Kraft and Philip Morris Be Acquired or Restructure?

The Stock Market Reaction

50.00

65.00

80.00

95.00

110.00

03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct

Share Prices

Kraft Philip Morris

90.00

110.00

130.00

150.00

170.00

03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct

Relative Share Prices

Kraft Price Philip Morris Price S&P price

Important dates

18 Oct. PM bid. Kraft’s price

doubles, excess return of 51% following the offer at

90$

20 Oct. Nabisco MBO

announced. Kraft’s price falls by 5%, market starts

doubting the merger

24. Oct The share price rebounds

thanks to Kraft announcing the

restructuring plan and KKR bidding on Nabisco

Share Price

0.00 20.00 40.00 60.00 80.00 100.00 120.00

Market price before offer

PM offer price

Market Price after PM offer

Value after restructuring

Market Value after restructuring announced

Share price High Yield Dividend

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct

Excess return Kraft Excess Return PM

Effective Excess return on announcement day 51%

Nabisco MBO announcement

Kraft restructuring announcement

Company by company

S&P500 No major moves in the index, that averages return of 0.5%

across the period

Kraft After the price jump on

announcement date, Kraft’s returns mirror the SP, but on the day the Nabisco MBO is announced and when the restructuring is made public

Philip Morris The price moves along with

the SP500,with two exceptions: -5% on

announcement day and +3% on Nabisco MBO announcement

Can Philip Morris afford it?

Net Income Assumptions

Revenue growth 5%

EBIT margins 14% adjusted to account for previous acquisitions

Debt Repayment Assumptions

The interest will be paid on the average amount of outstanding debt

Historical cost of debt at 9.5%

Acquisition price of $11b will be financed by 1.5b excess cash and 9.5b debt

FCF Assumptions

We assume all FCFE will be used to repay the principal

Historical ratios of Capex, Depreciation and NWC to sales

Historical Tax rate at 44%

Acquisition financing

-

500

1,000

1,500

2,000

2,500

3,000

3,500

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Interest FCFF

Philip Morris alone appears to be generating enough cash to service the interest on the loan and to pay down the principal. Even if the EBIT margins were to fall to 10% and the loan to increase to $10b, the company would still be able to face its

debt obligations.

If we were to add Kraft’s own cash flow projections, the situation would improve even further, since Kraft has virtually no debt at the moment ($900 million) and is

generating around 1b in cash every year.

We therefore conclude that Philip Morris does have enough financial means to acquire Kraft.

Assumptions

Projections

Revenue Trust Management

projections

Margin Do not trust Management

projections

Interest Payment Do not trust Management

projections

0%

5%

10%

15%

20%

25%

Average Historical

Average Management

EBIT Margin

0%

1%

2%

3%

4%

5%

6%

Average Historical

Average Management

Revenue Growth

-4%

-3%

-2%

-1%

0%

1%

2%

3%

1989

19

90

1991

19

92

1993

19

94

1995

19

96

1997

19

98

Difference Mngmt and own projections

Our Assumptions

Debt Interest

14% EBIT margin

5% Revenue Growth

Since the FCFE, which is entirely used to pay down the debt principal, is calculated on inflated EBIT margins, we develop a model that can calculate FCFE and feed it back into the debt schedule, so that is it easy to estimate debt interest and principal payments with different assumptions.

The growth rate in the first year of management projections is 6%, however it converges down to 5%. Albeit higher than historical growth rates, we believe this to be a reasonable assumption.

The EBIT margin increases considerably from the historical average of 9% to 20%. This cannot be justified even accounting for the retention of higher margin activities. We believe a more accurate margin would be 14%, calculated as: 9% * (1-19%) / (1- 45%), where (1-45%) is revenue retention and (1-19%) is profit retention

In the following analysis we will present the results that follow from our own assumptions, and we consider the management projections as the best case scenario.

Debt Schedule To calculate the amount of interest due every year, we computed the debt levels. To do so, we assume that: •  The high yield debt is worth 14$ per share. •  The regular debt will have an average cost of 13.63% •  The interest on the Bank debt will calculated on the average outstanding debt •  The Cash flows to equity will be entirely devoted to principal payments, according to management

schedule for the preexisting debt and using the remaining CF for the bank debt •  The chart shows the debt levels according to management projections. When we implement our

model the repayment schedule varies significantly.

