DocketNumber： CA 11184-VCS
Judges： Slights V.C.
Filed Date： 7/27/2018
Status： Precedential
Modified Date： 7/27/2018
IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE BLUEBLADE CAPITAL OPPORTUNITIES LLC, a Delaware limited liability company, and BLUEBLADE CAPITAL OPPORTUNITIES CI LLC, a Delaware limited liability company, Petitioners, v. : C.A. No. 11184-VCS NORCRAFT COMPANIES, INC., a Delaware corporation, Respondent. MEMORANDUM OPINION Date Submitted: April 25, 2018 Date Decided: July 27, 2018 David A. Jenkins, Esquire and Robert K. Beste, Esquire of Smith, Katzenstein & Jenkins LLP, Wilmington, Delaware and Michael E. Davidian, Esquire of Blueblade Capital Opportunities LLC and Blueblade Capital Opportunities CI LLC, New York, NeW York, Attorneys for Petitioners Blueblade Capital Opportunities LLC and Blueblade Capital Opportunities CI LLC. Raymond J. DiCarnillo, Esquire and Kevin M. Gallagher, Esquire Of Richards, Layton & Finger, P.A., Wilrnington, Delaware, Attorneys for Respondent Norcraft Companies, Inc. SLIGHTS, Vice Chancellor This statutory appraisal action arises out of a May 12, 2015, merger Whereby Fortune Brands Home & Security, Inc. (“Fortune”) acquired Norcraft Companies, Inc. (“Norcraft” or the “Company”) (the “Merger”) for $25.50 cash per share (the “Merger Price”). Petitioners, Blueblade Capital Opportunities LLC and Blueblade Capital Opportunities CI LLC (together, “Blueblade”), Were Norcraft stockholders on thc Merger’s effective date and seek a judicial determination of the fair value of their Norcraft shares as of that date. In an appraisal action under the DelaWare General Corporation Law, the trial court’s “fair value” determination must “take into account all relevant factors.”l The relevance (or not) of certain factors “can vary from case to case depending on the nature of the [acquired] company,” the nature of the process leading to the company’s sale and, perhaps most importantly, the evidence adduced by the parties at trial in support of their respective valuation positions.2 “In some cases, it may be that a single valuation metric is the most reliable evidence of fair value and that giving Weight to another factor Will do nothing but distort that best estimate. In other cases, “it may be necessary to consider two or more factors.”3 In all cases, however, 1 8 Del. C. § 262(h). 2 Merion Capital L.P. v. Lena'er Processing Servs., Inc.,2016 WL 7324170
, at *16 (Del. Ch. Dec. 16, 2016). 3 DFC Global Corp. v. Muizy‘ield Value P’rs, L.P.,172 A.3d 346
, 388 (Del. 2017). 1 the trial court’s determination respecting the “relevant factors” must be grounded in the evidentiary record and “accepted financial principles.”4 I am cognizant of the DelaWare Supreme Court’s embrace of “deal price” as a strong indicator of fair value in Dell and DFC. Those decisions teach that deal price often Will be a relevant factor in the trial court’s fair value calculus_ particularly Where the respondent company Was publicly traded and sold following a meaningful market check.5 In both cases, however, despite having been urged to do so, the Supreme Court declined to adopt a rule that the deal price is presumptively reflective of fair value.6 Mindful of DFC and Dell, I have considered carefully Whether the Merger Price (less synergies) reflects the fair value of Norcraft as of the Merger date. For the reasons explained beloW, l am satisfied it does not. 4 Dell, Inc. v. Magnelar Global Evem‘ Driven Master Funa’Lta’,177 A.3d 1
, 22 (Del. 2017); DFC, 172 A.3d at 388 (“What is necessary in any particular [appraisal] case though is for the Court of Chancery to explain its [fair value calculus] in a manner that is grounded in the record before it.”). 5 See Dell, 177 A.3d at 35; DFC, 172 A.3d at 349, 351, 372; cf DFC, 172 A.3d at 369 n.118 (eXplaining that a discounted cash flow analysis is “often used in appraisal proceedings When the respondent company Was not public or Was not sold in an open market check”). 6 DFC, 172 A.3d at 348 (rejecting the petitioner’s (and others’) argument that the Court should adopt a presumption in favor of the deal price, stating “[W]e decline to engage in that act of creation, Which in our view has no basis in the statutory text”); Dell, 177 A.3d at 21-22 (noting “We doubt[] our ability to craft the precise preconditions for invoking such a presumption”). In this case, the evidence reveals significant flaws in the process leading to the Merger that undermine the reliability of the Merger Price as an indicator of Norcraft’s fair value. There was no pre-signing market check; Norcraft and its advisors fixated on Fortune and never broadened their view to other potential merger partners. As the parties worked to negotiate the Merger agreement, Norcraft’s lead negotiator was at least as focused on securing benefits for himself as he was on securing the best price available for Norcraft. And, while the Merger agreement provided for a thirty-five-day post-signing go-shop, that process was rendered ineffective as a price discovery tool by a clutch of deal-protection measures. Dell reminded us that Delaware courts have “long endorsed” the “efficient market hypothesis” and emphasized “that the price produced by an efficient market is generally a more reliable assessment of fair value than the view of a single analyst, especially an expert witness who caters her valuation to the litigation imperatives of a well-heeled client.”7 l have heeded that guidance as well. Unfortunately, this case was tried before the Supreme Court decided Dell, and the record evidence regarding the efficiency of the market for Norcraft stock prior to the Merger is, in a word, thin. With that said, the evidence that can be drawn from the record reveals that, at the time of the Merger, Norcraft was fresh off an initial public offering of its stock, was 7 Dell, 177 A.3d at 24. relatively thinly traded given the niche market in which it operated and was also thinly covered by analysts. Under these circumstances, 1 can discern no evidence- based rationale that would justify looking to the unaffected trading price of Norcraft’s stock either as a standalone indicator of fair value or as a data point underwriting the use of a deal-price-less-synergies metric. Having concluded that flaws in the sales process leading to the Merger undermine the reliability of the Merger Price as an indicator of fair value, and that the evidence sub judice does not allow for principled reliance upon the efficient capital markets hypothesis, l have turned to a “traditional valuation methodology,” a discounted cash flow (“DCF”) analysis, to calculate the fair value of Norcraft as of the Merger date.8 In my view, given the evidence in this record, a DCF-based valuation provides the most reliable means by which to discharge the Court’s statutorily mandated function to appraise Norcraft. Not surprisingly, both parties proffered expert testimony regarding Norcraft’s fair value on a DCF basis. And, as we have come to expect in appraisal litigation, the experts’ DCF analyses yielded valuations that are miles apart. Neither expert walked the high road from start to finish during their respective DCF journeys. That is to say, both experts, at times, made choices in their analyses that were not 8 See Hz'ghfield Capital, Ltd. v. AXA Fin., Inc.939 A.2d 34
, 47 (Del. Ch. 2007) (describing DCF as a “traditional valuation methodology”). 4 supported by the evidence or not supported by “accepted financial principles” in order to support a desired outcome. l have, therefore, borrowed the most credible components of each expert’s analysis to conduct my own DCF valuation, in my best effort to obey our appraisal statute’s “command that the Court of Chancery undertake an ‘z``na’epena'ent’ assessment of fair value” when performing its mandated appraisal f``unction.9 As explained below, my DCF analysis reveals a valuation of $26. 16 per share. Insofar as Dell and DFC require that the trial court carefully consider deal price before disregarding it altogether, I have returned to the Merger Price as a “reality check” before locking in my DCF valuation as the last word on fair value. Having done so, l am satisfied that the $0.66 per share delta between the Merger Price and my DCF valuation of Norcraft is a product of the identified flaws in Norcraft’s deal process. Accordingly, I conclude that the fair value of Norcraft as of the Merger date was $26. 16 per share. I. FACTUAL BACKGROUND I recite the facts as l find them based on the evidence presented during a four- day trial. That evidence comprises testimony from thirteen fact witnesses 9 Dell, 177 A.3d at 21 (quoting Golden Telecom, Inc. v. Global GTLP, ll A.3d 214, 218 (Del. 2010) (emphasis in original)); see also Gholl v. eMachz``nes, Inc.,2004 WL 2847865
,
at *5 (Del. Ch. Nov. 24, 2004) (noting that both parties bear a burden of proof in a statutory
appraisal trial and holding that, “[i]f neither party satisfies its burden . . . the court must
then use its own independent business judgment to determine fair value”).
5
(some presented live and some by deposition) and three live expert witnesses, along
with over 500 exhibits. I accord the evidence the weight and credibility I find it
deserves. As noted, both parties carried a burden to prove their respective valuation
positions by a preponderance of the evidence. Thus, Petitioners were obliged to
prove that their proffered valuation of Norcraft, a DCF-based valuation of $34.78
per share, represented Norcraft’s fair value as of the Merger; Respondent’s burden
was to prove that its proffered valuation of $21.90 per share, the Merger Price less
synergies, was Norcraft’s fair value as of the Merger. With these competing burdens
in mind, 1 find that the following facts were proven by a preponderance of the
evidence.
A. Parties and Relevant Non-Parties
Respondent, Norcraft, is a Delaware corporation in the cabinetry
manufacturing business.10 Prior to the Merger, Norcraft’s stock traded on the New
York Stock Exchange.ll On May 12, 2015, Fortune acquired Norcraft for $25.50
cash per share in the Merger.12 ln connection with that transaction, Norcraft merged
10 JX 267 (“Norcraft FY2014 10-K”) at 1, 6; JX 221 (“Merger Agreement”), pmbl. & § 1.3.
11 JX 267 (Norcraft FY2014 10-K) at 1.
12 Joint Pre-Trial Stipulation and Order (“PTO”) 1111 2y, 2ff. 1 commend the parties, and
counsel in particular, for the substantial effort that was undertaken to prepare and submit
comprehensive pre-trial factual stipulations.
with an indirect, wholly-owned subsidiary of Fortune, Tahiti Acquisition Corp.
(“Tahiti”), with Norcraft surviving as a wholly-owned Fortune subsidiary.13
Petitioners were Norcraft stockholders as of the Merger date and collectively
held 557,631 shares of Norcraft common stock.14 It is undisputed that they properly
perfected their statutory appraisal right.
Non-party, Fortune, is a home and security products company with four
business segments: cabinets, plumbing, doors and security.15 Fortune sells its
products through several sales channels, “including kitchen and bath dealers,
wholesalers oriented to builders or professional remodelers, industrial and locksmith
distributors [and] ‘do-it-yourself remodeling-oriented home centers . . . . ”16
Non-parties, Mark Buller, Christopher Reilly, Michael Maselli, Harvey
Wagner, Ira Zecher and Edward Kennedy served on Norcraft’s board of directors
(the “Board”) at all relevant times.17 Buller also served as the Chief Executive
Officer of Norcraft (and its predecessors) from 2003 to the Merger’s consummation
13 JX 221 (Merger Agreement), pmbl. & § 1.3; see PTO jj 2y.
14 PTO 1111 2h, 2i. Blueblade acquired all of its Norcraft stock after the Merger was
announced. PTO 1111 2h, 2i.
15 PTO 11 2g; JX 270 (“Fortune FY2015 10-K”) at 6.
16 JX 270 (Fortune FY2015 lO-K) at 5.
17 See PTO 11 2f.
in May 2015.18 Non-party, Leigh Ginter, was the ChiefFinancial Officer of Norcraft
(and its predecessors) from 2003 through the Merger’s consummation.19 And non-
party, Eric Tanquist, was Norcraft’s Vice President of Finance Administration from
approximately 2007 through the Merger’s consummation.20
Non-party, Christopher Klein, is Fortune’s CEO and served in that capacity at
all times relevant to this action.21 Non-party, Robert Biggart, is Fortune’s general
counsel and served in that capacity at all relevant times.22 And non-party, Jason
Baab, served as Fortune’s Vice President of Corporate Development and M&A at
the time of the Merger.23
B. Pre-Merger Norcraft
As of the Merger date, “Norcraft was a leading manufacturer of kitchen and
bathroom cabinetry in the United States and Canada.”24 The Company sold its
products primarily to kitchen and bathroom cabinet dealers in the horne repair,
18 PTO 11 2f; JX 3 (Buller Dep.) at 19:9-21. Buller was also the Chairman of Norcraft’s
Board at all relevant times prior to the Merger. JX 3 (Buller Dep.) at 19:9-21.
19 PTO 11 2f; JX 1 (Ginter Dep.) at 18_19.
20 PTO 11 2f; JX 2 (Tanquist Dep.) at 21 :2_16.
21Projzg.
22 Ia'.
23 ]d_
24PTojza.
remodeling and new home construction markets through four business divisions:
Mid Continent Cabinetry, StarMark Cabinetry, UltraCraft Cabinetry and Urban
Effects (a.k.a. Norcraft Canada).25- Prior to the Merger, Norcraft regarded Fortune,
American Woodmark Corporation (“American Woodmark”) and Masco as its
principal competitors.26 lt also faced competition from “a large number of smaller
,,27
manufacturers
1. Buller and Two Private Equity Firms Acquire Norcraft’s Operating
Subsidiary in 2003
In October 2003, Buller, certain Buller family members and funds
affiliated with the private equity firms Saunders, Karp & Megrue (“SKM”) and
25 PTO 1111 2b, 2c; JX 267 (Norcraft FY2014 10-K) at 6_10. For FY2014, “kitchen and
bathroom cabinet dealers accounted for [86%] of Norcraft’s net sales, home builders
accounted for [9%], and wholesale retailers, or home centers, accounted for [5%].”
PTO 11 2b. “[A]pproximately 58% of [Norcraft’s FY2014] net sales were to the home
repair and remodeling market and the remaining net sales were to the new residential
construction market.” JX 267 (Norcraft FY2014 10-K) at 6. As of the Merger date,
Norcraft, Fortune and Masco Corporation (“Masco”) were the only three “dealer channel”
cabinet manufacturers in the United States with a market share of over 5%. See JX 112
(Gabelli & Co., T he Home Improvement Opportunily, published Jan. 29, 2015 [“Gabelli
Report”]) at CITI-00053582. In the cabinetry industry, the “dealer channel” comprises
third parties who purchase cabinets from manufacturers (or wholesalers) and sell them to
end users. See id.; JX 12 (Baab Dep.) at 36:8_20. In 2014, nearly half of U.S. cabinet
sales (representing approximately $6 billion) were made through the dealer channel, which
is generally considered the most profitable sales channel in the cabinetry industry.
See JX 112 (Gabelli Report) at CITI-00053582, CITI-00053595; JX 1 (Ginter Dep.)
at 153:17-154:1; JX 5 (Klein Dep.) at 293:25~294:3.
26 JX 267 (Norcraft FY2014 10-K) at 11.
27 Id.
Trimaran Capital Partners (“Trimaran”) acquired Norcraft Companies, L.L.C. for
approximately $315 million (the “2003 Acquisition”).28 At the same time, Norcraft
Companies, L.L.C. converted to a Delaware limited partnership, Norcraft
Companies, L.P. (“Norcraft LP”), and Buller became the CEO of that entity.29 For
the next ten years, Norcraft LP operated as a privately-held company.
