General Electric's Proposed Acquisition of Honeywell

MSc in Banking and International Finance

Course:

Finance and Investment (XXX)

Professor: XXX

Case Study

General Electric's Proposed

Acquisition of Honeywell

Presentation date: 20th November 2015

Submission date: 18th December 2015

General Electric's proposed acquisition of Honeywell

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Executive Summary

This paper examines the failed merger transaction of General Electrics and Honeywell in the

year 2001. In October 2000, GE agreed to acquire Honeywell for $45 billion, where

Honeywells shareowners will receive 1.055 shares of GE stock for one share of Honeywell. Nevertheless on March 01, 2001 the European Commission announced to review the

transaction in further extent after the US regulators already approved it. Four months later, they

prohibited the merger due to reduced competition in the aerospace industry, which will result

in higher costs for end consumers. The methodology of this paper is mainly based on literary

research and articles from the Anglo-Saxon area as well as the Harvard case study. It also

includes opinions from experts from the banking and finance industry, in particular from the

Hedge Fund, M&A and Sales & Trading area.

One of the key findings of this paper is that with a merger arbitrage strategy on GE &

Honeywell, it is possible to outperform the market by betting on a diminishing spread between

both stocks. Gallinellis equally short position in GE and long position in Honeywell provides a return on investment around 34%. Nevertheless there are also challenges to overcome such

as a limited trading volume as those trades involves often a high leverage to generate a risk-

adjusted return. Further to this, the arbitrage spread is acting as an indicator of the possibility

that GE-Honeywell merger goes through. The higher the arbitrage spread, the less the

possibility is. The arbitrage spread experienced a downward trend after the announcement of

this merger. However, 5 days before European Commission formally announced to stringently

investigate this case, the arbitrage spread started to rise significantly.

Additionally, this paper also analyses the projected synergy. The consolidated firm is expected

to gain market power among overlapped products. The deal can also expand the customer base

for both two firms as they can provide bundle offering for complement products. In addition,

synergy can arise from cost savings and improved overall efficiency in operations. GEs former CEO and chairman, John F. Welchs understanding of GE and the industry helped the firm to

achieve a well-diversified portfolio and become an industry leader.

We adjusted few ratio projections, such as revenue growth rate and dividend payout ratio as

well as correct inappropriate calculations in our discounted cash flow model. We provide

justifications for key assumptions as well as the sources for data inputs. The share price the

adjusted model is estimated to be $34.44 per share, $2.32 higher than the original estimation.

Moreover, we also analysed Honeywells value with the multiple method, arriving at the conclusion that the GEs bid price ($48.67) is fairly priced, compared to its peers equity value per share with a maximum of $50.75. We could evaluate Honeywells with-synergy value using comparable transactions stock premium. The difference between the percentage of stock premium prior to one month or week to the last day was significant higher than the respective

of the comparable transactions. Therefore, synergys added value to Honeywell can be displayed in its stocks performance which presents better results to the dates close to the

announcement date.


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Table of Contents

1. Investment Strategy ............................................................................................................ 4

2. Discounted Cash Flow Valuation ....................................................................................... 6

3. Relative Valuation .............................................................................................................. 7

4. Potential Merger Synergy ................................................................................................... 8

5. Return on Gallinellis position - Early closing position ..................................................... 9

6. Arbitrage Spread ............................................................................................................... 10

7. Investment Decision ......................................................................................................... 12

8. Conclusion ........................................................................................................................ 12

9. Bibliography ..................................................................................................................... 13

10. Appendix .......................................................................................................................... 16

Figures

Figure 1: Arbitrage Spread and Discount .................................................................................. 5

Figure 2: Performance Comparison ......................................................................................... 16

Tables

Table 1: Numerical Example of Return on Equity .................................................................... 5

Table 2: Original vs Adjusted DCF-model ................................................................................ 7

Table 3: Return on Investment on arbitrage position............................................................... 10

Table 4: Stand alone value and Probability ............................................................................. 11

Table 5: Calculations on both positions in Honeywell and GE ............................................... 16

Table 6: Dividend payout ratio over time ................................................................................ 16

Table 7: Multiple transaction methods - original ..................................................................... 17

Table 8: Multiple transaction methods - redifined ................................................................... 17

Table 9: Multiple transaction methods - result ........................................................................ 17

Table 10:Adjusted Stand alone valueation Honeywell ............................................................ 18

Table 11: Stand alone value and Probability (extended) ......................................................... 19

Equations

Equation 1 ................................................................................................................................ 11

Equation 2 ................................................................................................................................ 11

Equation 3 ................................................................................................................................ 11


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1. Investment Strategy

First of all, the main question Jessica Gallinelli has to answer, is what will be the impact on the

absolute and relative difference between the share prices of both companies, also called spread.

In other words, what will be the effect on the stock prices of General Electric (GE) and

Honeywell International Inc. on the latest news of the European Commission. In general, she

is running a market neutral strategy and thus, there are four possibilities: close, reduce, hold or

increase both positions at the same time. In addition she also have to think about how fast the

market will respond to the press release from European Commission antitrust chief Monti

(Schuetz, 2000) as both shares are listed on the US stock market.

