On December 8, 2000, management at General Mills proposed a plan to acquire Pillsbury, a baked-goods producer. Pillsbury is currently controlled by Diageo PLC, one of the world’s leading consumer goods companies. The deal specifies that General Mills is to create and thus issue additional shares of common stock to Diageo in exchange for complete ownership of the Pillsbury subsidiary. If the deal is executed, Diageo will become General Mills’ largest shareholder. The consideration to Diageo would include 141 million shares of the company’s common stock and the assumption of $5.142 billion of Pillsbury debt, making the deal worth over $10 billion. In addition, the agreement will contain a contingency payment, as up to $642 million of the total transaction value may be repaid to General Mills at the first anniversary of the closing, depending on its average stock price at that time. In this report, we will calculate and analyze various costs and benefits associated with the transaction to determine whether or not General Mills’ shareholders should vote for the proposed acquisition.
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If approved, General Mills will become the fifth largest food company in the world 2. OVERVIEW OF GENERAL MILLS, INC.
General Mills manufactures and markets branded consumer foods worldwide. It has a strong presence in the United States, as it is the nation’s largest producer of yogurt and the second largest producer of ready-to-eat breakfast cereals. The company owns many product segments that are marketed under high-profile brand names, such as Betty Crocker, Yoplait, Cheerios, and Big G. Each of these businesses in the United States was mature and offered relatively low organic growth. Because of this reason, the firm has pursued numerous expansion opportunities that have successfully positioned General Mills as a market leader.
Its expansion efforts have proved successful, as General Mills had annual revenues of about $7. 5 billion in the fiscal-year 2000. Although highly profitable, General Mills is facing increased competition in the food industry, as rivals are consolidating and becoming more difficult to compete against. Therefore, General Mills must be able to recognize and thus act on potentially high-yielding investments that will allow the company to expand despite the slow-growth food industry. Through a program of aggressive share repurchases in the 1990s, General Mills had increased its book value debt-to-equity ratio dramatically compared with its peers.
Despite this fact, General Mills still maintains an investment grade bond rating from the rating agencies. 3. OVERVIEW OF DIAGEO PLC AND PILLSBURY COMPANY Diageo is one of the world’s leading consumer goods companies formed in 1997 through the merger of GrandMet and Guinness. Its product portfolio consisted of prominent alcoholic-beverage brands such as J&B, Johnnie Walker, Smirnoff, Gordon’s, Tanqueray, and Guinness as well as the Burger King fast food chain and Pillsbury. Pillsbury is a baked goods company that operates under Diageo. Pillsbury is one of America’s best-recognized names in the food industry.
Marketing its goods under the popular Dough Boy character, Pillsbury has successfully positioned its brand and has created a longstanding platform for success in the food industry. The company also controls several other high-profile brands, such as Green Giant, Old El Paso, and Progresso. Not too far behind General Mills, in 2000, Pillsbury generated annual revenues of $6. 1 billion. 4. OVERVIEW OF GENERAL MILLS’ ACQUISITION OF PILLSBURY On December 8, 2000, management of General Mills recommended that its shareholders authorize the creation of more shares of common stock in order to acquire Pillsbury.
The transaction between Pillsbury and General Mills will involve a stock-for-stock exchange that would pay Diageo over $10 billion; 141 million shares of common stock in addition to the assumption of $5. 142 billion in debt. This debt figure includes Pillsbury’s existing debt of $142 million, along with $5 billion in new borrowings that will be distributed to Diageo in the form of a special dividend before the deal is closed. After the transaction is completed, Diageo will own about 33% of General Mills’ outstanding shares. If approved, the transaction would result in Pillsbury operating as a wholly-owned subsidiary of General Mills.
This essentially means that Pillsbury is completely controlled by General Mills, as General Mills would own 100% of Pillsbury’s stock. Diageo is primarily divesting its holding in Pillsbury in exchange for a substantial holding in General Mills. The transaction also includes a rare contingency payment, which specifies that $642 million of the transaction cost will be set aside by Diageo in an escrow account for one year following the closing of the deal. If General Mills’ average stock price is above $42. 55, Diageo is to transfer the $642 million back to General Mills.
