finance decision analysis

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Copyright Information goes hereCompany Proprietary and Confidential

Presentation on Case Study ofStone Container Corporation

Presented For

Sagar SenLecturerInstitute of Business Administration

Presented By

Md. Mainul Haque 09 (45 E)Poonam Barua 100Farhan Imtiaz 112

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Background of the company

• J.H. Stone & Sons, a cardboard container and paper products manufacturer – was founded by Joseph Stone in 1926

• After World War II, it reincorporated as Stone Container Corporation

• In 1993, it was the paper and forest products industry’s leading producer of containerboard and corrugated containers.

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Background of the companyPaid for its acquisitions either entirely in cash or borrowing funds with early repayment.

After its first IPO, the company began acquiring even more to better diversify itself in the paper industry.

By 1987 Stone had quintupled its production capacity, borrowed heavily to do so

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Stone Forest Industries was created to relieve some of this debt

$3.3 billion of debt in 1989 when it acquired Consolidated-Bathurst Inc

In 1993 Stone Containers future was a shaking one-$4.1 billion of debt.

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Background of the IndustryPrice Cyclicality

Most products in the paper industry have exhibited pronounced price cycles

• The industry is very much capital intensive.

• It requires to incur huge amount of fixed costs.

• Therefore, operating leverage of the companies in the industry is high by the nature of the business.

Capital intensive Industry

1980

1982

1984

1986

1988

1990

1992

$350.0

$375.0

$400.0

$425.0

$450.0

$475.0

$500.0

$525.0

$550.0

Unbleached Kraft Paper (1987 dol-lars)

Price/Ton

Year

Pri

ce p

er

ton

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Background of the Industry

• A magnification of profits (EBIT, or net operating income) that results from having fixed operating costs in the cost structure of the company.

• Operating leverage increases as the ratio of fixed costs to variable costs increases.

• With a high ratio of fixed costs to variable costs, a small percentage change in sales will lead to a large percentage change in operating profits. In other words, the percentage increase in EBIT is magnified.

Operating leverage

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Background of the Industry

• Degree of operating leverage is defined as the percentage change in EBIT divided by the percentage change in sales

• It measures to what extent operating profit will vary with the given change in sales for a given level of fixed costs

• The higher the DOL, the higher the volatility in EBIT due a given change in sales.

• A change in sales may result from external factors such as price movements, state of economy etc.

• The higher the DOL, the higher the business risk – the chance that external factors may be unfavorable causing decreasing sales.

Degree of Operating leverage (DOL)

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Background of the competition

Competitor Analysis

Company Products

Stone Container Corporation Container board, corrugated containers, kraft paper, bags, sacks, newspaper manufacturing products, wood pulp

Willamette Inds.

Chesapeake Corporation Commercial tissues, kraft paper, corrugated containers

Union Camp Corporation Pulp, uncoated white papers, paper bags, corrugated containers

Westvaco Corporation Paperboard, Containerboard

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Expansion strategy of the company

Acquisition A corporate action in which a company buys most, if not all, of the target

company's ownership stakes in order to assume control of the target firm. Acquisitions are often made as part of a company's growth strategy whereby

it is more beneficial to take over an existing firm's operations and niche compared to expanding on its own.

Acquisition turned out to be a profitable technique for Stone because- They acquired the plants during industry ‘troughs’ which allowed them

to expand at low cost and with greater speed.

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Vertical Integration The process in which several steps in the production and/or distribution of a product

or service are controlled by a single company or entity, in order to increase that company’s or entity’s power in the market place. When a manufacturer owns its supplier, it’s a backward integration. When a manufacturer owns its distributor, it’s a forward integration.

One of Stone Corporation’s acquisition objectives was to form strong backward integration. Stone acquired plants and/or companies that produce its raw materials -• Mills producing jute linerboard and corrugated medium-raw material for

corrugated containers.• Producers of kraft linerboard – raw material for containers.• Canada’s fifth largest pulp and paper producer, Bathurst.

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Conglomerate It is a combination of two or more corporations engaged in

entirely different businesses All corporations called subsidiaries - fall under one corporate

group called parent company Often, a conglomerate a multi-industry company E.g. Beximco group in Bangladesh. This conglomerate has

subsidiaries such as Beximco Synthetic Ltd. (textile), Beximco pharmaceuticals Ltd. (pharmaceuticals), Shinepukur Ceramics Ltd. (ceramic), Independent Television (media) etc.