2. Norcraft and the Cyclical Cabinetry Industry
The undisputed evidence reveals that Norcraft operated in a cyclical
industry.30 As one naturally might expect, the cabinetry industry is directly affected
by the home improvement industry, which, in turn, is affected by macro-economic
conditions, including employment levels, demographic trends, availability of
financing, interest rates and consumer confidence.31 The cabinetry industry is also
directly affected by housing starts, as a significant percentage of sales are connected
28 JX 3 (Buller Dep.) at 1613-24. As of 2003, Norcraft Companies, L.L.C. was the
operating entity in Norcraft’s organizational structure. JX 400 (Norcraft Amendment No. 5
to Form S-l, filed Oct. 30, 2013 [“Norcraft Amendment 5 to Form S-l”]) at 19. F or
purposes of this Memorandum Opinion, 1 have not distinguished SKM and Trimaran from
the SKM and Trimaran funds that owned Norcraft common stock prior to the Merger.
29 JX 27 (Mar. 29, 2004 Norcraft LP Press Release) at 2. Following the 2003 Acquisition,
Norcraft LP became the operating entity in Norcraft’s organizational structure. JX 400
(Norcraft Amendment 5 to Form S-l) at 19. Buller and his family collectively owned
approximately ll% of Norcraft LP’s equity. JX 3 (Buller Dep.) at 18:6_8.
30 TT 21:6_11, 21:20-21 (Eldridge), 96:22~97:7 (Biggart), 607:23~608:1 (Clarke).
31 Jx 267 woman FY2014 10-K).
10
to new home construction.32 When housing starts decrease, as they often do for
various reasons,33 cabinet sales decrease as well.34
Norcraft was no exception to this cyclicality. Norcraft LP enjoyed steady
growth of its earnings before interest, taxes, depreciation and amortization
(“EBITDA”) from 2003 through 2006_$47 million (2003) to $80 million (2006).35
This growth was fueled, in large part, by a significant acquisition in March 2002 and
a boom in the United States housing market.36 Growth stalled, however, beginning
in 2007, when Norcraft LP experienced the first of three consecutive years of
declining sales and adjusted EBITDA.37 As is typical in classically cyclical
businesses, Norcraft LP saw improved sales beginning in 2010, although its adjusted
EBITDA continued to decline until 2012 (with 2010 being the only exception). The
attached chart illustrates the trends38:
32 Id.; see also TT 607:23-608:1 (Clarke); JX 14 (Clarke Dep.) at 60 (“I do believe that the
home building industry is cyclical and at some point the housing starts would decrease.”).
33 JX 23 (Austin Smith Rebuttal Report) at 6.
34 Jx 267 (Norcraft FY2014 10-K).
33 JX 20 (Austin Smith Report) at 7.
36 JX 400 (Norcraft Amendment 5 to Form S-l) at 19.
37 JX 20 (Austin Smith Report) at 7.
38 Id_
ll
Net Sa|es Adjusted EB|TDA
{$Mil|ions] YoY%change ($ Mi||ions) YoY%change
[1] 2003 256 47
[2] 2004 330 29% 58 23%
[3] 2005 405 23% 70 21%
[4] 2006 441 9% 80 14°0
[5] 2007 394 ~11% 72 -10%
[6] 2008 332 -16% 51 -29%
[7] 2009 247 -26% 36 -29%
[8] 2010 263 6% 39 8%
[9] 2011 269 2% 37 -5%
[10] 2012 289 7% 34 -8%
[11] 2013 340 18% 43 26°0
[12] 2014 376 11% 52 21%
As reflected in the chart, Norcraft LP’s adjusted EBITDA trended up in 2013,
suggesting that its six-year period of decline had come to an end, at least for the time
being.39
3. Norcraft’s IPO and Reorganization
On November 13, 2013, Norcraft completed an initial public offering
(“IPO”)40 whereby the Norcraft enterprise was reorganized into the following
holding company structure41:
39 ld. 1 note that between 2006 and 2013, Norcraft LP’s management struggled accurately
to project the company’s future performance JX 3 (Buller Dep.) at 183-84.
40 JX 267 (Norcraft FY2014 10-K) at 12; PTO 11 2j.
41 JX 267 (Norcraft FY2014 lO-K) at 12, 15, 65; PTO 11 2d.
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ment\ Comp, 498_99 (Del. Ch. 2010) (“Both these men of valuation science purported to apply the same primary method of valuation_the discounted cash flow (‘DCF ’) method-_but the expert for the petitioners came up with a value of $139 per share and the expert for Golden came up with a value of only $88 per share_a modest $51 per share value gap.” (emphasis supplied)). Despite the repeated expressions of frustration by our courts, the practice continues When a rushing river flows against a resisting rock, eventually the river wins out. Perhaps that is the hope among appraisal advocates and the valuation experts they engage to sponsor their positions 180 TT 243-44 (Subramanian). Subramanian is “the H. Douglas Weaver Professor of Business Law at the Harvard Business School (HBS) and the Joseph Flom Professor of Law and Business at the Harvard Law School (HLS).” JX 19 (Expert Report of Guhan Subramanian [“Subramanian Report”]) at 2; seeid.
(describing qualifications).
42
post-signing go-shop process was not an effective tool for price discovery . . . . ”181
According to Clarke, a DCF analysis premised on the Base Case projections
provides the most reliable evidence of Norcraft’s fair value as of the Merger date.182
Based on his DCF analysis, Clarke concluded that Norcraft’s fair value as of the
Merger was $34.78 per share.183
For his DCF analysis, Clarke chose to extend the Base Case projections for an
additional five years (through 2024), before applying a perpetuity growth rate
(“PGR”) of 3.5% at the end of the projection period.184 He also adjusted the Base
Case projections to deduct for income tax expense in each projected year, which the
Base Case projections presented in Norcraft’s Schedule 14D-9 failed to do.185
181 JX 18 (Clarke Report) at 17 (quoting JX 19 (Subramanian Report) at 25) (intemal
quotation marks omitted). Clarke did not offer any independent analysis as to why the
Merger Price is not a reliable indicator of Norcraft’s fair value as of the Merger date;
instead, he adopted in full Subramanian’s conclusion on that point. See JX 18 (Clarke
Report) at 6, 17.
182 See id. at 2.
1831a1
184 Id. at 2-3. The extension of the proj ections, according to Clarke, was required to reduce
Norcraft’s growth rates gradually to a “steady state.” 1n this regard, Clarke notes that
“if 1he] had to use 2019 as the final year of [his] projections, [he] would then need to use a
higher [PGR of 4.4%] to account for the tapering of [Norcraft’s] growth to a steady state.”
JX 21 (Rebuttal Report of David G. Clarke, ASA [“Clarke Rebuttal Report”]) at 27 n.62.
183 JX 18 (Clarke Report) at 24; JX 1 (Ginter Dep.) at 44-45.
43
After determining Norcraft’s projected unlevered free cash flows through
Norcraft’s FY2024, Clarke then discounted each year’s projected free cash flow
amount to present value using a 9.6% discount rate based on an estimate of
Norcraft’s weighted average cost of capital (“WACC”).186 With these inputs, Clarke
concluded that the present value of Norcraft’s projected unlevered free cash flows
through FY2024 was $297.3 million.187
Clarke then calculated Norcraft’s terminal value by (1) dividing Norcraft’s
terminal year unlevered free cash flow by a capitalization rate of 6.1% and
(2) discounting the quotient of that calculation to present value using Norcraft’s
186 JX 18 (Clarke Report) at 3, 42. To derive Norcraft’s WACC, Clarke first “calculated
[1] Norcraft’s cost of equity based on the capital asset pricing model (‘CAPM’) and
[2] Norcraft’s long-term[,] [after-tax] cost of debt.” ld. at 3, 33. Clarke next multiplied
(1) Norcraft’s estimated cost of equity (11.4%) by the proportion of equity in Norcraft’s
capital structure (approximately 75%), as measured by Norcraft’s (undiluted) market
capitalization immediately before the Merger’s announcement ($396 million); and
(2) Norcraft’s estimated after-tax cost of debt (4.31%) by the proportion of debt in
Norcraft’s capital structure (approximately 25%), as measured by the book value of
Norcraft’s long-term debt on March 29, 2015 ($147.5 million). Id. at 33, 42 & sched. 5-B.
Finally, Clarke summed the product of each calculation to obtain a WACC of 9.6%.
Id. at 33.
187 Id., sched. 2-A (DCF analysis).
44
estimated 9.6% WACC.188 This yielded a terminal value of $509.5 million.189
Clarke then added Norcraft’s terminal value to the present value of Norcraft’s
projected unlevered free cash flows through FY2024 to obtain an $806.8 million
operating value.190
Clarke next made the following adjustments to Norcraft’s operating value to
derive Norcraft’s total equity value: (1) adding Norcraft’s excess cash, estimated at
$44.3 million; (2) adding the value (to Norcraft) of TRA-related tax benefits,
estimated at $4.4 million; (3) adding cash received by Norcraft from the (presumed)
exercise of all outstanding options on Norcraft stock, estimated at $18.3 million; and
(4) deducting the book value of Norcraft’s long-term debt_$147.5 million, per
Norcraft’s Form 10-Q for Ql FY2015.191 After making these adjustments, Clarke
188 Id., sched. 2-A (DCF analysis). Terminal year free cash flow is the future value implied
by (1) the subject company’s projected revenue and expense items in the final year of the
discrete projection period; and (2) the subject company’s estimated PGR. See id. Clarke
calculated Norcraft’s capitalization rate as the positive difference of Norcraft’s estimated
WACC (9.6%) and estimated PGR (3.5%). Id. at 43.
189 Id_, sched. 2-A (DCF analysis).
190 Id_
191 Id. Operating value, as stated here, represents the present value of Norcraft’s future
unlevered free cash flows Id. A DCF analysis, however, attempts to derive the value of
the subject company’s equity. Id. at 45. Thus, adjustments to the operating value are
generally necessary to add in equity in the form of excess cash (or cash equivalents) and to
remove debt. Id. at 45-47. Clarke based his excess cash and “cash from option exercise”
estimates on the information disclosed in the Base Case projections and Norcraft’s
Form 10-Q for Ql FY2015. Id. at 45. He based his estimation of the TRA-related tax
45
concluded that Norcraft’s total equity value was $726.3 million.192 Finally, Clarke
divided this aggregate value by Norcraft’s “fully diluted” shares outstanding
(20,880,123) to obtain an aliquot value of $34.78 per share.193
Clarke also performed a comparable company analysis to confirm the results
of his DCF analysis.194 For this analysis, he selected four companies for his peer
group: (1) American Woodmark, (2) Masonite 1nternational Corp. (“Masonite”),
(3) PGT Innovations, Inc. (“PGT”) and (4) Ply Gem Holdings, Inc. (“Ply Gem”).193
The analysis yielded a $33.92 per share valuation.196 Clarke “determined not to
weight this analysis in determining a specific per share value [for Norcraft],
however, due to the difficulties in finding any companies that were fully comparable
to Norcraft.”197
benefits on the “[I.R.C. §] 743(b) and [net operating loss] utilization” projections included
in Citi’s March 28, 2015 presentation to the Norcraft Board. Id. at 46.
192 Id. at 48.
193 Id. Clarke calculated Norcraft’s “fully diluted shares outstanding” as the sum of (1) the
total number of Norcraft shares and stock options outstanding as of the Merger date; and
(2) the total number of convertible Norcraft LLC units (convertible into Norcraft stock)
outstanding on that date. Id.
194 Id. at 2-4.
193 Id. at 51.
196 Id. 314.
197 Id. at 2.
46
2. Austin Smith’s Opinion Regarding Norcraft’s Fair Value
Austin Smith determined that the most reliable indicator of Norcraft’s fair
value as of the Merger date was the Merger Price, “less . . . contemporaneously
estimated synergies [of $3.60 per share]”198_a metric that yields a valuation of
$21.60 per share. Austin Smith also conducted an independent valuation using three
different valuation methodologies: DCF, comparable company and precedent
transaction analyses.199 Based on those approaches, Austin Smith determined that
Norcraft’s fair value as of the Merger date “ranged from 817.48 to no more than
$23.74.”200
Austin Smith’s primary DCF analysis, like Clarke’s, relied on the Base Case
projections (adjusted to deduct for income tax expense in each of the projected years)
and applied a 3.5% PGR at the end of the projection period.201 Unlike Clarke,
however, Austin Smith did not extend the Base Case projections.202
198 JX 20 (Austin Smith Report) at 29 (emphasis in original). Austin Smith based her $3.60
per share “synergies” figure on “the presentations of Citi and the work done by RBC.” TT
704:24_705:1 (Austin Smith).
199 JX 20 (Austin Smith Report) at l.
200 ld_
201Id. at 20-21, 23 & Ex. 6 (DCF Analysis). Austin Smith performed two additional DCF
analyses, one relying on the Ginter 2014 Proj ections, which valued Norcraft at $15.59 per
share, and another relying on a Capitalization of Cash Flow methodology, which valued
Norcraft at $12.65 per share. Id. at 23-24.
202 Id. at 23 & Ex. 6 (DCF Analysis).
47
After determining Norcraft’s projected unlevered free cash flows through
Norcraft’s FY2019, Austin Smith discounted each year’s projected free cash flow
amount to present value using a 11.2% discount rate based on her estimate of
Norcraft’s WACC.203 From this, Austin Smith concluded that the present value of
Norcraft’s projected unlevered free cash flows through FY2019 was $151 million.204
Austin Smith then calculated Norcraft’s terminal value by (1) dividing
Norcraft’s terminal year unlevered free cash flow by a capitalization rate of 7.69%
and (2) discounting the quotient of that calculation to present value using Norcraft’s
estimated 11.2% WACC.203 Austin Smith concluded that Norcraft’s terminal value
was $435 million.206 She then added Norcraft’s terminal value to the present value
203 Id. at 20.
204 Id., Ex. 6 (DCF Analysis). To derive Norcraft’s WACC, Austin Smith first calculated
(1) Norcraft’ s cost of equity based on CAPM and (2) Norcraft’ s after-tax cost of debt (using
a 37.69% tax rate). Id., Ex. 5 (Calculation of WACC). She next multiplied (1) Norcraft’s
estimated cost of equity (12.4%) by a target proportion of equity in Norcraft’s capital
structure (86%), based on the capital structure of selected comparable companies; and
(2) Norcraft’s estimated after-tax cost of debt (3.6%) by a target proportion of debt in
Norcraft’s capital structure (14%), again based on a “comparable capital structure”
approach. Id., Exs. 4 (Calculation of Beta) and 5 (Calculation of WACC). Finally, Austin
Smith summed the product of each calculation to obtain a WACC of 11.2%. Id., Ex. 5
(Calculation of WACC).
203 See id., Ex. 5 (Calculation of WACC). This is the same approach Clarke followed to
determine terminal value (with different inputs). JX 18 (Clarke Report), sched. 2-A (DCF
analysis).