One of the key consideration Gallinelli has to think about is what will be the impact on GEs and Honeywells stock valuation. As John F. Welch Jr., CEO of GE at that time, said after the merger announcement in October 2000, he expects the deal to be completed by early next year

(Sorkin and Deutsch, 2000). However, as a result of the announcement of EU commissioner

Monti to review the transaction, the merger will not be completed in the first few months of

2001, but rather in the third or fourth quarter 2001. This will not only increase the administrative

merger costs for both parties, but also decrease the likelihood that the deal will be accepted

without any operational merger restrictions. This means that the projected synergies and cost

reductions of total up to 15bn USD by end of 2002 (Sorkin, 2000), which are a substantial part

of Honeywells valuation, cannot entirely taken into account anymore. Therefore the latest news will result in a widen spread as the probability of the transaction decreases and the uncertainty

for the shareholders increases (ICIS Chemical Business, 2001).

Moreover, another key consideration for her is how to deal with the size of her positions, which

are 1.25% resp. 0.10% of the outstanding shares of Honeywell resp. GE as of March 1, 2001

(Bloomberg, 2015). This is especially crucial when she is going to fully close or substantially

reduce her positions in one or both companies, which will be very difficult due to limited daily

trading volume. More specific, based on data from Bloomberg, the daily average volume in

Honeywell stocks over a 100-day period is 5.96 million respective for GE 18.66 million shares.

As a result, according to Lange (2015), the maximal percentage in a US blue-chip company,

which can be traded without moving stock prices in an unfavourable direction, is around 5%

per trading day. As such, Jessica Gallinelli can only trade 3.0% (299,000 stocks) of her holding

in Honeywell and 9.3% (933,000 stocks) in GE. Therefore, it takes over 11 trading days for GE

and 34 days for Honeywell to fully close both positions and thus it is not possible to react in a

reasonable period of time on the latest news by only trading shares. All calculations are shown

in Table 5 in the appendix.

Additionally, Gallinelli has only a few hours left before the US stock pre-market will open,

particularly the regular market with high trading volume (NASDAQ, 2015). The news start to

make the round in Brussels around 12pm GMT on March 1, 2001 followed by the first report

on Bloomberg from Associated Press (2001) at 2:07 pm GMT. In order to react properly on the

latest news, without selling a substantial part of her positions on the market, which would lead

to highly adverse price movements, there are two more appropriate possibilities: either she

writes (sell) put and/or buys call options on GE and writes call and/or buys put options on

Honeywell. With such a strategy, she will be able to hedge her holdings against unfavourable

stock movements (widen spread) while profit from an additional leverage.

The main reason why Gallinelli does have nearly equally weighted positions in GE and

Honeywell, is a classical arbitrage strategy to explore short-term price differences between


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those two stocks, whereas the stock of Honeywell is following GE with a fixed exchange rate

of 1.055. This strategy is also called merger arbitrage or risk arbitrage, whereas the trader is

betting on decreasing spread between two merging companies (CMC Markets, 2015).

According to Seeking Alpha (2012), [...] it involves identifying target companies that are [...] bought out by another company, but whose prices have not quite appreciated to the takeover

price. As you can see below in the chart, before March 1, 2001, the spread between the stock price of GE and the bid price from GE (GE x 1.055) was between $1 and $4 (average $2.4),

which represent a discount rate of about 2% to 8% (average 5.2%). The trend of the spread,

however, is clearly shrinking over time, before end of February 2001 rumours start to circulate

on the stock market about the review through the EU

(Colle, 2015).

Therefore as an arbitrageur, Gallinelli is betting that over time, the price of Honeywells stock will be the same as the takeover value proposed by GE (spread = 0), which means that there

will not be any arbitrage possibilities anymore. There might be also the chance that other

competitors start to bid for Honeywell, which will result in a rising share prices for Honeywell

and falling GE-stocks as they would have to pay more for the acquisition. Moreover, Jessica

Gallinelli is also following a market neutral strategy with having both short and long positions.

When comparing it to the S&P 500 Index, being long on Honeywell and short on GE, both

positions equally weighted (in theory) performed clearly better and beat the index by 9.37%

over a 87-period, as shown in Figure 2 in the appendix.

Below are five numerical examples, which support her strategy (fees, transaction costs, interest

expenses are excluded and total margin of 100% on the short position according to Aebersold

(2015)).

Figure 1: Arbitrage Spread and Discount

absolute relative absolute relative absolute relative absolute relative absolute relative

March 01, 2001 416,000 49.87% 418,200 50.13% 834,200 100.00% 583,940 70.00% 250,260 30.00%

Bullish Market Scenario

(GE & HON +10%) 374,400 44.87% 460,020 55.13% 834,420 100.03% 583,940 69.98% 250,480 30.02%

Bearish Market Scenario

(GE & HON -10%) 457,600 54.87% 376,380 45.13% 833,980 99.97% 583,940 70.02% 250,040 29.98%

Worst case Scenario

(GE +10% & HON -10%) 374,400 49.87% 376,380 50.13% 750,780 90.00% 583,940 77.78% 166,840 22.22%

Best case Scenario

(GE -10% & HON +10%) 457,600 49.87% 460,020 50.13% 917,620 110.00% 583,940 63.64% 333,680 36.36%

Realistic Scenario

(HON = GE x 1.055) 416,000 48.66% 438,880 51.34% 854,880 102.48% 583,940 68.31% 270,940 31.69%

Total Equityin thousands

Total LiabilitiesGeneral Electric Honeywell Total Portfolio

Table 1: Numerical Example of Return on Equity


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As this table above shows, the investment strategy of Gallinelli is a merger arbitrage, whereas

she bets on shrinking spread between the proposed bid price of GE and the actual share price

of Honeywell. In the most. In the most realistic scenario, Honeywell will trade 1.055 times the

share of GE which means that her short position in GE did not generate any profit or loss but

the long position in Honeywell increased by 4.95% or $20.7 million. Therefore her market

neutral strategy performed on Investment (ROI) 2.48% and due to the leverage of 2.33 on

Equity (ROE) in total 8.26%. Of special note is that either both stocks are rising or falling, her

equity value stays nearly the same, which shows her market neutral strategy.