If General Mills’ average stock price is below $38, Diageo will only pay $450,000. If the stock price is between these two values, the escrow fund will be split on a pro-rated basis. It is important to note that there are two main constraints involved with the transaction. First, General Mills does not want Diageo to own in excess of 33% of its stock. Second, General Mills does not want to lose its investment-grade bond rating. 5. GENERAL MILLS’ STRATEGIC MOTIVES FOR ACQUIRING PILLSBURY Acquiring Pillsbury can provide General Mills with two main potential benefits.
The first potential benefit for acquiring Pillsbury is growth. The acquisition of Pillsbury gives General Mills the opportunity to double the size of its empire. If the transaction is approved, General Mills will become the fifth largest food company in the world. By acquire Pillsbury, General Mills would create value for shareholders by providing opportunities for accelerated sales and earnings growth. These opportunities would be exploited through product innovation, channel expansion, international expansion, and productivity gains.
In addition to growth, the transaction would also create positive synergies for General Mills through cost savings. General Mills’ management is motivated to close the deal because they believe that the two companies will grow faster together than either would alone. In other words, General Mills hopes to increase the value of the combined enterprise through synergy, which will benefit Diageo as well as the other shareholders of General Mills. The acquisition should accelerate earnings more quickly than if GM remains smaller and continues to focus solely on its core products.
If General Mills acquires Pillsbury, it will be able to combine the capital, resources, and technology of both firms, resulting in greater efficiencies and increased capacity for future expansion efforts. The transaction would also result in at least $645 million in pretax savings between fiscal year 2001 and 2003 ($25 million in fiscal 2001, $220 million in 2002, and $400 million in 2003). These savings are the results of supply chain improvements, efficiencies in selling, merchandising, and marketing, as well as the streamlining of administrative activities. 6.
The deal would be economically attractive if the benefit is greater than or equal to the cost of the acquisition. In other word, the deal would be considered economically attractive if: Value of Pillsbury + Synergies + Clawback Stock Paid + Debt Assumed If the benefit is greater than or equal to the cost of the acquisition, value will be created for the shareholders. In other words, General Mills’ shareholders, which will include Diageo, will be benefit from the transaction. 6. 1. VALUATION OF PILLSBURY (WITHOUT SYNERGIES)
Pillsbury was valued by both Evercore Partners and Merrill Lynch using three valuation methods: comparable firms (LTM EBITDA and LTM EBIT), comparable transactions (LTM EBITDA and LTM EBIT), and discounted cash flow (With and Without Synergies). Since synergies will be calculated separately in our discussion, it is important to value Pillsbury without synergies first (in other words, we need to find the value of Pillsbury by itself). The values that Evercore Partners and Merrill Lynch came up with are between $8. 4 billion and $13. 21.
For our analysis, we will use these numbers as our estimated standalone value for Pillsbury with $8. 4 billon as the low value and $13. 21 as the high value. 6. 2. VALUE OF SYNERGIES (COST SYNERGIES) If the transaction is approved by shareholders, General Mills’ management team believes that the deal would create cost savings of $25 million, $220 million, and $400 million in 2001, 2002, and 2003 respectively. These savings are the results of supply chain improvements, efficiencies in selling, merchandising, and marketing, as well as the streamlining of administrative activities.
However, through positive synergies between General Mills and Pillsbury, we believe that the cost savings will last longer than three years. Below is the discounted cash flow valuation of cost synergies given the following assumptions: a. WACC = 9. 3% b. Annual Inflation = 2% c. Free Cash Flow Perpetual Growth Rate = 2. 5% d. Tax Rate = 40% Based on the analysis above, the net present value of cost synergies is about $3. 24 billion. This number is very significant considered the valuation of Pillsbury itself is only worth between $8. 4 billion and $13. 21 billion.
Synergies will be an important factor in our consideration when we provide our recommendations later in the report. 6. 3. VALUE OF CLAWBACK As part of the agreement between General Mills and Diageo, a contingent payment clause is included in the transaction. The terms of this payment specify that up to $642 million of the total transaction value may be repaid to General Mills at the first anniversary of the closing, depending on its average stock price for the 20 trading days prior to that date. If General Mills’ average stock price is above $42. 55, Diageo is to transfer the $642 million back to General Mills.