206 JX 20 (Austin Smith Report), Ex. 6 (DCF Analysis).
48
of Norcraft’s projected unlevered free cash flows through FY2019 to obtain a
$5 86 million operating value.207
Austin Smith made two adjustments to Norcraft’s operating value to
determine Norcraft’s total equity value: (1) adding Norcraft’s excess cash, estimated
at $52.7 million208; and (2) deducting the book value of Norcraft’s long-term debt-
$147.5 million, per Norcraft’s Form 10-Q for Ql FY2015.209 Having made these
adjustments, Austin Smith concluded that Norcraft’s total equity value was
$491 million.210 She then divided this total equity value by Norcraft’s “fully diluted”
shares outstanding (20,880,123) to obtain an aliquot value of $23.54 per share.211
207 Id
208 JX 537 (native Excel version of Austin Smith’s DCF model). Austin Smith calculated
Norcraft’s excess cash on the Merger date based on the “Cash from Norcraft” figure in the
“Funds Flow Memorandum” prepared in connection with the Merger ($54,396,335.01),
JX 249 at 2, less a $20 million cash balance (cash for operations, per the Base Case
projections) plus the product of (1) Norcraft’s total options outstanding as of the Merger
date (1,142,383) and (2) the weighted average exercise price of those options ($16.01).
JX 20 (Austin Smith Report), Ex. 6 (DCF Analysis) (drawing option-related information
from Norcraft’s Ql FY 2015 10-Q, JX 248 at 14).
209 JX 20 (Austin Smith Report), Ex. 6 (DCF Analysis).
210 ]d_
211 Id. Austin Smith calculated Norcraft’s fully diluted shares outstanding as 20,869,976.
JX20 (Austin Smith Report) at 13 & n.25. lt is unclear how Austin Smith derived this
figure, and the figure conflicts with the information set forth in Norcraft’s Form 10-a for
Ql FY2015 and the “Funds Flow Memorandum” prepared in connection with the Merger.
See JX 248 (Norcraft’s Ql FY2015 Form 10-Q) at 4, 11 (17,311,573 shares of Norcraft
common stock outstanding, 2,426,167 convertible Norcraft LLC units outstanding and
1,142,383 options on Norcraft stock outstanding as of March 31, 2015); JX 249 (Funds
F low Memorandum) at 3, 11 (18,947,886 shares of Norcraft common stock outstanding,
49
Finally, upon “summing th[is] . . . component[] of [Norcraft’s] value” with the value
of the TRA-related tax benefits that Norcraft would realize in each projected year
(estimated at $0.20 per share), Austin Smith determined that “the per share value of
Norcraft was $23.74” as of the Merger date.212
As noted, Austin Smith also undertook to value Norcraft using two “market-
based” valuation methodologies Her comparable company analysis yielded a
valuation of $23.46 per share and her precedent transaction analysis yielded a
valuation of $17.48 per share.213
According to Austin Smith, “[t]he high level of consistency between [her]
three separately determined estimates of fair value and the [Merger Price] (less
synergies) provides strong analytical support that $21.90 accurately represents the
per share fair value of Norcraft.”214 1n addition, Austin Smith submits, “the fact that
the [Merger Price] derived from a robust deal process” lends “additional support” to
her fair value determination.213
789,854 convertible Norcraft LLC units outstanding and 1,142,3 83 options on Norcraft
stock outstanding as of May 11, 2015). Both documents indicate a figure of 20,880,123
fully diluted shares outstanding as of the Merger date.
212 JX 20 (Austin Smith Report) at 23.
213 Id. 3125-28.
214 Id. at 29.
213 Id. 1n her reports and trial testimony, Austin Smith provided only a cursory_and
mostly conclusory_discussion of Norcraft’s deal process See id. at 19_20; TT 701-703
50
3. Subramanian’s Opinion Regarding Norcraft’s Deal Process
Professor Subramanian served as Petitioner’s deal process expert.216
According to Subramanian, Norcraft’s deal process was flawed in several respects
that rendered the process “unlikely to have yielded fair value for the Norcraft
shareholders.”217 The principal flaws Subramanian identifies are (1) the lack of any
“competitive process to acquire Norcraft prior to the signing of the Merger
Agreement”218; (2) information asymmetries between Fortune and potential third-
party bidders219; and (3) the presence of certain deal protection mechanisms that
curbed the efficacy of the go-shop and effectively truncated the Go-Shop Period by
at least five days.220
a. Absence of Pre-Signing Competition
Subramanian posits that Norcraft’s “decision to negotiate exclusively with
Fortune” prior to signing the Merger Agreement “eliminated a standard source of
bargaining leverage for Norcraft”_namely, “invok[ing] the threat of an alternative
(Austin Smith). She also acknowledged that she had never before been called upon to offer
expert testimony on the efficacy of a sales process TT 791 :20_24 (Austin Smith).
216 JX 19 (Subramanian Report) at 24_25.
217 Id. 3126.
218 ]d_
219 Id. 3125, 33-36.
220 Id. at 25, 45_52.
51
deal” to extract a higher price.221 Consequently, Norcraft was unable to move
Fortune above its proposed purchase price of $25.50.222 Moreover, Subramanian
submits, it does not appear “that Norcraft extracted something else [from Fortune]
in exchange for exclusivity.”223
As a practical matter, the absence of pre-signing competition “meant that the
Norcraft Board was relying on [the] go-shop process to ensure that Norcraft
shareholders received fair value.”224 According to Subramanian, this reliance was
misplaced because Norcraft’s go-shop process was so poorly structured that it was
rendered entirely ineffective as a price discovery tool.225
b. Information Asymmetries
Subramanian next posits that certain information asymmetries between
Fortune and prospective acquirors vitiated the effectiveness of Norcraft’s go-shop
process.226 As noted, Fortune first approached Norcraft regarding a potential
acquisition on October 20, 2014, and the parties signed a confidentiality agreement
221 Id. at 30 (intemal quotation and footnote omitted).
222 Id. at 31; see TT 100:4_17 (Biggart); JX 238 (Norcraft Schedule 14D-9) at 13.
223 JX 19 (Subramanian Report) at 31.
224 Id. at 32.
225 Id. 21132-33.
226 Id. at 25, 33-36.
52
on December 11, 2014.227 Exclusivity soon followed.228 This dynamic gave Fortune
a substantial head start relative to other potential suitors in evaluating the benefits
and challenges of a Norcraft transaction, including the complex issues relating to the
TRAs.229 And, per Subramanian, “[t]his discrepancy . . . created a severe
information asymmetry problem, because it would be virtually impossible for
prospective third-party bidders to [leam] as much about Norcraft as Fortune
[already knew]” in the thirty-five days allotted for Norcraft’s go-shop process.230
Moreover, Subramanian submits, regardless of whether Fortune’s “first
mover” status provided it with an actual benefit, potential competing bidders would
have perceived Fortune to enjoy an informational advantage.231 That perceived
advantage, in tum, discouraged others from bidding for Norcraft to avoid the
“winner’s curse”_a phenomenon that occurs in common value auction settings
221 PTo 1111 2k, 2p.
221 PTo 11 2w.
229 JX 19 (Subramanian Report) at 29-30, 34 (“Fortune . . . signed a confidentiality
agreement on December 11th, 2014, and then had 110 days of exclusive access to
confidential information and management time at Norcraft before the deal was announced
on March 30th, 2015.”). During the course of those 110 days, both Norcraft and Fortune
had to deal not only with valuation issues relating to the Norcraft business, but also
complex tax and valuation issues (with the help of separate independent experts) relating
to the TRAs JX 5 (Klein Dep.) at 137-38.
230 JX 19 (Subramanian Report) at 34.
231 See id. at 35.
53
where the winning bidder has “buyer’ s remorse” because it has overpaid for the asset
in question.232 That remorse is a product, in part, of the winner’s perception that it
lacked an adequate understanding of the asset before it made its bid.233 Here,
Subramanian submits, because potential competing bidders for Norcraft perceived
that Fortune knew more about the Company than they could hope to learn in thirty-
five days, they may well have feared that they would end up overpaying to acquire
Norcraft if they outbid Fortune.234
c. Deal Structure Minimizes Eff"lcacy of the Go-Shop
According to Subramanian, the interaction between certain deal protection
provisions in the Merger Agreement and the TSAs effectively truncated the Go-Shop
Period “from 35 days to 30 days or even shorter.”233 As noted, the Merger
Agreement entitled Fortune to launch Tahiti’s tender offer for Norcraft’s stock
fifteen days into the Go-Shop Period.236 ln addition, under the TSAs, Buller, SKM
and Trimaran were obligated to tender 53 .6% of Norcraft’s outstanding voting stock
232 Id. at 35-36 (citing Guhan Subramanian, Deal Makz'ng: T he New Strategy of
Negotiauctions 87-88 (2011)).
233 Id. at 40-41.
234 Id. Per Subramanian, Fortune’s unlimited match right compounded the “winner’s
curse” problem, and so operated as a “‘powerful disincentive’ to prospective third-party
bidders.” Id. at 43 (footnote and citation omitted).
233 Id. at 52.
236 JX 221 (Merger Agreement), pmbl. & § 1.1.
54
into Tahiti’s tender offer “promptly following” the initiation of the offer and, in any
event, no later than two days before the offer’s initial expiration date.237 And that
tender could not be rescinded absent a “full-blown superior proposal.”238
Thus, if Fortune launched Tahiti’ s tender offer halfway through Norcraft’ s go-
shop process (as it did),239 53.6% of Norcraft’s voting shares would “promptly” be
tendered to Tahiti_and that tender would be irrevocable absent a superior proposal.
Moreover, even if Norcraft received a superior proposal during the Go-Shop Period,
Fortune would still have at least four days to match that proposal.240
According to Subramanian, the confluence of the deal protections, the limited
duration of the Go-Shop Period, Fortune’s unlimited match right, the definition of
“superior proposal” and Fortune’s ability to launch Tahiti’s tender offer during the
go-shop, resulted in a systematic “tightening and shortening” of the go-shop process.
The “tightening” occurred because “a third party would have to make a full-blown
»241
superior proposal, not just get to excluded party status, by the end of the 35 days.
The full-blown superior proposal was required for Norcraft to terminate the Merger
237 JX 229 (Buller TSA) § 3; JX 230 (SKM TSA) § 3; JX 231 (Trimaran TSA) § 3.
233 TT 254:21~255:7 (Subramanian); JX 221 (Merger Agreement) § 1.1.
239 PTO 1[ 2ee.
240 JX 221 (Merger Agreement) § 5.4(g).
241 TT 255:4_7 (Subramanian).
55
Agreement and prevent Tahiti from accepting the shares tendered pursuant to the
TSAS (a majority of the shares outstanding). Subramanian explained:
Ordinarily, if this was a normal go-shop, you’d have excluded party
status by the end of the go-shop period. But . . . [here] you’ve got to
get to a superior proposal. Got to get the whole shebang done, as
Chancellor Strine said it in Lear, by the end of the go-shop period. And
in my observation and in my experience looking at these go-shops, that
is a big deal. Having to get to an entire superior proposal by the end of
the go-shop period is a very different task than getting to simply
excluded party status.242
The ”shortening” occurred because any potential bidder contemplating
whether to participate in the go-shop could wait no longer than April 30_what
Subramanian terms the “last clear chance” date_to make its superior proposal if it
wanted to ensure that (i) the Norcraft Board had the two business days it was allowed
under the Merger Agreement to assess the proposal and declare it superior;
(ii) Fortune’s four-business-day period to match expired; and (iii) Norcraft
terminated the Merger Agreement before Fortune (via Tahiti) could close on the
tendered Covered Shares. The following graphic from Subramanian’s report
illustrates the “tightening and shortening” phenomenon:
242 TT 299:18-300:4 (Subramanian).
56
“Last C|ear Chance” For a Third-Party Was On April 30th
Mon Tue wad Thu Fri Mon Tue Wed 'Thu"\ Frl Ml:m Tue Wed Thu Frl Mr.\n Tue
4{20 4/21 rlle d,!?..’, 4!24 4}27 MZB 4/29 (\4{30!,- 5!1 5/4 515 516 517 513 5]11 5;1;!
Go-Shop Period (began on 3/30] _->
Coh"ci_l.ls``_i``on'; N_of*.":_``¢?aftitan '
Exc|uded Party _t¢'rmiq;:_;_t¢ ghe_Me_;_-Bgr_
identified .Agre_ernerj:'t'_hefqne ramp cruise .
the TO§-§'t!.)i'=h allows Ifhpus?§§
Superior Proposa! 1 does not§§§§euimj Cove``r'ed 3§§
Made Shares tb§:§§§l;§d 'f'l"oi'n' TO``
Norcraft board T one day befd;r§:'§§§°uid close
convenes, declares
Excluded Party & ¢Day
Superior Proposei 4- Match _»
Right
Tender Offer (began on 4/14} _"'__'P
Covered Shares
Must Be Tendered
Jx19 at 45_52 13
Subramanian also observes that, even without the “tightening and shortening”
of the go-shop, Fortune’s unlimited match right stands alone as a disabling feature
of this go-shop.243 According to Subramanian, from the perspective of a potential
bidder, unlimited match rights are typically perceived as limiting any “pathway to
success.”244 Indeed, Subramanian submits, “[e]verybody agrees that match rights
deter bids. lt [is] not even a debated question.”245
243 JX 19 (Subramanian Report) at 41~44; JX 221 (Merger Agreement) at § 5.4(g).
244 JX 19 (Subramanian Report) at 50.
245 TT 254;4_7 (Subramanian).
57
Here again, Fortune was acutely aware of the advantage it secured, while
Norcraft’s Board apparently did not understand what an unlimited match right was
6In
much less how that deal protection might work to hinder the go-shop.24
describing the disparity in the sophistication of the two parties negotiating this
Merger, Subramanian observed: “it seems like . . . the Fortune side was playing chess
and the Norcraft side was playing checkers.”247
J. ProceduralPosture
Petitioners filed a petition with this Court on June 22, 2015, seeking appraisal
of their 557,631 shares of Norcraft common stock.248 The Court held a four-day trial
in June 2017, and the parties thereafter submitted post-trial briefing
On December 20, 2017, the Court requested supplemental submissions from the
parties to address certain questions following the Delaware Supreme Court’s
December 14, 2017, decision in Dell.249 The Court heard post-trial argument on
Apri125, 2018.
246 Compare JX 232 (e-mail chain between RBC, Klein and other members of Fortune’s
deal team, Apr. 7, 2015) with JX 11 (Reilly Dep.) at 125:3-22 and JX 3 (Buller Dep.)
at 206:16-207:24.
247 TT 269:8-11 (Subramanian).
243 JX 260 (Petition for Appraisal).
249177 A.3d1;D.I.91.
58
II. ANALYSIS
Our appraisal statute, 8 Del. C. § 262, provides, “[t]hrough [the appraisal]
proceeding, the Court shall determine the fair value of the shares exclusive of any
element of value arising from the accomplishment or expectation of the merger or
consolidation, together with interest, if any, to be paid upon the amount determined
to be the fair value. In determining such fair value, the Court shall take into account
all relevant factors.”250 “Easy enough,” one might say on a first read, but the judicial
appraisal process, through the years, has proven to be anything but “easy.”231
“Section 262(h) unambiguously calls upon the Court of Chancery to perform
an independent evaluation of ‘fair value’ at the time of a transaction . . . [and] vests
250 8 Del. C. § 262(h).
