Eskimo Pie Corporation

Background and Issues

Eskimo pie sells ice-cream and related food products

--earns revenues primarily through licensing, not a big manufacturer

--key assets are brand name recognition
--fragmented industry is consolidating, recent entry by large food cos.
Why was Reynolds selling Eskimo?
Why did Eskimo management prefer the IPO to the Nestle offer?
What criteria should Reynolds use in deciding between selling Eskimo to another
firm versus taking Eskimo public in an IPO?

Valuing Eskimo Pie

To value Eskimo we need the following:
(1) An estimate of rWACC
(2) An estimate of expected cash flows in 1991
(3) An estimate of the growth rate of future cash flows
Step 1: Estimating WACC
(A) Estimate unlevered: Use equity betas of stock in table 8, unlever them using the
formula from chapter 12: equity = [1 + (1-TC)Debt/Equity]unlevered
Ben & Jerrys
Dreyers
Empire of Carolina
Steves Ice Cream
Hershey Foods
Tootsie Roll

equity
1.2
1.4
.3
2.5
1.0
1.0

unlevered
1.18
1.33
0.14
2.37
0.96
1.00

Average unlevered = 1.162, use this as our estimate.

Estimating WACC (continued)

(B)

Estimate equity at the target D/E ratio

What would Eskimos target capital structure be after IPO?
equity = unlevered = 1.162

(C)

Identify rf
Use 10 year bond yield from exhibit 9: 7.42%

(D)

Identify the market risk premium rM-rf

Use 7.43% given in the problem.

(E)

Use the CAPM to estimate requity

requity = 7.42 + (1.162) x (7.43) = 16.05%
Under the unlevered target capital structure, rWACC = requity = 16.05%

Step 2. Expected cash flows

Lets estimate year-end 1991 after-tax cash flows since the Exhibit 6 forecasts
seem too low.
Net income
Plus current interest expense less taxes (.6 x 67,000)
Plus: depreciation
Less: interest income from $13 mil. Cash
[$13 mil. paid out in the transaction
Lost interest: $13mil. x (1-.4) x 4.56%]
Less: capital expenditures
change in working capital
Total Expected Cash Flow at end of 1991

$4,000,000
40,200
$1,352,000
-$355,680

-$1,000,000
0
$4,036,520

Working capital changes

Working capital excluding cash has decreased over the period 1987 to 1991, even
though sales have increased.

1987

1988

1989

1990

Working capital

9,342

11,107

10,830

11,735

Cash

5,550

8,109

10,723

13,191

Working capital less cash

3,792

2,998

107

-1,456

Eskimo Pie is a marketing and licensing firm, not a manufacturer.

Would be reasonable to exclude working capital changes from cash flow
estimation.

Step 2. Expected cash flows

Lets estimate year-end 1991 after-tax cash flows since the Exhibit 6 forecasts
seem too low.
Net income
Plus current interest expense less taxes (.6 x 67,000)
Plus: depreciation
Less: interest income from $13 mil. Cash
[$13 mil. paid out in the transaction
Lost interest: $13mil. x (1-.4) x 4.56%]
Less: capital expenditures
change in working capital
Total Expected Cash Flow at end of 1991

$4,000,000
40,200
$1,352,000
-$355,680

-$1,000,000
0
$4,036,520

Step 3. Estimating a growth rate in future cash flows

Eskimo Pie grows substantially in 1991, which made IPO a potential alternative.

One approach: Estimate average annual growth in sales

1988
1989
1990
1991

(36,695-30,769)/(30,769)
(46,709-36,695)/(36,695)
(47,198-46,709)/(46,709)
(61,000-47,198)/(47,198)

Average sales growth

= 19.25%
= 27.29%
= 1.05%
= 29.24%
19.21%

Question: Is this a reasonable estimate of expected cash flow growth?

Has past 4-year period been special will growth slow down?

Other approaches to estimate growth

1. Past growth in net income

2. Past growth in operating income
3. Past growth in cash flows

Problem: These numbers are more variable, particularly for years with income or
cash flows close to zero.

Bringing in more information

What are analysts saying about future industry prospects?
What does Goldman-Sachs project? (forward looking estimates)
Expected 1992 growth in sales
Expected 1993 growth in sales
Average

4.54%
1.24%
2.89%

Expected 1992 growth in net income

Expected 1993 growth in net income
Average

10.44%
6.23%
8.34%

Net income more closely tracks changes in cash flow

Since growth is slowing down, lets use 6.23% for a constant growth rate.

4. Putting it all together

V = [Expected 1991 cash flow x (1+growth rate)] / [r growth rate]

V = [($4,036,520) x (1 + .0623)] / [.1605 - .0623]
V (or E) = 43,665,939

Should Reynolds sell to Nestle or do the IPO?

Nestle offer - $61 million cash

IPO proceeds

Cash from stock sale

Special dividend payment of
Total

$43,665,939
$15,000,000
$58,665,939

Looks like Nestle offer is slightly better.

Some Issues:
Results very sensitive to assumptions about growth rates - If more optimistic
since Goldman Sachs projection does not reflect the recent development.
Use 8.34% (the average growth rate) Total proceeds would be $71,720,697.
Other methods of valuing stocks? How about other firms in the same industry?

Comparable public firm multiples

There would be some multiples that could be used to check our estimates.
Equity-to-net income Total value-to-sales
Average of other firms

22.8

1.6

Estimate for Eskimo Pie

3.7

61

Implied value

84.4

97.6

The value of Eskimo Pie would range from about $84 to $98 million (excluding
the excess cash) our estimate seems to be undervalued.
Additional issues: Need to convince that IPO is feasible.