AS S IGNMENT 2

MCCAW CELLULAR COMMUNICATIONS: THE AT & T/MCCAW MERGER NEGOTIATION

SGMT 6050

SUBMITTED TO: MARIA RADFORD SUBMITTED BY: SONG LI MEMBERS OF GROUP NO. 6 STUDENT NO. 210191716 EMAIL ADDRESS: SLI09 @SCHULICH.YORKU.CA DUE DATE: MARCH 6, 2012

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Introduction:
Burdened with 5 billion in debt, McCaw Cellular Communications was considering a potential partnership offered by AT&T. It is clearly a great opportunity for McCaw Cellular to access to new technology, realize vertical integration with AT&T and increase advertising power under the well known name. It could also provide McCaw with the ability to refinance company debt at a more favourable AA credit rating. However the major issue for Craig, the Founder and CEO of McCaw is the risk of sacrificing his control of the company. Craig needed to come up with a negotiating strategy for the deal focusing on maximizing premium and synergy value without sacrificing major control of McCaw Cellular.

Valuation Step I Value as is

Valuation Approach Comparable Companies Analysis: Based on the information and data provided by Exhibit 12 for the leading firms within telecommunications industry, I have decided to calculate the Equity value/revenue ratios for each company to get the industry average and then adjust the ratio for factors that make McCaw more or less valuable than the industry in general ( see appendix 4 for detailed valuation). PE ratio in this case is not applicable because several companies within this industry posted net loss in 1991. The industry average for Equity Value/Revenue ratios is 7.28. Compared with industry peers, McCaw has relatively larger business scale and stronger management team with leading position in the industry. It also has promising growth potential. However due to its recent acquisition of LIN Broadcasting, the company was over levered in its capital structure. By incorporating those factors particular to McCaw, I have adjusted the Equity/Revenues multiples to 7.8, which results the equity value of McCaw at 10.64 B and enterprise value at 15.8B. Valuation Approach Comparable Transactions Analysis: Based on the data provided in exhibit 17, there were 11 M&A transactions in Cellular industry during 1989 till 1991. However some of the deals are of relatively small magnitude in its total value. In order to be at a comparable base with McCaw which involved large number of POPS, I have chosen only three deals to perform the comparable transactions analysis: Bell Atlantic Corp-Metro Mobils CTS, McCaw Cellular-Metromedia (NY) and Contel Corp-McCaw Cellular (Southeast). The average value/POP of these three transactions is $235/POP. As of Sept 30, 1992 McCaw Cellular had proportionate POPs 58,500,000 which leads to a rough valuation of 13.7 Billion (see attached appendix 5). The value which was derived from the past comparable transaction deals should already reflect the possible synergies created by the merger. Therefore it could be considered as a reasonable bench mark in estimating McCaws potential acquisition price without adding any synergy value.

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Valuation Approach Discounted Cash Flow Model When I started to value the firm using DCF model, I have made several assumptions: Annual growth rate at 25% assuming the reminder of LIN share will be purchased in 1995; WACC is calculated as 9.78% based on cost of debt of 12% and return on equity 14.3% (calculated at risk free rate plus company beta multiplied with market risk premium). Operating expense is estimated as 63% of sales. Selling and administration expenses are estimated at 2%. The interest rate on debt is calculated based on corporate Bond ratings and Yields with a reasonable spread to reflect McCaw CCC+ rating. I have also performed a sensitivity analysis based on different revenue growth, direct cost, marketing expense and WACC because the variations in those factors would significantly affect the result produced by DCF model. This sensitivity analysis has also formed the base for my calculation of post merger improvements, synergies and future options. (see appendix 6 and 7) Based on the base case parameter, the enterprise value of the company is estimated at 9.055 billion (see appendix 1 to 3 for detailed valuation). However this value is only the value as is. In the next steps I will calculate the post merger improvements, synergy and future option as add on value.

Valuation Step II Look at post merger potential improvements

Additional and improved cellular phone services combined with operational improvement would help attract more customers, increase the penetration rate and at the same time improve McCaws profitability and bottom line. McCaw was in negative profit since 1990. The merger could eliminate duplicate operational facilities or employees thereby achieve significant cost reduction. The base case valuation can be increased by 689,303 Million assuming revenue would increase by 1% and direct cost would decrease by 1% (see appendix 6 for detailed calculation for these potential improvements).

