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Business Valuation Case Study: Huff Fund Investment Partnership v. CKx, Inc

01-15-2015

Valuation Court Case Analysis

Huff Fund Investment Partnership v. CKx, Inc., 2014 Del. Ch. LEXIS 82 (May 19, 2014)

The Delaware Chancery Court rejected valuations based on a discounted cash flow (DCF) analysis due to the speculative nature of the assumptions.  According to the Court in the Huff case, under Delaware appraisal law, “When management projections are made in the ordinary course of business, they are generally deemed reliable.  But the Court has disregarded management projections where the company’s use of such projections was unprecedented, where the projections were created in anticipation of litigation, or where the projections were created for the purpose of obtaining benefits outside the company’s ordinary course of business.”

Case Facts and Background

The matter involved stockholders in a corporation (CKx), who opted for appraisal rather than the cash-out price received in the sale to an acquirer (Apollo).

CKx was founded by Robert F. X. Sillerman, a businessman with experience in managing and investing in media and entertainment companies.  CKx was created to own and manage entertainment properties, and their business strategy focused on content-specific entertainment delivered through the increasing number of distribution channels, e.g., television, computer and smartphones.  In pursuit of that business strategy, CKx purchased the rights to unique entertainment properties that included 19 Entertainment, a company that owned rights to American Idol and So You Think You Can Dance.  19 Entertainment assets alone contributed 60–75 percent of the CKx cash flow.

At the time of the CKx/Apollo merger in 2011, American Idol had seen several years of declining ratings.  In addition to the economic uncertainty surrounding the show’s ratings, 19 Entertainment’s broadcast contract was set to expire.  Although the American Idol ratings were declining, petitioners argued that the show’s value could actually increase.

Gleacher, a financial advisory company hired to assist in the sale of CKx, ran an auction for CKx and received offers from two financial buyers, Apollo and Buyer B.  The CKx board accepted Apollo’s bid upon the recommendation of Gleacher.

Management Projections

CKx management produced five-year projections in connection with the interest expressed by potential purchasers.  Built into those projections was an additional $20 million of annual revenue related to the to‑be-negotiated American Idol contract.  At issue for the Court was whether this estimate of future revenue was a genuine prediction or a marketing ploy to attract a higher bid for CKx.  According to Court testimony, CKx management stated, “For the purpose of evaluating the company’s value in a sale scenario or providing projections to a prospective buyer, that we ought to take a more optimistic view.”  Per the CKx chief executive officer, “A $20 million increase in payments … constituted the very outside best scenario that could result from negotiations.”

Expert Assumptions

The DCF analysis involves cash flow and the rate of return applied to that cash flow.  In this case, the valuation professionals differed in each component.  Each valuation expert prepared a DCF analysis with few changes in their assumptions but saw great impact in their conclusions.  Among those were different figures in the five-year cash flow projections, with one disregarding the forecasted $20 million increase under the to-be-negotiated American Idol contract and the other expert relying wholly on the revenues forecast by CKx.  Each expert applied differing long-term growth rates and weighted-average costs of capital (WACC).  The primary differences in the WACC calculation were the result of different betas (a measure of stock volatility) and differences in the market size premia selected for the cost of capital.

The Speculative Nature of the Projection Weighed Heavily on the Court’s Decisions

For the Court, this case presented “significant and atypical valuation challenges … in particular, the unpredictable nature of the income stream from the company’s primary asset renders the apparent precision of the expert witnesses’ cash flow valuation illusory.”

According to the court, “Deficiencies of both DCF analyses lead me to conclude that they are unreliable measures of CKx’s value.  DCF in theory is not a difficult calculation to make ….  However, without reliable five-year projections, any values generated by a DCF analysis are meaningless.  The reliability of a DCF analysis depends, critically, ‘on the reliability of the inputs to the model.’ ”  According to the Court, “The unreliability of the revenue estimates, both including and excluding the $20 million estimate, is a serious impediment to creating a reliable DCF analysis.”

The Court is charged with determining the fair value of the corporations’ shares as a going concern according to the appraisal statute, and, according to the Court (it) must evaluate “ ‘all relevant factors,’ and arrive at a going-concern value … but exclusive of synergy value that may have been captured by the seller.  While the court typically relies on expert valuation including DCF and comparable company analysis to determine statutory fair value, market value remains among the relevant factors for arriving at fair value.”

Reliance on Merger Price

Ultimately, the Court found that “because neither party presented a reasonable alternative valuation method, and because (it found) the sales price a reliable indicator of value,” the appropriate determinate of value was the merger price between Apollo and CKx.

Additional Appraisal Notes

Another takeaway from this case is the critique of one expert’s use of guideline companies and transactions.  According to the Court, “The true utility of a comparable company approach is dependent on the similarity between the company the court is valuing and the companies used for comparison.”  The expert stated the selection of companies was considered “guideline,” as opposed to “comparable.”  The expert’s testimony according to the Court “confirmed the important differences between ‘guideline’ companies and CKx:  none of the guideline companies were of comparable size; none owned assets resembling the assets of CKx; and none competed with CKx or utilized a comparable business model.”

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