De La Salle University

Graduate School of Business

MCF 213M: Securities Research and Valuation

Case Study: “Battle of the CEOS” Philip Morris Companies and Kraft Inc.

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rs e Prepared by:
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Bautista, Dia Nerissa
Chan, Iris
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Guño, Ed Patrick
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Ognita, Dominic
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Master of Science in Computational Finance

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Master of Science in Financial Engineering

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 BACKGROUND OF THE CASE

Kraft history is almost a history of the food industry. The history of KRAFT goes back to 1903, when, J.L.

Kraft started purchasing cheese at Chicago’s Water Street wholesale market and reselling it to local merchants.

Within a short time, four of J.L. Kraft’s brothers joined him in the business, and, in 1909, they incorporated as J.L.

Kraft & Bros. Co. They began producing processed cheese and its method of producing processed cheese was so

revolutionary, in 1916 he obtained a patent for it and in 1917 the company start.

Kraft is known for the brand names Miracle Whip, Seven Seas, and Kraft salad dressing, Kraft Mayonnaise,

Velveera Cheese, Parkay and Chiffon Margarines. In 1980, Kraft expanded its operations through a merger with

Dart Industries. Dart’s products are Tupperware, Duracell batteries and West Bend. The merger of Kraft and Dart

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was followed with an acquisition of Hobart Corporation, famous for the Kitchen Aid food equipment, in March

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1981.

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With this expansion, Kraft focused to a all-food strategy. In 1986, It transferred all non-food business with

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Premark International Inc. and subsequently, sold its last non-food asset, Duracell, to Kohlberg, Kravis, Robert & Co.

In 1987, Kraft reorganized its companies to three segments namely: U.S Consumer Food, U.S Commercial Food, and
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International Food.
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Along this focus to all-food strategy, Kraft received a tender offer from Philip Morris at $90 per share in

cash for the speculative purpose of using its management to revitalize General Foods. Kraft's directors rejected the

$90-a-share offer and proposed a complex dividend package. The package called for investors to get $84 in cash
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plus high-yield debt securities valued at $14. Kraft valued the post-restructuring stock at $12. Hence total

restructuring package is at $110.

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Philip Morris is cigarette and Tobacco Company and known for the brands Marlboro, Benson & Hedges,
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and Virginia Slims cigarettes. Philip Morris diversified its business starting from 1969 where the company acquired

Miller Brewing Co and fully taken over in 1970. A following acquisition in 1978 of Seven-Up diversified Philip
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Morris’ portfolio into the soft-drinks manufacturing industry.

In 1985, Philip Morris largest acquisition by far is General Foods with $5.6 Billion. General foods is famous

on brand names Maxwell House coffee, Birds Eye frozen foods, jell-O, Oscar Mayer meats, Ronzoni pasta, and Post

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 cereals. At the same year, Seven-up operation was sold for about a book value after a $50 million write-off

After the acquisition of General Foods, Philip Morris offered $90 per share to Kraft which, if the deal

proceeds, will increase Philip Morris’ market share and makes the company the largest food company in the world.

ANALYSIS

1. How did the stock market assess Philip Morris’ US90 bid for Kraft?

Prior to the tender offer, the Stock price was trading at the $60 level. The price rose to $88.25 when the

disclosure on the tender offer price of $90 was out in the market. The market may have anticipated that the deal

would push through and bought the stocks up to the near bid price of Philip Morris. The bid of 90 means that Philip

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Morris is valuing Kraft in that price. As a trader/investor who holds a position in Kraft, this means that if the deal

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pushes through then the value of the stock is already at 90, hence buying below the 90 price is still a discount. Also,

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this is a sign that the stock is undervalued by the market prior to the tender offer. It remains to be seen whether it

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is still undervalued at $90 since the stocks was traded at the $90-$102 in the following week. Also, Kraft announced

that the company will only talk about merging and deals when the price is at least $110.
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2. Can Philip Morris finance the Kraft acquisition?

Philip Morris can use the excess cash and the available bank credit lines to finance the acquisition. The

total value of the bid is at around $11 billion as seen below.

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Tender offer of Philip Morris Minimum Price requirement of Kraft

Number of shares (millions) 131.00 131.00

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Price $90 $110

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Total Value of bid (millions) $11,790 $14,440

There was an available credit line of $12 billion plus the excess cash of $1.5 billion for Philip Morris.
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Assuming that they consistently have an excess cash of at least $1.5 billion then the facility of $9-$10.5 billion could

be paid in the next 5-6 years. Excess cash flow is shown below. Hypothetically, Philip Morris would have not enough

sources of funds to fund an offer of $110 per share based on its excess cash and available credit line.

