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by Allen Michel and Israel Shaked
RJR Nabisco: A Case Study of a
Complox Lovoragod 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 problemsa declining return on assets and falling inventory
turnoverappeared 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.
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.^ The RJR Nabisco
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
transaction warrants particular attention. Not
sold 18 billion. The combination of creativity on
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
This article describes the RJR transaction. It
gives a brief history of the company, excimines
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
the production side and a well developed advertising campaign yielded a solid 50 per cent
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-
In many respects, RJR was a pioneer. It anticipated the increasing popularity of tobacco consumption, and in 1913 made a risky marketing
1. Footnotes appear at end of artide.
HNANCIAL ANALYSTS JOURNAL / SEPTEMBERense
Q. BALANCE SHEET (SMILUON)
ra. OTHER FINANCIAL DATA
Capital Expenditures ($million)
Return on Equity (%)
Return on Assets (%)
Dividend Payout (%)
Common Stock Price Range:
No. Common Shares (mill.)
Source: December 6, 1988 prospectus.
sures, RJR responded with four strategies. It
differentiated its products. Simultaneously, it
diversified into non-dgarette products. It also
increased its focus on overseas markets, where
dgarette growth was increasing at double-digit
rates. At the same time, it addressed increasing
health concerns at home.
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
RJR had low capital expenditures. Neither of its
businesses required much capital investment.
Indeed, as Table I shows, in each of the three
RJR as a Potential LBO
years following the Nabisco Brands purchase,
RJR Nabisco was a particularly attractive LBO less than 7 per cent of the firm’s revenues were
candidate. First, it exhibited steady growth unaf- committed to capital investment. Furthermore,
fected by business cycles. High growth and incon- the firm was able to avoid the high-technology
sistent growth often present unacceptable risks investments necessary in many industries,
when it comes to leveraged buyouts. High which require a significant R & D commitmpnt
growth requires a significant investment of to remain competitive.
working capital, whereas inconsistent growth
The firm had a low debt level. In an LBO
may threaten cash flow. Successful LBOs are situation, new management often takes advangenerally characterized by both low business tage of the debt capacity of the firm’s assets,
risk and moderate growth.
hence looks for low debt in the target firm. In
RJR’s unlevered beta, representing its busi- the ca§p of RJR, the pre-LBO ratio of long-term
ness risk, was 0.69. In other words, the firm was debt to assets was approximately 30 per cent.
relatively insensitive to maricet-wide fluctua- This offered significant opportunity for debt
tions. Both its tobacco and focKi operations were expansion following the LBO, especially when
non-cyclical and projected to have reasonably combined with RJR’s low systematic risk.
slow growth rates. Although the growth rate of
It is interesting to note that some studies have
the tobacco unit was a robust 9.8 per cent and determined that LBO target firms often exhibit
the growth rate of food operations was 3.5 per higher debt levels than their non-target countercent in the pedod between RJR’s purchase of parts.^ TTiese high pre-LBO debt levels may
FINANCIAL ANALYSTS JOURNAL / SEFimiffiR-OCTOTHl 1991 D 1 6
Table II RJR Break-Up Value
Nabisco cookies and crackers
Ready-toeat and hot cereals
Ortega Mexican food
A-1 Steak Sauce
Milkbone dog biscuits
Total Estimated Break-up Value
Value per Share:
-i-Numbe^’ of Shares
Break-Up Value Per Share
requires an in-depth understanding of the principles and tedious number crunching.* 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.
Table III presents the projected sales, operating
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 busi$85-92/share
ness, KKR assumed an increase from the 1988
pre-LBO level of 27 per cent to 35 per cent in
Source: R. Alsop, A. M. Freedman and B. Morris, “RJR Takeover
Could Hurt Marketers and Consumers,” Wali Street Journal, Decem- 1998. Though one might argue that this is an
ber 2, 1988.
unrealistically optimistic projection, the tobacco
industry had attained such operating margins in
the past. In 1987, for example, Philip Morris
a 35 per cent margin, the RJR tobacco
have appealed to buyers to the extent they
per cent margin, American Brands an
suggested more stable operating cash flows.
