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END OF CHAPTER CASE STUDY: BERKSHIRE HATHAWAYAND 3G BUY AMERICAN FOOD ICON HEINZCase Study Objectives: To Illustrate• Form of payment, form of acquisition, acquisition vehicle, and postclosing organizations• How complex LBO structures are organized and financed.In a departure from its traditional deal making strategy, Berkshire Hathaway (Berkshire), thegiant conglomerate run by Warren Buffett, announced on February 14, 2013, that it would buyfood giant H.J. Heinz (Heinz) for $23 billion or $72.50 per share in cash. Including assumed debt,the deal is valued at $28 billion. Traditionally, Berkshire had shown a preference for buyingentire firms with established brands and then allowing them to operate as they had been.Investors greeted the news enthusiastically boosting Heinz’s stock price by nearly 20% to theoffer price and Berkshire’s class A common stock price by nearly 1% to $148,691 a share.Unlike prior transactions, Berkshire teamed with 3G Capital Management (3G), a Brazilianbackedinvestment firm that owns a majority stake in Burger King, a company whose business iscomplementary to Heinz, and interests in other food and beverage companies. Heinz’s headquarterswill remain in Pittsburgh, its home for more than 120 years. The major attraction toBerkshire is the extremely well-known Heinz brand and the opportunity to use Heinz as aplatform for making additional acquisitions in the global food industry. Berkshire is addinganother widely recognized brand to his portfolio which already contains Dairy Queen and Fruitof the Loom. The strong Heinz brand gives it the ability to raise prices.The deal is intended to assist Heinz in growing globally. By taking the firm private, Heinzwill have greater flexibility in decision making not having to worry about quarterly earnings.Currently, about two-thirds of the firm’s total annual revenue comes from outside the UnitedStates. Heinz earned $923 million on sales of $11.65 billion in fiscal 2013. At 20 times 2013 current earnings, the deal seems a bit pricey when compared to price to earningsratios for comparable firms (Table 13.4). The risks to the deal are significant. Heinz willhave well over $10 billion in debt, compared to $5 billion now. Before the deal, Moody’sInvestors Service rated Heinz just two notches beyond junk. If future operating performancefalters, the firm could be subject to a credit rating downgrade. The need to pay a 9% preferredstock dividend will also erode cash flow. 3G will have operational responsibility for Heinz.Heinz may be used as a platform for making other acquisitions.Risk to existing bondholders is that 1 day they own an investment grade firm with a modestamount of debt and the next day they own a highly leveraged firm facing a potential downgradeto junk bond status. On the announcement date, prices of existing Heinz triple B rated bonds fellby over two cents on the dollar, while the cost to ensure such debt (credit default swaps) soaredby over 25% to a new high.The structure of the deal is described in Figure 13.3. H.J. Heinz Company, a PennsylvaniaCorporation, entered into a definitive merger agreement with Hawk Acquisition HoldingCorporation (Parent), a Delaware corporation, and Hawk Acquisition Sub (Merger Sub), Inc., aPennsylvania corporation and wholly owned subsidiary of Parent. The agreement called forMerger Sub to merge with Heinz, with Heinz surviving as a wholly owned subsidiary of Parent.Berkshire and 3G acquired one-half of the common stock of Parent for $4.12 billion each, withBerkshire also purchasing $8 billion in 9% preferred stock issued by Parent, bringing the totalcash injection to $18.24 billion. The preferred stock has an $8 billion liquidation preference (i.e.,assurance that holders are paid before common shareholders), pays and accrues a 9% dividend,and is redeemable at the request of the Parent or Berkshire under certain circumstances. The useof preferred stock has been a hallmark of Berkshire deals and has often included warrants tobuy common stock.Parent used the $18.24 billion cash injection from Berkshire and 3G (i.e., $14.12 fromBerkshire1$4.12 from 3G) to acquire the common shares of Merger Sub. J.P. Morgan and WellsFargo provided $14.1 billion of new debt financing to Merger Sub. The debt financing consisted of $8.5 billion in dollar-denominated senior secured term loans, $2.0 billion of Euro/BritishPounds senior secured term loans, a $1.5 billion senior secured revolving loan facility, and a $2.1billion second lien bridge loan facility. Total sources of funds equal $32.34 billion, consisting of$18.24 in equity plus $14.1 billion in debt financing.The deal does not contain a go shop provision, which allows the target to seek other bidsonce they have reached agreement with the initial bidder in exchange for a termination fee to bepaid to the initial bidder if the target chooses to sell to another firm. Go shop provisions may beused since they provide a target’s board with the assurance that it got the best deal; for firmsincorporated in Delaware, the go shop provision helps target argue that they satisfied