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Case

Analysis
Report

Philip Morris and Kraft,
nc.

Case Analysis Report

Acquisition oI KraIt, Inc. by Philip Morris
Overview
The Iood industry has been undergoing a major restructuring and revaluation. This comes oII
strong growth Irom the Iood industry in recent years and continues to oIIer diverse and rewarding
opportunities Ior all stakeholders. Firms looking to make large proIits have Ilooded into the Iood
industry through methods including mergers and acquisitions. They contribute to the current
tumultuous restructuring process oI the Iood industry. Notable acquisition attempts that have
occurred recently include Phillip Morris` bid Ior KraIt, Grand Metropolitan`s bid Ior Pillsbury, and
RJR Nabisco`s leveraged buyout attempt its own internal management which Iormed a combined
amount oI $34 billion an amount unprecedented in the history oI the industry.
Following a shiIt in KraIt`s industry strategy in 1986, it has now become one oI the largest
producers and distributors oI Iood products in the U.S. Its success largely comes Irom its shiIt
towards the all-Iood strategy and the reputation oI its brand. In 1987, KraIt`s net sales were $9.9
billion which was an increase oI 27 Irom the previous year, while net income also increased by
11 to $435 million. This Iollows an earlier attempt to diversiIy where in 1980 KraIt merged with
Dart Industries and then acquiring Hobart Corporation in 1981. However, by the end oI 1986 KraIt
had returned to a Iood-Iocused strategy.
Philip Morris is a company that has had huge success in the tobacco industry. Most oI Philip
Morris` income comes Irom its Marlboro, Benson & Hedges, and Virginia Slim cigarette brands.
Though tobacco sales have increased by 15 percent in 1987, Philip Morris has been aiming to
diversiIy away Irom tobacco products, as evident through their acquisition oI Miller Brewing
Company in 1969, as well as their acquisition oI Seven-Up and General Foods in 1978 and 1985
respectively. These acquisitions have achieved mixed results in terms oI proIitability and sales
growth. Philip Morris has since sold its Seven-Up operations, and with General Foods struggling
Irom a declining proIit Irom 1986 to 1987 oI $19 million and weakened management, Philip Morris
have been undergoing heavy research to not only diversiIy away Irom the tobacco industry, but to
revive subsidiaries within its business.

Why is Kraft a takeover target for Philip Morris
The Iood industry has been experiencing strong growth and as a result has seen a huge inIlux
oI investors into the market. KraIt who is at the IoreIront oI the Iood industry has beneIited Irom the
success oI the Iood industry and is clearly evident in their 1986-1987 net sales increase by 27 and a
net income increase by 11. Further, with research suggesting that the Iood industry still has
potential Ior Iuture growth, Irom reasons such as an increasing population, KraIt`s position as a
potential takeover target Ior Philip Morris appears certain.
In addition, with the history and reputation oI KraIt and its products, the acquisition oI KraIt
could see Philip Morris adopt a large market inIluence, not only in tobacco and alcohol sales, but also
in Iood products. In Iact, the merger oI KraIt and Philip Morris would see them become the largest
producers oI Iood products in the world. Also, KraIt has competent and highly successIul
management, with their CEO having shaped their Iirm to KraIt`s current success, will be a valuable
asset in reviving Philip Morris` Iood subsidiary, General Foods.
Lastly, with KraIt generating a Return on Equity (ROE) greater than that oI its closest rival,
Pillsbury, Iurther reinIorces its attractiveness as a takeover target Ior Philip Morris |reIer to Appendix
B-1|
Case Analysis Report

What is Kraft worth?
We need to value KraIt at the end oI 1987 to determine whether the market has Iairly priced
the share prices oI KraIt. The market values oI KraIt as at 1987 closed at $48.25. In valuing the share
price oI KraIt there are several methods that can be used. These methods include the Corporate
Valuation Model (CVM), the Adjusted Present Value Model (APV) and the Equity Residual Model.
In our analysis we used both the CVM and APV model to Iind a valuation oI KraIt`s shares at
the end oI 1987. In applying the CVM analysis, we valued KraIt`s share price at 1987 at $54.19,
while the APV method produced a value oI $52.79. Although these two methods provide diIIerent
share price results, both still seem to be signiIicantly higher than the market share price. Although
our valuations may be based on some debatable assumptions, considerable though, research and
analysis have been carried out by management and analysts. |Please reIer to Appendix 1-A on the
assumptions and calculations used to derive these share price values|
Clearly, one could argue that the market share price oI KraIt is undervalued. |A comparative
illustration oI the share prices as per our own independent valuations and the market valuations can
be seen in Appendix B-2|

