Hesco Bastion Environmental, Inc. (“Hesco” or the “Company”), along with its subsidiaries and related entities, operates in the flood barrier industry. Hesco sells rapidly deployable barriers that function as giant sandbags to its customers, which consist primarily of architecture and civil engineering firms as well as governmental organizations. Accordingly, Hesco’s revenue is in large part driven by natural disasters and other weather-related events. The larger the disaster, the more revenue Hesco generates, but revenue in any given year can be difficult to predict.
This Delaware Chancery Court case relates to Patricia Laidler (the “Petitioner”), a 10% owner of Hesco (the “Respondent”), and her demand for a statutory appraisal as a result of a short-form merger. The Petitioner was a party to a shareholder agreement, which, among other things, gave her a contractual right to compel Hesco to repurchase her shares. Petitioner was offered $180.00 per share and $207.50 per share in November 2011 and January 2012, respectively. Petitioner declined both offers. In May 2013, Petitioner filed her Verified Petition for Appraisal, pursuant to 8 Del. C. § 262 (the “Petition”), in the Court of Chancery of the State of Delaware (the “Court”).
As a result of the Petition, Petitioner and Respondent each hired a valuation expert to determine the fair value of the Petitioner’s shares. The Petitioner’s valuation expert opined on a value of $515.00 per share, while the Respondent’s valuation expert opined on a value of $250.30 per share. This article will address some of the most relevant valuation issues upon which the Court ruled.
The valuation experts, and therefore the Court, considered several valuation methodologies, including the actual price paid as a result of the merger, two different forms of the market approach, and the income approach.
The Respondent suggested that the Court should consider the merger price set by Hesco as persuasive evidence of Hesco’s value, citing “how the deal value was reached” and “the arms-length negotiations that took place.” However, given that the controlling shareholder held 90% of the shares of the Company (with the Petitioner holding the remaining 10%), the Court determined that the “controlling stockholder itself determined the price it would pay for the Company’s sole minority stockholder’s shares, and… consummated a merger transaction without that minority stockholder’s consent.” Ultimately, the Court declined to consider the merger price in determining the value of Hesco because it was not an arm’s-length transaction subject to negotiations or market indications, but rather a short-form merger that was unilaterally driven by the controlling owner.
The Respondent’s valuation expert considered comparable companies and comparable transactions in his market approach to valuation, while the Petitioner’s valuation expert did not rely on either of these approaches. Given the nature of Hesco’s business, it appears that both the comparable companies and comparable transactions analyses relied upon pricing multiples of companies that were not very similar to Hesco. The Respondent’s valuation expert even acknowledged this lack of comparability when he stated the following:
‘Hesco is not as similar to the guideline companies as we would prefer, therefore, this method was given relatively little weight in our final analysis,’ and further, that ‘the guideline merged and acquired company method was [also] given relatively little weight due to (1) the data points available and (2) the comparability of the transactions with Hesco’s specific line of business, size, and other specific factors;’ he similarly testified at deposition that “[i]n my review of the companies, again, I could not find a public company that had the kind of weather-driven, event-related sales volatility that [the Company] had,’ and conceded that ‘[a]ll of [the proposed comparable companies] are diversified companies, so to that extent, they do have a much smoother and less volatile revenue structure [than Hesco].’
Because of the lack of comparability to Hesco, the Court declined to rely on either of the Respondent’s expert’s methods under the market approach given that, “the Respondent has failed to demonstrate that the companies upon which its analyses are based are truly comparable to Hesco.” While the Court did acknowledge that it is generally preferable to employ multiple valuation approaches in order to determine a more supportable valuation range, it is clear from this ruling that it does not mean that a valuation expert must force a method to apply when the data is simply not there to support it.
