Rjb-a_Case_Study

RJR Nabisco: A Case Study of a Complex Leveraged Buyout Michel, Allen; Shaked, Israel Financial Analysts Journal; Sep/Oct 1991; 47, 5; ABI/INFORM Global pg. 15 by Allen Michel and Israel Shaked RJR Nabisco: A Case Study of a Complex Leveraged Buyout Several features of RJR Nabisco made it a particularly attractive LBO candidate. Its operations exhibited moderate and consistent growth, required little capital investment and carried low debt levels. Its problems—a declining return on assets and falling inventory turnover—appeared fixable. And it offered significant break-up value. Valuing RJR's equity at the time of the LBO requires detailed knowledge of the company's operations and extensive number crunching. The analysis is obviously quite dependent on the assumptions made about cash flow in the post-LBO period, as well as the long-term, steady-state growth rate. Nevertheless, the figures suggest that, even assuming a high, 5 per cent level of steady-state growth, RJR's cash flows would have to grow at a rate of at least 18 per cent per year to justify KKR's bid of $109 per share. RJR's board played a prominent role in the bidding process. By setting the bidding rules, the board successfully minimized the possibility of collusion and thus increased potential gains to stakeholders. The decision to accept KKR's offer over RJR management's higher bid appears to reflect the board's concern for employees and existing shareholders. B OTH THE POPULAR press and the academic press have devoted extensive coverage to leveraged buyouts, but neither has devoted much attention to analyzing the features of a specific LBO.1 The RJR Nabisco transaction warrants particular attention. Not only is it the largest LBO on record, but it also features a particularly wide range of sophisticated players, a complex set of innovative financial instruments, and a challenging valuation process. This article describes the RJR transaction. It gives a brief history of the company, examines the reasons why RJR was an attractive LBO target, provides a valuation of the company, analyzes the bidding dynamics, and describes the role of the board in determining the winning bid. Historical Perspective 1. Footnotes appear at end of article. In many respects, RJR was a pioneer. It anticipated the increasing popularity of tobacco consumption, and in 1913 made a risky marketing move, introducing four brands simultaneously. The strategy worked well. Among the new brands was Camel, a name brand that changed the company's history. In 1914, RJR sold 425 million Camel cigarettes; seven years later it sold 18 billion. The combination of creativity on the production side and a well developed advertising campaign yielded a solid 50 per cent market share. During the depression years, RJR was hurt by cheaper brands. But it was not ready to give up. It introduced the single-piece folding carton and made further improvements in packaging and wrapping. In 1935, the cigarette war ended with Camel regaining the number-one position it had lost in 1929. Though Camel retained its leadership for 15 years, the post-World War II era was very turbulent, primarily because of three factors. First, the advent of television introduced a new advertising medium. Second, filter-tip cigarettes created the first significant tobacco-market segmentation. Third, health concerns raised controversy over tobacco consumption. Responding to increased competitive pres- FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 □ 15 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. sures, RJR responded with four strategies. It differentiated its products. Simultaneously, it diversified into non-cigarette products. It also increased its focus on overseas markets, where cigarette growth was increasing at double-digit rates. At the same time, it addressed increasing health concerns at home. RJR as a Potential LBO RJR Nabisco was a particularly attractive LBO candidate. First, it exhibited steady growth unaffected by business cycles. High growth and inconsistent growth often present unacceptable risks when it comes to leveraged buyouts. High growth requires a significant investment of working capital, whereas inconsistent growth may threaten cash flow. Successful LBOs are generally characterized by both low business risk and moderate growth. RJR's unlevered beta, representing its business risk, was 0.69. In other words, the firm was relatively insensitive to market-wide fluctuations. Both its tobacco and food operations were non-cyclical and projected to have reasonably slow growth rates. Although