Should Philip Morris purchase Kraft?
Philip Morris should indeed purchase KRAFT. Many economic beneIits and inIlow will arise
due to this purchase. Quoting Hamish Maxwell the CEO oI Phillip Morris that, 'the acquisition oI
KraIt will result in creating the leading international Iood company. Main driving Iorces are the
beneIits oI synergy and revenue diversiIication.
Synergy is when the value derived Irom the combination oI company A and B which in this
case is KraIt and Philip Morris, is greater than their values in their respective individual states. An
example oI synergy is operating economies. Essentially, the merger oI KraIt will result in economies
oI scale with Iacilities being used with a higher degree oI utilization and becoming cost eIIicient and
thus reducing COGS. This would be a result oI the spreading oI manuIacturing overhead cost with
the advantages oI common learning curves and will all save any expenses related to building new
Iactories. It will also give greater pricing power as the merger will create the largest Iood company
creating greater market share.
KraIt itselI has a great marketing team as it has done very well with known brands such as
Miracle Whip and Seven Seas. In conjunction with Phillip Morris` resources, they can use the well
established KraIt brand to be combined with General Foods to allow the goodwill and positive image
oI KraIt to be attached to General Foods` products, and to Iurther enhance market presence.
DiIIerential eIIiciencies where the more eIIective and experienced management oI KraIt will
bring the underperIorming General Foods operations to greater eIIiciency. Philip Morris wants KraIt
to take over management oI general Ioods, who has been missing a chieI oIIicer since 1988.

Proposed Purchase of Kraft
The oIIer oI $90 per share is to be Iinanced through $1.5 billion in excess cash and up to $12
billion in available bank credit lines. The 50 premium is justiIied by the potential synergies (as
discussed above) and diversiIication that an acquisition oI KraIt by Philip Morris would bring.

Kraft`s counterproposal and evaluation
The restructuring plan would involve shareholders receiving a cash dividend oI $84, high-
yield debt valued at $14 and the stock (post-restructure) would be worth $12 per share.
Our valuation and take on KraIt`s Counterproposal:
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APV Method is used since it is very diIIicult to estimate using CVM model when the capital
structure is changing throughout the Iorecast period.
APV Method: To Iorecast the FCFs we used the Sales Iorecast Ior 1989-1998 given in
Exhibit 12 and Iorecasted another balance sheet Ior the restructure plan. We then Iorecasted
the income statement and calculated FCFs based on these Iigures. |For assumptions made in
the valuation oI KraIt`s share price please reIer to Appendix A-1|
The cost oI capital used is the Unlevered Cost oI Equity, Iound by using the Iormula: w
d
r
d

w
e
r
e(L)

Interest Payments are Iorecasted in Exhibit 12 oI Case Study.
Using the APV method we calculate a share price oI $21.10 Ior KraIt`s restructure plan.

Philip Morris` Options
In light oI the present circumstances, Philip Morris has the Iollowing options:
Increasing their bid - is a very Ieasible course oI action. However, a bid above the
maximum reservation price may destroy value. The Iurther the oIIer Irom the maximum
reservation price, the greater the synergistic beneIits Irom the acquisition.
Negotiation with Kraft - is unlikely as KraIt has stated that they are unwilling to negotiate
unless the bid is increased. A golden parachute may be negotiated to appease the
management but this is undesirable as KraIt`s experienced management is a main motivation
Ior the acquisition.
Changing Acquisition Target - is a desirable option but it is diIIicult to Iind a substitute Ior
KraIt as a target because oI a number oI reasons.
i
It is unlikely that Philip Morris would Iind
a suitable alternative target.
Abandonment of Acquisition - is an undesirable option as it contradicts Philip Morris` plans
Ior diversiIication out oI the tobacco business and into the Iood industry. Also, General
Foods expects to beneIit Irom synergies e.g. KraIt`s experienced management.