Valuation Step III Look at post merger synergies

I have identified three areas for post merge synergies: revenue, cost and financing structure. There would be great potential of incremental revenue for AT&T for bundling long distance service with cellular plan. AT&T would have instant access to McCaws customer base and potential subscribers. For McCaw, the well recognized AT&T brand name and its great capability for signing up customers would significantly contribute to its revenue increase. Another major cost saving potential for AT&T is the opportunity to receive local-access fee reductions and to bypass the restrictions from ROBC. For McCaw, SG&A consolidation between the two companies and marketing savings due to the increased advertising power would contribute to further cost reduction. Last but not least, after merging with AT&T, McCaw would enjoy a much higher debt rating at AA comparing with its current CCC+ rate, thereby resulting in reduced cost of debt in its long term borrowings. (See appendix 6 for detailed illustration) Based on the above analysis for the synergies between these two companies, the base case valuation can be increased by 3.9 Billion assuming revenue would increase by 2%, direct cost would decrease by 3%, market expense and WAA would decrease by 1% respectively.

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Valuation Step IV Look at future strategic options

The merger provides opportunities for integration of cellular and PCS with AT&T computers and data services, which would transform the telecommunication industry and offer the two companies strong position to collaborate in capturing the future opportunities in this market and expanding their market shares domestically. It would also offer a unique opportunity to expand into foreign market. An additional increase in value is estimated to be of 3.1 Billion. Based on the above four steps valuation, the final valuation for McCaw is 16.7 Billion (This result is based on value as is from DCF model, see appendix 6 and 7 for detailed illustration).

Final recommendation and Negotiation Strategy

Overall Strategy: The main aim is to maximize payment for possible improvements, synergy and future strategic options with a set floor price as the bottom line for negotiation. The deal could be structured as equity purchase by AT&T. Craig McCaw should seek a seat at AT&T board to maintain management control. Contingencies for Negotiation: McCaw could offer the opportunity for AT&T to perform partial purchase of its share, with the option to complete the remaining purchase in the future. In the worst case scenario that the deal fails, McCaw could consider capital restructuring by selling portion of its shares and retiring part of its long term debt. Steps for Negotiation- Opening offer and walk away price McCaw should make the opening offer based on the valuation incorporating all the post merger improvements, synergies and strategic future options. When comparing three values, I found that after adding the synergy value, the value resulted from comparable companies method (23.5B) is clearly an outlier. So I decided to take the average of the Enterprise values from DCF (16.7B) and the comparable transactions (13.7B) as our opening offer. I recommend our opening offer of enterprise value to be 15.2 Billion. After deducting the outstanding long term debt which is around 5.198 billion, the equity value of the company is approx. 10 billion. We can offer the price at $55/share. This is at 56% premium above our current share price. During our negotiation with AT&T, we have to keep in mind that our floor price should not below the price paid by British Telecom when they bought 20% of McCaw at $41.50 which translates into 7.6 Billion equity value. We have recognized that AT&T will need to keep part of the synergy value resulted from this merger. Therefore we should set our walk away price at the average of our opening offer and floor price, which is 8.9 billion. We expect our share to be bought at $49.00 which is 50% premium over current stock price.

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Appendix 1
McCaw company forecast Assumption Actual 1990 Assumptions Income statement Sales growth rate 68.90 % 2.00% 12.00 % 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% Actual 1991 Foreca st 1992 Foreca st 1993 Foreca st 1994 Foreca st 1995 Foreca st 1996 Foreca st 1997

Operating expenses as % of sales Selling and administration

65.00% 2.00%

63.00% 2.00%

63.00% 2.00%

63.00% 2.00%

63.00% 2.00%

63.00% 2.00%

63.00% 2.00%

Interest on long term debt on average balance Interest income on opening cash balance Income tax rate

12.00%

12.00% 6.25%

12.00% 6.25% 36%

12.00% 6.25% 36%

12.00% 6.25% 36%

12.00% 6.25% 36%

12.00% 6.25% 36%

36%

36%

36%

Balance sheet Cash and cash equivalents Accounts receivable - days sales Marketable securities Accrued expense % current liability Future income taxes Other assets Good will and other intangibles 1,855,40 7 687,237 15.0% used to plug balance sheet if required - no minimum cash on hand 38.54 assume constant 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% assumed constant amount assumed constant amount constant after this time 71.00 70.00 70.00 70.00 70.00 70.00

