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Course: Mergers and Acquisitions

Case Study: Philip Morris Companies and Kraft, Inc.


Course Instructor: Dr. Poonam Mehra

2027 | Sandeep K Biswal National Institute of Securities Markets

Sandeep K Biswal 2012

Case Study: Philip Morris Companies and Kraft, Inc.


Q1. How did the stock market asses Philip Morris $90 per share bid for Kraft?

In June 1998, Kraft sold its last nonfood asset, Duracell, for $1.8 billion and became an all food business. All three of Kraft's divisions; US consumer foods, US commercial foods, and International foods were doing well with popular brand names. o o o o o o o o In 1987 the US consumer foods had sales of $4.5 billion and an operating profit of $593 million. The US commercial food unit has sales of $3 billion and an operating profit of $86.4 million. International Food had sales of $2.3 billion and an operating profit of $229.8 million. Kraft's projected sales growth for the next several years is in the range of 12% to 15%. Net sales from continuing operations were $99 billion in 1987. This was an increase of 27% from1986. Net income from continuing operations rose 11% in 1987. Kraft had distributed $240 million in cash for dividends to its shareholders in 1987. Kraft used the money received from the sale of Duracell to repurchase shares of company stock and to repay off debt obligations.

With all the available information and as can be seen from the graph above, on Oct. 18, the day Philip Morris made a $90 per share bid for Kraft, Krafts share prices rose by $28, around 47%. During the day Philip Morris share prices dropped by 4.5%. The week following this, Krafts equity was trading in the range of $90 to $102 per share. All this shows that the market felt Kraft to be undervalued.

Course: Mergers and Acquisitions | PGPSM, National Institute of Securities Markets

Case Study: Philip Morris Companies and Kraft, Inc.


Q2. Can Philip Morris finance the Kraft acquisition? From Exhibit 5 (in the case): Consolidated Balance Sheet for Philip Morris, 1986 -87

Items Cash ($ Mil) Current Assets ($ Mil) Current Liabilities ($ Mil) Excess Cash ($ Mil)*

1986 73 5914 4482 1578

1987 189 6572 5176 1774

*Excess Cash = Cash - (Current Liabilities - Current Assets - Cash)


At $90 per share the total value of the bid to acquire Kraft stands at $11 billion. In its proposition Philip Morris Companies state that it has an available bank credit line of about $12 billion. Also as we can see from the above table, for the last two consecutive years Philip Morris has been generating more than $1.5 billion in excess cash. This means they will be able to pay off the $ 9.5 billion in debt they need to borrow to acquire Kraft, in roughly 6 years. So yes, Philip Morris can finance the Kraft acquisition. Q3. What is the value to shareholders of the restructuring proposed by Kraft? On 24th Oct. 1988, Kraft proposed a restructuring plan to its shareholders, as an alternative to the Philip Morris tender offer. Projections made under the plan estimated a growth of its sales and EBIT as follows.

Course: Mergers and Acquisitions | PGPSM, National Institute of Securities Markets

Case Study: Philip Morris Companies and Kraft, Inc.

The $13.2 billion restructuring plan proposed by Kraft in intended to result in a total value estimated to be in excess of $110 per share. Out of the $110 per share, shareholders would be paid $84 in cash dividend, $14 in high yield debentures. Shareholders would also retain their common stock interest, which will of course be adjusted by the market ($12 per share), to reflect the cash and securities distribution. For shareholders, the Kraft deal would also have tax advantages over the Philip Morris offer. Any gain on Philip Morris's all-cash deal would be taxable, but there would be no tax on the Kraft equity or on a portion of the dividend. But the restructuring plan would leave Kraft with a debt of $12.4 billion. At the $12 price it estimates for the common stock after market adjustments, the value of total shareholders equity in the company would be worth less than $1.5 billion. This makes Kraft a highly leveraged company with 90% debt and 10% equity. Such a capital structures leaves very little margin for error if things do not go as planned. On the other hand, the advantage of a highly leveraged company is that, if things go a little better than it hoped, profits to the small shareholder base would be enormous.

The stock market responded positively to the restructuring announcement. The price of Kraft common stock rose 11% to $102 per share as can be seen from the above graph. Course: Mergers and Acquisitions | PGPSM, National Institute of Securities Markets

Case Study: Philip Morris Companies and Kraft, Inc.


Q4. As Mr. Hamish Maxwell, Chairman and CEO of Philip Morris, what should you do next?