Kraft`s Options
To prevent Philip Morris succeeding in a hostile takeover, KraIt employ deIence tactics such as:
Changing the bylaws - so that it would require at least 75 oI the board to agree beIore a
merger proposal is approved, i.e. super majority instead oI simple majority.
#,83 ,3997:89 88:08 - that would result in the Justice Department's intervention, hence
preventing the hostile takeover Irom taking place. This course oI action is unlikely to deIend
KraIt as the merged entity control a monopoly in the packaged Ioods industry.
Devising and implementing strategies - that could add value to the Iirm. KraIt`s proposed
restructure plan is an example oI such a strategy.
Seeking out a white knight - to bid against Philip Morris. A white knight is another
corporation sought out by the targeted Iirm to take over the targeted Iirm at a price both
parties agree upon (Iriendly takeover) hence preventing hostile takeovers.
Poison pills - are tactics Iirms use to deIend against hostile takeovers, but oIten leave the
Iirm with a huge amount oI debt. Examples include borrowing debt that requires immediate
repayment iI the company is acquired. They are undesirable as they add no value to
shareholders

Recommended Course of Action
We recommend Philip Morris tentatively make an increased bid that is substantially below
the maximum reservation price. Philip Morris has signiIicant bargaining power as the proposed
Case Analysis Report
restructure is unlikely due to Iears over increased deIault risk, and the limited number oI competing
buyers.

Appendix A - Additional Information

1. Assumptions used for Valuation of Kraft`s Share Price
The growth rate Ior sales is measured arbitrarily. Since the geometric average sales growth
Ior the last 6 years does not clearly represent the recent sales growth oI KraIt (last year
growth rate oI 26), we assume that growth will still be high, and thus we use a growth
rate oI 16, and decline it over 6 years, until we assume that growth rate settles at 3.5
Ior 4 years, until it steadies Ior a terminal growth rate oI 3 Irom aIter the 10
th
year.
Estimated terminal growth rate oI 3 based on US economy long run average.
4 We assume KraIt will approach this value near the end oI our Iorecast period.
Income Statement: For most income statement items, we maintained the ratios comparing
the current year and the previous year, and pegged that ratio to sales revenue. Depreciation
was not calculated as a percentage oI revenue. Rather depreciation expense was assumed to
grow proportional to Capital Expenditure (i.e. Capex/Depreciation 1.20x)
Calculate NOPAT: Assumed tax rate oI 40 Ior EBIT(1-T)
Balance Sheet: We used oI revenue Iorecasting to Iorecast all balance sheet items
FCFF Calculation: In calculating Capital Expenditure (Capex) we Iound the change in net
PPE values Irom the current year to the prior year, and so Iorth. In calculating Net Working
Capital we included Cash, Accounts receivable and Inventories in Current Operating
Assets, whilst in calculating Current Operating Liabilities, we included Accounts payable
and Accruals.

Corporate Valuation Method (CVM):
WACC calculation: CAPM assumed risk Iree rate oI 8.345 based on geometric mean oI
monthly yields oI 10 year US t-bonds in 1987. Assumed expected market return oI
14.948 (geometric mean) based on annual returns oI the S&P 500 Irom 1977 to 1977,
while the Market Risk premium was 6.603 and is simply the expected return on the
market minus the risk-Iree rate. Beta oI 0.74 and Cost oI debt oI 8.65 were given.
Calculate WACC using the Iormula: w
d
r
d
(1-T)w
s
r
s


Adjusted Present Value Method (APV)
Value oI debt (both short term and long term) used in APV analysis Iound using Additional
Funds needed analysis
Debt interests Ior the period Iound by multiplying the cost oI debt (8.65) to the value oI
debt in the previous period.
The value oI unlevered cost oI equity Iound using Iormula: w
d
r
d
w
e
r
e(L)

We assumed that the terminal growth rates Ior FCFF and Tax Shields are 3
Calculating the enterprise value oI the Iirm by adding the PV oI FCFF and Tax shields,
assuming to be growing at a terminal growth rate oI 3 aIter 10 years

Firstly, KraIt has a steadily increasing proIit Iorecast. Secondly, KraIt is extremely
complementary to General Foods in that it has a wide range oI existing product lines, strong
sales on the international Iood market, leading management qualities and strong brand image.
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Finally, KraIt is easily transIerable because it has no convertible bonds or preIerence shares
holdings.


Appendix B - Tables and Graphs

1) A Comparison of the Return on Equity (ROE) of different firms and the Market Index




2) A Comparative Analysis of Kraft`s Stock Price valuations at the end of 1987

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