Bank indebtedness Accounts payable - days in payable (COGS & S&A) Unearned revenue % of sales Other long term liabilities Future income taxes Capital stock Contributed surplus Cumulative translation adjustment

plug to balance the balance sheet if required 70 70 3% assume constant assume constant assume constant assume constant assume constant 70 3% 70 3% 70 3% 70 3% 70 3% 70 3%

Dividends to be paid as percentage of previous year's net income

0%

0%

0%

0%

0%

0%

0%

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Appendix 2
McCaw free cash flows in thousands $'s Forecast 1992 Sales COGS SG&A Depreciation Operating income before tax Taxes Net operating profit after tax depreciation Net operating cash flow after tax 1,706,964 -1,075,387 -34,139 -24,299 573,139 -206,330 366,809 24,299 391,108 Forecast 1993 2,133,705 1,344,234 -42,674 -26,520 720,277 -259,300 460,977 26,520 487,497 Forecast 1994 2,667,131 1,680,293 -53,343 -28,786 904,709 -325,695 579,014 28,786 607,800 Forecast 1995 3,333,914 2,100,366 -66,678 -31,089 1,135,781 -408,881 726,900 31,089 757,989 Forecast 1996 4,167,393 2,625,458 -83,348 -33,409 1,425,178 -513,064 912,114 33,409 945,523 Forecast 1997 5,209,241 3,281,822 -104,185 -35,750 1,787,484 -643,494 1,143,990 35,750 1,179,740 CV

Change in working capital Change in Accounts receivable Change in inventories Change in accrued expenses Change in accounts payable Chang in income taxes payable Net change in working capital Investing activities Total investment in assets Change in goodwill and other assets Cash flow for investing activities Free cash flows -48,616 0 -48,616 220,552 -51,367 0 -51,367 346,280 -54,962 0 -54,962 440,768 -57,667 0 -57,667 557,589 -60,984 0 -60,984 706,074 -63,770 0 -63,770 892,934 910,793 -187,851 0 34,624 39,237 -7,950 -121,940 -77,164 0 -64,011 53,196 -1,871 -89,850 -102,301 0 -80,014 66,496 3,749 -112,070 -127,876 0 -100,017 83,119 2,041 -142,733 -159,845 0 -125,022 103,900 2,502 -178,465 -199,807 0 -156,277 129,874 3,174 -223,036

Terminal growth rate Terminal value Discount factor for WACC WACC = Discounted free cash flow 9.78%

2% 11,706,847 0.9109 200,904 0.8298 287,330 0.7558 333,150 0.6885 383,903 0.6272 442,827 0.5713 510,129 0.5713 6,688,066

Total value of discounted free cash flows assuming end of year flow

8,846,309

Percentage of terminal value Enterprise Value

76%

Move discounted free cash flows forward 0.25 year Less market value of debt Long term debt and short term debt Less redundant liabilities

9,055,093

(note - (1 + WACC) ^0.25 cash flows fall in the Sept of the year, not at the end) -5,198,838

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Add redundant assets Value of equity Number of shares outstanding (thousands) Value per share

0 3,856,255 182,499.000 $21.13

Appendix 3 Cost of Capital

Debt as of Dec 31,1991 Equity as of Dec 31, 1991 5,935,387 2,781,309.00 68% 32%

8,716,696.00 Levered Beta Tax rate Risk free rate Risk Premium R e levered 1.75 36% 5.50% 5% 14.3% (from case material) ( McCaw's current tax rate) ( use five year treasury note close Sept 25,1992) ( assumed) Cost of Equity=risk free rate + Beta x Risk Premium (Since McCaw cellular has CCC+, cost of debt is relatively high, data from the course material.)