The Court’s determination in this case is telling with regard to employing the market approach to a company in a unique industry or with unique driving forces. The Court’s ultimate opinion was that, “The ‘true utility’ of either approach ‘is dependent on the similarity between the company the court is valuing and the companies used for comparison,’ and ‘when the comparables involve companies that offer different products or services, are at a different stage in their growth cycle, or have vastly different multiples, a comparable companies or comparable transactions analysis is inappropriate.’”
Both experts relied on the direct capitalization of cash flow (“DCCF”) method, a form of the income approach. Both experts opined that employing a discounted cash flow (“DCF”) method, though more common, was not feasible in the valuation of Hesco given that management never made cash flow projections in the ordinary course of business and the Company’s results had significant volatility historically. Despite a historical preference for the DCF method, the Court opined that in the instant case the DCCF method was the most appropriate methodology to use in determining the value of Hesco given the lack of comparable companies or transactions, the lack of management projections, and the agreement of the experts that this methodology was the most appropriate to utilize in the valuation of Hesco.
Although both experts agreed that the DCCF method was most appropriate to value Hesco, they disagreed on the appropriate inputs to utilize with respect to normalized cash flows and the capitalization rate.
Normalized Cash Flow
The Court noted that the parties’ valuations differed primarily due to the fact that the Petitioner’s valuation expert developed his cash flow figure by weighting Hesco’s actual revenues in 2010 and 2011 40% and 60%, respectively, then multiplying that figure by a projected 55% profit margin and subtracting $1.5 million in estimated overhead expenses. The Respondent’s valuation expert, on the other hand, developed a cash flow figure by weighting to varying degrees actual and “normalized” earnings before interest, taxes, depreciation and amortization figures for 2009, 2010, and 2011. The Respondent’s valuation expert normalized earnings by removing what he considered to be nonrecurring events related to revenues generated from certain unusual natural disasters.
Ultimately, the Court found that, “the best predictor of future cash flows is past cash flows in 2009, 2010, and 2011, weighted equally.” With respect to the Petitioner’s valuation expert, the Court found it suspect that he placed 60% weight on 2011 cash flows given that this was the “highest grossing year at more than double the revenue of any other year,” even though it was the most recent year of financial performance. Further, the Court found that the Respondent’s valuation expert’s contention that certain revenues were nonrecurring was unsupportable, noting that “the Company is primarily in the business of providing asset protection in anticipation of natural disasters, so the Respondent’s suggestion that all natural disasters are non-recurring, and therefore a poor predictor of future revenue streams, seems to me misplaced.”
Typically, it is not uncommon when relying on historical earnings as a basis for estimating future earnings to eliminate abnormal years or to remove any nonrecurring income and expenses. However, given the nature of the business that Hesco is in, it appears hard to support the removal of revenue generated from large natural disasters, when the Company’s revenues are generated from these very events. Based thereon, the Court ruled in this case that all of Hesco’s historical results were relevant when analyzing a normalized level of cash flow, and no normalizing adjustments were appropriate.
When performing a DCCF, it is important to remember that this analysis is a forward-looking analysis, just as the DCF is. Therefore, the cash flow that is capitalized should represent expected future income. A simple average of past results is not typically an adequate procedure to develop projected cash flow, unless the expert can justify that this historical average is a reasonable proxy for future cash flows.1 In the instant case, because management had never prepared projections due to the extreme volatility of the Company’s results and the inability to accurately forecast future weather-related events, the Court determined that the DCCF based on an average of the Company’s last three years of results was the most reasonable method to value Hesco.
Both valuation experts determined the capitalization rate by subtracting the Company’s long-term growth rate from its weighted average cost of capital (“WACC”). Further, both valuation experts agreed that the appropriate long-term growth rate was 4%, but disputed various inputs of the Company’s WACC. Both experts utilized a build-up model to determine the Company’s cost of equity, but disagreed on the appropriate industry and size risk premium.
It is interesting to note that the Court allowed the use of the build-up model to determine Hesco’s cost of equity, despite significant criticisms in prior cases.2 It is unclear from this decision whether or not the Court has changed its view on the build-up model in general, or if it was allowed simply because both experts utilized the method and, therefore, it was not a contested issue.
