March 2011 | Issue 52
Delaware Chancery Court, when called upon to opine on the value of a business, has in recent years given pride of place to the discounted cash flow (DCF) method of valuation. A recent case, Muoio v. Hallmark, C.A. No. 4729-CC, March 9, 2011, serves notice that the Court’s reliance on the DCF method does not constitute blind acceptance.
Hallmark Cards, Inc. was the controlling stockholder of Crown Media Holdings, Inc., a cable media company. Hallmark was also Crown’s primary debt holder. For years, Crown was unable to make its debt payments, and was forced to obtain extensions on its debt from Hallmark.
In May of 2009, Hallmark proposed a recapitalization of Crown. Under the terms of the recapitalization, Hallmark would exchange its Crown debt for an increased percentage of Crown’s Class A common stock, new preferred stock and a new and smaller amount of debt with longer maturities. This would permit Crown to avoid default and bankruptcy.
In July of 2009, S. Muoio & Co. LLC, a Crown shareholder, filed an action in Delaware Chancery Court seeking to block or reverse the recapitalization. The Plaintiffs contended that the recapitalization would be consummated at an unfair price that drastically undervalued Crown. This, they said, would unfairly transfer significant value and voting power from the Crown minority stockholders to Hallmark.
Despite the lawsuit, the transaction closed in June, 2010. The parties ended up in Chancery Court in September.
The key valuation issue that the Court (C. Chandler) had to decide was whether the value of Crown exceeded the $1.2 billion of debt it had outstanding. The Plaintiffs asserted that it did, the Defendants that it did not.
Plaintiffs’ principal valuation expert, Daniel Schecter of L.E.K. Consulting, relied solely on a discounted cash flow analysis (DCF). He arrived at a valuation of $2.9 billion for the company. He had also performed two other valuation calculations, a comparable company analysis ($803 million) and a comparable transaction analysis ($1.3 billion). He rejected these two conclusions, however, as being “absurdly low” in comparison to his DCF analysis.
The Defendants presented the valuation testimony of three experts, Morgan Stanley, Houlihan and Jerry Hausman, an MIT professor. Morgan Stanley and Houlihan used multiple valuation methodologies, and both arrived at values for Crown that were less than the amount of Crown’s debt. Hauseman, a cable TV expert, testified that a DCF analysis is more reliable when it can be verified by alternative valuation methods.
The Court’s Reaction
The Court commented as follows on the valuation testimony: “Schechter’s single methodology valuation of Crown is roughly three times higher than any of the other valuations. The more robust approaches taken by Defendants’ experts and advisors, however, used multiple valuation methodologies and independently reached results that fell within the same range. Although there certainly may be circumstances where using only one valuation method is appropriate and reliable, this is not such a circumstance.”
The Court’s opinion contains a chart (I call it the “Sore Thumb Chart”) which displays Schechter’s $2.9 billion valuation and contrasts it to sixteen other valuations or valuation indications, all falling within the range of $500 million to $1.3 billion. The Court commented as follows: “As the chart plainly reveals, Schechter’s sole valuation of Crown using his own DCF methodology was wildly divergent from all other valuations.”
The Court was also influenced by the fact that Schechter’s DCF ignored management’s contemporaneous projections and used his own “hypothetical and overly optimistic set of projections.”
Schechter was also faulted for not giving sufficient weight to the fact that Crown had been widely known to be “for sale” since 2005, and that no prospective buyer had indicated interest at a price remotely close to his value.
The Court concluded by acknowledging the fact that DCF valuations have featured prominently in the Delaware Chancery Court, because it is the approach that merits the greatest confidence within the financial community. The Court gives more credit and weight, however, to experts who apply multiple valuation techniques that support each other and serve as a cross-check.
Because the Plaintiffs’ expert failed to do this, and because Defendants’ experts proffered testimony that persuasively and thoroughly supported their valuation conclusion that Crown’s debt exceeded the value of the company, the Court concluded that the recapitalization was entirely fair.