The document analyzes the stock market reaction and strategic options for Kraft Foods and Philip Morris following Philip Morris' bid to acquire Kraft. It shows that Kraft's share price doubled on the acquisition announcement but fell when a management buyout of Nabisco was announced, raising doubts. The price rebounded when Kraft announced a restructuring plan and KKR bid on Nabisco. The document models the financial viability of the acquisition for Philip Morris and valuations of Kraft under different ownership scenarios and assumptions. It considers negotiation tactics and strategies for both companies to increase or maintain the deal price.
2. The Stock Market Reaction
50.00
65.00
80.00
95.00
110.00
03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct
Share Prices
Kraft Philip Morris
90.00
110.00
130.00
150.00
170.00
03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct
Relative Share Prices
Kraft Price Philip Morris Price S&P price
Important
dates
18 Oct.
PM bid. Kraft’s price
doubles, excess return of
51% following the offer at
90$
20 Oct.
Nabisco MBO
announced. Kraft’s price
falls by 5%, market starts
doubting the merger
24. Oct
The share price rebounds
thanks to Kraft
announcing the
restructuring plan and
KKR bidding on Nabisco
3. Share Price
0.00 20.00 40.00 60.00 80.00 100.00 120.00
Market price before offer
PM offer price
Market Price after PM offer
Value after restructuring
Market Value after restructuring announced
Share price High Yield Dividend
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct
Excess return Kraft Excess Return PM
Effective Excess return on
announcement day 51%
Nabisco MBO
announcement
Kraft restructuring
announcement
Company
by company
S&P500
No major moves in the index,
that averages return of 0.5%
across the period
Kraft
After the price jump on
announcement date, Kraft’s
returns mirror the SP, but on
the day the Nabisco MBO is
announced and when the
restructuring is made public
Philip Morris
The price moves along with
the SP500,with two
exceptions: -5% on
announcement day and +3%
on Nabisco MBO
announcement
4. Can Philip Morris afford it?
Net Income
Assumptions
Revenue growth 5%
EBIT margins 14% adjusted to account for previous acquisitions
Debt
Repayment
Assumptions
The interest will be paid on the average amount of outstanding debt
Historical cost of debt at 9.5%
Acquisition price of $11b will be financed by 1.5b excess cash and 9.5b debt
FCF
Assumptions
We assume all FCFE will be used to repay the principal
Historical ratios of Capex, Depreciation and NWC to sales
Historical Tax rate at 44%
5. Acquisition financing
-
500
1,000
1,500
2,000
2,500
3,000
3,500
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Interest FCFF
Philip Morris alone appears to be generating enough cash to service the interest
on the loan and to pay down the principal. Even if the EBIT margins were to fall to
10% and the loan to increase to $10b, the company would still be able to face its
debt obligations.
If we were to add Kraft’s own cash flow projections, the situation would improve
even further, since Kraft has virtually no debt at the moment ($900 million) and is
generating around 1b in cash every year.
We therefore conclude that Philip Morris does have enough financial means to
acquire Kraft.
6. Assumptions
Projections
Revenue
Trust Management
projections
Margin
Do not trust Management
projections
Interest Payment
Do not trust Management
projections
0%
5%
10%
15%
20%
25%
Average
Historical
Average
Management
EBIT Margin
0%
1%
2%
3%
4%
5%
6%
Average
Historical
Average
Management
Revenue Growth
-4%
-3%
-2%
-1%
0%
1%
2%
3%
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
Difference Mngmt and own
projections
7. Our Assumptions
Debt
Interest
14%
EBIT margin
5%
Revenue
Growth
Since the FCFE, which is entirely used to pay down the debt principal, is calculated on
inflated EBIT margins, we develop a model that can calculate FCFE and feed it back
into the debt schedule, so that is it easy to estimate debt interest and principal
payments with different assumptions.
The growth rate in the first year of management projections is 6%, however it
converges down to 5%. Albeit higher than historical growth rates, we believe this to be
a reasonable assumption.
The EBIT margin increases considerably from the historical average of 9% to 20%. This
cannot be justified even accounting for the retention of higher margin activities. We
believe a more accurate margin would be 14%, calculated as: 9% * (1-19%) / (1- 45%),
where (1-45%) is revenue retention and (1-19%) is profit retention
In the following analysis we will present the results that follow from our own assumptions, and we consider
the management projections as the best case scenario.