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 Cash 73 189

Receivables 1,878 2,083

Inventories 3,836 4,154

Other current assets 127 146

Current Assets 5,914 6,572

Current liabilities 4,482 5,176

Excess Cash 1,578 1,774

( Cash - ( Current Liabilities - Current Assets - Cash))

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3. What is the value to the shareholders of the restructuring proposed by Kraft?

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Kraft's directors proposed a complex dividend package. The package called for investors to get $84 in cash

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plus high-yield debt securities valued at $14. Kraft valued the post-restructuring stock at $12. Hence total

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restructuring package is at $110. The restructuring will be finance $3 billion high yield debt, $6.8 billion bank debt,
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$0.904 billion existing debt.

Due to the restructuring, the company will incur tax shield from interest expense incurred from the debt
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used. Considering the debt of $12,678 million (less the cram-down debt), the post-restructuring stock price creates
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a $26.25 value per share for 126 million shares. (Refer to Annex I).

Illustration of the Total Value of the Firm after Proposed Restructuring Package with the Interest Tax Shield:
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Dividend per Share $84

Value Per Share $25
Cram-Down Debt $14
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Total Value $123

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4. As Mr. Maxwell, chairman and CEO of Philip Morris, what should you do next?

The initial $90-a share tender offer was rejected by Kraft’s directors and proposed a complex dividend
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package that it valued at $110 a share. The market responded by increasing the stock price of Kraft to $102 per

share after the announcement of restructuring. As CEO of Philip Morris, if I plan to make this happen, then I should

consider the price range of $102-$110.

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 The takeover of Kraft will complement the food portfolio of Philip Morris. Also, Kraft will provide significant

synergies as Kraft’s management team will revitalize General Foods which had been without a chief executive

officer since July 1988. Kraft has an outstanding record of profitability and growth, with a return on equity of 25.8%

in 1987. The combination of Philip Morris and Kraft will create the leading international food company, a U.S. based

food company that will compete more effectively in world food markets.

5. As Mr. John Richman, Chairman and CEO of Kraft, what should you do next?

The CEO of Kraft, if the proposed restructuring plan is the best move then the company should stick to it and clarify

the idea that the Company will not be for sale. It is fair to believe that this will provide a good sign of confidence in

the proposed action. This will boost shareholder's confidence to hold on the stock and support the action proposed

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by the management. Seeing the stock price increase after the announcement of the plan is a good sign that it is

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perceived as a positive action by the market. On the other hand, if selling is the best option then I believe that it is

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good to have meeting with Philip Morris as they are a potential buyer. If it is a part of my strategy to boost up the

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price then it is a good start not to show intention of selling it at 90. The price that will make the deal happen will
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only push through once both parties meet and discuss the factors to their valuation.
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CONCLUSION
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The decision of Kraft to reject the offer of $90 from Philip Morris is the correct decision. The stock price of

Kraft at $60 is quite undervalued. Also, the plan to restructure will further boost the value of the company. We
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derived a value of $123 using and considering all the assumptions given on the restructuring plan plus the benefits

of the tax shield. This means that the value of the company will increase when this strategy is successfully
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executed. Likewise, the decision to take offers at $110 is also a good decision as this will not put the shareholder to
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sell the company at a discount. For Philip Morris, we believe that there is still room for them to grow and maximize

the benefits at $110. So arriving at a deal of $110 would still be beneficial to the company as this will boost their
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strategy to divest out from tobacco business. This will also make them a big player in the market in the food

industry.

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 REFERENCES:

Cole, R. J. (1988, October 31). KRAFT BEING SOLD TO PHILIP MORRIS FOR $13.1 BILLION. Retrieved from
http://www.nytimes.com/1988/10/31/business/kraft-being-sold-to-philip-morris-for-13.1-billion.html?
pagewanted=allKRAFT BEING SOLD TO PHILIP MORRIS FOR $13.1 BILLION. (October 1988).
http://www.nytimes.com/1988/10/31/business/kraft-being-sold-to-philip-morris-for-13.1-billion.html?
pagewanted=all

The History of Kraft Foods Inc. (n.d.). Retrieved from http://web.mit.edu/allanmc/www/kraftfoods.pdf

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Annex 1

Discounted Future Cash FLow

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