-

2,000

4,000

6,000

8,000

10,000

12,000

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Existing Debt Bank Debt Debt High Yield

Discount rates

• βasset = 0.65 • Market premium = 8% • Rf = 9%

R0

• We start assuming a value of 12$ per share, and we assume that equity is going to grow at g = Re

• We calculate the β equity re-levering β assets for every year

• We use Rf and Market premium to calculate Re for every year

Re

• We assume that the cost of debt stays constant throughout the period. We use the previously calculated Re and Rd to compute the WACC

WACC

14.2%

58.2% 18.1%

12.9 13.6%

Cash Flows C

ASH

FLO

WS

FCFF EBIT 1,380 1,270 1,310 1,286 1,278 1,257 1,212 1,155 1,086 1,010

TAX @41% 565.80 521 537 527 524 515 497 474 445 414 Capex -dep-change

NWC -442 -368 -423 -353 -409 66 72 77 83 63 720

Asset Sales 2,146

FCFF 3,402 1,117 1,196 1,112 1,163 676 643 604 558 533 6,092

Tax Shield Bank Tax Shield 276.26 206.57 180.93 158.25 134.02 112.47 99.06 81.57 57.44 25.24

Debt Tax Shield 167.59 167.59 167.59 167.59 167.59 167.59 167.59 167.59 167.59 167.59 Preexisting Debt Tax Shield 32.06 28.12 26.95 24.93 14.75 11.21 7.66 4.11 0.57 -

High Yield Tax Shield 110.58 128.08 148.36 171.84 199.05 230.56 230.56 230.56 230.56 230.56

Tot Tax Shield 586.48 530.36 523.83 522.62 515.41 521.83 504.87 483.84 456.16 423.39 5,666

CCF FCFF 3,402 1,117 1,196 1,112 1,163 676 643 604 558 533

Tax Shield 586 530 524 523 515 522 505 484 456 423

CFF 3,989 1,648 1,720 1,634 1,678 1,197 1,148 1,088 1,014 956 10,931

FCFE NI -61 128 213 277 333 400 483 577 680 791

Capex -dep-change NWC -442 -368 -423 -353 -409 66 72 77 83 63

Asset Sales 2,146

FCFE 2,527 496 636 630 742 334 411 500 597 728 8,812

Comparables Valuation

Column1 Premium P/E EV/Book P/S Min 9.90 13.10 2.50 0.61 Max 39.50 23.00 4.10 0.92 Mean 29.03 16.93 3.12 0.74 Median 33.35 16.20 2.95 0.72 Lower range 33 13 2.5 0.75 Upper Range 38 15 2.7 0.95 Lower Value 80 126 113 71 Upper Value 83 145 122 90

We compute Min, Max,

Median and Average

values for all comparable transactions

We subjectively

select a range, basing our

selection on the previously

calculated values and the overall value of the deal

We calculate the enterprise

value using the multiples.

Valuations Summary

50 60 70 80 90 100 110 120 130 140 150

FCFE

WACC

APV

CFF

P/S

P/E

EV/Book

Multiples Valuations

DCF Valuations

We obtain valuations ranges that are consistent with Kraft’s projections, but only when the more optimistic assumptions are used. If we use our own assumptions, the valuation looks very fragile, with Net Income being negative for the better part of the following decade, due to the burden of interest rates expenditure. In comparable transactions, we disregard the P/S multiples, since it is often inaccurate.

Possible issues

We are assuming from the start that the High Yield debt is work 14$ per share

Similarly, we are assuming that the equity is worth 12$ per share

Having chosen different assumptions, the Capex, NWC and Depreciation calculations are based on our own analysis and might not be accurate

The choice of which debt to pay down first may heavily affect the valuation

We are considering the debt to be risk free, although with a D/EV close to 90%, this is probably not the case