251See, e.g., In re Orchara'Enters., Inc., 2012 WL 2923305, at * 18 (Del. Ch. July 18, 2012) (“As a law-trained judge who has to come up with a valuation deploying the learning of the field of corporate finance, I choose to deploy one accepted method as well as I am able, given the record before me and my own abilities.”); Global GTLP,993 A.2d at
517 n.126 (explaining that “academics and professionals throw around . . . ranges of value [that] are used by a law-trained judge to come to a single point estimate of value” and that “[t]he law-trained judges who must perform such analyses are more conscious than anyone of the inherent risk of error in such an endeavor, and indeed of the reality that no one can really tell if an error was made”), ajj"d,11 A.3d 214
; Finkelstein,2005 WL 1074364
, at *12 (“The judges of this court are unremittingly mindful of the fact that a judicially selected determination of fair value is just that, a law-trained judge’s estimate that bears little resemblance to a scientific measurement of a physical reality.”). Indeed, “the judges of this Court” have lamented the challenges posed by the appraisal statute for many years. While perhaps repetitive, these expressions serve a valuable function; they serve as a longhand way of saying to the parties and the community of interest: “I’ve done the best l can here.” 59 the Chancellor and Vice Chancellors with significant discretion to consider ‘all relevant factors’ and determine the going concern value of the underlying company.”252 “By instructing the court to ‘take into account all relevant factors’ in determining fair value, the statute requires the Court of Chancery to give fair consideration to ‘proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.’ Given that ‘[e]very company is different; [and] every merger is different,’ the appraisal endeavor is ‘by design, a flexible process.”’233 Taking to heart the mandate of Section 262(h), as reiterated by our Supreme Court, I have carefully considered all relevant factors. And 1 have assigned those factors the weight (or not) 1 determined they deserve based on my evaluation of the credible evidence, and my application of “accepted financial principles” as derived from that evidence.254 A. The Merger Price is Not a Reliable Indicator of Norcraft’s F air Value As our Supreme Court has recognized, “corporate finance theory reflects a belief that if an asset_such as the value of a company as reflected in the trading 252 DFC, 172 A.3d at 364 (quoting 8 Del. C. § 262(h)). 233 Dell, 177 A.3d at 21 (quoting Weinberger v. UOP,457 A.2d 701
, 713 (Del. 1983); Golden Telecom,11 A.3d at 218
; and In re PetSmart, Inc.,2017 WL 2303599
, at *26 (Del. Ch. May 26, 2017)) (alteration in original). 254 Dell, 177 A.3d at 22. 60 value of its stock-can be subject to close examination and bidding by many humans with an incentive to estimate its future cash flows[’] value, the resulting collective judgment as to value is likely to be highly informative[.]”233 So long as “all estimators hav[e] equal access to information, the likelihood of outguessing the market over time and building a portfolio of stocks beating it is slight.”256 Thus, the Supreme Court has emphasized that our courts must appreciate “the economic reality that the sale value resulting from a robust market check will often be the most reliable evidence of fair value, and that second-guessing the value arrived upon by the collective views of many sophisticated parties with a real stake in the matter is hazardous.”237 Nevertheless, our Supreme Court has declined on several occasions to pronounce a presumption in favor of deal price in determining fair value.238 Instead, it has reiterated the “flexible” nature of the trial court’s fair value calculus, while also noting its lack of “confidence in [its] ability to craft, on a general basis, the 255 DFC, 172 A.3d at 370. 2561d 257 Id. at 366. 233 See, e.g., id.; Golden Telecom,11 A.3d at 217-18
. 61 precise pre-conditions that would be necessary to invoke a presumption” in favor of the deal price.239 Here, Norcraft’s deal process did not include a meaningful market check and, consequently, the Merger Price was not “arrived upon by the collective views of many sophisticated parties with a real stake in the matter.”260 Prior to the execution of the Merger Agreement, the Company chose to negotiate with Fortune and Fortune alone.261 That decision, if made as a strategic choice, does not alone render Norcraft’s deal process unsound.262 Nor does it preclude a finding that Norcraft’s deal process resulted in a reliable indication of fair value (reflected by the Merger Price). lndeed, even Petitioners’ expert has acknowledged that negotiating with a 239 DFC, 172 A.3d at 366. 2601d. 261 TT 13_15 (Eldridge). 262 See In re Fort Howara' Corp. S’hola'ers Litig.,1988 WL 83147
, at *13~14 (Del. Ch. Aug. 8, 1988) (finding board-chosen single-bidder process satisfied Revlon duties); In re Pennaco Energy, Inc.,787 A.2d 691
, 706 (Del. Ch. 2001) (“[T]he mere fact that the Pennaco board decided to focus on negotiating a favorable price with Marathon and not to seek out other bidders is not one that alone supports a breach of fiduciary duty claim.”); In re MONY Gp. Inc. S’holder Litig.,852 A.2d 9
, 21 (Del. Ch. 2004) (same) (quoting Pennaco,787 A.2d at 706
). 62 single potential buyer pre-signing can, in certain instances, lead to significant value.263 But the single bidder focus here, while perhaps not amounting to a breach of fiduciary duty,264 did not provide a meaningful market check as would yield a reliable indication of fair value. First, there is no evidence that the Board or Citi employed a single bidder approach for the sake of achieving a strategic advantage or maximizing value. Second, and more troubling, the Board’s focus on only one bidder was tainted by the fact that Buller (who was conflicted) served as Norcraft’s lead negotiator from start to finish. The shambolic pre-signing process left Norcraft’s post-signing go-shop as the only meaningful opportunity to check the market.265 Unfortunately, Fortune 263 JX 31 (Guhan Subramanian, Go-Shops vs. No-Shops in Private Equity Deals: Evia’ence and lmplicalions, 63 Bus. Law. 729 (2008)) at 755 (“[A] pure go-shop can be a valuable tool for extracting the highest possible price in the sale of [a] company.”). 264 M.P.M Enters., Inc. v. Gilbert,731 A.2d 790
, 797 (Del. 1999) (“A fair merger price in the context of a breach of fiduciary duty claim will not always be a fair value in the context of determining going concern value.”); In re Traa'os Inc. S’holder Litig.,73 A.3d 17
, 78 (Del. Ch. 2013) (“A court could conclude that a price fell within the range of fairness and would not support fiduciary liability, yet still find that the point calculation demanded by the appraisal statute yields an award in excess of the merger price.”); Reis v. Hazelett Strip- Castz``ng Corp.,28 A.3d 442
, 466 (Del. Ch. 2011) (same). 263 Petitioners urge the Court to conclude that “a go-shop only process” is, per se, inadequate to generate fair value. Pet’rs’ Post Trial Opening Br. 3 (citing IQ Hldgs. v. Am. Commercial Ll``nes,2013 WL 4056207
(Del. Ch. Mar. 18, 2013) and Hujj’FundInv. P ’ship v. CKx, Inc.,2013 WL 5878807
, at *13 (Del. Ch. Nov. 1, 2013)). Having reviewed the cited authority, I do not see where IQ Holdings addressed the issue at all. As for CKx, Inc., while the court acknowledges that a scenario where the only market check is an 63 extracted concessions from Norcraft that rendered the go-shop process equally ineffective as a price discovery tool. 1. The Board’s Singular Focus on Fortune, Failure to Manage Buller’s Conflicts and Misplaced Reliance on the Go-Shop There is no dispute that neither Norcraft nor Citi contacted other bidders before Norcraft signed the Merger Agreement This resulted in lost opportunities Not only did Norcraft miss the opportunity to test the market before committing to Fortune, it also missed the opportunity to leverage the interest of another suitor to extract a higher price from Fortune. Given these missed opportunities, it is not surprising that, by the time the parties settled on the Merger Price, Norcraft’s management still believed that the merger consideration was too low.266 The plan, therefore, was to put all eggs in the go-shop basket as a means to achieve fair value for Norcraft stockholders.267 unsuccessful go-shop might undermine the reliability of the deal price as an indicator of fair value, the court says nothing of adopting a rule that a go-shop alone will never produce fair value for the target. Id. at *13. I see no basis in law or fact to adopt such a rule. 266 JX 140 (e-mail from Reilly to Buller, Maselli and Citi representatives, Feb. 20, 2015) (Reilly: “I do believe we are leaving $ on the table”); TT 29:19_22 (Eldridge) (Buller “eager to try and find a buyer at a higher valuation”); JX 13 8 (e-mail from Ginter to Buller, Feb. 19, 2015) (“Current offer will be 10.9x or less by the time we close in April at $25.50. so we weren’t happy with the deal in [O]ct[ober] but now we are?”). 267 See JX 3 (Buller Dep.) at 85-86. 64 Of course, on the other side of the table, Fortune perceived the Merger Price as very favorable (to Fortune).263 lt was protective of that price and sought to avoid or limit the go-shop to preclude a topping bid.269 And that is precisely what it did. Norcraft’s Board left the negotiations principally to Buller. Yet Buller was just as (if not more) fixated on extracting commitments from Fortune regarding the TRAS and his future role with the combined company as he was on securing the best price possible for Norcraft. Fortune, for its part, was “stringing Buller along” as it negotiated with him over the Merger Price, leading him to believe he might continue 268 JX 185 (e-mail chain between Fortune director David Mackay and Klein, Mar. 20, 2015) (Mackay: “Looks very positive[.] A good strategic fit at a reasonable price . . . I fully support the deal and hope no one comes along and offers more.”); id. (Klein:“You are spot on _ its [sic] a good price, and there is a risk someone comes along and tries to top the offer.”); JX 300 (Mar. 31, 2015 e-mail from Fortune director Mackay to Fortune’S other directors and deal team members) (“Let’s hope no one bids!”). 269 TT 146:18-147:9 (Biggart) (explaining a Fortune presentation analyzing potential go- shop competitors “[b]ecause at this point in time, we’re about to agree to a go-shop, and our CEO is very upset about the idea of doing this”); see also JX 5 (Klein Dep.) at 164:1 1- 22 (“Q. And Norcraft insisted on some type of go-shop process, right? A. Yes. Q. And in the context of negotiating that, your goal was to minimize the chances that the go-shop process would result in a higher bidder, -- A. l wanted to -- Q. -- correct? A. -- give them what they needed _ the minimum amount they needed to satisfy their fiduciary responsibility which I know they had.”). Of course, it is not unusual_or inherently problematic-for a prospective acquiror to want to avoid being outbid after having expended considerable time, effort and funds. Fortune’s attitude, however, suggests that it appreciated the pre-sign process did not yield fair value for Norcraft stockholders and that it wanted to protect that advantage throughout the go-shop process. Again, this is precisely what the Board reasonably should have expected from the party sitting on the other side of the table. 65 his employment with Fortune post-close.270 When Fortune finally informed Buller (after settling on the Merger Price) that he would have no place at Fortune post- close, Fortune secured Buller’s continued commitment to the Merger by stringing him along again, this time by dangling the possibility that Fortune would be willing to sell Norcraft Canada to Buller after the closing.271 The Board either did not appreciate Buller’s conflict, or chose not to manage it, until Buller announced that he would pursue the acquisition of Norcraft Canada after closing.272 By then, Buller had been spurring with Fortune in an attempt to extract every dollar he demanded for the TRAs (diverting consideration from the stockholders) and had pushed hard for post-closing employment with Fortune. Yet all along, the Board did nothing to manage the conflict_it did not form a special committee of its members to negotiate with Fortune or take any other steps to neutralize Buller’s influence. Even its half-hearted effort to recuse Buller from 276 JX 166 (e-mail from Klein to Fortune deal team, Mar. 12, 2015); TT 205 (Biggart) (On March 6, 2015, Fortune “definitively told [Buller] he didn’t have the job.”). 271 See JX 189 (e-mail chain between Dave Randich, head of Fortune’s cabinet division, Klein and members of F ortune’s deal team, Mar. 23, 2015); JX 199 (Mar. 26, 2015 e-mail from RBC to Klein and other members of Fortune’s deal team); JX 202 (Mar. 27, 2015 e- mail from Buller to PwC); JX 194 (e-mail chain between members of Norcraft and Fortune deal teams, Mar. 25, 2015). 272 JX 11 (Reilly Dep.) at 158-160. 66 further Board deliberations regarding the Merger following his demonstrated interest in Norcraft Canada proved ineffective.273 Given that the single-bidder pre-signing process led by a conflicted negotiator yielded what at least some within Norcraft deemed unsatisfactory consideration, it was imperative that the Norcraft Board run an effective post-signing go-shop. It did not. 2. The Post-Sign Go-Shop Provides No Basis to Rely on the Deal Price Although it is hardly clear that Norcraft’s Board appreciated this fact, the ineffective pre-signing process should have made clear that the post-signing go-shop would offer the only real opportunity for a meaningful market check.274 Unfortunately, that process fell far short on many levels, as the following evidence illustrates: l Prior to the Go-Shop Period, it was not widely known that Norcraft was “up for sale”273; thus, potentially interested parties did not know that Norcraft was 273 JX 13 (Biggart Dep.) at 107_109, 111:6_112:3; JX 194 (e-mail chain between members of Norcraft and Fortune deal teams, Mar. 25, 2015). 274 In re AOL, Inc.,2018 WL 1037450
