Merger discounts galore

Deal values plummet with market In the current Wall Street environment, the lag time between when a merger is announced and when a deal closes can be an anxious time for executives and, if the company is public, the shareholders of the acquired company.

That's because they most likely have their eyes on the share price of the acquiring company, an intangible they have no control over. But it is the acquirer's shares that are used as the currency in the transaction. So if the acquired company's stock takes a beating, the currency is devalued, lowering the price the acquirer actually pays.

The recent downturn for telecom stocks has put many merger deals in this difficult situation. For example, while optical components maker JDS Uniphase awaits regulatory approval for its acquisition of SDL, its share price has nosedived to the $70 range from its closing price of $101.125 on July 10, the day the merger was announced.

Under the deal's agreement, JDS will exchange 3.8 shares of its stock for one share of SDL. While JDS' once stratospheric stock price meant SDL shareholders were going to receive a substantial premium, the drop in JDS share price wiped that out. If the deal closed last week, SDL would have received just about $4 billion above the company's current market capitalization.

The VoiceStream Wireless deal, announced in July, is similarly undervalued. The price of Deutsche Telekom's bid is down by more than $10 billion due to a decline in the German carrier's share price abroad and in the U.S.

What's causing the big drop in the value of deals and how is it likely to affect merger and acquisition activity? For the most part, analysts and M&A gurus attribute the phenomenon to the strong downdraft in the telecom sector."There's always a dip [after a merger is announced]; it's just a matter of how much. This is not new," said Peter Horoszko, partner in the Transaction Services Group at PricewaterhouseCoopers. "This is a time, though, when a lot of people don't quite see where the end is - where the market's going to go and how fast [companies] will able to execute on [their] strategies."

As a result, Wall Street is taking a tougher view of potential deals, particularly if they involve mixing companies with disparate cultures and business models or combining a traditional telecom business with that of an emerging service provider, said Robert Filek, a partner at PricewaterhouseCoopers. "The market tends to be little harder on those deals because they're tougher deals to do," he said.

Savvy shareholders and telecom executives are better off taking a long-term view of a deal's value. "In some cases, the dips in these stocks are the flavor of the month," Filek said."If you let your merger strategy be led by that short-term influence, you could make major strategic mistakes."

Kopp Investment Advisors, a large institutional shareholder in SDL, is concerned about the drop in value of JDS shares but sees it as a general market downturn not specific to the deal, said Peter Conrad, senior research analyst for Kopp. "A shareholder certainly needs to view the potential merger through the perspective of what's taking place in the optical environment," Conrad said. "There clearly is consolidation taking place. Based on technology and culture, this clearly looks to be a very nice fit. It's a deal that can enhance shareholder value in the end."

Of course, telecom executives have some power to lock in the value of these deals before merger agreements are signed. For example, some acquisition targets are now renegotiating deals so that the final deal price is determined at the time of the transaction close rather than at the time the letter of intent is signed, said Bruce Milne, CEO of The Corum Group.

Another tool used in M&A transactions is the so-called "collar" - a price range for the deal's value that protects the acquired company and its shareholders from a drastic reduction in the value of the acquirer's stock. According to the fine print in the VoiceStream deal, for example, if for seven random days during a 15-day window prior to the deal's closing DT's average share price on the Frankfurt exchange falls below 33 euros, VoiceStream shareholders can renegotiate the terms or block the merger.

Breakup fees are another option, although they are used sparingly. While the JDS/SDL deal is not protected by a collar, it does include a $1 billion breakup fee, which would go to JDS should SDL pull out of the deal."One billion [dollars] is a big number, but if Corning came along with a $45 billion offer, $1 billion [wouldn't be] that much," Conrad said.

On the other hand, the reduction in value of many merger deals may actually be a good thing, according to some analysts. "It's more difficult to pull off the strategic mergers when valuations are unrealistic," Filek said. Lower share values also can mean bargains for opportunistic companies.

Still, the fallout from the drop in merger values could lead to a short-term cooling off of large mergers, Milne said. "A lot of the bigger deals are being set aside because they don't want to use cheap stock and are worried about the oversensitivity of the analyst community to such deals," he said. Smaller deals, however, are picking up, he said, because the M&A market is the last alternative for companies that have exhausted their venture funding options and don't have the visibility or maturity to go public in a tough IPO market.