RJR’s problems appeared fixable. The firm’s 11 per cent margin and Universal a 7 per cent
retum on assets had declined steadily from 15.5 margin.
per cent in 1985 to 11.5 per cent in 1988. Over
In addition to its somewhat optimistic margin
the same period, its inventory turnover had assumption, KKR assumed that tobacco sales and
fallen from 10.0 to 3.9. To the extent new operating income would grow by 8.3 per cent and
management viewed these problems as “fix- by more than 10 per cent per year, respectively,
able,” there was potential for value creation.
liiough the U.S. tobacco market is declining
RJR offered significant break-up value. In virtu- annually by approximately 3 per cent, U.S.
ally all LBOs, the value of the deal is calculated exports of cigarettes rose by 56 per cent in 1987
based upon both a cash-flow value of the firm and by 25 per cent in 1988. In addition, like any
and a break-up option, which assumes that the other acquiring group, KKR expected to imfirm is to be broken into units and sold off prove performance. As it indicated in the suppiecemeal. Table II gives RJR’s break-up value, plement to its tender offer, “Tobacco operating
as estimated by Smith Barney and reported in income for 1990 and years thereafter grows at
the Wall Street Jourtial.^ The break-up value of rates greater than net sales due to expected
$85 to $92 per shcu:e was significantly higher production and other operating efficiencies and
than RJR’s market price of $56 prior to the initial reduction in product development costs.”
offer of RJR’s CEO, Ross Johnson.
KKR’s projections for the food business were
not out of line with industry expectations. The
projected sales growth of 6 per cent, for examThe discounted-cash-flow methodology deter- ple, aithough higher than RJR’s historical sales
mines value by taking a projected stream of cash growth, was comparable to that of General
flows and discounting them at an appropriate MiUs.
discount rate. Though it sounds simple and
RJR’s total cash flows represent the “free cash
straightforwaid, the process, if done correctly. flows” available to meet both debt and equity
HNANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 D 1 7
Table III Projected Cash Flows (millions of dollars)
II. Cash Flows:
Tobacco Operating EBIT*
-I- Food Operating KBnr
= Total EBIT
– Corporate Expenses
Increased Work Capit.
Total Free Cash Flows
Source: December 6, 1988 prospectus. Incremental working capital estimates based on a Prudential Bache report dated October 28, 1988.
* Earnings before interest, taxes and corporate expenses.
* Earnings before interest but after taxes.
obligations. These cash flows will be discounted
in the valuation process, so, to avoid doublecounting of the interest cost, interest expense is
not deducted from operating income.
Once operating income is derived, two further adjustments are made. Thefirstis a vmbng
capital adjustment. If inventory is projected to
increase over time, for example, RJR wiU 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 How.
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 armual report,
management projected capital expenditures of
$5 billion for the foUowing three years, or af>proximately $1.7 billion per year. As indicated
in Table in, KKR’s projection for the first postbuyout year is approximately $1.7 billion; it
subsequently declines over four years to $700
The Appropriate EHscount 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 ccKt of debt calcu-
lated. 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 exerdse. In virtually all mergers and
LBOs, however, the features, cost of funds and
even amoimts are structured in a relatively
complex marmer. The amounts are frequently
provided as ranges, rather than exact values.
The features include both cash and PIK (paidin-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
urJoiown 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 apd Revolving Credit and Term Loan Fadjity.
Because of their omplexity, many of the rates
are not structured in a manner easily analyzed
in the context of an LBO. Consider, for example.