the socalledRevlon Duties, which require a board to get the highest price reasonably available for thefirm. While Heinz did not have such a go shop provision, if another bidder buys Heinz, it willhave to pay a termination fee of $750 million, plus $25 million in expenses. If Berkshire and 3Gcannot close the deal they must pay Heinz $1.4 billion before they can walk away.Heinz may not have negotiated a go shop provision which is common in firms seeking toprotect their shareholder interests because it is incorporated in Pennsylvania. Pennsylvaniacorporate law is intended to give complete latitude to boards in deciding whether to accept orreject takeover offers because it does not have to consider shareholders’ interests as the dominantdeterminant of the appropriateness of the deal (unlike Delaware). Instead, the directors can basetheir decision on interest of employees, suppliers, customers and creditors and communities.This may explain why Berkshire and 3G have agreed to have Heinz’s headquarters remain inPittsburgh, keep the firm’s name, and preserve the firm’s charitable commitments. Firms incorporatedin Delaware may be subject to greater pressure to negotiate go shop arrangementsbecause Delaware corporate law requires the target’s board to get the highest price for itsshareholders.Discussion Questions1. Identify the form of payment, form of acquisition, acquisition vehicle, and postclosingorganization? Speculate why each may have been used.2. How was ownership transferred in this deal? Speculate as to why this structure may havebeen used?3. Describe the motivation for Berkshire and 3G to buy Heinz.4. How will the investors be able to recover the 20% purchase price premium? Explain youranswer.5. Do you believe that Heinz is a good candidate for an LBO? Explain your answer.6. What do you believe was the purpose of the $1.5 billion senior secured revolving loan facility,and the $2.1 billion second lien bridge loan facility as part of the deal financing package?7. Why do you believe Berkshire Hathaway wanted to receive preferred rather than commonstock in exchange for its investing $8 billion? Be specific.END OF CHAPTER CASE STUDY: THERMO FISHER ACQUIRESLIFE TECHNOLOGIESCase Study Objectives: To Illustrate How Acquirers Utilize Financial Models To• Evaluate the impact of a range of offer prices for the target firm, including what constitutesthe “maximum price”• Determine which financing structures are consistent with maintaining or achieving a desiredcredit rating• Investigate the implications of different payment structures (form and composition of thepurchase price)• Identify the impact of changes in operating assumptions such as different revenue growth ratesor the amount and timing of synergy.BackgroundAlmost 9 months after reaching an agreement to combine their operations, the mergerbetween Life Technologies Corporation (Life Tech) and Thermo Fisher Scientific Inc. (ThermoFisher) was completed on January 14, 2014. Thermo Fisher is the largest provider by marketvalue of analytical instruments, equipment, reagents and consumables, software, and servicesfor scientific research, analysis, discovery, and diagnostics applications. Life Tech is the secondlargest by market value provider of similar products and services to the scientific research andgenetics analysis communities. While the fanfare surrounding the closing echoed sentimentssimilar to those expressed when the deal was first announced, the hard work of integratingthe two firms was just beginning. What led to this moment illustrates the power of financialmodels. Life Tech had been evaluating strategic options for the firm since mid-2012, concluding thatputting itself up for sale would be the best way to maximize shareholder value (see Case Study11 titled “Life Tech Undertakes a Strategic Review” for more detail.). After entering into discussionswith Thermo Fisher in late 2012, the two firms announced jointly on April 15, 2013, thatthey had reached an agreement to merge. Exuding the usual optimism accompanying such pronouncements,Mark N. Casper, president and chief executive officer of Thermo Fisher stated“We are extremely excited about this transaction, because it creates the ultimate partner for ourcustomers and significant value for our shareholders. . . enhancing all three elements of ourgrowth strategy: technological innovation, a unique customer value proposition, and expansionin emerging markets.” Expressing similar confidence, Greg T. Lucier, chairman and chief executiveofficer of Life Tech noted “This transaction brings together two companies intent on acceleratinginnovation for our customers and achieving greater success in a highly competitive globalindustry.”This case study utilizes the publicly announced terms of the merger of Life Tech into awholly owned subsidiary of Thermo Fisher, with Life Tech surviving. The terms were used todevelop pro forma financial statements for the combined firms. These statements are viewed asa “base case.”42The financial model discussed in this chapter is used to show how changes in key deal termsand financing structures impacted the base case