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AT&T™s Financing of NCR
AT&T offered NCR™s shareholders the right to exchange 100 percent of their shares for
AT&T stock, valued at $110 per NCR share, unless AT&T was not satis¬ed that an all-
stock merger could be accounted for as a pooling of interests. In that case, target stock-
holders would exchange 40 percent of their shares for AT&T stock and 60 percent for
cash, where both stock and cash were valued at $110 per share. High and low collars
were added to the stock deal to ensure that NCR™s stockholders were protected in the
event of a decline in AT&T™s stock price. In either event the acquisition was to be treated
as a tax-free purchase of stock.
AT&T™s offer is unusual because it indicates that the ¬rm had a strong preference for
having the acquisition accounted for under the pooling-of-interests method. AT&T™s
managers argued that it was important for the ¬rm to use pooling-of-interests accounting
to avoid any goodwill amortization, which would hurt the ¬rm™s earnings and stock
price. And certainly, goodwill amortization would have hurt earnings: pro forma esti-
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mates indicate that 1990 earnings per share for AT&T (including the earnings of NCR)
would have been $2.42 under the pooling-of-interests method and only $1.97 under the
purchase method. However, it is not so obvious that this earnings decline would have
affected the stock price.
In summary, AT&T chose to ¬nance NCR with a 100 percent stock offer, primarily to
ensure that it could use pooling-of-interests accounting. Because this is a very conserva-
tive approach, the ¬nancing of the acquisition does not impose additional ¬nancial risks
on AT&T™s stockholders. However, AT&T™s explanation of the offer should raise ques-
tions for analysts about whether the form of the offer really maximized value for AT&T™s
existing shareholders.


ACQUISITION OUTCOME
The ¬nal question of interest to the analyst evaluating a potential acquisition is wheth-
er it will indeed be completed. If an acquisition has a clear value-based motive, the
target is priced appropriately, and its proposed ¬nancing does not create unnecessary
¬nancial risks for the acquirer, it may still fail because the target receives a higher
competing bid or because of opposition from entrenched target management. There-
fore, to evaluate the likelihood that an offer will be accepted, the ¬nancial analyst has
to understand whether there are potential competing bidders who could pay an even
higher premium to target stockholders than is currently offered. They also have to
consider whether target managers are entrenched and, to protect their jobs, likely to
oppose an offer.


Other Potential Acquirers
• If there are other potential bidders for a target, especially ones who place a higher
value on the target, there is a strong possibility that the bidder in question will be
unsuccessful. Target management and stockholders have an incentive to delay ac-
cepting the initial offer to give potential competitors time to also submit a bid. From
the perspective of the initial bidder, this means that the offer could potentially re-
duce stockholder value by the cost of making the offer (including substantial invest-
ment banking and legal fees). In practice, a losing bidder can usually recoup these
losses, and sometimes even make healthy pro¬ts from selling to the successful ac-
quirer any shares it has accumulated in the target.


Key Analysis Questions
The ¬nancial analyst can determine whether there are other potential acquirers for
a target and how they value the target by asking the following questions:
• Are there other firms that could also implement the initial bidder™s acquisi-
tion strategy? For example, if this strategy relies on developing benefits from
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complementary assets, look for potential bidders who also have assets com-
plementary to the target. If the goal of the acquisition is to replace inefficient
management, what other firms in the target™s industry could provide manage-
ment expertise?
• Who are the acquirer™s major competitors? Could any of these firms provide
an even better fit for the target?



Target Management Entrenchment
If target managers are entrenched and fearful for their jobs, it is likely that they will op-
pose a bidder™s offer. Some ¬rms have implemented “golden parachutes” for top man-
agers to counteract their concerns about job security at the time of an offer. Golden
parachutes provide top managers of a target ¬rm with attractive compensation rewards
should the ¬rm get taken over. However, many ¬rms do not have such schemes, and op-
position to an offer from entrenched management is a very real possibility.
While the existence of takeover defenses for a target indicates that its management is
likely to ¬ght a bidding ¬rm™s offer, defenses have typically not prevented an acquisition
from taking place. Instead, they tend to cause delays, which increase the likelihood that
there will be competing offers made for the target, including offers by friendly parties so-
licited by target management, called “white knights.” Takeover defenses therefore increase
the likelihood that the bidder in question will be outbid for the target, or that it will have to
increase its offer signi¬cantly to win a bidding contest. Given these risks, some have ar-
gued that acquirers are now less likely to embark on a potentially hostile acquisition.