the growth rate of the tobacco unit was a robust 9.8 per cent and the growth rate of food operations was 3.5 per cent in the period between RJR's purchase of Nabisco Brands in 1985 and the buyout announcement, most analysts had forecast a significantly slower long-term tobacco growth rate and a somewhat slower growth rate in food operations. RJR had low capital expenditures. Neither of its businesses required much capital investment. Indeed, as Table I shows, in each of the three years following the Nabisco Brands purchase, less than 7 per cent of the firm's revenues were committed to capital investment. Furthermore, the firm was able to avoid the high-technology investments necessary in many industries, which require a significant R&D commitment to remain competitive. The firm had a low debt level. In an LBO situation, new management often takes advantage of the debt capacity of the firm's assets, hence looks for low debt in the target firm. In the case of RJR, the pre-LBO ratio of long-term debt to assets was approximately 30 per cent. This offered significant opportunity for debt expansion following the LBO, especially when combined with RJR's low systematic risk. It is interesting to note that some studies have determined that LBO target firms often exhibit higher debt levels than their non-target counterparts.2 These high pre-LBO debt levels may FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 □ 16 Table II RJR Break-Up Value Food Operations U.S.: Nabisco cookies and crackers $5 bill. Canned vegetables 500 mill. Canned fruits 300 mill. Ready-to-eat and hot cereals 750-$l bill. Planter's peanuts 800-900 mill. Lifesavers 400-500 mill. Candy bars 300 mill. Bubble gum 200 mill. Margarine 200-300 mill. Fresh Fruit 700 mill. Ortega Mexican food 150 mill. A-l Steak Sauce 100-150 mill. Milkbone dog biscuits 200 mill. International Miscellaneous foods $2.5-3 bill. Total Food 12.1-13.1 bill. Tobacco 12.5-13 bill. Total Estimated Break-up Value 24.6-26.1 bill. Value per Share: Break-Up Value 24.6-26.1 bill. -Long-Term Debt 4.6 bill. Equity Value 20.-21.5 bill. -h Number of Shares 234 mill. Break-Up Value Per Share $85-92/share Source: R. Alsop, A. M. Freedman and B. Morris, "RJR Takeover Could Hurt Marketers and Consumers," Wall Street Journal, December 2, 1988. have appealed to buyers to the extent they suggested more stable operating cash flows. RJR's problems appeared fixable. The firm's return on assets had declined steadily from 15.5 per cent in 1985 to 11.5 per cent in 1988. Over the same period, its inventory turnover had fallen from 10.0 to 3.9. To the extent new management viewed these problems as "fix-able," there was potential for value creation. RJR offered significant break-up value. In virtually all LBOs, the value of the deal is calculated based upon both a cash-flow value of the firm and a break-up option, which assumes that the firm is to be broken into units and sold off piecemeal. Table II gives RJR's break-up value, as estimated by Smith Barney and reported in the Wall Street Journal' The break-up value of $85 to $92 per share was significantly higher than RJR's market price of $56 prior to the initial offer of RJR's CEO, Ross Johnson. Discounted-Cash-Flow Valuation The discounted-cash-flow methodology determines value by taking a projected stream of cash flows and discounting them at an appropriate discount rate. Though it sounds simple and straightforward, the process, if done correctly, requires an in-depth understanding of the principles and tedious number crunching.4 The valuation of RJR consists of three steps: 1. develop a set of base-case cash-flow scenarios, 2. derive the appropriate discount rate, 3. discount the cash flows from Step 1 at the cost of capital derived in Step 2; account for the value of existing debt to obtain the value of RJR's equity. Below we discuss RJR's cash flows and determination of the appropriate discount rate. We then value RJR's equity. Cash Flows Table III presents the projected sales, operating profits and cash flows assumed by Kohlberg Kravis Roberts (KKR) in the supplement to their December 6, 1988 tender offer. For the operating margins of the tobacco business, KKR assumed an increase from the 1988 pre-LBO level of 27 per cent to 35 per cent in 1998. Though one might argue that this is an unrealistically optimistic projection, the tobacco industry had attained such operating margins in the past. In 1987, for example, Philip Morris reported a 35 per cent margin, the RJR tobacco unit a 27 per cent margin, American Brands an 11 per cent margin and Universal a 7 per cent