scenario. The discussion questions following thecase address how the maximum offer price for Life Tech could be determined, what the impactof an all-debt or all-equity deal would have on the combined firms’ financial statements, and theimplications of failing to achieve synergy targets. Such scenarios represent the limits of the rangewithin which the appropriate capital structure could fall and could have been part of ThermoFisher’s predeal evaluation. As announced by Thermo Fisher, the appropriate capital structure isthat which maintains an investment grade credit rating following the merger. Thermo Fisher’ssenior management could have tested various capital structures between the two extremes of alldebtand all-equity before reaching agreement on the form of payment with which they weremost comfortable. Therefore, the form of payment and how the deal was financed were instrumentalto the deal getting done.Payment and Financing TermsAccording to the terms of the deal, Thermo Fisher acquired all of Life Tech’s common sharesoutstanding, including all vested and unvested outstanding stock options, at a price of $76 pershare in cash, with the Life Tech shares canceled at closing. The actual purchase price consistedof an equity consideration (i.e., what was paid for Life Tech’s shares) of $13.6 billion plus theassumption of $2.2 billion of Life Tech’s outstanding debt.The purchase price was funded by a combination of new debt, equity, and cash on ThermoFisher’s balance sheet. Thermo Fisher executed a commitment letter, dated April 14, 2013, withJPMorgan Chase Bank, N.A., J.P. Morgan Securities LLC, and Barclays Bank PLC that provideda commitment for a $12.5 billion 364-day unsecured bridge loan facility. The facility enabled thefirm to pay for much of the purchase price before arranging permanent financing by issuing newdebt and equity in late 2013. Maintaining an Investment Grade Credit RatingIn an effort to retain an investment grade credit rating43 by limiting the amount of newborrowing,44 Thermo Fisher issued new common equity and equity linked securities suchas convertible debt and convertible preferred totaling $3.25 billion to finance about one-fourthof the $13.6 billion equity consideration. The $3.25 billion consisted of $2.2 billion of commonstock sold in connection with its public offering prior to closing, and up to a maximumof $1.05 billion of additional equity to be issued at a later date in the form of convertibledebt and preferred shares. Thermo Fisher financed the remaining $10.35 billion of thepurchase price with the proceeds of subsequent borrowings and $1 billion in cash on itsbalance sheet.Thermo Fisher and Life Tech compete in the medical laboratory and research industry. Theaverage debt-to-total capital ratio for firms in this industry is 44.6%,45 and the average interestcoverage ratio is 4.0.46 Thermo Fisher expects that available free cash flow will allow for a rapidreduction in its debt. The firm expects to be below the industry average debt-to-total capital ratioby the end of the third full year following closing and about 12 percentage points below it within5 years after closing. The firm’s interest coverage ratio is expected to be equal to the industryaverage by the second year and well above it by the third year and beyond. These publicly statedgoals established metrics shareholders and analysts could use to track the Thermo Fisher’s progressin integrating Life Tech.Consistent with management’s commitment to only make deals that immediately increaseearnings per share, Thermo Fisher expects the deal to increase adjusted earnings per share duringthe first full year of operation by as much as $0.70_$1.00 per share. Adjusted earnings pershare exclude the impact on earnings of transaction-related expenses and expenses incurred inintegrating the two businesses. Including these expenses in the calculation of EPS is expected toresult in a $(0.16) per share during the first full year following closing, but excluding theseexpenses will result in $0.99 per share.47Quantifying Anticipated SynergyRealizing synergy on a timely basis would be critical for Thermo Fisher to realize its publiclyannounced goal that the deal would be accretive on an adjusted earnings per share basis at theend of the first full year of operation. Synergies anticipated by Thermo Fisher include the realizationof additional gross margin of $75 million and the realization of $10 million in SG&A savingsin 2014, the first full year following closing. Gross margin improvement and SG&A savings areprojected to grow to $225 million and $25 million, respectively, by 2016, and to be sustained atthese levels indefinitely. Most of the cost savings are expected to come from combining globalinfrastructure operations. Revenue-related synergy is expected to reach $25 million annuallyfrom cross-selling each firm’s products into the other’s customer base by the third year, up from$5 million in the first year.ConclusionsMark Fisher, CEO of Thermo Fisher knew that the key to unlocking value for shareholdersonce the deal closed was realizing the anticipated synergy on a timely