, at *9 (Del. Ch. Feb. 23, 2018) (observing “if front- end information sharing is truncated or limited, the post-agreement period should be correspondingly robust, so to ensure that information is sufficiently disseminated that an informed sale can take place and bids can be received without disabling impediments”). 273 The Merger Agreement was publicly announced on March 30, 2015. See JX 227 (Norcraft Mar. 30, 2015 Proxy Statement) at 3. That same day, the Go-Shop Period began. PTO 11 200. 67 “in play” before the Merger was announced, putting them Several steps behind Fortune in pursuing an acquisition of Norcraft276; l Norcraft’s Board appeared to lack even a basic understanding of the terms and function of the go-shop277; 276 JX 19 (Subramanian Report) at 34; JX 243 (Citi Buyers Log) at 2 (“investment is too big [] to consider in a short period”); ia'. at 12 (“can’t move fast enough in 35 days”); ia’. at 2, 5, 7~9 (prospective bidders explaining they had no interest in competing against Fortune). 277 See, e.g. , JX 3 (Buller Dep.) at 207:5-24 (“Q. Do you know what Norcraft’s rights were if another proposal came in during the go-shop period? A. Don’t recall. Q. Do you have any knowledge of what Norcraft could have done if one of the go-shop parties was interested and made a bid? A. We could have pursued the offer. Q. Were there any restrictions on Norcraft’s ability to pursue an offer? A. Some, but 1 don’t recall what they were. . . . Q. Do you recall anything about Fortune’s rights if another offer came in? A. I don’t recall.”); JX 8 (Eldridge Dep.) at 85:17-19 (“Q. What kind of matching rights did Fortune have in this transaction? A. I don’t recall.”); JX 9 (Maselli Dep.) at 75:5- 78:5 (“Q. Under the terms of the merger agreement, what needed to occur for a go-shop participant to continue to negotiate with Norcraft regarding a possible sale after the go- shop period ended? . . . A. I don’t know what the threshold was, but . . . if it was a sufficiently robust offer, they would have an opportunity to complete the transaction.”); JX 11 (Reilly Dep.) at 121:3-130:20 (“Q. Did you personally ever consider what effect the tender and support agreements would have on the go-shop process? A. I can’t recall. . . . To be honest with you, l’m not an expert in going private transactions, though I’ve been around for a while; and, in my estimation, the retention of both Ropes and Citibank and to rely on their advice and counsel with respect to the process was, you know, doing my duty. So that’s kind of what we really looked to the experts to help us. . . . Q. What are matching rights? A. I have no idea. . . . Q. Okay. Well, do you know what type of matching rights Fortune had in Norcraft’s go-shop process? . . . A. I don’t recall. . . . Q. Do you recall any discussions among Norcraft’s directors or officers with respect to Fortune’s matching rights in this go-shop process? A. I do not. Q. Under the merger agreement that Norcraft signed with Fortune Brands, what needed to happen for a go-shop participant to continue to negotiate with Norcraft regarding a possible sale after the go- shop period ended? A. Idon’t recall.”); cf. JX 1 (Ginter [CFO] Dep.) at 140:9_14 (“A. My knowledge of a go-shop is limited in that regard. I know the banks ran it for us and prepared a list of potential investors that may be interested in looking at Norcraft. But my knowledge of a go-shop is limited to that and what I learned during the process.”). 68 l Any potential bidder had to value the TRAs_and provide for the satisfaction of Norcraft’s payment obligations thereunder_within the Go-Shop Period, a task that Fortune had several months to complete (and struggled to navigate successfully, even with the assistance of expert tax advisors)273; l Fortune had an unlimited match right under the Merger Agreement, which gave Fortune four business days to match a superior proposal by a third-party bidder and two business days to match any subsequent proposal by the same bidder279; l In order to proceed with an alternate transaction, Norcraft had to receive a “Superior Proposal” by the end of the Go-Shop Period, “essentially requir[ing] the bidder to get the whole shebang done within the [Go-Shop Period].”230 This requirement was made more onerous by the TRAS’ interaction with the Merger Agreement’s go-shop provisions, allowing “Fortune [to] close its tender offer for the 54 percent [of Norcraft common stock] before Norcraft [could] terminate the merger agreement, because Norcraft [couldn’t] terminate on the possibility of a superior proposal. [Rather, Norcraft could] only terminate after [it had] given Fortune four days to match. And the four days [could] go beyond the tender offer expiration.”231 273 JX 5 (Klein Dep.) at 137-139; JX' 11 (Reilly Dep.) at 164_165; JX 130 (Feb. 9, 2015 RBC presentation regarding TRA value); JX 162 (Mar. 10, 2015 RBC email attaching questions regarding TRAs). 279 JX 221 (Merger Agreement) § 5.4(g); see Lena'er Processing,2016 WL 7324170
, at *25 (“In this case, the most persuasive explanation is that the existence of an incumbent trade bidder holding an unlimited match right was a sufficient deterrent to prevent other parties from perceiving a realistic path to success. . . . Without a realistic path to success, it made no sense to get involved.”). Fortune’s Vice President of M&A confirmed that “the team at Fortune understood that unlimit[ed] matching rights would discourage potential bidders in a go-shop process.” JX 12 (Baab Dep.) 99-100. And, Fortune’s CEO touted Fortune’s match right when instructing RBC how to dissuade potential go-shop participants from bidding. JX 232 (e-mail chain between RBC, Klein and other members of Fortune’s deal team, Apr. 7, 2015). 230 In re Lear Corp. S ’hola’er Ll``tig.,926 A.2d 94
, 119-20 (Del. Ch. 2007). 281 TT 289;1_7 (Subramanian). 69 l On April 14, 2015, about two weeks into the thirty-five-day Go-Shop Period, Fortune launched Tahiti’s tender offer,232 triggering the TSAS and causing 53.6% of Norcraft’s outstanding shares to be committed to supporting the Norcraft-Fortune transaction absent a superior proposal233; ana’ l In a fit of bad judgment, RBC attempted to contact and dissuade possible bidders from topping Fortune’s bid during the go-shop.234 Presented with this factual record, I am not persuaded that Norcraft’s go-shop process provided a meaningful market check that resulted in a transaction price derived from the “collective views of many sophisticated parties with a real stake in the matter.”235 Accordingly, I do not accord any weight to the deal price in my fair value calculus.236 232 PTO 11 2ee. As noted, the Go-Shop Period began on March 30, 2015. PTO 11 2cc. 233 JX 229 (Buller TSA); JX 230 (SKM TSA); JX 231 (Tl'imararl TSA). 234 JX 232 (e-mail chain between RBC, Klein and other members of Fortune’s deal team, Apr. 7, 2015) (RBC describing its planned efforts to dissuade potential buyers);id.
(Klein expressing his interest in RBC “shutting the door on [potential buyers] and their willingness to look at [Norcraft]”). 233 DFC, 172 A.3d at 366. Respondent advanced deal price less synergies as reflecting Norcraft’s fair value. Accordingly, it was Respondent’s burden to prove the reliability of Norcraft’s deal process. Respondent, however, failed to meet that burden_its witnesses struggled to recall basic aspects of the deal process and its valuation expert presented only a cursory, mostly conclusory, analysis of that process. Petitioners, on the other hand, presented credible evidence demonstrating that deal price less synergies is not a reliable indicator of Norcraft’s fair value. 236 This, of course, means that l give no weight to Austin Smith’s deal price less synergies valuation, 70 3. Insuff``icient Evidence to Consider the Efficient Market Hypothesis Following our Supreme Court’s renewed endorsement of the efficient capital market hypothesis in Dell, 1 requested that the parties submit supplemental post-trial briefing addressing whether Norcraft’s unaffected trading price was probative of Norcraft’s fair value on the Merger date.237 Because this case was tried before the Supreme Court’s decision in Dell, the parties presented limited evidence at trial respecting Norcraft’s trading history and the market for its stock. Consequently, the parties had a rather limited record to draw upon when addressing this issue in their supplemental submissions.233 To the extent the trial evidence is informative at all on this issue, it does not support assigning any weight to Norcraft’s unaffected trading price for purposes of determining Norcraft’s fair value on the Merger date. Norcraft had a limited public trading history given that it had just completed an IPO eighteen months before the Merger.239 What trading did occur following the IPO was relatively limited, an 237 D.1. 91. 233 See AOL,2018 WL 1037450
, at *10, n.118 (declining to engage in an extensive analysis of the efficient market hypothesis when the parties did not present either an argument to that effect or sufficient evidence to allow the court to undertake the analysis on its own). 239 JX 216 (e-mail from RBC to Biggart, Mar. 29, 2015, attaching RBC presentation on Norcraft) at FB0047792, FB0047795. 71 unsurprising phenomenon given the niche market in which Norcraft operated.290 The analyst coverage of Norcraft’s stock was relatively sparse.291 Based on this record, 1 am unable to conclude that the market for Norcraft’s common stock was efficient or semi-strong efficient.292 Absent that finding, 1 do not assign any weight to Norcraft’s unaffected trading price as an indicator of Norcraft’s fair value on the Merger date.293 B. Norcraft’s Fair Value under “Traditional Methods” of Valuation Having determined that neither the Merger Price nor Norcraft’s unaffected stock price provide a reliable indicator of the Company’s fair value, 1 must now consider the remaining valuation analyses presented by the parties’ experts. 1n this regard, our law is clear that: 290 See JX 68 (Sept. 18, 2014 Fortune Presentation) at FB0089499; JX 215 (Citi Board Discussion Materials) at FB0049833. 291 See JX 215 (Citi Board Discussion Materials) at FB0049845. 292 See Dell, 177 A.3d at 25 (“A market [for a company’s stock] is more likely efficient, or semi-strong efficient, if [the company] has many stockholders; no controlling stockholder; ‘highly active trading’; and if information about the company is widely available and easily disseminated to the market.” (quoting DFC, 172 A.3d at 373-74)). 293 See Verition P’rs Master Funa’ Lta’. v. Aruba Nelworks, Inc.,2018 WL 922139
, at *24 (Del. Ch. Feb. 15, 2018) (“DFC and Dell teach that if a company’s shares trade in a market having attributes consistent with the assumptions underlying a traditional version of the semi-strong form of the efficient capital markets hypothesis, then the unaffected trading price provides evidence of the fair value of a proportionate interest in the company as a going concern.” (footnote omitted)). 72 1n discharging its statutory mandate, the Court of Chancery has the discretion to select one of the parties’ valuation models as its general framework or to fashion its own. The Court of Chancery’s role as an independent appraiser does not necessitate a judicial determination that is completely separate and apart from the valuations performed by the parties’ expert witnesses who testify at trial. It must, however, carefully consider whether the evidence supports the valuation conclusions advanced by the parties’ respective experts.294 1 have followed this guidance as 1 have worked through the experts’ competing analyses here. 1. Comparable Companies and Precedent Transaction Analyses Are N ot Reliable As previously mentioned, both experts performed a comparable company analysis. Austin Smith also performed a precedent transaction analysis. “The utility of a comparable company [or precedent transaction] approach is dependent on the similarity between the company the court is valuing and the companies [or precedent transactions] used for comparison.”295 When there are no sufficiently comparable companies or precedent transactions, such analyses are unavailing in the search for fair value.296 294 MG. Bancorp., Inc. v. Le Beau,737 A.2d 513
, 525-26 (Del. 1999). 293 IQ Hla’gs., Inc.,2013 WL 4056207
, at ’1‘1 (quoting Doft & Co. v. Travelocily.com Inc.,2004 WL 1152338
, at *8 (Del. Ch. May 20, 2004)) (internal quotation omitted); see also Merz``on Capital,2013 WL 3793896
, at ’1‘5; James R. Hitchner, Financz``al Valuation.' Applicatz``ons ana’ Moa’els 291-93, 297 (4th ed. 2017) (cited in JX 21 (Clarke Rebuttal Report)). 296 In re Orchara’Enters., Inc.,2012 WL 2923305
, at *9 (Del. Ch. July 18, 2012) (“Reliance on a comparable companies or comparable transactions approach is improper where the 73 After carefully reviewing the evidence, 1 see no factual basis to rely on a precedent transaction or comparable company analysis as an indicator of Norcraft’s fair value as of the Merger date. The parties agree that there had not been an acquisition of any publicly-traded, “dealer channel” cabinet manufacturer-or a satisfactorily comparable business297-in any temporal proximity to the Merger.293 Nor were the parties (or their experts) able to identify any truly comparable companies that could support a reliable comparable company analysis.299 1t is, purported ‘comparables’ involve significantly different products or services than the company whose appraisal is at issue, or vastly different multiples.”); see also Hitchner, supra, at 292-93. 297 See JX 13 (Biggart Dep.) at 75:1-76:23, 152:22-153:1 (explaining he could not recall any precedent transaction in the dealer channel since 2010). Many of the precedent transactions identified by Austin Smith preceded the Norcraft-Fortune Merger by three or more years during a time in which the housing market was still recovering from the Great Recession. See JX 20 (Austin Smith Report), Ex. 14 (Precedent Transaction Method) (showing that 11 out of the 16 transactions predated 2012). The remaining transactions involved very small, non-public companies, making them unfit for comparison. See ia’. Under these circumstances, 1 see no reason to dwell on a precedent transaction analysis in determining Norcraft’s fair value on the Merger date. See Merion Capital,2013 WL 3793896
, at *5 (“The utility of a market-based method depends on actually having companies that are sufficiently comparable that their trading multiples provide a relevant insight into the subject company’s own growth prospects.”); see also Hitchner, supra, at 304_06. 293 See JX 20 (Austin Smith Report), Ex. 14 (Precedent Transaction Method) (showing that 11 out of the 16 transactions predated 2012); JX 18 (Clarke Report) at 4 n.8; JX 21 (Clarke Rebuttal Report) at 6. 299 Cf JX 20 (Austin Smith Report) at 25~28 (explaining, “of the guideline public companies, [Norcraft] is most similar to (though smaller than) American Woodmark, the only other pure-play cabinet manufacturer,” “Norcraft is significantly smaller than most of the guideline public companies based on revenue, EBITDA, or assets”); TT 510:10-13 74 therefore, unsurprising that neither expert relied on market-based approaches (comparable company or precedent transaction analyses) as the principal metric by which to value Norcraft.300 1nstead, they offered these valuations to corroborate the results they reached utilizing their preferred valuation methodologies301 Because 1 disagree that market-based valuation metrics provide any guidance here, 1 do not consider those metrics further. 2. The DCF Analysis “[A] DCF analysis can provide the court with a helpful data point about the price a sale process would have produced had there been a robust sale process involving willing buyers with thorough information and the time to make a bid.”302 The basic premise underlying the DCF methodology is that the value of a company is equal to the value of its projected future cash flows, discounted to the present value at the opportunity cost of capital. Calculating a DCF involves three steps: (1) one estimates the values of future cash flows for a discrete period, where possible, based on contemporaneous management projections; (2) the value of the entity attributable to cash flows expected after the end of the discrete period must be estimated to produce a so-called terminal value, preferably using a perpetual growth model; and (3) the value of the cash flows for (Clarke) (“1 view Norcraft being somewhat unique in that regard. So these are not -- you know, these are not perfect comps.”). 300 JX 18 (Clarke Report) at 32, 55; TT 636:17-637:6 (Clarke); JX 20 (Austin Smith Report) at 29. 301 JX 18 (Clarke Report) at 32, 55; TT 636:17~637:6 (Clarke); JX 20 (Austin Smith Report) at 29. 302 Dell, 177 A.3d at 35. 75 the discrete period and the terminal value must be discounted back using the capital asset pricing model or “CAPM.” 1n simpler terms, the DCF method involves three basic components: (1) cash flow projections; (2) a discount rate; and (3) a terminal value.303 a. The Disputed Inputs As is typically the case, the substantial delta between the experts’ DCF valuations can be traced to their disagreements regarding the DCF inputs. Their most significant disagreements are: (1) whether to extend the Base Case projections by an additional five years; and (2) how to calculate Norcraft’s beta in connection with estimating Norcraft’s WACC. On the latter point, the experts disagree regarding (i) the selection of appropriate guideline public companies (“GPCS”) for a proxy beta calculation and whether net debt or gross debt should be used to unlever the GPC betas and relever the resulting proxy beta304; and (ii) whether Norcraft’s observed capital structure or a target capital structure should be used to relever the concluded 303 Merion Capital,2013 WL 3793896
