The Stock Market Assess Philip Morris
How did the stock market assess Philip Morris’s $90 per share bid for Kraft? Note page 21 of the case study contains a timeline of stock prices in the days before and immediately after Phillip Morris' bid.
The stock price of Kraft, Inc. is undervalued.
With all the available information and as can be seen from the graph above, on October 18, 1988 the day Philip Morris made a $90 per share bid for Kraft, Kraft’s share prices rose by $28, around 47%. During the day Philip Morris’ share prices dropped by 4.5%. The week following this, Kraft’s equity was trading in the range of $90 to $102 per share. All this shows that the market felt Kraft to be undervalued.
What is the value to shareholders of the restructuring proposed by Kraft?
The main positive change of the proposed restructuring plan would be the interest tax shield for the shareholders as well as an operational restructuring. There would also be a financial stress associated with such as high-risk high debt restructuring plan as proposed by Kraft. The Kraft restructuring proposition also provided tax shield advantages over the Philip Morris offer.
While the gains to the shareholders on the Philip Morris's all-cash deal would be taxable, the Kraft’s restructuring deal would provide a tax shield to the shareholders. The restructuring plan would leave Kraft with a debt of $12.4 billion. This makes Kraft a highly leveraged company with 90% debt and 10% equity This was a risky capital structure but if such a highly leveraged company could actually perform this, then the small base of shareholders can gain unexpected profits. The proposed restructuring would also force Philip Morris to pay more or give up. Therefore, it provided an alternative for Kraft shareholders through a high-risk debt-to- value.
What is the nature of the restructuring proposed by Kraft? You do not need to value it in detail but should explain the plan and how it creates value.
On 24th Oct. 1988, in opposition to the Philip Morris offer, Kraft announced its restructuring plan to its shareholders. The plan was rooted in the estimate of boosting the sales and EBIT of Kraft. Kraft had projected that its proposed $13.2 billion restructuring plan would raise the value per share to nearly $110 per share of more. Of this estimated $110 per share, the shareholders stand to gain at least $84 worth of cash dividends and $14 worth of debentures at high yields.
What were the negotiating tactics? As Mr Hamish Maxwell, chairman and CEO of Philip Morris, what would you do next?
On Oct. 18, 1988, Philip Morris offered to purchase all Kraft common stock at $90 per share in cash. On Oct. 23, 1988, Kraft’s board of directors rejected the bid and termed it as “inadequate” as well as “low”. Instead on October 24, 1988, Kraft proposed its own restructuring plan and proposed that the stocks would be worth $110 per share post the proposed restructuring. It sent a market signal that it Kraft was wiling to go forward with the takeover provided the minimum bid price was $110 per share. Kraft used aggressive negotiation tactics while asserting their premise that a valuation less than $110 was not justified. The restructuring plan through a high-risk debt also displayed that Kraft was deeply committed to care about its shareholders. Kraft’s negotiation was based around the assessment of the operational cost synergies involved in the merger with Philip Morris. The deal would reduce Morris’ overead expenditures related to sales and delivery by consolidating manufacturing and delivery. Value of the synergies according to the market was $2.3 Billion. Philip Morris was easily in a position to pay a maximum premium of 120% of the market price. This will translate to about $132 per share, which indicates that Kraft’s demand for $110 per share is reasonable. As CEO of Philip Morris, if I plan to make this happen, then I should consider the price range of $102-$110. The takeover of Kraft will complement the food portfolio of Philip Morris. 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. The combination of Philip Morris and Kraft will create the leading international food company.
As Mr John Richman, chairman and CEO of Kraft, what would you do next? (Think in terms of game theory.)
As Mr Richman, I would signal to Philip Morris my commitment to my shareholders through moving ahead on the proposed restructuring plan. This would signal Philip Morris to adjust its bid upwards to a realistic and accurate price per share. It will further indicate to the market greater confidence in my ability to achieve higher premiums for my shareholders and will be a sign of confidence in the proposed action. This will boost shareholder's confidence as well to not easily accept Philp Morris’ proposition. They will have greater confidence then to hold on the stock and support the action proposed by the management. The highly leveraged restructuring plan can put off potential acquirers from targeting Kraft. Hence, any bid in excess of $112 per share should be accepted by Kraft, with an objective to improve the wealth of shareholders.
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