basis. However, rationalizingfacilities by reducing redundant staff, improving gross margins, and increasing revenue was fraught with risk. Eliminating staff had to be done in such a way as not to demoralize employeesretained by the firm and increasing revenue could only be achieved if the loss of existingcustomers due to the attrition that often follows M&As could be kept to a minimum. He alsoknew to expect the unexpected, despite having completed what he believed was an extensivedue diligence.Having been through postmerger integrations before, he knew first hand the challengesaccompanying these types of activities. At the time of closing, many questions remained.What if synergy were not realized as quickly and in the amount expected? What if expensesand capital outlays would be required in excess of what had been anticipated? How patientwould shareholders be if the projected impact on earnings per share, a performance metricwidely followed by investors and Wall Street Analysts alike, was not realized? Only timewould tell.Discussion QuestionsAnswer questions 1_4 using as the base case the firm valuation and deal structure data in theMicrosoft Excel model available on the companion site to this book entitled Thermo FisherAcquires Life Technologies Financial Model. Please see the Chapter Overview section of this chapterfor the site’s internet address. Assume that the base case assumptions were those used byThermo Fisher in its merger with Life Tech. The base case reflects the input data described inthis case study. To answer each question you must change selected input data in the base case,which will change significantly the base case projections. After answering a specific question, eitherundo the changes made or close the model and do not save the model results. This will cause the modelto revert back to the base case. In this way, it will be possible to analyze each question in termsof how it is different from the base case.1. Thermo Fisher paid $76 per share for each outstanding share of Life Tech. What is themaximum offer price Thermo Fisher could have made without ceding all of the synergy valueto Life Tech shareholders? (Hint: Using the Transaction Summary Worksheet, increase theoffer price until the NPV in the section entitled Valuation turns negative.) Why does the offerprice at which NPV turns negative represent the maximum offer price for Life Tech? Undochanges to the model before answering subsequent questions.2. Thermo Fisher designed a capital structure for financing the deal that would retainits investment grade credit rating. To do so, it targeted a debt-to-total capital andinterest coverage ratio consistent with the industry average for these credit ratios.What is the potential impact on Thermo Fisher’s ability to retain an investment gradecredit rating if it had financed the takeover using 100% senior debt? Explain youranswer. (Hint: In the Sources and Uses section of the Acquirer Transaction SummaryWorksheet, set excess cash, new common shares issued, and convertible preferred sharesto zero. Senior debt will automatically increase to 100% of the equity consideration plustransaction expenses.48) Undo changes to the model before answering subsequentquestions.3. Assuming Thermo Fisher would have been able to purchase the firm in a share for shareexchange, what would have happened to the EPS in the first year? Explain your answer.(Hint: In the form of payment section of the Acquirer Transaction Summary Worksheet, set the percentage of the payment denoted by “% Stock” to 100%. In the Sources and Usessection, set excess cash, new common shares issued, and convertible preferred shares to zero.)Undo changes made to the model before answering the remaining question.4. Mark Fisher, CEO of Thermo Fisher, asked rhetorically what if synergy were not realized asquickly and in the amount expected. How patient would shareholders be if the projectedimpact on earnings per share was not realized? Assume that the integration effort is far morechallenging than anticipated and that only one-fourth of the expected SG&A savings, marginimprovement, and revenue synergy are realized. Furthermore, assume that actual integrationexpenses (shown on Newco’s Assumptions Worksheet) due to the unanticipated need toupgrade and colocate research and development facilities and to transfer hundreds ofstaff are $150 million in 2014, $150 million in 2015, $100 million in 2016, and $50 million in2017. The model output resulting from these assumption changes is called the ImpairedIntegration Case.What is the impact on Thermo Fisher’s earning per share (including Life Tech) and theNPV of the combined firms? Compare the difference between the model “Base Case” andthe model output from the “Impaired Integration Case” resulting from making the changesindicated in this question. (Hint: In the Synergy Section of the Acquirer (Thermo Fisher)Worksheet, reduce the synergy inputs for each year between 2014 and 2016 by 75%and allow them to remain at those levels through 2018. On the Newco AssumptionsWorksheet, change the integration expense figures to reflect the new numbers for 2014,2015, 2016, and 2017.)