, at * 10 (internal citation omitted). 304 See Shannon P. Pratt & Roger J. Grabowski, Cost of Capital.' Applz'cations and Examples 223 (5th ed. 2014) (cited in JX 18 (Clarke Report)) (“Using betas of guideline public companies for estimating a proxy beta has been found to provide reasonably accurate estimates of the subject company”); Duff & Phelps, 2015 Valuation Handbook, Guide to Cost of Capital 5-3 (2015) (cited in JX 18 (Clarke Report)); Andaloro v. PFPC Worldwide, Inc.,2005 WL 2045640
, at * 15 (Del. Ch. Aug. 19, 2005). “A company’s debt capital can be measured by [gross] debt or net debt, where net debt is equal to total debt less excess cash.” JX 23 (Austin Smith Rebuttal Report) at 23 (emphasis in original). 76 beta when calculating Norcraft’s cost of equity.305 The experts generally agree on the remaining DCF inputs. i. Management Projections “The most important input necessary for performing a proper DCF is a projection of the subject company’s cash flows. Without a reliable estimate of cash flows, a DCF analysis is simply a guess.”306 While Norcraft’s management (Buller and Ginter) prepared several sets of projections, the experts agree that the most reliable projections are the Base Case projections_and both experts relied on those projections in their primary DCF analyses.307 The record reflects that Norcraft management did not prepare long-term projections in the ordinary course of Norcraft’s business.303 Nevertheless, Buller and Ginter knew how to prepare long-term projections and they approached the Base 303 The capital structure used to relever the subject company’s unlevered beta should also be used when calculating its WACC (for weighting purposes). TT 854: 17~857: 10 (Austin Smith). 306 AOL,2018 WL 1037450
, at *11 (quoting Del. Open MRI Radiology Assocs., P.A. v. Kessler,898 A.2d 290
, 332 (Del. Ch. 2006)). See also Shannon P. Pratt, Robert F. Reilly & Robert P. Schweihs, Valuing a Business: T he Analysis and Appraisal of Closely Held Companies 156 (4th ed. 2000) (cited in JX 18 (Clarke Report)) (hereinafter “Valuing a Business”). 307 As noted, Austin Smith performed two additional DCF analyses, one relying on the Ginter 2014 Projections and another relying on a Capitalization of Cash Flow methodology. See JX 20 (Austin Smith Report) at 23-24. Neither analysis, however, formed the basis for her final conclusion regarding fair value. See id. at 1. 303 JX 1 (Ginter Dep.) at 27:2-28:14, 34:5_10; JX 3 (Buller Dep.) at 101:20-24. 77 Case projections with a view to providing the Board with a reliable estimate of Norcraft’s future financial performance.309 When all was said and done, Buller and Ginter were confident they had prepared a set of realistic, reasonable projections upon which Citi and the Board could rely in assessing Norcraft’s value during the course of negotiations.310 While not perfect, 1 am satisfied that the Base Case projections provide a reliable foundation for a valid DCF.31l The experts’ dispute regarding the Base Case projections does not turn on their reliability (or lack thereof), but rather on whether the projections should be extended 309 JX 3 (Buller Dep.) at 115:8-18 (explaining that the Base Case projections were “something [management] felt very, very comfortable in doing”); id. at 114:11_22; JX 1 (Ginter Dep.) at 93:23-25 (stating the Board approved the Base Case projections); JX 11 (Reilly Dep.) at 55:9-19. 310 JX 3 (Buller Dep.) at 115:8_18. Cf Petsmart,2017 WL 230359
, at * 12 (noting that the respondent company’s management characterized their projections as “bordering on being too aggressive”_even “approaching ‘insan[ity]”’) (alteration in original) (internal quotation marks, footnote and record citation omitted). 311 TT 473-75 (Clarke) (explaining why the Base Case projections are reasonable). Austin Smith found several “significant limitations” to the Base Case projections: (1) they were not created in the ordinary course; (2) they were not created using the same procedure as Norcraft’s annual budgets (i.e. , bottoms-up); (3) they projected an additional five years of growth after two years of already achieved growth in a cyclical industry; and (4) Ginter and Buller, who prepared the Base Case projections, allegedly knew they were going to lose their jobs if the transaction was completed_introducing the possibility of bias. TT 734: 10-736: 14 (Austin Smith). Despite all of her concerns, however, Austin Smith relied on the Base Case projections for her primary DCF analysis. TT 737:13-23 (Austin Smith). See In re Appraisal ofAncestry.com, Inc.,2005 WL 399726
, at ’1‘ 18 (Del. Ch. Jan. 30, 2015) (noting that “in a number of cases Delaware Courts have relied on projections that were prepared by management outside of the ordinary course of business and with the possibility of litigation”) (collecting cases). 78 by an additional five years. Clarke opined that the extension was necessary, while Austin Smith opined that a PGR should be applied at the end of the five-year Base Case projection period. According to Clarke, extending the Base Case projections is necessary to capture Norcraft’s future cash flows because “the Base Case [p]rojections had not reached [a] steady state at the end of the [five-year] projection period” and, therefore, “it would be inappropriate to apply a standard [PGR] at th[e] last year [of that period:|.”312 To account for Norcraft’s growth potential as of 2019, Clarke extended the Base Case projections by an additional five years_through 2024_“to gradually reduce growth rates over time until reaching [a 3.5%] PGR.”313 Austin Smith, on the other hand, maintains that extending the Base Case projections is inappropriate because doing so forecasts growth that Norcraft almost certainly could not achieve. 1n this regard, she points out that the cabinetry industry is cyclical, as demonstrated by trends in (1) the industry’s historical performance (growth and decline); and (2) the historical growth (and decline) of the residential 312 JX 18 (Clarke Report) at 2. 313Id.
2_3. Clarke “gradually reduce[d] growth rates over time until reaching the PGR,”id.,
by applying a “straight line reduction in growth” from the end of the Base Case projections to the end of his additional five-year projection period. TT 606-607. According to Clarke, “if [he] had to use 2019 as the final year of [his] projections, [he] would need to use a higher [PGR of 4.4%] to account for the tapering of [Norcraft’s] growth to a steady state.” JX 21 (Clarke Rebuttal Report) at 27 n.62. 79 construction market.314 Extending the Base Case projections by an additional five years implies a ten-year period of consistent growth following two years of already achieved growth. According to Austin Smith, projecting twelve years of steady growth for a business in the cabinetry industry is patently unreasonable.315 On this point, 1 find Austin Smith most credible. The evidence adduced at trial supports her view that the cabinetry industry is cyclical and follows the cycle of the residential construction market.316 The evidentiary record also reflects that the residential construction market is projected to reach a “steady state” at or slightly before the last year of the Base Case projection period (2019).317 Moreover, insofar 314 JX 23 (Rebuttal Report of Yvette R. Austin Smith [“Austin Smith Rebuttal Report”]) at 5-6. 313 See id. at 4-6. 316 See JX 20 (Austin Smith Report) at 21-22 & Ex. 3 (Indexed Growth of Norcraft Adjusted EBITDA versus Key Economic 1ndicators 2013_2015); TT 21:8-9 (Eldridge) (“[B]uilding products companies are cyclical . . . . ”); JX 23 (Austin Smith Rebuttal Report), Fig. 1 (Comparison of Normalized Growth Patterns); id. at Fig. 2 (Historical and Forecasted EBITDA Margins); TT 607:23-608:1 (Clarke) (“Q: Mr. Clarke, the cabinet business is cyclical, isn’t it? A. Yes.”); see also JX 23 (Austin Smith Rebuttal Report), Fig. 1 (Comparison of Normalized Growth Patterns); id. at Fig. 2 (Historical and Forecasted EBITDA Margins); JX 5 (Klein Dep.) at 312:4-10. 1n light of this determination, 1 decline to apply Petitioners’ suggested 4.4% PGR since that PGR is based on an unrealistic assessment of Norcraft’s iiiture financial performance See JX 21 (Clarke Rebuttal Report) at 27 n.62. 317 See JX 112 (Gabelli Report) (stating, as of January 2015, “[w]e see a gradual recovery in housing that will materialize over the next several years”); JX 535 (Fortune 1nvestor Presentation, “Maximum Long-Term Value,” May 1, 2015) (“Expectation is for the housing market to return to steady state (1.5 million [new construction] starts and 5-6% [average] annual [repair and remodeling] growth) by 2017 or 2018.”). According to “accepted financial principles,” Dell, 177 A.3d at 22, “terminal value must reflect an 80 as Norcraft’S own management was not inclined to project Norcraft’s financial results beyond FY2019, 1 see no basis to do so post hoc for the sake of reaching a litigation result. ii. Norcraft’s Estimated WACC The parties also dispute how to calculate the applicable discount rate based on Norcraft’s estimated WACC. More specifically, they dispute how to calculate Norcraft’s beta in connection with estimating Norcraft’s cost of equity capital (a key component of WACC). The application of a discount rate to financial projections attempts to “convert the [subject company’s] expected economic income stream to present value.”313 appropriate estimate of sustainable growth.” Pratt, supra, at 49. “[F]or cyclical businesses[] the discrete [projection] period commonly corresponds to the number of years or periods until the point is reached where the net cash flow represents an average base net cash flow expected over an entire business cycle,” i.e., until the midpoint of the cycle. Id. at 47 (emphasis supplied); see also Robert W. Holthavsen & Mark E. Zmijewski, Corporate Valuation.' Theory, Evidence & Practice 216 (2014) (“[T]he steady state for a company in a cyclical industry should be at the midpoint of the cycle.”). Clarke’s extension of the Base Case projections posits a ten-year growth trend but does not account for cyclicality in the cabinetry industry and the impact of such cyclicality on Norcraft’s free cash flows. See JX 14 (Clarke Dep.) at 60-61 (explaining his extension does not reflect cyclicality prior to 2025); JX 23 (Austin Smith Rebuttal Report), Fig. 1 (Comparison of Normalized Growth Patterns); JX 18 (Austin Smith Report), Fig. 1 (Norcraft Net Sales and EBITDA (Historical 2003-2014) (citing JX 99 (Norcraft Jan. 2015 Management Presentation))). See also AOL,2018 WL 1037450
, at * 19 (“In a fast-paced industry with
significant fluctuations, where management is hesitant to project beyond four years, using
a three-stage DCF model or a ten year projection period seems particularly brazen.”).
313 Pratt, supra, at 8; see also Duff & Phelps, supra, at 10-15.
81
Where the discount rate is based on the subject company’s WACC, the projected
future cash flows and terminal value are discounted by the WACC to bring them
back to present value.319 A company’s WACC represents the cost (to the company)
of financing its business operations; it comprises the weighted average of the
company’s cost of debt and equity320:
E D
WACC : (requny X I_/) + ('“deb¢ X _``} >< (1 - t))
where.'
reqw~,y = cost of equity capital
E = market value of the company’s equity
mem = cost of debt capital
D = value of the company’s debt
V = E + D = total value of the company’s equity and debt
t = applicable tax rate
Here, both experts calculated Norcraft’s cost of equity capital pursuant to CAPM.321
Following CAPM, a company’s cost of equity is calculated as follows322:
319 Pratt, supra, at 546 (“WACC generally works as a substitute for the enterprise-cash-
flow discount rate.”). See also Valuing a Business, supra, at 184.
320 Valuing a Business, supra, at 184; Duff & Phelps, supra, at 10-16.
321 JX 18 (Clarke Report) at 33; JX 20 (Austin Smith Report), Ex. 5 (WACC Calculation).
322 Duff & Phelps, supra, at 2-13.
82
requity : rrw~risk '1' (B X ERP) + SS
where.'
r,w_,,'sk = risk-free rate of return
13 = beta coefficient of the subject company
ERP = equity risk premium
SS = size premium
The experts generally agree on many of the relevant inputs to calculate
Norcraft’s WACC; both experts used the same risk-free rate of return (2.75%),
equity risk premium (6.21%) and size premium (2.69%).323 The experts differed,
however, in their respective estimates of Norcraft’s pre-tax cost of debt. Clarke
estimated Norcraft’s pre-tax cost of debt as 6.95%_based on “the average of the
15-year yield-to-maturity of B and BB rated bonds” as of the Merger date.324 Austin
Smith, by contrast, estimated Norcraft’s pre-tax cost of debt as 5.85%_based on the
“[a]verage of (a) BofA Merrill Lynch US High Yield B Effective Yield as of 5/12/1 5
[the Merger date] and (b) total return on Norcraft[’s] [then-outstanding] term loan
(including [the] effect of issuance discount).”323
323 JX 21 (Clarke Rebuttal Report) at 27.
324 JX 18 (Clarke Report) at 41.
323 JX 20 (Austin Smith Report), Ex. 5 (WACC Calculation). The BofA Merrill Lynch US
High Yield B Effective Yield “represents the effective yield of the ICE BofA[]
[Merrill Lynch] US Corporate B Ind'ex, a subset of the ICE BofA[] [Merrill Lynch] US
High Yield Master 11 Index tracking the performance of US dollar denominated below
investment grade rated corporate debt publically issued in the US domestic market This
subset includes all securities with a given investment grade rating B.” ICE BofAl\/IL US
High Yield B Effective Yield, retrieved from FRED, Fed. Reserve Bank of St. Louis;
83
The experts’ respective estimates of Norcraft’s pre-tax cost of debt are both
reasonable. As of the Merger date, Norcraft’s long-term debt was rated “B2” by
Moody’s Global Credit Research and “B+” by Standard & Poor’s, and the yield to
maturity on high-yield U.S. corporate bonds with 10+ year maturity on that date was
approximately 6.34%.326 Accordingly, 1 use the average of the experts’ respective
estimates of Norcraft’s pre-tax cost of debt (_6.40%) for my DCF analysis.327
As to the estimation of Norcraft’s cost of equity, the experts’ principal point
of disagreement concerns Norcraft’s beta coefficient. “Beta is a measure of the
https://fred.stlouisfed.org/series/BAMLHOA2HYBEY (last visited July 24, 2018). By way
of reference, Citi used a pre-tax cost of debt of 5.3% in its calculation of Norcraft’s WACC
and RBC used 4.5%. See JX 18 (Clarke Report) at 41 n.91.
326 JX 267 (Norcraft FY2014 10-K) at 21; ICE BofAML US High Yield B Effective Yield,
retrieved from FRED, Fed. Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/BAMLHOA2HYBEY (last visited July 24, 2018); S&P
U.S. High Yield Corporate Bond 10+ Year Index, available online at
https://us.spindices.com/indices/fixed-income/sp-us-high-yield-corporate-bond-10-year-
index (last visted on July 24, 2018). The experts do not challenge each other’s estimates
of Norcraft’s pre-tax cost of debt. See JX 21 (Clarke Rebuttal Report) at 31 (“Austin
Smith’s conclusion [regarding Norcraft’s pre-tax cost of debt] is in the range of
reasonableness given Norcraft’s improving performance and generally positive industry
outlook as well being consistent with the financial advisors’ cost of debt estimate.”).