2. Discounted Cash Flow Valuation

This section will review the discounted cash flow (DCF) model, its estimations and forecasts.

The main assumptions are that Honeywell will continue its steady operation over the next few

years and major cost items experience no significant change. We found a number of major

misstatements in the model which distorts the final results.

The model starts with a 5-year revenue forecast. Expenses in the income statement and balance

sheet items are tied to the revenue, as their balances are expressed as a percentage ratio of total

revenue. One can argue the 6% revenue growth for the next four years may seem to be over

optimistic as the past 3 years average is merely 3.6%. However, this argument fails to include the unrealised effect of the merger between Honeywell and AlliedSignal and Honeywell and

GE. Indeed the revenue growth was 0.8% in 1999, but it may because, during that year, the

firm spent most of the time and effort in completing the merger with AlliedSignal. During 2000,

the next financial year, the firm was back on track of strong revenue growth (5.4%). The

revenue forecast then takes into account of the potential synergy between Honeywell and

AlliedSignal and cautiously generates a mid-term forecast. On the other hand, a 6% revenue

growth forecast does not overestimate the synergy either because the revenue can also be

stimulated by the synergy from the merger with GE. In a longer term, the firms growth is in line with the overall economy. Therefore, we use the US GDP growth rate for 2000, 4.1%

according to World Bank (2011), as the perpetual revenue growth rate. This also affects the

calculation for terminal value using constant growth model.

Two items are not in line with the revenue growth - rate of borrowing and dividend payout

ratio. The interest rate of firms borrowings in the model uses 10-Year A-rating bond rate as proxy. According to a number of rating action reports (e.g. Moodys, 1998 and Moodys, 1999), Honeywell has maintained a firm credit rating at A2. Honeywell is assumed to remain its

healthy debt structure and steady revenue growth. Therefore, we do not expect any negative

inputs on the credit rating. The merger with GE, on the other hand, will have positive effect on

Honeywells credit outlook as GEs support will become a significant rating factor. After the merger completion, Honeywell would be able to raise finance from the debt market at a cheaper

price as GEs rating was Aaa at that time. Therefore, we set the interest rate at 6%, considering the US Corporate Bonds yields for Aaa and A are 5.8% and 6.3%, respectively.

The dividend payout ratio projection also needs adjustment. The model averages the dividend

payout ratio from 1997-2000 and assumes the firm would maintain the average rate. According

to Table 6 in the appendix, during the past 9 years between 1992 and 2000, the average dividend

payout ratio is merely 27%. Only in 1999 and 2000, Honeywell paid dividend at a rate above

30%. Consider companies rarely cut their dividend due to the asymmetric market reaction to a

decrease in dividend, Honeywell is more likely to payout dividends at a rate that can sustain.

Therefore, we adjust the forecasted payout ratio 2% down for each of the following years. The


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discussion now turns to the discount rate estimation. The estimation for cost of debt, as

discussed earlier, is decreased to 6% as the expectation of Honeywell receiving a higher credit

rating after its merger with GE.

The model uses capital asset pricing model (CAPM) to determine the cost of equity. The

calculation of debt and equity value in the model is incorrect. The adjusted ratio takes into

consideration of the market value of Honeywells debt and share value. We also disagree with decision of considering the risk free rate in line with 30-year US Treasury Bond. According to

Koller et al. (2010), the estimates may be misleading as the result is distorted by the illiquidity

of 30-year Treasury. As a result, we take the 10-year US bond yield as the proxy for risk free

rate since the bond itself can better match the cash flow stream that we evaluate. We use the

historical US stock premium as proxy for risk premium. Our estimate for cost of equity has

gone up slightly to 10.39%, compared with 12.49% stated in the original model.

The table below summarises all the adjustments and calculates the correct share price estimate.

The fair value of Honeywell is estimated as $34.44 per share, with synergy. This is slightly

higher than the close price before the merger announcement ($32.34).

Original DCF

Adjusted

Model Notes

Long-term growth rate 5.27% 4.10% World Banks data

Interest rate 7.8% 6.0% Improved rating

Dividend 30.5% -33.1% 28.5% - 31.1% Each year down by 2%

D/E ratio 25:75 12:88 Correct calculation of wD&wE

CAPM

Risk-free rate 5.29% 4.87% 10-year T-Bill

Risk Premium 6% 4.6% Historial US stock premium

Cost of Debt 7.8% 6.0% Improved rating

Cost of Equity 12.49% 10.39% Cost of Equity part of CAPM

Net Debt Calculation 5,251 4,427 Use current years balance

Share Price Projection $36.72 $34.44 Up by $2.32 (-6.3%)

Table 2: Original vs Adjusted DCF-model

3. Relative Valuation

In the third section, we will use a different method to value Honeywell. For the estimation of

Honeywells stand-alone value, multiple transaction method will be used. In the multiple transaction method all the firms selected should be comparable. In our case, we were given the

financial data, such as EBIT, EBITDA, Sales and Net Income, of six comparable to Honeywell

firms. These companies are Emerson Electric, Textron, Tyco International, United

Technologies (UT), General Electrics and Honeywell.

