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Financial Analysis on an Oil Corporation Takeover

Gulf Oil Corp.–Acquisition

summary of facts

o George Keller of Standard Oil Company of California (Socal) is trying to determine how much he wants to bid for Gulf Oil Corporation. Gulf will not consider offers below $70 per share even though its last closing price per share was valued at $43.

o Between 1978 and 1982, Gulf doubled its exploration and development spending to increase its oil reserves. In 1983, Gulf began to cut exploration spending significantly due to falling oil prices when Gulf management repurchased 30 million of its 195 million outstanding shares.

o The acquisition of Gulf Oil was the result of a recent takeover attempt by Boone Pickens, Jr. of the Mesa Petroleum Company. He and a group of investors had spent $638 million and obtained about 9% of all outstanding Gulf shares. Pickens engaged in a power struggle for control of the company, but Gulf executives opposed Boone’s takeover while he followed through with a $65-per-share partial public offering. Gulf then decided to liquidate on its own terms and contacted several companies to participate in this sale.

o The upgrade opportunity was Keller’s main attraction for Gulf and now he has to decide if Gulf, if liquidated, is worth $70 a share and how much he will bid for the company.

Issues

o What is Gulf Oil’s value per share if the company is liquidated?

o Who is Socal’s competition and how is it a threat?

o What should Socal offer for Gulf Oil?

o What can be done to prevent Socal from operating Gulf Oil as a going concern?

Competence

The main competitors to get Gulf Oil include Mesa Oil, Kohlberg Kravis, ARCO and of course Socal.

Table oil:

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, which would increase Mesa’s holdings to 21.3%.

o Under reinstatement, they would have to borrow many times the value of Mesa’s net worth to obtain the majority needed to win a seat on the board.

o Mesa is unlikely to raise as much capital. Still, Boone Pickens and his investor group will make a substantial profit if they sell their current shares to the winner of the bid.

BOW:

o The offer price will likely be less than $75 per share, as a $75 offer will cause your debt ratio to skyrocket, making it more difficult to borrow.

o Socal’s debt is only 14% (Exhibit 3) of total capital, and banks are willing to lend enough to make offers in the possible $90.

Kohberg Kravis:

o Specializes in leveraged buyouts. Keller feels his is the offer to beat since the heart of his offer lies in the preservation of the Gulf name, assets and jobs. Gulf will essentially be a going concern until a longer-term solution can be found.

Socal’s offer will be based on the value of Gulf’s reserves without further exploration. Gulf’s other assets and liabilities will be absorbed into Socal’s balance sheet.

Gulf Oil Weighted Average Cost of Capital

o Gulf’s WACC was determined to be 13.75% using the following assumptions:

o CAPM used to calculate cost of capital using beta of 1.5, risk-free rate of 10% (1-year Treasury), market risk premium of 7% (Ibbotson Associates arithmetic mean data from 1926 to 1995 ). Cost of own resources: 18.05%.

o The capital market value was determined by multiplying the number of shares outstanding by the 1982 share price of $30. This price was used because it is the non-inflated value before the acquisition attempts drove the price up. Equity market value: $4,959 million, weight: 68%.

o The value of the debt was determined using the book value of the long-term debt, $2,291. Weight: 32%.

o Cost of debt: 13.5% (given)

o Tax rate: 67% calculated on net income before taxes divided by income tax expense.

Gulf Oil Valuation

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 projection was made from 1983, estimating oil production until all reserves were exhausted (Annex 2). Production in 1983 was 290 million composite barrels, and it was assumed to be constant until 1991 when the remaining 283 million barrels are produced.

o Production costs were held constant relative to the amount of production, including depreciation due to the unit-of-production method Gulf currently uses (production will be the same, so the amount of depreciation will be the same)

o Because Gulf uses the LIFO method to account for inventory, it is assumed that new reserves are expensed the same year they are discovered and all other exploration costs, including geological and geophysical costs, are charged against the reserves. income as it is incurred.