327 This average figure tracks the ICE BofA Merrill Lynch US High Yield B Effective
Yield as of the Merger date (6.39%) and the S&P U.S. High Yield Corporate Bond 10+
Year Yield to Maturity as of that date (6.34%). ICE BofAML US High Yield B Effective
Yield, retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/BAMLHOA2HYBEY (last visited July 24, 2018); S&P
Dow J ones Indices LLC, S&P U.S. High Yield Corporate Bond 10+ Year Index, available
online at https://us.spindices.com/indices/fixed-income/sp-us-high-yield-corporate-bond-
10-year-index (last visited on July 24, 2018).
84
systematic risk of a stock; the tendency of a stock’s price to correlate with changes
in the market. . . . [B]etas for equity capital are used as a modifier to the equity risk
premium [] in the context of [calculating a company’s cost of equity].”323
A company’s beta is measured by tracking relative change in the trading price
of its stock over a discrete time period (the “lookback period”), with a set frequency
(e.g., daily, weekly, monthly).329 When there is insufficient data on the trading
history of a company’s stock, the company’s “beta must be an estimate based on the
[observed] betas of comparable, publicly traded companies” (i. e. , a “proxy beta”).330
Observed betas are levered betas; they reflect a company’s operating risk and its
financial risk.331 Thus, when calculating a proxy beta, one must “unlever” each
GPC’s observed (levered) beta to remove the debt-related risk(s) of that particular
GPC.332 Once the GPC betas are unlevered, and the mean or median of those betas
is calculated, the unlevered summary measure beta (i.e., the unlevered proxy beta)
323 Duff & Phelps, supra, at 5-1.
329 lCl. 211 5-3.
330 Id.; Pratt, supra, at 223. When calculating a company’s beta, change in the trading price
of the company’s stock is measured relative to change in the returns of the overall market
(or a proxy therefor) over the relevant observation period. JX 18 (Clarke Report) at 34.
331 JX 18 (Clarke Report) at 34-35.
332 See Duff & Phelps, supra, at 5-25 and 10-17.
85
must be relevered to add back financial risk.333 The relevant financial risk, however,
is the subject company’s not the GPCs’.334
The experts generally agree that there is insufficient information regarding
Norcraft’s own beta to allow a reliable beta calculation based solely on that
information_a function of Norcraft’s limited trading history.333 Accordingly, they
agree that the use of a proxy beta is appropriate. They disagree, however, as to
(1) which GPCs should be used to derive the proxy beta; (2) whether gross debt or
net debt should be used to unlever the GPC betas and relever the resulting unlevered
proxy beta; and (3) whether Norcraft’s observed capital structure or a target capital
structure should be used to relever the proxy beta.
1 begin with the first point of disagreement_appropriate GPCs. Clarke used
four GPCS for his proxy beta calculation_American Woodmark, Masonite, PGT
and Ply Gem336_which he selected by applying a set of comparability-related
333 See JX 18 (Clarke Report) at 34_35.
334 See Duff & Phelps, supra, at 10-21; Pratt, supra, at 244.
333 See JX 18 (Clarke Report) at 37_39; JX 23 (Austin Smith Rebuttal Report) at 18-20.
While Clarke found Norcraft’s observed beta “statistically relevant,” he did not rely upon
that beta beyond using it to define the lower end of a range of betas. He ultimately selected
the higher end for his DCF. See JX 18 (Clarke Report) at 37-39.
336 JX 18 (Clarke Report) at 51. Clarke notes in his report that RBC used all four of his
chosen companies and Citi used three of the four in their respective analyses of Norcraft.
Id.
86
screening criteria.337 After selecting these four GPCS, Clarke then calculated each
GPC’s beta over a two-year lookback period (measured weekly) and a one-year
lookback period (measured daily)_-both periods relative to the Merger date_and
unlevered each observed GPC beta using the gross debt of the corresponding GPC.333
This led Clarke to derive an (unlevered) proxy beta for Norcraft of 0.80 based on the
mean and median of the unlevered GPC betas.339
Austin Smith, by contrast, identified sixteen GPCs for her proxy beta
calculation; the four companies selected by Clarke and twelve additional companies,
337 Id. at 48~49. Clarke’s screening criteria were: (1) public company; (2) industry
classification of “Building Products”; (3) 2014 Calendar Year Revenue between
$40 million and $4 billion; (4) primary geographic location in the U.S. or Canada; and
(5) no recent maj or divestures or pending significant acquisitions Id. Clarke’s application
of these criteria yielded a set of sixty-five companies, which Clarke then screened “for
companies with a minimum expected EBITDA margin of 7.5% for fiscal year 2016
(approximately half of Norcraft’s EBITDA margins) and a maximum expected EBITDA
margin of 22.5% for fiscal year 2016 (approximately 50% above Norcraft’s margins).
In addition, [he] screened for companies that had forecasted 2016 revenue growth between
5% (approximately half of Norcraft’s expected growth) and 15% (approximately 50%
above Norcraft’s expected growth). Based on those two criteria, the 65 companies were
reduced to 28.” Id. at 50. Clarke then determined that four of those companies_his four
chosen GPCs_“had a primary business in manufacturing products for the [repair and
remodeling] and/or new construction residential home construction [markets].” Id.
333 Id. at 38 & sched. 5-C; JX 517 (native Excel version of Clarke’s DCF model).
339 JX 18 (Clarke Report) at 39 (“An unlevered beta of 0.80 is slightly above the median
and average of the one-year daily betas of the [GPCs] (0.75 to 0.79) while slightly below
the median and average two-year weekly betas of the [GPCS] (0.81 to 0.87).”). Clarke
relevered his concluded unlevered beta for Norcraft based on Norcraft’s actual (observed)
capital structure as of the Merger date (75% equity, 25% debt, per Clarke). Id., sched. 5-
B. This resulted in a relevered beta for Norcraft of 0.97. Id.
87
including Fortune and Masco.340 Having selected these sixteen GPCS, Austin Smith
derived a proxy beta for Norcraft based on the median of the unlevered GPC betas,
measured weekly over a two-year lookback period_relative to the Merger date_
and unlevered using each GPC’s net debt.34l This resulted in an unlevered proxy
beta for Norcraft of 1.02.342
Each expert disputes the suitability of the other’s selected GPCs. According
to Clarke, Austin Smith’s selected GPCs “were either not comparable [to Norcraft]
and/or were going through significant restructuring events that impacted their
historical betas.”343 Austin Smith, for her part, maintains that Clarke’s methodology
for selecting GPCs is “fundamental[ly]” flawed, principally because: (i) it “results
340 JX 20 (Austin Smith Report) at 26 & Ex. 4 (Beta Calculation). The other ten GPCs
were: Armstrong World 1ndustries, Inc., Beacon Roofing Supply, Inc., Builders
FirstSource, Inc., Caesarstone Ltd., Continental Building Products, 1nc., Mohawk
1ndustries, Inc., Patrick Industries, 1nc., Quanex Building Products Corporation, Trex
Company, Inc. and Universal Forest Products, Inc. Id., Ex. 4 (Beta Calculation). Austin
Smith divided her sixteen GPCs into two groups: Group 1 (comprising American
Woodmark, Masco and Fortune), “which consists of companies operating specifically
(though not exclusively) in the cabinet market, and Group 11 [comprising the rest of the
GPCs], which consists of companies operating in the general residential building products
sector.” Id. at 26.
341 Id., Exs. 4 (Beta Calculation) and 5 (WACC Calculation).
342 Id., Exs. 4 (Beta Calculation) and 5 (WACC Calculation). Austin Smith relevered her
concluded unlevered beta for Norcraft based on a target capital structure comprising 86%
equity and 14% debt. Id., Ex. 5 (Calculation of WACC). This yielded a relevered beta for
Norcraft of 1.12. Id.
343 JX 21 (Clarke Rebuttal Report) at 28.
88
in the exclusion of two of the three publicly-traded cabinet manufacturers:
Fortune . . . and Masco”; and (ii)-'it yields a relatively small set of companies, all but
one of which manufacture products other than cabinets_meaning they are less
comparable to Norcraft than Fortune and Masco.344
Both experts present valid arguments After considering the evidentiary
record, 1 have determined to derive a proxy beta for Norcraft based on the weekly
observed betas of Fortune, Masco, American Woodmark, Masonite, PGT and Ply
Gem, measured over a two-year lookback period (relative to the Merger date).
1 acknowledge the size difference between Norcraft, on one hand, and Fortune and
Masco, on the other, but there are few publicly-traded, “dealer channel” cabinet
manufacturing businesses operating in the United States from which to draw.345
To account for this dynamic, 1 have selected a set of GPCs that includes publicly-
traded companies directly competing with Norcraft (Fortune, Masco and American
Woodmark), and also public companies operating in the same general industry that
are more comparable in size to Norcraft (Masonite, PGT and Ply Gem).346 Since
344 JX 23 (Austin Smith Rebuttal Report) at 17.
345 See .lX 112 (Gab€lli R€pOl‘t) at C111-00053582.
346 See Pratt, supra, at 223 (“The more guideline companies used in the sample size, the
better the accuracy.”); id. (“The accuracy is also enhanced if the guideline public
companies are reasonably close in size to the subject company. When the guideline public
companies are larger than the subject company, the beta estimate for the subject company
is likely biased low because of the propensity of betas of larger companies to be smaller
than the betas of smaller companies.”). My selection of GPCs is further supported by RBC
89
neither party has provided me with a principled way to assign different weights to
the betas of individual GPCs, 1 have determined to derive the proxy beta by taking
the median of the unlevered GPC betas.347
As to the question whether to use gross or net debt for unlevering and
relevering purposes, 1 have determined that Clarke’s approach (gross debt) is most
appropriate 1 consulted the finance literature cited by both experts with regard to
this issue and have come to the conclusion that using gross debt is the more generally
accepted approach when applying the Hamada unlevering and relevering formulas
and Citi’s choices of GPCs RBC included all six of the selected companies JX 216
(Mar. 29, 2015 e-mail from RBC to Biggart, attaching RBC presentation) at FB0047799,
and Citi included five out of the six (it did not include Masonite). JX 505 (Citi Discussion
Materials for the Fairness Opinion Committee) at C1T1-00075076.
347 See Pratt, supra, at 204 (explaining that to derive a proxy beta, one will take the median
or an average of the unlevered betas). This approach also avoids additional risk for error
that might flow from assigning different weights See JX 530 (Bradford Cornell, Corporate
Valuation, Toolsfor Etective Appraisal and Decision Making (1993)) at 68. As previously
explained, Austin Smith derived a proxy beta for Norcraft based on the median of the
unlevered betas of her selected GPCs. JX 20 (Austin Smith Report), Exs. 4 (Beta
Calculation) and 5 (WACC Calculation). Clarke’s proxy beta calculation, by contrast, took
into account both the median and the mean of the unlevered betas of his selected GPCs
JX 18 (Clarke Report) at 39. My proxy beta calculation utilizes the median rather than the
mean of the unlevered GPC betas 1 took that approach to account for Masonite. Austin
Smith and Clarke included Masonite in their respective analyses but both acknowledged
that its business was less comparable to Norcraft than some of the other companies
considered lndeed, Masonite exhibited a significantly lower unlevered beta that risked
distorting the Court’s measurement of Norcraft’s relative operating risk (if the Court were
to use the mean for summary measure purposes).
90
(as both experts did),343 which utilize “total debt” as an input.349 1 also find that
considering net debt, while it might eliminate some of the drawbacks of the Hamada
approach if done properly,330 complicates the analysis and adds a significant risk of
error to an already abstract process
1n her deposition, Austin Smith explained that using net debt requires
“a judgment call” because “public companies don’t report excess cash.”331
1n essence, to derive net debt, one “look[s] at how the cash balances for th[e chosen]
companies changed over time, and [then] look[s] at the relationship between cash
and debt, and come[s] to an assessment.”332 1f insufficient data about excess cash is
343 JX 18 (Clarke Report), sched. 5-B (Cost of Equity Calculation per CAPM); JX 20
(Austin Smith Report), Exs. 4 (Calculation of Beta) and 5 (Calculation of WACC).
349 Pratt, supra, at 243. The Hamada unlevering formula is as follows:
13lezi)ered
1 + ((1 - tax rate) X (Total Debt/Equity)))
13unlevered : (
Id. at 247.
By corollary, the Hamada relevering formula is:
_ "l‘otal Debt
15levered _ Bunlevered X [1 +(1 5 tax rate) X ']_‘gta] Equity]
Id.
350 See ia'. at 262-63.
331 JX 16 (Austin Smith Dep.) at 192:5-12.
332 Id. at 192:13-16.
91
”333 Considering the many
available, “total cash is assumed to equal excess cash.
variables already at play in a DCF analysis (especially when deriving a proxy beta),
1 find that figures based on a “judgment call” are unreliable in the absence of a
principled way to evaluate the soundness of the underlying “judgment.” For all these
reasons, 1 have utilized gross debt rather than net debt for unlevering and relevering
purposes
That takes me to the final beta-related dispute: the appropriate capital structure
to relever the unlevered proxy beta. Austin Smith submits that a target capital
structure based on the capital structure of comparable companies provides the most
reliable input, while Clarke advocates the use of Norcraft’s actual (observed) capital
structure as of the Merger date. Austin Smith explains her choice by noting that
Norcraft only went public in 2013 and its management had not indicated as of the
Merger that it intended to maintain the Company’s then-existing capital structure.334
According to Austin Smith, it is likely that, over time, Norcraft’s capital structure
would come to resemble that of its peers.333 Clarke counters that Norcraft’ s observed
capital structure as of the Merger date was the “operative reality” of the Company at
353 Id. at 192118-21.
334 See JX 23 (Austin Smith Rebuttal Report) at 22; TT 764:1-19 (Austin Smith).
333 See TT 764:1-19; JX 23 (Austin Smith Rebuttal Report) at 22.
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that time and, as such, is the appropriate capital structure to apply when relevering
the unlevered proxy beta.336
Clarke has the better of this debate. While there are instances where using a
target capital structure for relevering purposes would be appropriate,337 especially
where the target’s capital structure is in flux, that is not the case here. 1t is true that,
as of the Merger, Norcraft had operated for only eighteen months after its 1P0. There
is no evidence, however, that management intended to change Norcraft’s capital
structure, and any suggestion that it would do so is nothing more than sheer
[Remainder of Page 1ntentionally Left Blank]
336 TT 506:11-17 (Clarke).
337 See Duff & Phelps, supra, at 1-15, 1-16.
93
speculation.333 Accordingly, 1 refer to Norcraft’s observed capital structure as of the
Merger (75% equity, 25% debt) to relever Norcraft’s concluded unlevered beta.339
333 TT 859:4-16 (Austin Smith) (“-Q. And you testified earlier that you found no evidence
in the record which would guide you in selecting what that target capital structure would
be for Norcraft. Correct? A. That’s right. Q. And so you had to use the data from
comparable companies Correct? A. Right. Q. And just to be explicit, there’s no evidence
in the record that Norcraft had any expectation of changing its capital structure after the
transaction Correct? A. That’s correct.”). Austin Smith herself recognizes that use of a
target capital structure is only appropriate when “the company’s existing capital structure
is not equal to the company’s target capital structure.” JX 23 (Austin Smith Report) at 21-
22. According to Austin Smith, Clarke’s estimation of Norcraft’s actual capital structure
as of the Merger date is erroneous because it fails to account for Buller et al.’s ownership
of Norcraft LLC units convertible into a 12.3% equity ownership interest in Norcraft (in the
form of shares of Norcraft common stock). Id. at 21. Austin Smith’s criticism in this
regard is based on her (apparent) assumption that the conversion of the Norcraft LLC units
into Norcraft common stock would not affect the per share trading price of that stock. See
id. (calculating Norcraft’s fully diluted market capitalization on the Merger date without
adjusting for the potential dilutive effect of a Norcraft-LLC-unit-to-Norcraft-common-
stock conversion on the per share trading value of Norcraft common stock). Upon
reviewing the record, it is unclear how such a conversion would affect Norcraft’s market
capitalization_and, by extension, the equity component of Norcraft’s capital structure. In
addition, Austin Smith’s calculation of Norcraft’s fully diluted market capitalization on the
Merger date does not account for the exercise of all outstanding options on Norcraft stock
on that date. See id. (“The total equity in Norcraft[’s] capital structure was $452 million . . .