In our view not all given firms are appropriate for estimating the Honeywells stand-alone value. To begin with, Tyco International. that operates in a different industry, as it is a security

services company, while other peer are specialised in the aerospace industry. What is more,

GE is excluded from the analysis as on one hand it is directly involved in the transaction and,

on the other hand, the firm is significantly larger than the given peer firms. Moreover, we

decided to exclude Honeywell from our valuation as we want to calculate its value in


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comparison to the defined peergroup. We evaluate Honeywells stand-alone value according to the three remaining firms (Emerson Electric, Textron, UT) using the Enterprise Value as

multiple of Sales, EBIT, EBITDA and Net Income (Table 7 in the appendix).

Firstly, we have to recalculate EBIT and EBITDA as the case studys exhibit uses equity value as the denominator instead of enterprise value. As a consequence, it changes the estimates for

multiples and the results are stated in Table 8 in the appendix. The adjusted peergroup can be

found in the appendix (Table 9) including the refined multiples. According to Table 8, there

are differences between the given peergroup and the refined one. The most significant

differences are between Sales and EBIT, which changed from 60,400 to 36,198 and from

63,227 to 49,097 respectively. The refined values after the recalculations are more reliable as

an indicator of Honeywells value and show us a more accurate analysis for the peer companies.

Given the adjusted enterprise values, we arrived in the conclusion that Honeywell is overvalued

in comparison to its peer firms. In the most significant multiples, such as EBIT and EBITDA,

Honeywells values are above the average. The multiple EV/EBIT measures a companys return on investment while EV/EBITDA, one of the most common used and reliable multiple,

compares the value of a company, inclusive of debt and other liabilities, to the actual cash

earnings exclusive of the non-cash expenses. Honeywells enterprise value as a multiple of sales is in the same levels of the average of the respective multiple of the firms in the industry.

EV/SALES shows how much it costs to the investors to pay for companys sale. That means that it operates in the same levels as the other firms of the industry. Last, but not least, EV/NET

INCOME is a meaningless multiple because the numerator applies to shareholders and

creditors, but the denominator accrues only to shareholders. Therefore, it does not give us any

additional information for Honeywells valuation.

With respect to the comparable transactions we are going to use the data from the Jumbo deals,

since Honeywells acquisition by GE is considered as a Jumbo deal with a transaction value is

$39bn. Based on the data given, we excluded the GTEs acquisition by Bell Atlantic as an

outlier. This case presents discount premiums either because the sector was out of investors

interest either because of poor performance of the firms or because of the illiquidity of the

assets. With respect to the BP-Amoco transaction the data are not available.

Therefore, we calculate the average of the premium over the stock price between the two

transactions, Quest-US West and Chevron-Texaco. The average of premium over the stock

price prior one month, one week and one day was 33.64, 36.33 and 25.08 respectively. Whereas

the values of stock premium for Honeywell were 48.70, 55.94 and 17.39. In order to evaluate

synergys contribution to Honeywells value we calculate the difference between the

percentage of the stock premium prior one month to one day and the difference between prion

one week to one day. As you may see in the table 10 in appendix, Honeywells difference was

significant higher that the respective of the comparable firms, which means that synergy-added

value in Honeywell is larger than that in the comparable transactions.

4. Potential Merger Synergy

Several synergies could be achieved through the merger between GE and Honeywell. As GE

is specialised in commercial aircraft engines and Honeywell is the leading aircraft subsystem,

such as avionics system, it could make each firms product portfolio as a perfect complement to another. Additionally, it has been pointed out by academics that the merger would enable

GE to gain market power in those areas where two firms have overlap in product range, such


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as large regional jet engine (Grant, 2005). This would allow GE to gain higher bargain power

to customers and, eventually, raising the price of their product.

The merged firm could also engage in product bundling to expand the network of both products.

Fox (2002) suggests that once an aircraft manufacturer, like Airbus and Boeing, chooses one

type of engine and other parts, they are more likely to continue using the same brand of product.

Once GE and Honeywell completed the merger, they can pitch the groups product bundling to customers by offering a discount. The potential merger synergy can, therefore, be achieved

by stimulated revenue as a number of customers who previously purchase competitor's product will prefer to use GE/Honeywell bundle and stay that way.

The merger synergy could also be achieved through improved efficiency. Firstly, the

transaction allows two firms to share their competitive technology. In the aerospace industry,

it takes years or even decades to develop a core technology and the related costs are always

substantial. Both two firms possessed several unique technology before the merger. By sharing

these innovative technology, it can substantially reduce the consolidated firms R&D costs. Secondly, indirect expenses, such as administrative cost, could be reduced through removing

the overlap layers in management and central service department. Since two firms have similar

culture and control system (e.g. Six Sigma) throughout operation process, cost savings could

be achieved in a timely and effective manner.