o Since there will be no further exploration in the future, the only expenses that will be considered are costs related to production to deplete reserves.

o The price of oil was not expected to increase in the next ten years, and since inflation affects both the selling price of oil and the cost of production, it is canceled out in the cash flow analysis.

o Income less expenses determined cash flows for the years 1984-1991. Cash flows cease in 1991 after all oil and gas reserves are liquidated. Derivative cash flows only account for the liquidation of oil and gas assets, and do not account for the liquidation of other assets such as current assets or net property. The cash flows were then discounted at net present value using Gulf’s cost of capital as the discount rate. Total cash flows until the liquidation is completed, discounted by Gulf’s 13.75% discount rate (WACC), amount to Ch$9,981 million.

Gulf’s value as a going concern

o The second component of Gulf’s value is its value as a going concern.

o Relevant to the valuation because Socal does not plan to sell any Gulf assets other than its oil under the liquidation plan. Instead, Socal will use other Gulf assets.

o Socal may elect to return Gulf to a going concern at any time during the liquidation process, all that is required is for Gulf to start the exploration process again.

o Going concern value was calculated by multiplying the number of shares outstanding by the 1982 share price of $30. Value: $4,959 million.

o 1982 share price chosen because it is the value the market assigned before the price was raised by takeover attempts.

bidding strategy

o When two companies merge, it is common practice for the acquiring company to overpay for the purchased company.

o It causes the shareholders of the purchased company to 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 determined the value of Gulf Oil, in liquidation, at $90.39 per share. Paying anything above this amount would result in a loss to Socal shareholders.

o The maximum offer amount per share was determined by finding the value per share with Socal’s WACC, 16.20%. The resulting price was $85.72 per share.

1. This is the price per share that Socal must not exceed to continue to earn profits from the merger, because Socal’s WACC of 16.2% is closer to what Socal expects to pay its shareholders.

o The minimum offer is usually determined by the price at which the shares are currently selling, which would be $43 per share.

1. However, Gulf Oil will not accept an offer of less than $70 per share.

2. In addition, the addition of the competitor’s willingness to bid at least $75 per share raises the price of the winning bid.

o Socal took the average of the high and low offer prices, resulting in an offer price of $80 per share.

Maintain the value of Socal

o If Gulf is purchased by Socal at $80, it is based on the liquidation value of the business and not as a going concern. Therefore, if Socal operates Gulf as a going concern, its shares will be devalued by about half. The fear of Socal shareholders that management could take over Gulf and control the company as it is, which is only valued at its current share price of $30.

o After the acquisition, there will be large interest payments that could force management to improve performance and operating efficiencies. The use of debt in acquisitions serves not only as a financing technique but also as a tool to force changes in managerial behavior.

o There are some strategies that Socal could employ to assure shareholders and other relevant parties that Socal will acquire and use Gulf at the appropriate value.

o An agreement could be executed at or before the time of the offer. It would specify the future obligations of Socal’s management and include its liquidation strategy and projected cash flows. Although management may honor the agreement, there is no real motivation to prevent them from implementing their own agenda.

o Management could be supervised by an executive; however, this is often an expensive and inefficient process.

o Another way to reassure shareholders, especially when monitoring is too costly or too difficult, is to make management’s interests more like 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 powerful incentive to act in the interests of the owners by maximizing shareholder value. This is not a perfect solution because some managers with many stock options have committed accounting fraud to increase the value of those options long enough to cash in some of them, but to the detriment of their company and their other shareholders. .

o It would probably be more beneficial and less costly for Socal to align the concerns of its managers with those of shareholders by paying its managers in part with stock and stock options. There are risks associated with this strategy, but it will definitely be an incentive for management to liquidate Gulf Oil.

Recommendation

o Socal will make an offer for Gulf Oil because its cash flows reveal that it is worth $90.39 in a liquidated state.

o Socal will bid $80 per share, but cap additional bids at $85.72 because paying a higher price would hurt Socal shareholders.

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