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Conglomerate Conglomerate has businesses in various industries. Therefore,

its risk can be well diversified It can enjoy the benefits of vertical integration However, it may lose its focus on its core businesses and not be

able to manage unrelated businesses equally well

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Horizontal Integration The acquisition of additional business activities that are at the

same level of the value chain in similar or different industries. E.g. Acquiring a competitor entity is a horizontal integration

Stone Corporation acquired Light corrugated box company in Philadelphia – a competitor in the region – to expand the business beyond Chicago.

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Current situation of the company

Financial Leverage The company made many highly leveraged acquisitions. This made the financial leverage of the company very high.• The use of debt funds in a profit-making and tax-paying business

improves the equity returns (ROE). • Financial leverage is the effect that the use of debt funds

produces on returns • Financial leverage refers to a firm's use of fixed-charge securities

like debentures in its plan of financing the assets.

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Financial Leverage Financial leverage is a double-edged sword.

It magnifies returns and Increases their volatility as well. Increased volatility implies greater financial risk – the chance that the

company may not be able to meet its debt obligation and go bankrupt. The higher financial leverage, the more it magnifies profits as well as

losses. It is measured by Debt to total capital ratio or by Debt to equity ratio

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Degree of Financial Leverage (DFL) It measures to what extent net income will vary with the change

in operating profit (EBIT) given a certain level of debt. It is calculated by dividing %change in net income by %change in

operating profit. The higher the DFL, the higher the impact of financial leverage,

and the more it magnifies profits as well as losses

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Degree of Combined Leverage (DCL) It measures the total impact of DFL and DOL. It is calculated by dividing %change in net income by %change in

sales. The higher the DCL, the higher the impact of total leverage, and

the more it magnifies profits as well as losses Companies with high DOL should maintain low DFL to reduce risk

– so, companies which require to incur high fixed costs to carry out businesses should go for low level of debt

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Current situation of the companyCross sectional comparison: year 1992 Financial

RatiosStone

CorporationChesapeake

Corp.Union Camp

Corp.Westvaco

Corp.Willamette

Inds.

Return on sale (NPM) (3.2%) 0.5% 2.5% 5.8% 3.4%

Return on total capital

(ROI)3.5% 4.4% 3.2% 6.6% 6.0%

Return on Equity (ROE)

(14.7%) 1.3% 4.1% 7.7% 7.0%

Current Ratio 1.8 2.4 4.2 1.9 1.5

Debt to total capital

78.2% 51.1% 48.9% 37.8% 43.7%

Interest Coverage

0.5 1.6 1.3 3.6 2.4

Earnings per share (EPS)

(2.50) 0.17 1.10 2.06 1.52

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Current situation of the companyCross sectional comparison

Retur

n on

sale

s (N

PM)

Retur

n on

tota

l cap

ital (

ROI)

Retur

n on

equ

ity (R

OE)

Debt t

o to

tal c

apita

l

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

Stone Container Corp.

Chesapeake Corp.

Union Camp Corp.

Westvaco Corp.

Willamette Inds.

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Current situation of the companyTime series comparison: Stone Container

Financial Ratios 1992 1991 1990

Return on sales (NPM) (3.2%) 0.5% 2.5% Return on total capital (ROI) 3.5% 5.2% 10.6% Return on equity (ROE) (14.7%) (3.2%) 6.5% Current ratio 1.8 1.8 1.4 Debt to total capital 78.2% 73.1% 73.7% Interest coverage 0.5 0.8 1.4 Earnings per share (2.50) (0.78) 1.56 %change in sales 2.53% -6.46% %change in EBIT -35.49% -49.14%%change in net income -261.30% -151.47% DOL 14.01 7.61 DFL 7.36 3.08 DCL 103.15 23.46

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Current situation of the companyTime series comparison

1990 1991 1992

-30.00%

-10.00%

10.00%

30.00%

50.00%

70.00%

90.00%

Return on sales (NPM)Return on total capi-tal (ROI)Return on equity (ROE)Debt to total capital

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Problem in Question

• High financial leverage and high operating leverage with cyclical downward movement in prices of output

• This situation left the company with the uncertainty on how to pay back the large amounts of debt that were due in the coming year.

• Operating leverage cannot be decreased since high operating leverage is the essence of the business

• Therefore, financial leverage must be brought down• They now face the problem of which of the 5 alternatives available to

them is the best plan of action to take to arrive at a sound financial plan. • The goal of this plan was to relieve the immense debt that was plaguing

them, help it get through the paper pricing trough, and also restore the company to its former glory of financial stability.