The synergy can also be reflected from the advantage of economic scale. After merger

completion, the consolidated firms operating activities can raise finance from the debt market at a lower price as the generally better credit outlook of GE at Aaa rating (Moodys, 2002) can benefit Honeywell. In addition, GE Capitals enormous financial resources can support Honeywells research as they will be given more space for the development of innovative technology. GE, on the other hand, will be able to maintain their high credit rating since the

merger will significantly stimulate the growth in revenue and cash flow generation.

As GEs CEO at the time, Welch added unique value to the proposed merger. During the 20-year governance, he made significant contribution in restructuring GEs portfolio and made GEs operations more diversified (Barlett, 2002). His strong understanding in the industry allows the firm to always keep on the right track of expanding. In addition, Welchs aggressive cost cutting actions helped GE to save substantial payroll expense (Murray, 2001). It also

allows GE to utilise its resources efficiently in R&D rather than pointless administration. It has

been mentioned by Swaine (2001) that Welchs personality in business and government played an important role in the GE-Honeywell merger proposal. In fact, the merger between

Honeywell and GE successfully gained support from 11 anti-trust bodies with their approval,

including the Department of Justice. In line with Welchs ambitious, GE kept itself in the front line of aggressive but valuable M&As. One could argue that, without his contribution to GE, a

proposal at such scale would not even be exist.

5. Return on Gallinellis position - Early closing position

Estimation of ROI on Risk-Arbitrage Position

Position opened 20-Oct-2000 20-Oct-2000

Position closed 1-Mar-2001 1-Jul-2001

Days in holding period 132 254


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Position and Payoff in Target Shares

Buy target shares at $41.46 $41.46

Value of target shares at end of holding period $41.82 $43.89

Gross spread per share on target shares $0.36 $2.43

Total value of gross spread on target shares (100) $36 $243

Position and Payoff in Buyer Shares

Short buyer shares at $47.08 $47.08

Value of buyer shares at end of holding period $41.60 $41.60

Gross spread per share on buyer shares $5.48 $5.48

Total value of gross spread on buyer shares (100) $548 $548

Total Assets of the Arbitrage Position $4,146.00 $4,146.00

Short position in buyer shares $4,708.00 $4,708.00

Borrowed shares of buyer ($4,708.00) ($4,708.00)

70% Debt of total Portfolio $2,902.20 $2,902.20

Capital employed $1,243.80 $1,243.80

Total Liabilities & Capital of the Position $4,146.00 $4,146.00

Net Spread Calculation

Gross spread $584.00 $791.00

- Interest @ 15% ($157.43) ($302.94)

- Short dividends foregone $0.00 $0.00

+ Long dividends received $0.00 $0.00

Net spread $426.57 $488.06

Results

Return on capital for holding period only 34.30% 39.24%

Return on capital annualised 94.83% 56.39%

Table 3: Return on Investment on arbitrage position

The return on investment for her position is 34% and 39% for two specific holding period,

respectively as shown in the table above. The short position of GEs share contributed majority of the return while Honeywells share also provides considerable returns.

6. Arbitrage Spread

The market will react negatively to the review initiated by European Commission with share

prices of both GE and Honeywell going down instantaneously. Reasonably, before the news

was released by regulators, both stocks had been underperforming for several days. This

preceding decrease is typically because the market had anticipated the bad news. As post-event

drift is mainly after news and is usually very robust (Wesley. Chan, 2000), then after the official

announcement, the stocks will continue drifting downwards unless other good news are

presented to the public or the market revises its expectation.

Concerning arbitrage spread, it is defined as the difference between post-announcement share

price for the target firm and the offer price by the bidder (Betton, Eckbo and Thornburn, 2008).

Based on our formulas below,


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Pcurrent = prob. x Pbid + (1 prob.) x Pstand-alone (1)

Equation 1

Arbitrage spread = Pbid - Pcurrent (2)

Equation 2

we can arrive at formula (3), which interprets that the spread is related inversely to the

possibility that the deal goes through, i.e. with other factors remaining constant, the higher the

probability of consummation is, the narrower the discrepancy (between todays share price for

the acquiree and the bid price) is, or vice versa.

Arbitrage spread = (Pbid - Pstand-alone) x (1 prob.) (3)

Equation 3

Therefore, arbitrage spread is an indicator of the possibility of merger. Specifically, when the

arbitrage is small, good opportunities are that the merger will be conducted eventually. While

when arbitrage spread is big, it may, to a large extent, suggest that the deal will not be

consummated at all (Bruner, 2004). Since the arbitrage spread diminishes at the end of an M&A

when target firms share price equals to the share price of the takeover firm, the conclusion

suits best when M&A is done entirely through stock exchange (Value Research, 2012).

Additionally, as probability always fall into the range of 0 and 1, we delete all cells with

probability outside the range, which occurs Honeywells stand-alone values exceed its share

prices. Nevertheless, it is necessary to clarify that even though we delete these values, it is still

possible for this M&A to be conducted. Because the market always leads bidders to purchase

assets of undervalued targets (Betton, Eckbo, Thorburn, 2008) and when the share price is less

than the stand-alone value, it implies that the firm is undervalued by the market.

To be more specific, Figure 1 in Question 1 demonstrates this inverse relationship between

arbitrage spread and possibility as well. From the declaration of GE-Honeywell merger to the

beginning of December 2000, the arbitrage spread decreased continuously from $4.27 to $2.62.