Key Analysis Questions
To assess whether the target ¬rm™s management is entrenched, and therefore likely
to oppose an acquisition, analysts can ask the following questions:
• Does the target firm have takeover defenses designed to protect manage-
ment? Many such defenses were used during the turbulent 1980s, when hos-
tile acquisitions were at their peak. Some of the most widely adopted include
poison pills, staggered boards, super-majority rules, dual-class recapitaliza-
tions, fair-price provisions, ESOP plans, and changes in ¬rms™ states of incor-
poration to states with more restrictive anti-takeover laws.
• Has the target been a poor performer relative to other firms in its industry? If
so, management™s job security is likely to be threatened by a takeover, lead-
ing it to oppose any offers.
• Is there a golden parachute plan in place for target management? Golden
parachutes provide attractive compensation for management in the event of a
takeover to deter opposition to a takeover for job security reasons.
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Analysis of Outcome of AT&T™s Offer for NCR
AT&T had good reason to be concerned about the outcome of an offer for NCR. NCR had
rejected AT&T™s preliminary friendly offers made to the company before any public an-
nouncement, indicating that target management intended to oppose the offer and use
whatever anti-takeover measures were at their disposal. NCR followed up this opposition
by creating a quali¬ed ESOP and announcing a special dividend of $1 and a $.02 per
share regular dividend increase, all intended to prohibit AT&T from using pooling of in-
terests to account for the acquisition. NCR™s opposition certainly increased the likeli-
hood that either AT&T would overpay for NCR, or that it would be forced to drop its offer.
No competing offers for NCR emerged, probably because the high price offered by AT&T
scared off any competitors. The acquisition was ¬nally completed on September 19,
1991, ten months after AT&T™s initial offer.


SUMMARY
This chapter summarizes how ¬nancial statement data and analysis can be used by ¬-
nancial analysts interested in evaluating whether an acquisition creates value for an ac-
quiring ¬rm™s stockholders. Obviously, much of this discussion is also likely to be
relevant to other merger participants, including target and acquiring management and
their investment banks.
For the external analyst, the ¬rst task is to identify the acquirer™s acquisition strategy.
We discuss a number of strategies. Some of these are consistent with maximizing ac-
quirer value, including acquisitions to: take advantage of economies of scale; improve
target management; combine complementary resources; capture tax bene¬ts; provide
low-cost ¬nancing to ¬nancially constrained targets; and increase product-market rents.
However, other strategies appear to bene¬t managers more than stockholders. For ex-
ample, some unpro¬table acquisitions are made because managers are reluctant to return
free cash ¬‚ows to shareholders, or because managers want to lower the ¬rm™s earnings
volatility by diversifying into unrelated businesses.
The ¬nancial analyst™s second task is to assess whether the acquirer is offering a rea-
sonable price for the target. Even if the acquirer™s strategy is based on increasing share-
holder value, it can overpay for the target. Target stockholders will then be well rewarded
but at the expense of acquiring stockholders. We show how the ratio, pro forma, and val-
uation techniques discussed earlier in the book can all be used to assess the worth of the
target to the acquirer.
The method of ¬nancing an offer is also relevant to a ¬nancial analyst™s review of an
acquisition proposal. If a proposed acquisition is ¬nanced with surplus cash or new debt,
it increases the acquirer™s ¬nancial risk. Financial analysts can use ratio analysis of the
acquirer™s postacquisition balance sheet and pro forma estimates of cash ¬‚ow volatility
and interest coverage to assess whether demands by target stockholders for consider-
ation in cash lead the acquirer to increase its risk of ¬nancial distress.
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Finally, the ¬nancial analyst is interested in assessing whether a merger is likely to
be completed once the initial offer is made, and at what price. This requires the analyst
to determine whether there are other potential bidders, and whether target management
is entrenched and likely to oppose a bidder™s offer.