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Option 1

Loan restructuring• The borrower works with the same agreement. • The terms of the agreement are altered, such as extending

the date by which balance must be paid off. • This means the borrower does not create a new account and

continue to work with the same creditor as before. • restructuring equates to modification. • In the case of Stone Corporation, among the five alternatives,

one was loan restructuring

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Option 1

• Loan restructuring– The terms on the bank loans could be renegotiated to

extend their maturities and ease some of the binding covenants. Fees for this transaction would range from $70 to $80 million.

• The effects of this would be $70-80 million in fees. • This option doesn't decrease the Stone's family's interest in

the company further • However, it doesn't involve any new inflow of fund.• It can be accepted.

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Option 2

• Assets or equity interest in a Stone Container Corporation subsidiary could be sold for a cash flow of $250 to $500 million.

• Selling equity interest would decrease the Stone family's interest in the company further below 30%

• Selling assets is not good for the future of the core business • However, it would bring in the funds needed to help decrease

the company's debt• It should NOT be accepted

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Option 3 & 4

Loan refinancing• Borrower applies for a new loan and thus start working with a

new lender. • Borrower may get better terms under the new contract, but

does not alter the terms of the original loan. • Borrower uses the funds from the new loan to pay off the

original debt. • refinancing equates to replacement. • In the case of Stone Corporation, among the five alternatives,

two were loan refinancing

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Option 3

• Debt refinancing– The bank debt could be repaid by selling intermediate-term senior

notes to the public. $300 million of 5-year notes bearing a coupon in from 12% to 12 ½% could be sold.

– This is a bond that takes priority over the other debt securities sold by the company. If Stone were to go bankrupt, this debt must be repaid before other creditors receive payment.

– This would replace the debt that was due in the coming year. The company would avoid a possible default • without losing its creditworthiness,• Without reducing Stone family’s interest in the company• Without selling any asset of the company

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Option 4

• Debt refinancing– The company could sell up to $300 million of convertible subordinated

notes. The notes would have 7 year life, bear a coupon of 8 ¾%, and be convertible into Stone's common stock

– The other debt securities sold by the company take priority over this bond. If Stone were to go bankrupt, this debt would be repaid only after other senior creditors receive payment.

– This would replace the debt that was due in the coming year. The company would avoid a possible default • without losing its creditworthiness,• Without reducing Stone family’s interest in the company• Without selling any asset of the company

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Option 3 and 4 compared

EBIT(M)

Loan amount

(M)Loan term

in yrinterest

rateannual interest

(M)EBT(M)

Tax(M)

Net income

(M)ROE

Total interest

(M)

Option 3 169.04 300 5 12.50% 37.5 131.54 46.04 85.50 7.10% 187.5

Option 4 169.04 300 7 8.75% 26.25 142.79 49.97 92.81 7.71% 183.75

From the table above,• Subordinated notes offered the higher ROE and involved the

lower amount of interest charges. • Additionally, subordinated notes had claim only after the claims

of other senior debts were met.• Then, subordinated notes had longer maturity• Therefore, convertible subordinated notes should be preferred to

the senior notes in this case

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Option 5

• Common stock of up to $500 million could be issued to the public which would produce net proceeds for the company of 95% of the offering price.

• This option could potentially allow the company to put $475 million towards its debt.

• However, this would decrease the Stone family's interest in the company further below 30%

• It should not be accepted

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Recommendation

Option 1– Renegotiating the terms of loans would allow the company

more time to restructure its debt portfolio and give them a chance to depend less on an alternative that decreases the family's share in the company.

– This option outweighs the alternative to sell equity in the company or its subsidiaries because there is no loss of family stake in the company.

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Recommendation

Option 4– The shareholders of the company could earn good return

on their equity. – This alternative outweighs the option to issue senior notes

because the ROE is higher and the total interest paid is less – The longer life of this option would allow Stone to spread

out its default risk farther than any of the other options. – This option would also keep the Stone family's interest in

the company the greater than compared to option number five.

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Conclusion

• If Stone Corporation wants to stay out of bankruptcy it needs to restructure its debt.

• The company had a long time standing of not needing debt or paid it off quickly but that changed because of large acquisitions.

• Five debt reducing alternatives were presented to the company in order to – relieve the immense debt that is plaguing them, – help it get through the paper pricing trough, – help restore the company to its former glory of financial stability.

• Two options offered the biggest rewards. – The company should restructure its loan terms and – issue $300 million in convertible subordinated notes

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