However, the spread leaped back to $4.15 on December 15th as Honeywell pre-announced its

would-be lower-than-expectation quarter earnings (ICIS Chemical Business, 2001). Its bad

performance and customer uncertainty due to divesting business units may well influence GEs

interest in taking it over. Simultaneously, the market updated the prediction that probability of

consummation would be impaired by the news, which explains the abrupt jump in the spread.

Afterwards, the spread did not go against the decreasing trend until EC announced the antitrust

$30.00 $32.86 $34.00 $35.30 $38.00 $40.00 $42.00 $44.00 $47.16 $50.00

1-Nov-00 $48.22 $49.17 $51.87 $3.65 83.29% 80.79% 79.56% 77.95% 73.66% 69.22% 62.99% 53.59% 22.44% 100%

16-Jan-01 $43.31 $42.93 $45.29 $1.98 87.04% 84.07% 82.45% 80.17% 72.83% 62.56% 39.80% 100% >100%

1-Feb-01 $43.19 $41.89 $44.19 $1.00 92.93% 91.15% 90.15% 88.71% 83.79% 76.06% 54.24% 100% >100%

15-Feb-01 $44.05 $43.48 $45.87 $1.82 88.52% 86.01% 84.66% 82.77% 76.86% 68.98% 52.95% 2.67% >100% >100%

1-Mar-01 $41.82 $41.60 $43.89 $2.07 85.11% 81.26% 79.09% 75.92% 64.88% 46.81% 100% >100% >100%

Probability

Stand alone value Honeywell

Dat

e

Hon

ey-

wel

lGE

Bid

pric

e

Spr

ead

Table 4: Stand alone value and Probability


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scrutiny. Since the investigation raised stakeholders concern that this combination would fail

in the end, a significant increase in spread was brought about.

7. Investment Decision

First of all, as already mentioned in question 1, the whole transaction will not be completed in

the first quarter of 2001 and thus lead to higher merger-related expenses (Elliott, 2001). Further

to this, it also diminishes the potential synergies, which are already projected and reflected the

current value of GE and Honeywell. As a result, those news will clearly affect GE and

Honeywell negatively and will lead to falling stock prices, but even more important for

Gallinelli, it will widen the spread between both companies. This is highly unfavourable for

her positions as the share of Honeywell will no longer have the same correlation to GEs stock price and thus her merger arbitrage strategy will not work anymore.

In our view, the best strategy from this situation is to reduce/close her long position in

Honeywell and increase instead the short holding in GE to profit from falling stock prices.

However, this strategy is hard to follow due to the limited trading volume, nevertheless as an

interesting alternative, she can buy either put options and write call options on both stocks.

Further to this, buying put options is the better alternative than writing call options as on one

hand the implied volatility will increase after the EU-announcement, which will lead to higher

intrinsic value of the option. On the other hand, Gallinelli would only get the option premium,

which would only partly offset her losses, depending on strike price and time to maturity

(Mullaney, 2009). Unfortunately, she will not running a merger arbitrage strategy anymore,

however she will be able to perform clearly better from the dropping stocks. If she is going to

follow a market neutral strategy as it is probably written in the fund prospectus, another

possibility is to bet on widen spread as the deal will not be completed in the first quarter of

2001 and thus the uncertainty of the transaction will increase, which will result in a widen

arbitrage spread. That means, she has to reverse both positions by selling Honeywell and

buying GE stocks simultaneously. To further enhance this strategy, she has to buy as well put

options on Honeywell and buy call options on GE. As a result, she will be able to generate

profit from a widen arbitrage spread in the short-term.

8. Conclusion

First of all, the example of Gallinelli shows us what the merger arbitrage strategy is and how

an individual, mostly hedge funds, can generate market neutral profit by betting on diminishing

spread between both companies. Additionally, it taught us the power of regulators in reality, as

EU Commissioner Monti rejected the merger between two US companies, which is a drawback

of the globalisation in general. Moreover it showed us as well how the market reacts on mergers,

in particular the uncertain prospects caused by a delay of the transaction, which often results

in substantial expenses to both parties.

Multiple method for firm valuation requires a carefully choice of industry peers and

comparable financial ratios. While a robust DCF model requires both reasonable projections

for key ratios and, also, accurate calculations through the model. To analyse the synergy of a

merger, one can look at a specific deal. However, in order to achieve a comprehensive

conclusion, an analysis of the wider industry sector is also necessary as it adds valuable insights.


SMM122 Page 13

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10. Appendix

Table 5: Calculations on both positions in Honeywell and GE

March 01, 2001 General Electrics Honeywell

Shares outstanding 9,908,802,000 797,486,000

Stake in the company with 10m

shares 0.1009% 1.2539%

100 days avg. trading volume 18,658,073 5,964,635

max. daily trading volume (5%) 932,904 298,232

Duration to close the position 10.72 days 33.53 days Table 5: Calculations on both positions in Honeywell and GE

Figure 2: Performance Comparison

Figure 2: Performance Comparison

Table 6: Dividend payout ratio over time

Year 1992 1993 1994 1995 1996 1997 1998 1999 2000

Pay-out ratio 26.7% 24.7% 23.7% 24.8% 25.6% 25.2% 25.2% 34.2% 36.1%

4-year Average (DCF Model) 30.19%

9-year Overall Average 27.38% Table 6: Dividend payout ratio over time


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Table 7: Multiple transaction methods - original