Philip Morris had been generating most of its sales and profits from its tobacco business segment. Unfortunately, since the peak in 1981, tobacco consumption had been on the decline for the seventh year in a row. Philip Morris's immediate reaction to combat the loss of revenues was to increase cigarette sales abroad. Exports were projected to increase by 15% in 1988. But Phillip Morris had something else up there sleeve. The time had come for the company to consider a more diversified portfolio. Diversification into other lines of business can especially make sense when the core product market is uncertain. Anticipating that the cigarette industry would continue to decline in the future, Philip Morris decided to diversify its product offerings and looked for acquisitions of unrelated products to decrease dependence on the future of tobacco. In 1970, it acquired Miller Brewing for $ 227 million. Miller was the eighth largest U.S. breweries with a 4.4% market share. In 1978, it acquired Seven-Up for $520 million. Its largest food acquisition by far was General Foods in 1985 for $5.6 billion. In line with the food product diversification strategy, Philip Morris approached Kraft in an attempt to create the leading international food company with estimated sales in excess of $20 billion. On Oct. 18, 1988, Philip Morris offered to purchase all Kraft common stock at $90 per share in cash. The offer represented a 50% premium over the $60.125 previous closing price. The total value of the bid stood at $11 billion. On Oct. 23, 1988, Krafts board of directors rejected the bid. In its address to the shareholders, it stated, We strongly believe the $90 bid by Philip Morris undervalues Kraft for two important reasons. First, our investment banker Goldman Sachs & Co. has advised us that the bid is inadequate; and the second, our stock has been trading above the $90 offer, a clear signal that investors see the bid as low. On Oct. 24, 1988, Kraft proposed a restructuring plan as an alternative to the Philip Morris offer. Kraft valued the post-restructuring stock at $110 per share. In a statement issued by Kraft, it stated that, If Philip Morris or another company truly wishes to negotiate with Kraft, a simple phone call proposing a price of more than $110 is all that is necessary. The question to analyze here is whether the $110 per share value estimated by Kraft is justified? In order to address this issue, we estimated the value of potential synergies using the Free Cash Flow (FCF) model. The major sources of potential synergies in this are cost savings and growth. But we are discounting any potential cost synergies. This is because a statement by Philip Morris states that, Kraft would remain wholly intact as its own business unit. Growth, on the other hand is a potentially valuable synergy. Pre-bid future estimates of Kraft, shows it has a bright future - particularly in the immediate future. Given the fact that Phillip Morris owns General Foods, by acquiring Kraft, it in effect would be buying growth.

Course: Mergers and Acquisitions | PGPSM, National Institute of Securities Markets

Case Study: Philip Morris Companies and Kraft, Inc.

In the valuation process one assumption has been made that both firms are paying corporate tax of 34% annually, which was the prevailing rate during 1988.

Current Financial Information Revenues in current year = Operating Expenses as % of Revenues = Tax Rate on income = Interest Expenses = Current Depreciation = Current Capital Spending = Working Capital as % of Revenue = Projections of growth in earnings Expected growth rate - next 5 years = Expected growth rate - after 5 years = Risk measures Beta of the stock = General Information Riskfree rate (10 yr US TB) = Risk premium over riskfree rate = 8.35% 5.50% 1.15 1.50 10.00% 5.00% 12.00% 6.00% $27,695.00 $0.30 $0.34 $685.00 $704.00 $715.00 4.50% $9,876.00 23.00% 34.00% $91.00 $103.00 $233.00 1.00%

With the above information we have estimated the post-merger growth rates with and without synergy for the company (Bidder + Target).

Post-Merger growth rates with and without synergy The growth rate in earnings in the next five years without synergy is The growth rate in earnings in the next five years with synergy is expected to be The growth rate after year 5 without synergy is The growth rate after year 5 with synergy is expected to be
Finally with expected growth figures, we have estimated the value of the synergy as follows.

10.57% 13.00% 5.30% 7.50%

Maximum bid value for Kraft Gains from synergy = Most that bidder firm can bid for target = % Premium over the market price = $73,820.93 $134,606.81 121.44%

Course: Mergers and Acquisitions | PGPSM, National Institute of Securities Markets

Case Study: Philip Morris Companies and Kraft, Inc.

From the above as it can be seen, Philip Morris can pay a maximum premium of roughly 120% of the market price. This will translate to about $132 per share, which indicates that Krafts demand for $110 per share is reasonable. And this is with the assumption that there will be no change in the cost synergies. While Phillip Morris states that Kraft would be left to continue business as usual, it is highly unlikely that this would occur. In fact, it would not be advisable to acquire Kraft without mandating some efficiency between General Foods and Kraft. With all the above information it would be reasonable to say that Mr. Hamish Maxwell should renegotiate with Kraft. Q5. As Mr. John Richman, Chairman and CEO of Kraft, what should you do next? Its funny as we can see from our valuation estimates that Kraft itself has undervalued its price. Nevertheless, its rejection of Philip Morris offer of $90 per share and the simultaneous plan of restructuring, suggests the long term value strategy. As Mr. Richman once points out, their long term strategy has been working, but frustratingly the stock market has been undervaluing companies like Kraft, who sacrifice short-term profit in order to invest in long term growth. Now, Kraft has a restructuring plan which is highly leveraged. This may put off potential acquirers from targeting Kraft. But at the same time, it will require enormous efforts from the employees of Kraft to make the plan work as per their expectations. Debt service becomes utmost important for Kraft with the new capital structure. Along with all this Mr. Richman cannot ignore the major restructuring and reevaluation happening in the food industry. These things would put serious challenge in the future, in term of size, even for Kraft which has several known brands in the market. Hence, any bid in excess of $132 per share should be accepted by Kraft, with an objective to improve the wealth of shareholders.

Course: Mergers and Acquisitions | PGPSM, National Institute of Securities Markets

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