Corporate Mergers & Restructuring

Final Take-Home Exam

Axxxxx Sxxxxxxx Corporate Mergers and Restructuring / Mannheim Full-time MBA 2012 Prof. Dr. Dxxxx Yxxxxxx 07.07.2012

Table Of Contents
1. 2. 3. 4. Family ownership of Dillards Inc. ..................................................................................... 3 Stock options for EDS CEO..................................................................................................... 4 Farmland Industries goes bankrupt due to over-diversification ........................... 5 Declaration of Authorship .................................................................................................... 7

1. Family ownership of Dillards Inc.

Imagine you are 37-year-old William Dillard III, the executive referred to near the end of the article. Would you be interested in meeting with the hedge funds? Why or why not? This article clearly highlights the dilemma that any owner of a family business undergoes in times of financial distress. As a 37-year-old William Dillard III (B3), I would not have any incentive to be jobless at such a young age. At the same time it is also clear from the article that B3 is an incompetent manager. What remains to be seen is if he is a responsible manager for Dillards. Selling off the company to a hedge fund would clearly increase the value for the shareholders in the short term. The hedge fund company usually starts by cutting costs extensively by selling off bad assets and firing the unproductive workforce to increase the utilization. This action is usually not preferred by family owners as they are too emotionally attached to the companys old but unproductive assets. They are also used to certain luxuries that arise from owning their own business like unlimited use of corporate jets and charitable donations. These costs are generally referred to as agency costs of family ownership/management. Raising capital by selling off these high-valued but unproductive assets is a forte of a Hedge Fund company. These actions are very favorable for the shareholders of the company as the immediate cash received from these transactions can fuel future growth. In an efficient market, selling off the company to a hedge fund company is rewarded by stock price rise. On the other hand the hedge fund companies usually do not know the intricacies of a business as well as the old family owners who have been passed on the knowledge through the generations. Having a family owner also gives the company the bargaining power in the industry through the reputation and respect of the family in the business. Hence a responsible family manager might actually be a better option than a hedge fund company. It is reported in the article that Dillards is now in a process of selling off its bad assets and unproductive luxuries like the corporate jets. This trend, if initiated by the family owner, is good for the future of the company as it encompasses the best of both worlds. As a young manager of Dillards, I would be reluctant to step down as the manager of my heritage family business but if I start thinking responsibly I would start to look for opportunities to cut down costs and generate immediate cash to finance future projects. This scenario, although unlikely in the real world, is very much possible. Another option would be to convince the hedge fund company to keep me onboard as the CEO after the merger which

is highly unlikely as they hold me responsible for the current fragile state of the company and are looking to sell it off in the short term anyway.

2. Stock options for EDS CEO

Consider the events involving EDS described near the end of the article. If you had been a shareholder of EDS, would you be pleased to read in this article that the company had issued 2,000,000 stock options to its CEO on February 13, 2008? Announcement of additional stock options to the CEO could potentially be very well received by the market (assuming, of course an efficient market). At first glance it may seem like a simple golden parachute provision for the 3 month old CEO but in reality it is much more. It is a legal practice for incentivizing the managers of a company to be open to competitive acquisition bids from the market. The announcement (mentioned in the article) from EDS emphasizes that the reason for providing this additional stock to the new CEO is to motivate him to consider all options to achieve a high shareholder value. Selling off the company to HP would be highly beneficial for the shareholders as they would receive a high premium (usually 30%) over the current market value of their shares. This would also be beneficial in long term because of the cost savings that would arise from merging with a company with a long history in business and great reputation as HP. As a shareholder, any measure to enable or push such a deal would be very well received and rewarded with an increase in the share price. Hence a fair market will not see this as a take-over avoidance measure but rather a positive bonding initiative from the management. On the other hand, over-incentivizing is another concept that could be in play in this scenario where the CEO is offered 2 million stock options. The article suggests that the CEO of EDS (Mr. Rittenmeyer) earned a total of USD 13.4 million from this transaction. It is clear that a difference of few basis points in the asking price would not matter much to the new CEO as he would still make huge amount of money. He might instead be over enthusiastic about selling the company and might not negotiate very keenly to get the best price out of the

deal. The overwhelming 2 million stock options can only be justified as an appropriate price for motivating the new CEO if he does not (already) have a huge stake in the company and would be otherwise unwilling to step down from a job that he just started with. In conclusion I can say that overall the decision to offer 2 million shares to the CEO would be seen as positive move by the market. But it will also see its fair share of skepticism and result 4

in a controlled increase in share price which would have soared in case of an appropriate number of stock issuance.

3. Farmland Industries goes bankrupt due to over-diversification

An agricultural co-operative is a mutual corporation. What, if anything, do you think Farmland Industries should have done differently? Farmland Industry is a cooperative (co-op) that comprises of multiple smaller co-ops which are owned by various small farmers and other small players in the agriculture industry. The primary purpose of forming this co-op was to have a higher bargaining power against their rapidly shrinking customers (thanks in great part to large players like Wal-Mart) and suppliers. Hence its origin seems to be more because of political reasons rather than monetary reasons. But it is evident from its operations and acquisition strategies that this co-op is very much profit driven. The businesses owned by Farmland are highly capital intensive and highly sensitive to the economic cycles and annual sales trends. Diversification efforts in such a case should be targeted to decrease the overall riskiness of the company. Farmland went against this strategy and decided to integrate in both reverse and forward directions in the supply chain. To add to the riskiness they embarked on this integration strategy by taking on debt from banks. The timing of the expansion strategy was also not right and the overaggressive approach mandated an even larger capital requirement which could have been met (potentially) through retained earnings which were rather returned back to the farmers instead of being invested in the business. The reverse and forward integration led to inefficiencies in the operations as selling/buying internally was less consequential than a third party transaction. The bonds issued by Farmland were redeemable on demand and the bond holders wanted their money back as soon as the profits started going south. Although it is not clear in the article, the reason for these mistakes could be a power hungry manager. It is clear from the problems mentioned above that a different strategy than the selfdestructive leveraged integration strategy might have not lead to a similar fate for Farmland. My suggestion, to Farmland, would be to concentrate on a core business area which should be derived from the core vision of the co-op. Other co-ops in the market focus on their core businesses, for e.g. milk & milk products in case of Dairy farmers of America. The overall strategy of the co-op should also be aligned with their mission of bringing more power to the farmers. This mission should put sustainability on top priority for the co-op managers hence 5

ruling out high dependence on debt. The co-op should stick to its commitment of 20% profit sharing instead of stretching it to 50%. The focus should be on reducing risk through acquisition of multiple products in agriculture industry and not moving to absolutely tangential businesses such as natural gas and retail which can both be negotiated with by adding more farmers to the co-op and demanding better prices from both while maintaining efficiencies in business at the same time. It is also clear that Farmland should have looked for more creative ways to raise capital instead of mounting on debt. A membership fee for new members and variable profit sharing based on performance might be avenues to new capital. -

4. Declaration of Authorship
I hereby certify that the work presented here is, to the best of my knowledge and belief, genuinely the result of my own investigations, except as acknowledged, and has not been submitted, either in part or in its entirety, for a degree at this or any other university.

Axxxxx Sxxxxxxx Mannheim, 07.07.2012 -