Table 7: Multiple transaction methods - original

Table 8: Multiple transaction methods - redifined

Table 8: Multiple transaction methods - redifined

Table 9: Multiple transaction methods - result

Table 9: Multiple transaction methods - result

Table 10: Comparable transactions

Comparable transactions

Target Name GTE Amoco US WEST Texaco

Acquirer Name Bell Atlantic BP Quest Chevron

Premium over stock price:

1 day prior (%) -2.72 na 32.48 17.68 25.08 17.39

1 week prior (%) -2.72 na 50.11 22.55 36.33 55.94

1 month prior (%) -4.94 na 49.77 17.51 33.64 48.70

GTE Acquisition from Bell Atlantic excluded as an outlier

Not available data for Amoco's acquisition from BP

Average

Honeywell's

premium over

stock price

Multiple transaction method

Original Peergroup Reasons for non consideration

Company EPS Sales EBIT EBITDA

Net

Income EPS

Book

Value

Emerson Electric Co. 3.33 2.00 12.26 9.67 21.90 18.86 4.19

Textron Inc. 1.55 1.01 8.33 6.35 60.36 28.37 1.55

Tyco International Ltd. 2.68 3.54 17.80 14.24 22.64 20.49 5.44

United Technologies 3.84 1.33 11.27 9.44 19.57 17.32 3.87

General Electric Co. 1.28 5.09 22.03 17.47 51.22 36.45 9.19 Numbers seem to be outliers

Honeywell Int'l. Inc. 2.06 1.51 10.42 8.18 22.79 20.13 3.44

Median 2.37 1.76 11.76 9.56 22.72 20.31 4.03

Average 2.46 2.41 13.68 10.89 33.08 23.60 4.61

Refined Peergroup


Net

Income EPS Book Value


Textron Inc. 1.55 1.01 8.33 6.35 60.36 28.37 1.55


Median 3.33 1.33 11.27 9.44 21.90 18.86 3.87

Average 2.91 1.45 10.62 8.49 33.94 21.52 3.20

EV/Sales EV/EBIT EV/EBITDAEV/Net

IncomeAverage

Sales 25,023

EBITDA 3,629

EBIT 4,624

Net Income 1,659

36,198.5 49,097.0 30,796.4 56,311.6 43,100.9

60,400.6 63,277.9 39,521.1 54,882.5 54,520.5Enterprise value (Original

Peergroup)

Exclude the Honeywell from the medians

Exclude the outliers

Non comparable, as operations

are a different industry

Enterprise value (Refined

Peergroup)




Net

Income EPS

Book

Value


Textron Inc. 1.55 1.01 8.33 6.35 60.36 28.37 1.55





Median 2.37 1.76 11.76 9.56 22.72 20.31 4.03

Average 2.46 2.41 13.68 10.89 33.08 23.60 4.61

Refined Peergroup


Net



Textron Inc. 1.55 1.01 8.33 6.35 60.36 28.37 1.55


Median 3.33 1.33 11.27 9.44 21.90 18.86 3.87

Average 2.91 1.45 10.62 8.49 33.94 21.52 3.20


IncomeAverage

Sales 25,023

EBITDA 3,629

EBIT 4,624

Net Income 1,659

36,198.5 49,097.0 30,796.4 56,311.6 43,100.9


Peergroup)






Peergroup)




Net

Income EPS

Book

Value


Textron Inc. 1.55 1.01 8.33 6.35 60.36 28.37 1.55





Median 2.37 1.76 11.76 9.56 22.72 20.31 4.03

Average 2.46 2.41 13.68 10.89 33.08 23.60 4.61

Refined Peergroup


Net



Textron Inc. 1.55 1.01 8.33 6.35 60.36 28.37 1.55


Median 3.33 1.33 11.27 9.44 21.90 18.86 3.87

Average 2.91 1.45 10.62 8.49 33.94 21.52 3.20


IncomeAverage

Sales 25,023

EBITDA 3,629

EBIT 4,624

Net Income 1,659

36,198.5 49,097.0 30,796.4 56,311.6 43,100.9


Peergroup)






Peergroup)


SMM122 Page 18

Table 11: Adjusted Stand alone valueation Honeywell

able 10:Adjusted Stand alone valueation Honeywell

Multiples Enterprise Value Equity Value

Low High Low High Low High

$24,340 $29,533

Per share $30.37 $36.85

Comparable firms:

2000 revenue 1.01 2 25,273 50,046 17,019 41,792

Per share 21 52.15

2000 EBIT 8.33 12.26 23,982 35,297 15,728 27,042.54

Per share 20 33.74

2000 EBITDA 6.35 9.67 19,279 29,358 11,025 21,104.12

Per share 14 26.33

2000 net income 19.57 60.36 32,467 100,137 24,213 91,883

Per share 30 52.15

2000 EPS 17.32 28.37408 28,734 47,073

Per share 35.85 58.73

2000 book value 1.55 4.19 15,046 40,672

Per share 18.77 50.75

Median equity value 17,019 $40,672

Per share $21.24 $50.75

Enterprise value as a multiple

of:

Equity value as a multiple of:

Trading value prior to merger

announcement

Stand-Alone Valuation Summary Honeywell International


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$30.00 $32.86 $34.00 $35.30 $38.00 $40.00 $42.00 $44.00 $47.16 $50.00

