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November 2010: De Chancery Rejects DCF Analysis As 'Standard'

November 2010: De Chancery Rejects DCF Analysis As 'Standard'

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NOVEMBER 2010
Case Update - November 2010
provided by BV Resources | Sherrye Henry, editor sherryeh@bvresources.com___________________________________________________________________________________________________________________
WaveDivision Holdings, Inc. v. Millennium Digital Media Systems, LLC, 2010 WL 3706624 (Del. Ch.)(Sept. 17, 2010)
There may be a strong perception among ASA BV members that the Delaware Chancery Court preers a discounted cash ow analy-sis to other valuation methods, especially when assessing air value in statutory appraisal actions. Certainly, the deendant in thiscase argued that a DCF analysis was “standard.” In this breach o contract action, however, the court ocuses less on a particularvaluation method than whether it fts the applicable law and acts o the case.
Troubled cable company engages in ‘stealth’ fnancing.
For fve years ollowing the 2000 burst o the telecomm bubble, Millen-nium Digital Media Systems tried to keep its cable operations aoat in an increasingly competitive industry. Ater several ailedrefnancing attempts, in 2006 it agreed to sell its Michigan and Pacifc Northwest holdings to WaveDivision Holdings LLC or $157million. The parties’ agreements included an express “no-shop” provision, but the day ater signing, Millennium began looking orrefnancing alternatives, led by its unsecured creditors, primarily several private equity unds that held high-yield, increasing ratenotes (IRN note holders).As unsecured creditors, the IRN note holders would receive no pay-o rom the Wave sale and would have to depend on the com-pany’s remaining assets or any uture return. Some o them also held seats on Millennium’s management committee, the sameone that approved the sale to Wave. Thus, at the same time Millennium was pushing ahead with the Wave transaction, it was alsopursuing a parallel path with the IRN note holders, even retaining an outside consultant to develop an refnancing plan and generat-ing projections to estimate its aects.Its “stealth” eorts paid o: In July 2006, Millennium signed a restructuring agreement with the IRN note holders that eectivelytranserred control o the company to its ormer creditors. That same day, Millennium terminated its agreement with Wave, whichsued or breach o contract. Following the terminated sale, Wave also purchased two cable systems or approximately $147 million.Based on the acts and applicable law, the Delaware Chancery Court, in an opinion by Vice Chancellor Strine, ound that Millenniumhad breached its agreements with Wave. The proper measure o damages was to put Wave “in as good a position as [it] would havebeen had Millennium not breached,” or the value it expected to realize rom the agreements minus any avoided costs (most obvi-ously, the contract price), and minus any mitigation (the post-breach purchase o the two cable systems).
Both parties retain top guns.
The deendant Millennium argued that by terminating the sale o the cable systems, it did the plainti Wave a avor, and thus no damages were due. The plainti claimed the systems’ value would have grown substantially under itsstewardship, in excess o $85 million. Both parties retained the managers o national valuation practices as experts to prove theirdisparate claims.In particular, the plainti’s expert used a multiple o EBITDA analysis to estimate the plainti’s net loss. He reviewed two o theplainti’s recent (2005 to 2008) acquisitions o cable companies, deriving an implied valuation multiple o 8.8. To determine
DE CHANCERY REJECTS DCF ANALYSIS AS ‘STANDARD‘NOVEMBER 10, 2010
 
NOVEMBER 2010
EBITDA, he looked at three prior transactions that he believed were most comparable to what Wave would have acquired rom theMillennium systems in terms o both growth potential and capex requirements. He then calculated an average growth rate or thosecomparable systems or 2006 to 2008 o 48.5%. Finally, he applied that growth rate to the 2006 annualized EBITDA ($24.9 mil-lion) o the Millennium systems to arrive at an annualized EBITDA as o September 30, 2008 o $36.9 million. By applying the 8.8multiple, the expert calculated nearly $325 million in post-breach damages, reduced to roughly $102 million ater mitigation andother adjustments.The plainti’s expert later supplemented his report to account or the 2009 economic downturn. His approach remained the same:He selected three o Wave’s prior acquisitions, calculated their cash ow growth rate rom 2006 to 2009 and applied that rateto the Millennium systems; he then used a multiple o cash ows to estimate EBITDA as o December 2009 at $42.4 million. Byindexing the multiples used at the time o the acquisitions to guideline public comparables, he adjusted his original 8.8 multipledown to 7.9. Based on these new inputs, the expert’s EBITDA analysis yielded approximately $332 million in damages, adjustedor mitigation to $85.5 million.By contrast, the deendant’s expert used a DCF approach, valuing the two Millennium systems (Michigan and Pacifc NW) sepa-rately because o their dierent operating characteristics. For his DCF inputs, the expert relied primarily on the orecasts that Waveprovided the bank to fnance the Millennium acquisition (“base case” projections), adjusted as necessary by cable industry analystorecasts and a report by Millennium’s advisor during its pursuit o alternative refnancing. The expert believed these earningsadjustments were necessary because the base case projections were “unrealistically optimistic.” He also reduced cash ow by 3%corporate overhead.The expert used his adjusted base case numbers to perorm his two DCF analyses or the Millennium systems, applying an11.75% weighted average cost o capital or each and growth rates o 3.3% and 3% to yield a total value o $140 million. He ap-plied the same approach using the slightly more conservative projections prepared by Millennium’s independent advisor during itsrefnancing strategy, or a total systems’ value o $122 million. Because both values were less than the $157 million purchaseprice, the deendant’s expert concluded that no damages were due.
Court isn’t entirely convinced.
The deendant argued that Wave was entitled to recover no more than the amount the marketwould have placed on the Millennium systems at the time o the breach. Accordingly, its expert adjusted the plainti’s “base case”projections or industry and economic actors, the court explained. This approach assumed that Wave would sell the systems im-mediately ater purchase and that damages would equal their air market value as a going concern under current management.Yet there was no doubt that Wave hoped to upgrade the Millennium systems as it had prior acquisitions and then sell them or aproft or retain the higher operating revenues, the court added. Wave’s own expert assumed as much by using the growth ratesrom previous deals to calculate uture earnings or the Millennium systems.The court ound neither expert’s approach entirely convincing. I air market value were the proper measure o damages, then“buyers would be reluctant to purchase anything,” because a market-based damages determination would, by defnition, cause noinjury to a jilted buyer i a seller reneged. Further, Millennium’s approach relied on “unreliable, sel-interested, and thinly justifed”reductions to the base case projections, depriving the plainti o all expected beneft o the bargain. On the other hand, Wave’s ex-pert extrapolated continued success rom too small o sample size without grounding the analysis in the specifcs o the acquiredsystems, according to the court.Based on the record, the base case projections that Wave provided to its lenders were the airest representation o its actualexpectations, the court held. Wave argued that its bank orecasts were overly conservative, but it didn’t oer any alternative con-temporaneous projections, and the base case projections had the “added beneft” o reliance by the bank, which had “a stronginterest in getting repaid,” the court said. Finally, the base case projections were not materially out o line with those prepared orMillennium’s deal with its note holders.

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