Industry Risk Premium
Both valuation experts relied on information published by Morningstar, Inc. in its Stocks, Bonds, Bills, and Inflation Valuation Yearbook (“SBBI”) to determine Hesco’s industry risk premium. The Petitioner’s valuation expert utilized data from three separate industry classifications over several years. The Respondent’s valuation expert, however, relied upon only one industry classification and utilized information published by Morningstar for only one year; the most recent year immediately preceding the valuation date (i.e., 2011). The Respondent’s valuation expert testified that he contacted Morningstar and was informed that “the appropriate use of their statistic is to use the latest available data.” In this regard, the Court concluded that the Respondent’s valuation expert’s industry risk premium was most appropriate given the Respondent’s valuation expert’s “credible expert testimony” on this topic.
Both valuation experts again relied on information contained in SBBI to derive their respective size premiums. The Respondent’s valuation expert concluded that the appropriate size premium was that associated with the 10th decile of companies, while the Petitioner’s valuation expert contended that the appropriate size category for the size premium was the 10a decile. The Respondent’s valuation expert argued that the 10a decile should not be relied upon given that this size category “includes companies with market capitalizations between 144 million and 236 million, despite the fact that Hesco is worth far less.” The Petitioner’s valuation expert, on the other hand, made the case that the 10th decile should not be considered given that it includes those companies in the 10b decile, which “includes a disproportionately large number of highly leveraged or poorly performing companies that have low equity values, not because their business operations are ‘small,’ but because their equity valuations are low.” While the Court noted that both experts provided credible testimony on this subject, it concluded that the size premium suggested by the 10th decile was most appropriate given that it contains the 10a decile, which accounts for companies with a more similar debt structure to Hesco, and the 10b decile, to account for companies with more similar market capitalization.
Company-Specific Risk Premium
Another interesting item to note is that the Court allowed the use of a company-specific (i.e., unsystematic) risk premium to determine Hesco’s cost of equity, despite very harsh criticisms in prior cases.3 Like the use of the build-up model, it is unclear from this decision whether or not the Court actually agreed with the implementation of the company-specific risk premium, or if it was just not addressed because both experts utilized the same assumptions.
While there are many important valuation concepts addressed in this case, perhaps the key takeaway is that it is always important to consider the specifics of the company that you are valuing. Hesco was a company in a very unique industry that had a business that was driven by events that are virtually impossible to predict. As the Court noted here, a valuation expert should not just perform a DCF method because it is typical, and a market approach does not have to be employed if there are no companies comparable to the subject company. The Court made it clear in this case that it was looking for the most supportable analysis available, even if it was outside of what might be considered typical. Another key takeaway is that the Court allowed two rate of return concepts in this case that have been fully dismissed previously: the build-up model and the company-specific risk premium. Based thereon, it is clear from this case that just because the Court has previously rejected a theory, it does not mean that you should completely disregard the concept if you believe it is valid and supportable based on the case at hand. However, because both experts utilized these concepts and the Court did not provide any material commentary, it is still advisable to proceed with caution and come prepared to fully support your assumptions if you plan to employ the build-up model or add on a company-specific risk premium in Delaware.
1 Shannon P. Pratt, Valuing A Business – The Analysis and Appraisal of Closely Held Companies, Fifth Edition (New York, NY: McGraw-Hill, 2008), page 247.
2 See the decision for “In Re: Appraisal of the Orchard Enterprises, Inc.” for the Court’s review of the build-up model.
3 See the decisions for “Delaware Open MRI Radiology Associates, P.A. v. Howard B. Kessler, et al.”, “In Re Sunbelt Beverage Corp. Shareholder Litigation”, and “In Re: Appraisal of the
Orchard Enterprises, Inc.” for the Court’s review of the company-specific risk premium.