We did not compute a B for the debt

The Comparables ranges are subjectively selected

Kraft’s Choices

Possible Course of action

Accept Philip Morris Offer 90$

Undervalues the company

Lower than current Stock

price

Proceed with the Restructuring Plan

High risk implementation

Management Incentive

Wait for Philip Morris to increase their offer price

Use restructuring to force PM to

pay more

Encourage appearance of another bidder

Negotiations

Philip Morris • Calm and ready to negotiate, willing to meet on short

notice • Simultaneously pressuring Kraft to obtain information

through non conventional measures • Involve Kraft in litigation to distract management and to

prevent the restructuring

Kraft • Aggressive • Hired Goldman Sachs • Setting the pace (“We will take our time”) • Clear, Strong, Committed Shareholders

communication • Stressing 90$ (PM offer) versus 110$ (restructuring

value) • Keep the door open for further negations, while

clearly stating 90$ is not enough

$

$

Moving Forward

• Continue with aggressive communication • Find an alternative bidder (White Knight) • Stress the importance of being independent • Release private information (Business strategy,

growth forecasts,…)

Kraft How to increase the

Price

• Expose fragility of Kraft’s proposed restructuring • Tender offer directly to Shareholders (premium of

50% over undisturbed share price) • Offer more than 90$ but less than 110$ to initiate

talks

Philip Morris How to Keep the Price

APPENDIX We show in the appendix the debt and cash flows that would result in keeping the

management assumptions of 23% EBIT margin, 5% growth and starting share price of 12$. To observe what the model forecasts the value of the company to be in other situations, we suggest inputting the assumptions in the excel spreadsheet directly.

Philip Morris Debt and Cash Flow

Debt 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Start balance 5,222 13,243 11,753 10,070 8,179 6,060 3,697 1,069 - - Issuance 9,500 - - - - - - - - - Repayment 1,479 1,490 1,683 1,892 2,118 2,363 2,628 1,069 - - End Balance 13,243 11,753 10,070 8,179 6,060 3,697 1,069 - - -

Average balances 9,232 12,498 10,912 9,125 7,120 4,879 2,383 534 - - Interest 889 1,203 1,050 878 685 470 229 51 - -

Income Statement 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Revenue 29,080 30,534 32,060 33,663 35,347 37,114 38,970 40,918 42,964 45,112 Dep 748 786 825 866 909 955 1,003 1,053 1,105 1,161 EBIT 4,187 4,397 4,617 4,848 5,090 5,344 5,612 5,892 6,187 6,496 Interest 889 1,203 1,050 878 685 470 229 51 - - EBT 3,299 3,194 3,566 3,969 4,405 4,875 5,382 5,841 6,187 6,496 Tax 1,462 1,416 1,581 1,759 1,952 2,161 2,386 2,589 2,742 2,879 Net Income 1,837 1,778 1,985 2,210 2,452 2,714 2,997 3,252 3,444 3,617

FCFF EBIT 4,187 4,397 4,617 4,848 5,090 5,344 5,612 5,892 6,187 6,496 Tax @ 44% 1,856 1,949 2,046 2,149 2,256 2,369 2,487 2,612 2,742 2,879 Capex 949 996 1,046 1,099 1,153 1,211 1,272 1,335 1,402 1,472 Dep 748 786 825 866 909 955 1,003 1,053 1,105 1,161 NWC 1,552 1,630 1,711 1,797 1,887 1,981 2,080 2,184 2,294 2,408 Change in NWC 156 78 81 86 90 94 99 104 109 115 FCFF 1,974 2,159 2,267 2,381 2,500 2,625 2,756 2,894 3,039 3,190

FCFE Net Income 1,837 1,778 1,985 2,210 2,452 2,714 2,997 3,252 3,444 3,617 Capex 949 996 1,046 1,099 1,153 1,211 1,272 1,335 1,402 1,472 Dep 748 786 825 866 909 955 1,003 1,053 1,105 1,161 Change NWC 156 78 81 86 90 94 99 104 109 115 FCFE 1,479 1,490 1,683 1,892 2,118 2,363 2,628 2,865 3,039 3,190

Management Underlying assumptions for Kraft's Restructuring 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Rev Growth 6% 4% 5% 5% 5% 5% 5% 5% 5% 5% EBIT Margin 20% 22% 23% 23% 23% 23% 23% 23% 23% 23% Tax 39% 41% 41% 41% 41% 41% 41% 41% 41% 41% Op costs 5,235 5,317 5,454 5,726 6,013 6,313 6,629 6,960 7,309 7,674