not the 83 96 [million] calculated by Mr. Clarke. The operating cash flows of Norcraft were
supported not just by the equity of Norcraft Inc. but also by [Buller et al.’s] ownership
interest [in Norcraft] LLC.”); but cf id. at 13 & n.25 (“[Norcraft’s] implied fully diluted
market capitalization was $532 million based on the transaction price of $25.50 [multiplied
by] 20,869,976 fully diluted shares [outstanding].”) (emphasis supplied). Moreover, as
previously noted, Austin Smith’s calculation of Norcraft’s fully diluted shares outstanding
as of the Merger date is inconsistent with the information set forth in Norcraft’s Form 10-
Q for Ql FY2015 and the Funds Flow Memorandum prepared in connection with the
Merger. The inclusion of all options on Norcraft stock outstanding as of the Merger date
in the equity component of Norcraft’s fully diluted capital structure (together with all
Norcraft common stock and convertible Norcraft LLC units outstanding on that date)
implies a capital structure of approximately 76% equity and 24% debt. 1 am satisfied,
therefore, that Clarke’s estimation of Norcraft’s actual capital structure on the Merger date
captures Norcraft’s “operative reality” on that date. Accordingly, 1 have adopted that
estimation.
94
b. The Court’s DCF Valuation of Norcraft
Like Clarke and Austin Smith, 1 begin my DCF analysis with the Base Case
projections adjusted to deduct for income tax expense in each of the projected years
(based on a 38% tax rate).> This adjustment yields the following figures for
Norcraft’s net operating profit after taxes (“NOPAT”)360:
FY2015-E
(Stub)
$18.3 million $31.8 million $36.0 million $41.9 million $50.3 million
FY2016-E FY2017-E FY2018-E FY2019-E
1 next adjust the NOPAT figures to obtain unlevered free cash flow figures for each
projected year by (1) adding back non-cash charges_depreciation, amortization and
stock compensation expense; (2) deducting Norcraft’s capital expenditures; and
(3) deducting year-over-year change in Norcraft’s net working capital (“NWC”).
My adjustments with respect to each item track those made by both experts.361
339 For these same reasons, 1 refer to that same capital structure to calculate Norcraft’s
WACC (for weighting purposes).
360 The calculation of Norcraft’s NOPAT (and unlevered free cash flow) for FY2015 is
based on the Base Case projections for the May_December 2015 period. Hence the “Stub”
notation. Austin Smith took this same approach in her DCF analysis JX 20 (Austin Smith
Report), Ex. 6 (DCF Analysis). 1 have adopted Austin Smith’s approach in this regard,
given that the operative valuation date here is May 12, 2015 (the Merger date).
361 See JX 18 (Clarke Report), sched. 2-A (DCF Analyis); JX 20 (Austin Smith Report),
Ex. 6 (DCF Analysis). 1n calculating the period-over-period change in Norcraft’s NWC,
both experts excluded Norcraft’s current TRA liability in each of the projected years
JX 20 (Austin Smith Report), Ex. 6 (DCF Analysis) (“Working capital excludes tax-related
items.”); see JX 517 (native Excel version of Clarke’s DCF model). The rationale for this
95
The foregoing adjustments yield the following figures for unlevered free cash
flow in each of the projected years:
FY2015-13 FY2016-E FY2017-E FYZOIS-E FY2019-E
(Stub)
$20.8 million $36.73 million $40.06 million $44.36 million $49.84 million
To calculate the present value of these unlevered cash flows, like Clarke and
Austin Smith, 1 have applied a discount rate based on Norcraft’s estimated WACC.
My WACC calculation also uses CAPM to estimate Norcraft’s cost of equity_
based on the parties’ common risk-free rate of return (2.75%), equity risk premium
(6.21%) and size premium (2.69%)_and uses a 6.40% pre-tax cost of debt, which
yields a post-tax cost of debt for Norcraft of 3.97% (again based on a 38% tax rate).
exclusion appears to be that Norcraft’s payment obligations under the TRAs are non-
ordinary-course, non-operating liabilities See JX 18 (Clarke Report) at 29, 46. 1t is,
therefore, more accurate to describe the experts’ respective NWC-related computations as
calculating period-over-period change in Norcraft’s net operating working capital
(“NOWC”). The Court’s calculation of period-over-period change in Norcraft’s NWC_
or rather, its NOWC-likewise excludes Norcraft’s current TRA liability in each of the
projected years 1 also note that both experts departed from the Base Case projections’
forecast of Norcraft’s “current portion of long-term debt” in FYs 2018 and 2019. See JX 20
(Austin Smith Report), Ex. 6 (DCF Analysis); JX 517 (native Excel version of Clarke’s
DCF model); JX 509 (native Excel version of Base Case projections). Both experts
projected a $1.5 million figure for each year, whereas the Base Case projects zero for both
years Compare JX 20 (Austin Smith Report), Ex. 6 (DCF Analysis) and JX 517 (native
Excel version of Clarke’s DCF model), with JX 509 (native Excel version of Base Case
projections). The record is unclear as to why, exactly, the experts chose to depart from the
Base Case in this particular respect. Nevertheless, because both experts made the same
adjustment to the Base Case projections with regard to Norcraft’s “current portion of long-
term debt” in FYs 2018 and 2019, 1 have followed suit.
96
To derive a beta for my cost of equity calculation, 1 have unlevered the
observed weekly betas of my selected GPCs over a two-year lookback period
relative to the Merger date, using the Hainada unlevering formula and gross debt
rather than net debt. That computation yielded the following unlevered betas:
Guideline Public Company Levered Beta Unlevered Beta
American Woodmark 1.09 1.02
Masco 1.26 0.99
Fortune 1.15 1.07
Masonite 0.55 0.47
PGT 0.88 0.78
Ply Gem 1.60 0.98
The median of the unlevered GPC betas, 0.98, constitutes Norcraft’s
concluded unlevered beta. 1 then relevered that beta using Norcraft’s observed
capital structure of 75% equity and 25% debt (per Clarke’s estimation), resulting in
a levered beta for Norcraft of 1.187. Incorporating this levered beta into my WACC
calculation, along with the other inputs already mentioned_again using Norcraft’s
observed capital structure_l derived a WACC for Norcraft of 10.60%. Applying
Norcraft’s concluded WACC to discount its projected future cash flows to present
value, 1 have calculated the present value of those cash flows to be $149.7 million.
To calculate Norcraft’s terminal value, 1 have used the Perpetuity Growth
method (as did both experts),362 which posits that terminal value equals the quotient
362 JX 18 (Clarke Report) at 43 (“1 calculated [Norcraft’s] terminal value using the
Perpetuity Growth Method[.]”); JX 20 (Austin Smith Report) at 20 (“To calculate
97
of (1) the subject company’s terminal year free cash flow (here, $51.41 million); and
)363_discounted to present value
(2) the applicable capitalization rate (here, 7.10%
using the applicable discount rate (here, Norcraft’s WACC of 10.60%).364 This
yields a terminal value of 8477.2 million.
Summing together the present value of Norcraft’s projected unlevered cash
flows ($149.7 million) and its terminal value ($477.2 million) results in an operating
value for Norcraft of $626.9 million. To calculate Norcraft’s total equity value, 1
then made the following adjustments to Norcraft’s concluded operating value:
[Norcraft’s] terminal value 1 relied upon the Gordon Growth (or Perpetuity Growth)
model.”).
363 1n the Perpetuity Growth model, the capitalization rate is calculated as the positive
difference between the applicable discount rate and the subject company’s PGR. JX 18
(Clarke Report) at 43. 1 have used Norcraft’s WACC (10.60%) as the applicable discount
rate and a 3.5% PGR for Norcraft, which together imply a capitalization rate of 7.10%.
364 Id. Mindful of Clarke’s justified criticism of Austin Smith’s calculation of Norcraft’s
terminal year free cash flow, my calculation of that value adjusts for the fact that Norcraft’s
projected depreciation and amortization expense in the final year of the Base Case
projections (FY2019) exceeds Norcraft’s projected capital expenditures in that year by
approximately $100,000. The adjustment entails implying a 3:4 relationship between
Norcraft’s depreciation/amortization expense and capital expenditures in perpetuity and
thereby avoids “underinvesting in net PP&E.” JX 21 (Clarke Rebuttal Report) at 25; see
Hitchner, supra, at 138 (“[I]n a growing business, long-term annual estimated capital
expenditures exceed annual depreciation, primarily due to inflation.”); see also Gilbert E.
Matthews & Arthur H. Rosenbloom, Delaware’s Unwarranted Assumption that Capex
Should Equal Depreciation in a DCF Model, (May 15, 2018),
https://corpgov.law.harvard.edu/201 8/05/ 1 5/delawares-unwarranted-assumption-in-dcf-
pricing/ (“The assumption that depreciation equals capital expenditures is only appropriate
if it is also assumed that there is no growth and no inflation. However, . . . the normalized
capital expenditures of a [perpetually] growing company must materially exceed
depreciation over time.”).
98
l adding Norcraft’s excess cash as of the Merger date, calculated as
$62.6 million363;
l adding the value of the TRA-related tax benefits realized by Norcraft in
each of the projected years calculated as $4.3 million366; and
l deducting Norcraft’s long-term debt as of the Merger date, calculated as
$147.5 million.367
363 Both experts added Norcraft’s estimated excess cash to its operating value in order to
calculate the Company’s total equity value. JX 18 (Clarke Report), sched. 2-A (DCF
Analysis); JX 20 (Austin Smith Report), Ex. 6 (DCF Analysis). The experts differed,
however, in how they calculated Norcraft’s excess cash and thus reached different
estimates of that figure. As noted, Austin Smith calculated Norcraft’s excess cash on the
Merger date based on the “Cash from Norcraft” figure in the “Funds Flow Memorandum”
for the Merger ($54,396,335.01), JX 249 at 2, less a $20 million cash balance
(cash for operations per the Base Case proj ections), plus the product of (1) Norcraft’s total
options outstanding as of the Merger date (1,142,383) and (2) the weighted average
exercise price of those options ($16.01). JX 20 (Austin Smith Report), Ex. 6 (DCF
Analysis). Clarke, by contrast, calculated Norcraft’s excess cash on the Merger date as the
sum of (1) the cash balance indicated in Norcraft’s Ql FY2015 Form 10-Q ($63,135,000),
JX 248 at 4, and (2) the Merger-related fees indicated in that same filing ($1.2 million),
less $20 million cash for operations (per the Base Case projections). JX 18 (Clarke Report)
at 45. 1 have adopted Clarke’s approach, but have added to his excess cash figure
Norcraft’s cash receipts from the exercise of all options outstanding on the Merger date
(1,142,383) at the weighted average exercise price ($16.01). JX 248 (Norcraft’s Ql
FY2015 Form 10-Q) at 14. 1 find that this holistic approach best approximates Norcraft’s
“operative reality” as of the Merger date.
366 Clarke valued the TRA-related tax benefits realized by Norcraft in each of the projected
years at $4.4 million, JX 18 (Clarke Report) at 46, while Austin Smith valued them at
$4.2 million. JX 20 (Austin Smith Report), Ex. 7 (Tax Characteristics Analysis). Having
considered each expert’s (quite complicated) approach to valuing those tax benefits 1 find
that both approaches_and both resulting valuations_are reasonable (they differ by
approximately $200,000). Accordingly, 1 have adopted the average of the experts’
respective value estimates
367 Like Clarke and Austin Smith, 1 have drawn this figure directly from Norcraft’s Ql
FY2015 Form lO-Q. JX 248 (NOrCraft’S Ql FY2015 FOI‘m 10-Q) at 4; JX 18 (Clarke
Report) at 47; JX 20 (Austin Smith Report), Ex. 6 (DCF Analysis).
99
These adjustments to Norcraft’s operating value yield a total equity value for
Norcraft of $546.3 million. Dividing Norcraft’s total equity value by Norcraft’s
fully diluted shares outstanding as of the Merger date (20,880,123),363 1 conclude
that Norcraft’s equity value per share on that date was $26.16.
3. The Merger Price as a “Reality Check”
As explained above, 1 have determined that the Merger Price is not a reliable
indicator of Norcraft’s fair value as of the Merger date. That does not mean,
however, that the Merger Price is irrelevant for purposes of the Court’s fair value
determination To the contrary, it is appropriate to consider the Merger Price as a
“reality check” on the Court’s DCF valuation of Norcraft.369 1nsofar as 1 arn obliged
to articulate a principled, evidence-based explanation for the delta between the
Merger Price and the Court’s DCF valuation (here, $0.66 per share), 1 am satisfied
that the process infirmities 1 have identified resulted in the Board leaving $0.66 per
share on the bargaining table.370 With that said, 1 am also satisfied that the delta
363 JX 248 (Norcraft’s Ql FY2015 Form 10-Q) at 11.
369 See AOL, 2018 WL 1037450, at *2 (“1 take the parties’ suggestion to ascribe full weight to a [DCF] analysis . . . [and thus] relegate transaction price to a role as a check on that DCF valuation: any such valuation significantly departing from even the problematic deal price here should cause me to closely revisit my assumptions.”). 370 1 am mindful that “[t]he issue in an appraisal is not whether a negotiator has extracted the highest possible bid. Rather, the key inquiry is whether the dissenters got fair value and were not exploited.” Dell, 177 A.3d at 33. Here, in light of the identified flaws in Norcraft’s deal process (pre- and post-sign), 1 find it more likely than not that the Board 100 between the Merger Price and the DCF value is not so great as to cause me to question whether the DCF value is grounded in reality.371 III. CONCLUSION For the foregoing reasons 1 have found the fair value of Norcraft shares as of the Merger date (May 12, 2015) was $26.16 per share. The statutory rate of interest, compounded quarterly, shall accrue from the date of closing to the date of payment. The parties should confer and submit an implementing final judgment within ten (10) days “left a portion of [Norcraft’s] fundamental value on the table.” Verition P ’rs Master Fund,2018 WL 922139
, at *44. 371 See AOL,2018 WL 1037450
, at *2. 101
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