Purpose The purpose of this Case Analysis Report is to advise Philip Morris on the Acquisition of Kraft Inc. Overview Kraft is a food-focused company with many well known brand names. In 1987 net sales were $9. 9 billion which was an increase of 27% over the previous year. , and net income increased by 11% to $435 million. This follows an earlier attempt to diversify where in 1980 Kraft merged with Dart Industries and then acquiring Hobart Corporation in 1981. However, by the end of 1986 Kraft had returned to a food-focused strategy. Philip Morris is a company that is dependant on the tobacco industry.
Most of Philip Morris’ income is from its Marlboro, Benson & Hedges, and Virginia Slim cigarette brands. Though tobacco sales have increased by 15 percent in 1987, Philip Morris wishes to diversify out of the tobacco business, as evidenced by their 1969 acquisition of 53 percent of Miller Brewing Company’s common shares with the remaining shares following in 1970, and their purchase of Seven-Up in 1978 and General Foods in 1985. These acquisitions have had mixed results, with Philip Morris selling its Seven-Up operations in 1986 and General Foods having a declining profit from 1986 to 1987 of $624 million to $605 million.
Why is Kraft a takeover target for Philip Morris The food industry is a growing one. For Kraft, in 1987 net sales were $9. 9 billion which was an increase of 27% over the previous year. , and net income increased by 11% to $435 million. It is expected with an increasing population that the food industry will grow. As Philip Morris is seeking to diversify out of the tobacco business and into the food industry, the acquisition of Kraft would strengthen their position as they would then become the largest food company in the world.
Kraft is internationally recognised with many well known brand names such as Miracle Whip, Seven Seas, and its range of Kraft salad dressings. What has occurred thus far On the 18th of October Philip Morris made a hostile tender offer to the shareholders of Kraft for $90 per share in cash, which was a 50% premium over the closing price ($60. 125) on the 18th of October. In response to this tender offer, Kraft Management have proposed a major restructuring plan as an alternative to the tender offer made by Philip Morris. What is Kraft worth?
We need to value Kraft at the end of 1987 to determine whether the market has fairly priced the share prices of Kraft. The market values of Kraft as at 1987 closed at $48. 25. In valuing the share price of Kraft 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 find a valuation of Kraft’s shares at the end of 1987. In applying the CVM analysis, we valued Kraft’s share price at 1987 at $54. 19, while the APV method produced a value of $52. 9. Although these two methods provide different share price results, both still seem to be significantly higher than the market share price [please refer 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 of Kraft is undervalued. [A comparative illustration of the share prices as per our own independent valuations and the market valuations can be seen in Appendix B-1. [for an explanation of the calculations used to determine Kraft’s share price please refer to Appendix A-1, for tables and charts refer to Appendix B-1]
Should Philip Morris purchase Kraft Philip Morris should indeed purchase KRAFT. Many economic benefits and inflow will arise due to this purchase. Quoting Hamish Maxwell the CEO of Phillip Morris, that “the acquisition of Kraft will result in creating the leading international food company. ” Main driving forces are the benefits of synergy and revenue diversification. Synergy is when the value derived from the combination of company A and B which in this case is Kraft and Philip Morris, is greater than their values in their respective individual states.
An example of synergy is operating economies. Essentially, the merger of Kraft will result in economies of scale with facilities being used with a higher degree of utilization and becoming cost efficient and thus reducing COGS. This would be a result of the spreading of manufacturing overhead cost with the advantages of common learning curves and will all save any expenses related to building new factories. It will also give greater pricing power as the merger will create the largest food company creating greater market share.
Kraft itself 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 Kraft brand to be combined with General Foods to allow the goodwill and positive image of Kraft to be attached to General Foods’ products. Differential efficiencies where the more effective and experienced management of Kraft will bring the underperforming General Foods operations to greater efficiency. Philip Morris wants Kraft to take over management of general foods, who has been missing a chief officer since 1988.
Proposed Purchase of Kraft The offer of $90 per share is to be financed through $1. 5 billion in excess cash and up to $12 billion in available bank credit lines. The 50% premium is justified by the potential synergies and diversification that an acquisition of Kraft by Philip Morris would bring. Kraft’s counterproposal and evaluation The restructuring plan would involve shareholders receiving a cash dividend of $84, high-yield debt valued at $14 and the stock (post-restructure) would be worth $12 per share. for more information about the restructure, please refer to Appendix A-2] We must now evaluate the counterproposal ourselves. for tables and charts refer to Appendix B] •APV Method is used since it is very difficult to estimate using CVM model when the capital structure is changing throughout the forecast period. •APV Method: To forecast the FCFs we used the Sales forecast for 1989-1998 given in Exhibit 12 and forecasted another balance sheet for the restructure plan. We then forecasted the income statement and calculated FCFs based on these figures. Hamada’s Equation: since we assume the firm is 100% equity financed, the cost of equity is the WACC. •Interest Payments are forecasted in Exhibit 12 of Case Study. •Using the APV method we calculate a share price of $21. 10 for Kraft’s restructuring plan. Philip Morris’ Options With everything that has occurred thus far, Philip Morris now has the following options; ? Increase their bid – This is a very possible course of action. However, too high a bid could negate any value. Thus, the maximum bid should be kept a secret as to maximise the potential synergies for Philip Morris. Negotiate – This is unlikely as Kraft 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 Kraft’s experienced management is one of the value drivers of the acquisition. ?Halt Acquisition Attempt – This is a very undesirable option as it goes against Philip Morris’ plans for diversification out of the tobacco business and into the food industry. Also, the synergies associated with the acquisition and Kraft’s experienced management are desired in order to raise General Foods.
Kraft’s Options Aside from going ahead with the restructuring plan, accepting the offer, and negotiating, Kraft may employ various defence tactics in order to affect the likelihood of a hostile takeover. [for definitions of the following terms refer to Appendix A-3] ? White knight – This is very limited due to the size of Kraft. As a result it is a very unlikely option. ?Greenmail – This is highly unlikely as it results in loss of value for shareholders. ?Poison Pill – This defence against hostile tender offers dilutes the holdings of the raider.
However, this defence is unlikely as it doesn’t provide value to the shareholders. ?Restricting Voting Rights – Though this doesn’t take away value from the shareholders, it also doesn’t add any value either. Recommended Course of Action It is recommended to increase the bid but to keep it low, between $90 – $105 as not only is a restructure unlikely (due to the debt composition of the company changing to one similar in a leveraged buyout), but there isn’t likely to be any competition (the initial offer of $90 already being potentially the second largest acquisition ever. ) Appendices