DISCUSSION QUESTIONS
1. Mary Saxon, a Dutch investment banker, is advising a local client on a potential for-
eign acquisition in the U.S. Currently, there is a competing cash bid for the target
by a U.S. competitor. However, Saxon argues that the target should be worth more
to the Dutch client than to the U.S. competitor, since Dutch accounting rules permit
the considerable goodwill from the transaction to be written off against owners™ eq-
uity, thus avoiding any ongoing charges against income. In contrast, U.S. rules re-
quire goodwill to be written off over 40 years or less. What would you recommend
to the Dutch bidder?
2. During the early 1990s there was a noticeable increase in mergers and acquisitions
between firms in different countries (termed cross-border acquisitions). What fac-
tors could explain this increase? What special issues can arise in executing a cross-
border acquisition and in ultimately meeting your objectives for a successful com-
bination?
3. In the 1980s leveraged buyouts (LBOs) were a popular form of acquisition. Under
a leveraged buyout, a buyout group (which frequently includes target management)
makes an offer to buy the target firm at a premium over its current price. The buyout
group finances much of the acquisition with debt capital, leading the target to be-
come a highly leveraged private company following the acquisition.
a. What types of firms would make ideal candidates for LBOs? Why?
b. How might the acquirer add sufficient value to the target to justify a high buyout
premium?
4. Kim Silverman, CFO of the First Public Bank Company, notes: “We are fortunate
to have a cost of capital of only 10 percent. We want to leverage this advantage by
acquiring other banks that have a higher cost of funds. I believe that we can add sig-
nificant value to these banks by using our lower cost financing.” Do you agree with
Silverman™s analysis? Why or why not?
5. The Boston Tea Company plans to acquire Hi Flavor Soda Co. for $60 per share, a
50 percent premium over current market price. John E. Grey, the CFO of Boston
Tea, argues that this valuation can easily be justified, using a price-earnings analy-
sis. “Boston Tea has a price-earnings ratio of 15, and we expect that we will be able
to generate long-term earnings for Hi Flavor Soda of $5 per share. This implies that
Hi Flavor is worth $75 to us, well below our $60 offer price.” Do you agree with
this analysis? What are Grey™s key assumptions?
6. You have been hired by GS Investment Bank to work in the merger department. The
analysis required for all potential acquisitions includes an examination of the target
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for any off-balance-sheet assets or liabilities that have to be factored into the valu-
ation. Prepare a checklist for your examination.
7. Company T is currently valued at $50 in the market. A potential acquirer, A, be-
lieves that it can add value in two ways: $15 of value can be added through better
working capital management, and an additional $10 of value can be generated by
making available a unique technology to expand T™s new product offerings. In a
competitive bidding contest, how much of this additional value will A have to pay
out to T™s shareholders to emerge as the winner?
8. In 1995 Disney acquired ABC television at a significant premium. Disney™s man-
agement justified much of this premium by arguing that the acquisition would guar-
antee access for Disney™s programs on ABC™s television stations. Evaluate the
economic merits of this claim.
9. A leading oil exploration company decides to acquire an Internet company at a 50
percent premium. The acquirer argues that this move creates value for its own
stockholders because it can use its excess cash flows from the oil business to help
finance growth in the new Internet segment. Evaluate the economic merits of this
claim.
10. a. How would the following ratios differ for a company that used the purchase
method to account for an acquisition versus the pooling-of-interests method in
the year following the acquisition?
• Return on sales
• Return on assets
• Asset turnover
b. Two years after the acquisition, the company decides that it was a failure and
sells the target at a price substantially below its original price but above the orig-
inal book value. What effect will this transaction have on the earnings of the
acquirer in the two cases (purchase versus pooling)?


NOTES
1. In a review of studies of merger returns, Michael Jensen and Richard Ruback, “The Market
for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11, (April
1983): 5“50, conclude that target shareholders earn positive returns from takeovers, but that ac-
quiring shareholders only break even.

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