Date Honeywell GE Bid price Spread

24-Oct-00 $48.05 $48.21 $50.86 $2.81 86.52% 84.39% 83.33% 81.93% 78.14% 74.11% 68.27% 59.02% 23.98% 100% >100%

19-Jan-01 $43.77 $42.59 $44.93 $1.16 92.22% 90.38% 89.37% 87.93% 83.23% 76.43% 60.36% 100% >100%

22-Jan-01 $42.57 $41.45 $43.73 $1.16 91.55% 89.34% 88.08% 86.25% 79.76% 68.91% 32.95% >100% >100% >100%

24-Jan-01 $42.86 $41.96 $44.27 $1.41 90.13% 87.66% 86.29% 84.30% 77.54% 67.01% 37.92% 100% >100%

25-Jan-01 $42.80 $41.63 $43.92 $1.12 91.96% 89.88% 88.71% 87.01% 81.09% 71.43% 41.67% >100% >100% >100%

26-Jan-01 $42.01 $40.44 $42.66 $0.65 94.83% 93.33% 92.45% 91.12% 85.97% 75.44% 1.51% >100% >100% >100%

29-Jan-01 $41.43 $40.21 $42.42 $0.99 92.02% 89.64% 88.23% 86.08% 77.57% 59.05% 100% >100% >100%

30-Jan-01 $42.85 $41.91 $44.22 $1.37 90.40% 87.98% 86.64% 84.69% 78.04% 67.61% 38.37% 100% >100%

31-Jan-01 $42.74 $41.66 $43.95 $1.21 91.32% 89.08% 87.83% 86.00% 79.65% 69.34% 37.92% >100% >100% >100%

1-Feb-01 $43.19 $41.89 $44.19 $1.00 92.93% 91.15% 90.15% 88.71% 83.79% 76.06% 54.24% 100% >100%

2-Feb-01 $43.15 $41.93 $44.24 $1.09 92.37% 90.46% 89.39% 87.85% 82.58% 74.36% 51.43% 100% >100%

5-Feb-01 $44.71 $43.36 $45.74 $1.03 93.43% 91.97% 91.19% 90.09% 86.64% 81.99% 72.37% 40.69% >100% >100%

6-Feb-01 $44.55 $43.13 $45.50 $0.95 93.86% 92.47% 91.72% 90.67% 87.31% 82.69% 72.81% 36.61% >100% >100%

7-Feb-01 $43.92 $42.54 $44.88 $0.96 93.55% 92.02% 91.18% 89.98% 86.05% 80.33% 66.67% 100% >100%

8-Feb-01 $44.13 $42.71 $45.06 $0.93 93.83% 92.39% 91.60% 90.48% 86.84% 81.64% 69.63% 12.28% >100% >100%

9-Feb-01 $42.70 $41.37 $43.65 $0.95 93.07% 91.24% 90.20% 88.67% 83.25% 74.07% 42.54% >100% >100% >100%

12-Feb-01 $44.38 $43.05 $45.42 $1.04 93.27% 91.74% 90.91% 89.75% 86.01% 80.85% 69.64% 26.80% >100% >100%

13-Feb-01 $44.05 $42.73 $45.08 $1.03 93.17% 91.57% 90.70% 89.47% 85.45% 79.72% 66.56% 4.63% >100% >100%

14-Feb-01 $43.12 $41.92 $44.23 $1.11 92.23% 90.28% 89.19% 87.62% 82.24% 73.84% 50.32% 100% >100%

15-Feb-01 $44.05 $43.48 $45.87 $1.82 88.52% 86.01% 84.66% 82.77% 76.86% 68.98% 52.95% 2.67% >100% >100%

16-Feb-01 $43.78 $42.59 $44.93 $1.15 92.28% 90.46% 89.46% 88.04% 83.38% 76.64% 60.70% 100% >100%

20-Feb-01 $44.68 $43.21 $45.59 $0.91 94.18% 92.88% 92.18% 91.19% 88.05% 83.77% 74.72% 42.86% >100% >100%

21-Feb-01 $44.20 $42.86 $45.22 $1.02 93.31% 91.77% 90.93% 89.74% 85.90% 80.50% 68.38% 16.43% >100% >100%

22-Feb-01 $43.77 $42.68 $45.03 $1.26 91.63% 89.67% 88.60% 87.08% 82.11% 74.99% 58.47% 100% >100%

23-Feb-01 $42.69 $41.84 $44.14 $1.45 89.74% 87.14% 85.69% 83.59% 76.37% 64.96% 32.22% 100% >100%

26-Feb-01 $44.21 $43.48 $45.87 $1.66 89.53% 87.24% 86.01% 84.29% 78.89% 71.70% 57.09% 11.22% >100% >100%

27-Feb-01 $43.73 $43.49 $45.88 $2.15 86.45% 83.48% 81.89% 79.67% 72.70% 63.41% 44.57% 100% >100%

28-Feb-01 $42.44 $42.13 $44.45 $2.01 86.11% 82.69% 80.79% 78.06% 68.87% 54.87% 17.98% 100% >100%

1-Mar-01 $41.82 $41.60 $43.89 $2.07 85.11% 81.26% 79.09% 75.92% 64.88% 46.81% 100% >100% >100%

Stand alone value Honeywell

Probability

Table 11: Stand alone value and Probability (extended)

Table 11: Stand alone value and Probability (extended)

General Electric's Proposed Acquisition of Honeywell

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