offer is twice of Carborundum’s market value, was due to the bidding war across different bidders. Kennecott should continue searching for targets that are not engaged in such war to lower the premium. As such, we would not vote on this acquisition.
5. Review management’s decisions over the 10 years covered by the case,
including the acquisition of Peabody, its divestiture, the proposed use of the proceeds of the Peabody sale and the selection of Carborundum as an acquisition target. What were the motivations underlying these decisions? Were they in the best interest of shareholders?
Kennecott Copper Corporation was the largest domestic producer of copper and copper products. However, there had been a high volatility in their profitability as their business highly depended on the change of copper price and was over-committed to copper.
Therefore, Kennecott’s management had been exploring different acquisition opportunities in order to diversify their business. Their motivations were to seek ways to stabilize their profitability as well as to explore significant investment opportunity outside copper. The divestiture of Peabody was an unfortunate outcome from the court. Having said that, the management did choose to divest Peabody through a private sale in order to maximize the offer. After sitting with a significant proceeds from the sale, they were still looking for a replacement of Peabody and identified Carborundum, who is one of the world’s principal producers of a complete line of abrasive products. There would be more value-added components in the supply chain instead of a pure commodity producer whose profits were so sensitive to the underlying commodity price.
By looking Kennecott’s developments during this decade, they were acting on the best interest of their shareholders in long-term. Being a copper producer, Kennecott might have simply hedged their exposure to volatile copper price by derivative to achieve a relatively stable profit. However, in the view of gloomy outlook that copper price recovery and consumption growth were modest while costs were increasing, they decided diversification by acquisitions. Especially, having received the proceeds from the sale of Peabody, they didn’t distribute back to the shareholders as special dividend nor subsidize their potential operational loss due to the competitive copper market because either would lead Kennecott’s share price to drop further and they might become a potential target to be acquired in the market. The cash offer to acquire Carborundum had been the best use of this.
6. Critically evaluate the actions and recommendations by Kennecott’s financial advisors (Morgan Stanley and First Boston) and its legal advisors (Sullivan and Cromwell). Kennecott’s financial advisors and its legal advisors are formally employed by Kennecott to act on behalf of their principal, as such they are known as agents. There are potential conflicts of interests between the principal and the agents.
First, Morgan Stanley is an agent for both Carborundum and Kennecott. Under this setting, Morgan Stanley is without doubt, having serious conflicts of interest between both parties since Morgan Stanley will receive a fee for being retained by Kennecott to analyzing the potential options to use Peabody’s proceeds, and at the same time, being retained as advisers to Carborundum about the tender offer. With this in mind, Morgan Stanley would have a motive to increase the premium Kennecott needed to pay for Carborundum since for each dollar increment, Morgan Stanley would increase their pay. Referring to the case, before engaged by Carborundum, Morgan Stanley advised Kennecott “favoring a significant diversification, with the amount open but preferably in the $400 million – $600 million range…” However, the deal paid by Kennecott was $66 per share or $680 million which was higher than the proposed range.
Second, First Boston was retained by Kennecott to examine all feasible form of Peabody’s divestiture. They advised that the value would be worth most if the divestiture was done privately. Critically speaking, if there are potential conflicts of interests here, it could be that First Boston have close relationship with the buyers such that there exists some form of conflicts between all parties, or by earning an extra fee on the newly issued notes and bonds.
Third, Sullivan and Cromwell was the legal advisor of Kennecott retained to analyze the deal for Peabody. Their statement “this acquisition does not violate any of the federal antitrust laws as so far construed by the court or the Federal Trade Commission, and that an action seeking divestiture would not be successful” underestimated the FTC’s power and thus did not act
prudently towards Kennecott. Although the deal ended being divested, Sullivan and Cromwell had already received their legal fees. This is clearly a conflict of interest.