What cash dividend 84 high yield 14 stock 12 Tot 110

How

Structure Sell businesses 2.1 % Revenues 55% % Profits 81%

Bank debt Bank borrowings 6.8 Interest 12%

Debt

Debt 3.00 Interest low 12.50% Interest high 14.75% Average 13.63%

Existing Debt repaid 2.1 Debt retained 0.904 Interest on retained 8.65%

High Yield high Yield interest 15.25% Effective 7.63% No payment (years) 5.00

Shares Number of shares 1987 131 Number or shares 1988 121.7

Restructuring Assumptions

Average Historical

Average Management

Own Assumption

Revenue Growth 3% 5% 5% EBIT Margin 9% 23% 14% Dep/Sales 1% 1% Capex/Sales 2% 2% NWC/sales 5% 5%

Debt Schedule Existing debt

DEB

T . 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Start Balance 904 793 760 703 416 316 216 116 16 - Interest 78 69 66 61 36 27 19 10 1 - Principal 111 33 57 287 100 100 100 100 16 - End Balance 793 760 703 416 316 216 116 16 - -

Bank debt (interest paid on average yearly balance) Start Balance 6,800 4,430 3,967 3,388 3,045 2,403 2,169 1,858 1,458 877 Interest 674 504 441 386 327 274 242 199 140 62 Principal 2,370 463 579 343 642 234 311 400 581 728 End Balance 4,430 3,967 3,388 3,045 2,403 2,169 1,858 1,458 877 149

Debt Start Balance 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Interest 409 409 409 409 409 409 409 409 409 409 Principal - - - - - - - - - - End Balance 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000

High Yield debt Start Balance 1,704 1,973 2,286 2,647 3,067 3,552 3,552 3,552 3,552 3,552 Interest Paid Out - - - - - 562 562 562 562 562 Interest Accrued 270 312 362 419 485 - - - - - Tot Interest 270 312 362 419 485 562 562 562 562 562 End Balance 1,973 2,286 2,647 3,067 3,552 3,552 3,552 3,552 3,552 3,552 Total Interest 1,430 1,294 1,278 1,275 1,257 1,273 1,231 1,180 1,113 1,033 Total Interest Mngmt 1,380 1,270 1,310 1,286 1,278 1,257 1,212 1,155 1,086 1,010 Total Debt Year End 10,196 10,013 9,738 9,528 9,271 8,937 8,526 8,026 7,429 6,701 Total Debt Mngmt 10,197 10,013 9,739 9,528 9,272 8,938 8,527 8,027 7,430 6,702 Total Initial debt 12,408 10,196 10,013 9,738 9,528 9,271 8,937 8,526 8,026 7,429 FCF 2,481 496 636 630 742 334 411 500 597 728 Preexisting debt payment 111 33 57 287 100 100 100 100 16 - Bank Debt Payment 2,370 463 579 343 642 234 311 400 581 728

Rf 9% Market Premium 8% Beta Leveraged 0.74 Debt 895 Equity MV 6321 E/EV 88% Beta asset 0.65 R0 14.2%

Discount Rates

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Value of Debt 12,408 10,196 10,013 9,738 9,528 9,271 8,937 8,526 8,026 7,429

Value of Equity 1,460 2,311 3,167 4,136 5,227 6,463 7,861 9,439 11,220 13,228

Value of Kraft 13,868 12,507 13,180 13,874 14,755 15,734 16,798 17,965 19,246 20,657

D/V 89% 82% 76% 70% 65% 59% 53% 47% 42% 36%

E/V 11% 18% 24% 30% 35% 41% 47% 53% 58% 64%

Beta equity 6.16 3.51 2.70 2.17 1.83 1.58 1.39 1.23 1.11 1.01

Re 58.2% 37.1% 30.6% 26.4% 23.6% 21.6% 20.1% 18.9% 17.9% 17.1%

Rd 12.8% 12.8% 12.8% 12.8% 12.8% 12.8% 12.8% 12.8% 12.8% 12.8%

WACC 12.9% 13.0% 13.1% 13.2% 13.3% 13.3% 13.4% 13.5% 13.6% 13.7%

Scenario assumptions

Lower range Difference Upper Range Lower Range

. .

DC

F

FCFE 101 16 116 g 4%

WACC 72 33 106 Ebit Margin 14%

APV 113 23 136 Stock value 12$

CFF 127 25 151 Upper Range

0

Mul

tiple

P/S 71 19 90 g 5%

P/E 126 19 145 Ebit Margin 23%

EV/Book 113 9 122 Stock Value 12$