If General Mills’ average stock price is below $38, Diageo will only pay $450,000. If the stock price is between these two values, the escrow fund will be split on a pro-rated basis. Exhibit 1 shows the payoff diagram for this contingent payment. With the stock price on the x-axis and the payoff amount on the y-axis, we are able to show the payoff amount (according to the terms in the contingency plan) with respect to the price of General Mills’ stock. As shown in the graph, the payoff is flat at $450,000 when the stock price is in between $0 and $38.
However, the payoff begins increasing when the stock price is between $38 and $42. 55. The closer the stock price comes to $42. 55, the higher the payoff amount to General Mills. Once the stock price reaches $42. 55, the payoff is flat again, as General Mills is to receive a fixed amount of $642 million regardless of the price increase after it reaches the point of $42. 55. Some financial professional called this contingent payment “claw-back” provision because it would reclaim some value for General Mills if its share price rose. This contingent plan serves an important purpose in this transaction.
Since General Mills and Diageo had differences in opinions with regards to the value of General Mills’ stock, the contingency payment serves as a “deal saver”. The entire transaction was about to fall apart over a price disagreement. General Mills didn’t want to pay more than $10 billion, whereas Diageo didn’t want to accept anything less than $10. 5 billion. Therefore, the contingency payment established the “bridge the gap” in purchase price. In addition, General Mills believes that its stock is undervalued, whereas Diageo believes the stock price will stay the same or decrease within a year.
In other words, General Mills thinks the stock is worth more than it is trading for. It serves as an opportunity for General Mills to take advantage of its perception of the strength of its stock. From General Mills’ point of view, the contingent payment is equivalent to a bull spread: a long call with exercise price of $38. 00 and a short call with exercise price of $42. 55. Using Black Scholes option pricing model, the analysis below shows the value for this combined position. From the analysis above, the present value of the contingent payment (Clawback) is between $195. 43 million and $331. 63 million.
If the deal is approved by shareholders, Diageo will own 141 million shares of General Mills’ common stock. To determine the value of General Mills’ stock payment to Diageo, it is important to note that General Mills’ board of directors approved the merger in July of 2000 but General Mills’ executives did not ask the shareholders for creation of more shares of its common stock until December of that year. Due to this reason, the average stock price of July and December will be used to calculate the value of General Mills’ stock payment to Diageo. Using the average price of the July stock price ($35.50 per share), the value of General Mills’ stock payment to Diageo is $5. 006 billion (141 million shares x $35. 50/share). Using the average price of the December stock price ($41. 00 per share), the value of General Mills’ stock payment to Diageo is $5. 781 billion (141 million shares x $41/share). 6. 5. VALUE OF DEBT ASSUMED If the deal is approved by shareholders, General Mills will take on $5. 142 billion in new debt. This debt figure includes Pillsbury’s existing debt of $142 million, along with $5 billion in new borrowings that will be distributed to Diageo in the form of a special dividend before the deal is closed.
This is one of the factors that shareholders should consider when making the decision to whether or not to vote for the deal. It is important to note that General Mills already have a higher increase in debt to equity ratio compared with its peers due to aggressive share repurchase back in the 1990s. General Mills may lose its investment grade bond rating if it has too much debt on its balance sheet. Now that we have all the components of costs and benefits for the acquisition, let’s put it all together to see if the acquisition of Pillsbury will be economically attractive to shareholder.
In other word, will the acquisition of Pillsbury create value for shareholders? The table below summarizes the costs and benefits of Pillsbury Acquisition. Based on the analysis above, the benefits for both low and high end of the acquisition are higher than the costs of the acquisition. Due to this reason, the acquisition of Pillsbury is economically attractive to both General Mills’ managements and shareholders. 7. RECOMMENDATION FOR GENERAL MILLS’ SHAREHOLDERS Based on the cost and benefit analysis, the acquisition of Pillsbury is a promising investment.
Acquiring Pillsbury can help General Mills create synergies through both income / earning growth and cost savings. One key information that all shareholders should keep in mind when making decision is synergies. As shown in the calculation above, synergies account for a large part of the benefit side of the acquisition. If shareholders vote for this deal, they are making a big bet on the creation of synergies between the two companies. If synergies cannot be created between the two companies, no value will be created for the shareholders. Exhibit 1: Payoff Diagram for the Contingent Payment (Clawback) Payoff $38 $42. 55Stock Price