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Market Value Trumps Dodgy DCF in Verizon Case

March 2013 | Issue 64

Introduction

On November 17, 2006, Verizon Communications spun off its Yellow Pages subsidiary, Idearc, Inc.  The debt load assumed by Idearc in the transaction ultimately proved to be too heavy a burden and, 28 months later, the company went into bankruptcy.

U S Bank NA, as Trustee of the Idearc Litigation Trust, filed an action against Verizon alleging a variety of claims arising from the spinoff.  Many of these claims revolved around the question of what the value of Idearc was at the time it was spun off from Verizon.  Accordingly, the court bifurcated the trial, with the first part to be devoted to a single factual question; what was Idearc’s value on November 17, 2006.  The case is U.S.Bank NA v. Verizon Communications Inc., et al., 10-01842, U.S. District Court, Northern District Texas (January 22, 2013).

The Plaintiffs’ Case

The Trust retained an appraisal expert, Carlyn Taylor (“Taylor”) to value Idearc.  She performed three valuation calculations; a discounted cash flow analysis (DCF), a valuation based on the market prices of five comparable public companies, and a valuation based on acquisition transactions of 17 other somewhat similar companies.  The market multiple and comparable transaction approaches produced values for Idearc ranging from $11.7 billion to $15.8 billion. By contrast, the DCF approach produced a value of only $5.8 billion.

At the time of the spinoff, Idearc was a public company with its stock trading on the New York Stock Exchange.  Its trading price implied a value for the company of $12.8 billion.

The plaintiffs’ expert developed her final value for Idearc by assigning a 70% weight to the DCF value, and weights of 15% each to the market multiple and comparable transaction approaches.  This produced a final value of $8.15 billion.  She assigned no weight at all in her analysis to Idearc’s own stock trading price.  She chose not to on the grounds that the investing public was unaware of certain negative facts concerning the company, making the market price an unreliable indicator of value.

The Pushback

The defendants took exception to the plaintiffs’ expert’s valuation analysis on a number of grounds.  Here are some of their key objections:

  • The cash flow projections Taylor used in the DCF approach were unduly pessimistic.
  • The terminal cash flow projections for Idearc assumed an annual rate of EBITDA decline into perpetuity, an assumption that is commercially unreasonable.
  • The discount rate used in the DCF analysis, 9.75%, was too high, for several reasons, (i) It assumed too much equity in the capital structure, and (ii) it included a 2% company specific risk premium.  The use of a company specific risk premium represents double counting, as the conservative projections already take into account company specific risk.
  • Taylor’s valuation conclusion under the DCF approach produced a significant “outlier” in comparison to her calculations under the market multiple and comparable transaction methods.  Normally, outliers are given less weight in coming to a value conclusion.  In this case, Taylor gave the outlier the greatest weight.

The Court’s View

Agreeing for the most part with the foregoing  criticisms, the court said;

”At nearly every step in the DCF analysis, Taylor selected inputs that forced Idearc’s value lower.  From her selection of only the most pessimistic projections of Idearc’s future performance, to her reliance on a ‘commercially unreasonable’ terminal value projection and calculation, to her selection of a remarkably high discount rate, the method produced a valuation that is low in the extreme and that implied an incredibly low trading multiple for Idearc. [ ] Rather than disregarding or assigning low weight to her DCF valuation, Taylor did the opposite.  She assigned low weight to the consistent valuations (the market multiple valuation and the comparable transaction valuation).”

The Outcome

Based on the evidence, the court concluded that the company, on November 17, 2006, was worth “at least $12 billion.”

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) addressed herein.