Cost of Debt

12.00%

D+E WACC

8,716,696.00 9.78%

Appendix 4 - Valuation by comparable companies

BT Equity value/Revenue Equity value/NI 1.66 11.79 LIN Broadcasting 7.85 NA US Cellular 9.57 39.5 Vanguard Cellular 7.58 NA Contel Cellular 9.78 NA Average 7.288

* Information obtained from case material Adjust the industry average to reflect McCaw's situation: Size Capital structure Growth profile Profitability Industry position Diversification Off Balance sheet issues Management Team Tax 1 -2 0.5 -1 1 0.5 0 0.5 0 Company scale is relatively large in the industry Heavily burdened by debt, company is over levered Has better growth prospect compared to industry Company has negative earning Has leading position in the industry Reasonably diversified not mentioned in the case Has relatively strong management team Neutral

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Other factors specific Total adjustment factor McCaw's Equity/Revenue ratio Equity value McCaw Outstanding debt Enterprise Value

0 0.5 7.788 10,635,066.95 5,198,838.00 15,833,904.95

NA

Appendix 5 - Valuation by comparable Transactions

Purchaser Bell Atlantic Corp. McCaw Cellular Comcast Corp. BellSouth Corp. GTE Corp. McCaw Cellular Time Warner Inc. Price Communications Contel Corp. Vanguard Cellular Vanguard Cellular Target Metro Mobiles CTS Crowley Cellular Metromedia McCaw Cellular ( southern) Providence Journal Metromedia (NY) Pricellular Corp. Utica/Rome MSA Wireless McCaw Cellular ( southern) Palmer Communications(ME) Palmer Communications(NH) Value 2450 105 675 360 710 1900 13 35 1300 NA NA POPs 11.5 0.61 4.9 2.7 3.5 6.8 0.43 0.22 6.1 NA NA Average Proportionate POPs- McCaw Enterprise Value $58,500,000.00 13,758,614,942.77 Value/POP 213.04 172.13 137.76 133.33 202.86 279.41 30.23 159.09 213.11 148.00 145.00 235.19

Appendix 6 Sensitivity Analysis/ Post Merger improvement, synergies and future options
Post Merger potential improvements: Revenue growth Base Case Revenue incr by 1% Direct cost decr by 1% Post Merger Synergies: Revenue growth Base Case Revenue incr by 2% Direct cost decr by 3% Marketing expense decr by 1% Financing WACC decr by 1% 25% 27% 60% 1% 8.80% 13,002,651 3,947,558.00 Direct Cost 63% Marketing Expense 2% WACC 9.78% Valuation 9,055,093 Increase in Value 25% 26% 62% 9,744,396.00 689,303 Direct Cost 63% Marketing Expense 2% WACC 9.78% Valuation 9,055,093 Increase in Value

SGMT 6050 Case Assignment 2: THE AT&T/MCCAW MERGER NEGOTIATION

Song Li

Future options Revenue growth Base Case Revenue estimated at 5% increase Direct cost decr by 3% 25% 30% 60% 12,127,064 3,071,971 Direct Cost 63% Marketing Expense 2% WACC 9.78% Valuation 9,055,093 Increase in Value

Appendix 7
The value of the target:
Value as it is under DCF Post merger potential improvement Post merger synergies Future options The value of the target Outstanding Debt 9,055,093.00 689,303 3,947,558 3,071,971 16,763,925.00 -5,198,838 11,538,087 Value as it is under comparable companies Post merger potential improvement Post merger synergies Future options The value of the target

15,800,000.00 689,303 3,947,558 3,071,971 23,508,832.00

Equity Value

Sensitivity analysis based on different WACC and revenue growth rate WACC 9.5% 14% 16% 18% 20% 22% 26% 5.9/22.56 6.07/25.32 6.9/28.26 7.4/31.40 8.0/34.75 8.7/38.31 Revenue Growth 10% 5.5/20.48 5.7/23.03 6.4/25.75 6.9/28.66 7.5/31.75 8.1/35.05 10.5% 5.1/18.64 5.6/21.01 6.0/23.54 6.5/26.24 7.1/29.12 7.6/32.17 11% 4.8/17.00 4.98/19.22 5.6/21.58 6.1/24.10 6.6/26.78 7.1/29.63 11.5% 4.6/15.55 4.95/17.62 5.3/19.83 5.7/22.18 6.2/24.69 6.7/27.35

Reference: SGMT 6050 Mergers & Acquisitions course kit