8. Debt Schedule
To calculate the amount of interest due every year, we computed the debt levels. To do so, we assume
that:
• The high yield debt is worth 14$ per share.
• The regular debt will have an average cost of 13.63%
• The interest on the Bank debt will calculated on the average outstanding debt
• The Cash flows to equity will be entirely devoted to principal payments, according to management
schedule for the preexisting debt and using the remaining CF for the bank debt
• The chart shows the debt levels according to management projections. When we implement our
model the repayment schedule varies significantly.
-
2,000
4,000
6,000
8,000
10,000
12,000
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Existing Debt Bank Debt Debt High Yield
9. Discount rates
• βasset = 0.65
• Market premium = 8%
• Rf = 9%
R0
• We start assuming a value of 12$ per share, and we assume
that equity is going to grow at g = Re
• We calculate the β equity re-levering β assets for every
year
• We use Rf and Market premium to calculate Re for every
year
Re
• We assume that the cost of debt stays constant throughout
the period. We use the previously calculated Re and Rd to
compute the WACC
WACC
14.2%
58.2%
18.1%
12.9
13.6%
11. Comparables Valuation
Column1 Premium P/E EV/Book P/S
Min 9.90 13.10 2.50 0.61
Max 39.50 23.00 4.10 0.92
Mean 29.03 16.93 3.12 0.74
Median 33.35 16.20 2.95 0.72
Lower range 33 13 2.5 0.75
Upper Range 38 15 2.7 0.95
Lower Value 80 126 113 71
Upper Value 83 145 122 90
We compute
Min, Max,
Median and
Average
values for all
comparable
transactions
We
subjectively
select a range,
basing our
selection on
the previously
calculated
values and the
overall value
of the deal
We calculate
the enterprise
value using the
multiples.
12. Valuations Summary
50 60 70 80 90 100 110 120 130 140 150
FCFE
WACC
APV
CFF
P/S
P/E
EV/Book
Multiples Valuations
DCF Valuations
We obtain valuations
ranges that are
consistent with Kraft’s
projections, but only
when the more
optimistic
assumptions are
used.
If we use our own
assumptions, the
valuation looks very
fragile, with Net
Income being
negative for the
better part of the
following decade,
due to the burden of
interest rates
expenditure.
In comparable
transactions, we
disregard the P/S
multiples, since it is
often inaccurate.
13. Possible issues
We are assuming from the start that the High Yield debt is work 14$ per share
Similarly, we are assuming that the equity is worth 12$ per share
Having chosen different assumptions, the Capex, NWC and Depreciation
calculations are based on our own analysis and might not be accurate
The choice of which debt to pay down first may heavily affect the valuation
We are considering the debt to be risk free, although with a D/EV close to 90%,
this is probably not the case
We did not compute a B for the debt
The Comparables ranges are subjectively selected
14. Kraft’s Choices
Possible Course of
action
Accept Philip
Morris Offer 90$
Undervalues the
company
Lower than
current Stock
price
Proceed with the
Restructuring Plan
High risk
implementation
Management
Incentive
Wait for Philip
Morris to increase
their offer price
Use restructuring
to force PM to
pay more
Encourage
appearance of
another bidder
15. Negotiations
Philip Morris
• Calm and ready to negotiate, willing to meet on short
notice
• Simultaneously pressuring Kraft to obtain information
through non conventional measures
• Involve Kraft in litigation to distract management and to
prevent the restructuring
Kraft
• Aggressive
• Hired Goldman Sachs
• Setting the pace (“We will take our time”)
• Clear, Strong, Committed Shareholders
communication
• Stressing 90$ (PM offer) versus 110$ (restructuring
value)
• Keep the door open for further negations, while
clearly stating 90$ is not enough
$
$
16. Moving Forward
• Continue with aggressive communication
• Find an alternative bidder (White Knight)
• Stress the importance of being independent
• Release private information (Business strategy,
growth forecasts,…)
Kraft
How to increase the
Price
• Expose fragility of Kraft’s proposed restructuring
• Tender offer directly to Shareholders (premium of
50% over undisturbed share price)
• Offer more than 90$ but less than 110$ to initiate
talks
Philip Morris
How to Keep the Price
17. APPENDIX
We show in the appendix the debt and cash flows that would result in keeping the
management assumptions of 23% EBIT margin, 5% growth and starting share price of
12$. To observe what the model forecasts the value of the company to be in other
situations, we suggest inputting the assumptions in the excel spreadsheet directly.