margin. In addition to its somewhat optimistic margin assumption, KKR assumed that tobacco sales and operating income would grow by 8.3 per cent and by more than 10 per cent per year, respectively. Though the U.S. tobacco market is declining annually by approximately 3 per cent, U.S. exports of cigarettes rose by 56 per cent in 1987 and by 25 per cent in 1988. In addition, like any other acquiring group, KKR expected to improve performance. As it indicated in the supplement to its tender offer, "Tobacco operating income for 1990 and years thereafter grows at rates greater than net sales due to expected production and other operating efficiencies and reduction in product development costs." KKR's projections for the food business were not out of line with industry expectations. The projected sales growth of 6 per cent, for example, although higher than RJR's historical sales growth, was comparable to that of General Mills. RJR's total cash flows represent the "free cash flows" available to meet both debt and equity FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 □ 17 obligations. These cash flows will be discounted in the valuation process, so, to avoid double-counting of the interest cost, interest expense is not deducted from operating income. Once operating income is derived, two further adjustments are made. The first is a working capital adjustment. It inventory is projected to increase over time, for example, RJR will have fewer funds available to meet debt and distribute to equity holders. In other words, increases in working capital items decrease free cash flow; similarly, decreases in working capital items increase cash flow. The second adjustment deals with capital expenditures. As capital expenditures increase, fewer funds are available for distribution to equity and debt holders. For the short period following the buyout, KKR's projections were reasonably compatible with those of RJR's management in previous years. For example, in RJR's 1987 annual report, management projected capital expenditures of $5 billion for the following three years, or approximately $1.7 billion per year. As indicated in Table III, KKR's projection for the first post-buyout year is approximately $1.7 billion; it subsequently declines over four years to $700 million. The Appropriate Discount Rate Deriving an appropriate discount rate requires three steps. First, the amount of each debt instrument must be determined and the weighted average after-tax cost of debt calculated. Second, the rate of return required by shareholders must be adjusted to reflect the increase in the firm's leverage following the LBO. Third, given the proportions of debt and equity and their costs, a weighted average cost of capital must be derived. Cost of Debt: In a typical corporate finance textbook, the derivation of the cost of debt is a simple exercise. In virtually all mergers and LBOs, however, the features, cost of funds and even amounts are structured in a relatively complex manner. The amounts are frequently provided as ranges, rather than exact values. The features include both cash and PIK (paid-in-kind) securities. Interest rates are floating, based upon various base rates. Moreover, an interest rate base is sometimes selected by the borrower and sometimes by the lender. Also, many of the initial sources are assumed to be refinanced at some unspecified time at a rate unknown at the time of the transaction. These complexities are illustrated in Table IV, which provides the sources of financing used in the RJR buyout. Note that the funds borrowed under the Tender Offer Facility are to be used to purchase the shares tendered to RJR. This amount is to be refinanced upon the completion of the transaction by the Asset Sales Bridge Facility, Refinancing Bridge Facility and Revolving Credit and Term Loan Facility. Because of their complexity, many of the rates are not structured in a manner easily analyzed in the context of an LBO. Consider, for example, FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 □ 18 Type Amount Rate Characteristics Tender Offer Facility (T.O.F.; Asset Sale Bridge Facility Refinancing Bridge Facility Revolving Credit and Term Loan Facility Bridge Financing Increasing-Rate Notes Partnership Debt Securities Senior Convertible Debentures Cumulative Exchangeable Preferred Stock Equity $13.6 billion $6 billion SI.5 billion $5.25 billion $5.0 billion S5.0 billion $0.5 billion $1.8 billion $4,059 billion $1.5 billion Base Rate +2%" or Eurodollar Rate +3% Base Rate +l'/2%a or Eurodollar Rate +2Vz% Base Rate +2Vj%b or Eurodollar Rate +3