HNANC3AL ANALYSTS JOIflOMAL / ^PTEMKR-OCTC»ER 1991 D 1 8
Table rV Sources of Financing
Tender Offer Facility (T,O,F,)
Asset Sale Bridge Facility
Refinancing Bridge Facility
Revolving Credit and Term
Base Rate +
6% for 1st 6 mos,
8% for following 3 mos,
a) Floating 90-day LIBOR
b) Fixed rate plus
Partnership Debt Securities
Interest = 550 basis points
Base Rate +2%’ or
Eurodollar Rate +3%
Base Rate +W2%’
or Eurodollar Rate +2Vi%
Base Rate +2V4%”
or Eurodollar Rate +3V4%”
Base Rate +1V2%”
or Eurodollar Rate
over the greater of
1) 3-mo, T-bill
2) 10-yr, T-notes
3) 30-yr. T-bonds
Minimum rate = 1Va%
Maximum rate = 16%
Dividend = 550 basis points
over the greater of
1) 3-mo, T-bill
2) 10-yr. T-notes
3) 30-yr, T-bonds
Minimum rate = 12%%
Maximum rate = 16%%
No Fixed Dividend
Bank financing used to purchase shares
tendered to KKR,
Bank financing used to refinance the
T,O,F, At least $5.5 billion must be
obtained from the sale of assets.
Bank financing used to refinance T.CF,
Bank firtancing used to refinance the
T.CF, After 2 yrs,, both facilities are
to be converted to 4-yr, term loans
upon satisf3dng key debt covenants
relating to working capital, asset
sales, solvency, etc.
Drexel Bumham Lambert and Merrill
Lynch commit $1,5 bill, each of Senior
Subordinated Bridge financing and
Drexel agreed to provide $2 bill, of
sub, bridge financing.”
Used to redeem non-bank bridge
financing. Two classes: (1) 8-yr. First
Subordinated Notes, (2) 8-yr. Second
Subordinated Notes, Can use
addifional notes as interest payment
for second subordinated notes during
period between month 18 and month
6-mo, debt security, which can be
extended up to 7 years with
adjustment in rate schedule,
20-year maturity. For the first 10 years,
interest is paid in securities or cash at
the option of KKR, Following the 10year period, cash payments are
mandatory. At option of debenture
holder can be converted to common
stock after year 4. Debentures are
convertible into 25% of RJR equity in
1993, Security has reset provision to
trade at par.
First 6 years, dividends are paid in cash
or additional shares, at KKR’s option.
Following year 6, dividends are paid
in cash. Shares have no voting rights.
Then shares have a prior claim to that
of the senior convertible debentures.
Provided by KKR investing group set up
as a limited partnership.
Source: January 31, 1989 prospectus,
a. RJR has the option of making interest rate selection. Base rate is defined as the 30-day commercial paper rate for firms whose bond ratines
b. Increasing to 2Vi% for the 6-month period following the first anniversary of the tender offer expiration date and 2^*% thereafter,
c. Increasing to 3V2% for the 6-month period following the first anniversary of the tender offer expiration date, and 2Vt% thereafter,
d. Subordinated rates have similar structure, but are increased by Vi%.
e. Adjustment is based on seniority and length of time since issuance.
the Increasirg-Rate Notes described briefly ir
Table IV. These eight-year riotes comprise two
classes. Approximately $1.25 billion are eightyear First Subordinated Increasing-Rate Notes
bearing cash interest payment. The other class
$3.75 billion of Second Subordinated IncreasingRate Notes^pay interest in cash for the first 18
months, in cash or additional Second Subordinated Increasing-Rate Notes (at the option of
KKR) for the following 60 months, and again in
cash for the remaining 18 months.
The terms for these notes indicate that the
interest rate will be adjusted monthly and will
equal the greater of
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 D 1 9
(1) a floating-rate 90-day LIBOR, plus a 400basis-point spread for the first qiiarter in
the case of the first class of increasing-rate
notes and a 500-point spread in the case of
the second class. For each class, the
spread will increase by 50 basis points per
quarter for the first two years and by 25
basis points per quarter thereafter;
(2) a fixed rate equal to the floating rate for
the initial quarter detennined in (1) above,
less V8 of 1 per cent in each case, increasing by 50 basis points per quarter during
the first two years and by 25 basis points
per quarter each qua …
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