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1. How did Roger Stones management of the company compare to that of his predecessors?
In general, would you judge his leadership to have been successful? Why or why not?
Roger Stone, with highly leveraged acquisitions of distressed producers, stimulated much
higher financial and equity risks with the addition of layered debt. He was able to expand
capacity more than 5 times at one-fifth of the normal cost of building new plants; however
the high degree of operating leverage inherent in the production of paper/ paperboard
exposed the company to a greater degree of cyclicality and pricing risk. Given the high
fixed-cost nature of paper manufacturing, Rogers aggressive capacity expansion left the
company particularly exposed to periods of decline where producers will cut prices before
production. Further, via additional equity offerings overseen by Roger, the Companys family
ownership was diluted to 30% by the late 1980s.
Initially, Rogers strategy was fairly successful as he was growing the earnings of the
business and fulfilling debt obligations. While the acquisition of Bathurst turned Stone into
an industry juggernaut with new access to the European market, a 47% purchase price
premium was paid near the peak of the industry cycle. The Bathurst transaction was at
detour from Rogers strategy of buying depressed assets1 and added significant financial
risk (evidenced by a long-term debt to capital increase from 38.9% at 12/31/1988 to 69.3%
at 12/31/1989) and additional reliance on junk bonds for financing. This transition was a
turning point that set Stone on a path toward financial distress (e.g. near insolvency,
reliance on the sale of assets, revolver refinancing accompanied by heave fees, reluctant
equity issuances likely plagued by adverse selection, LT-debt/EBITDA of >8.0x at 12/31/12)
and rendered Rogers leadership unsuccessful. Further, it is possible that Roger was ill-
advised to turn down Boise Cascades offer to purchase Stone in 1979 for 2X market value.
2. How did Stone Container in recent years finance acquisitions? How did the financing
evolve after the acquisition was completed? Why might Stone Container finance acquisitions
in such a manner, in the language of theories we covered in Class 2?
Gave Champion 12 to 14% of Stones Stock (Less than 40% ownership) $457 million
Purchased during the peak of pricing cycle at 49% over market value.
Became the Worlds 2nd largest producer of pulp, paper and paperboard.
Stone Container had grown increasingly dependent on the issuance of high yield debt in an
effort to balance the benefit of the tax-shield with the costs of bankruptcy, as the trade off
theory from MM states. In line with the pecking order theory, Roger Stone financed the
sizable Bathurst acquisition with short term bank debt, which minimized information
asymmetry and signaled to investors that Stone had quality inside information. Given the
capital intensive nature of the paper industry, Stone had a large amount of tangible assets
on its balance sheet. These assets, whether formally secured as collateral or available to
senior debt holders with priority, reduced agency costs for the debt market and allowed the
company to take advantage of lower cost financing. However, bank loans were eventually
refinanced via the issuance of public debt with junk bonds (higher level of asymmetry)
creating a firm more sensitive to insider information.
By 1992 junk bonds represented 35% of the total public bond issues in the U.S. When this
line of financing was exhausted and no other options were available, Stone Container chose
to make the use of equity as it did in 1991 when it had to sell 9 million shares of stock for
$175 million to raise cash. Eventually, Stone refinanced and restructured its debt using
complex securities such as convertible exchange preferred stock, interest rate swaps, and
high yield subordinated debentures.
3. How sensitive are Stone Containers earnings and cash flow to the paper and linerboard
pricing cycle? Estimate the effect on earnings and cash flow of a $50 per ton industry-wide
increase in prices. How about a $100 per ton industry-wide increase in prices? Assume Stone
Containers sales volume approximates its 1992 production level of 7.5 million tons per year,
and costs, other than interest expenses, remain the same. Also assume a 35% tax rate.
Single variable regression analysis shows that there is noteworthy correlation between: i) the
price of linerboard and Stones net income; and ii) the price of paper and Stones EBITDA
(utilized as a cash flow proxy), while there is weak correlation at the other two cross-
sections.
As indicated by F-tests with significance levels above 95%, the multi variable regression
results below indicate that movements in paper and linerboard pricing as a group have a
statistically significant impact on the Net Income and EBITDA of Stone Container.
When assuming: i) the 1992 production level of 7.5 million tons per year; ii) 1992 costs (with
the exception of interest expense) iii) interest expense of $400 million as implied by the
case2; and iv) a 35% tax rate, earning and EBITDA are highly sensitive to price increases of
$50 and $100 as illustrated below. For full Income Statement details, refer to Appendix I.
4. What would be effect under both these pricing scenarios if production and sales volume
increased to full capacity of 8.3 million tons per year (for simplicity, assume costs per ton
remain constant)?
Of note, the calculated EBITDA forecast for 2013 of $1,241 million with a pricing change of
$100/ton (see question #3) resembles EBITDA of $1,212 million forecasted for a production
increase to 8.5 million tons, holding pricing flat. Therefore, EBITDA resulting from a 13.6%
isolated increase in pricing is comparable to an isolated 13.1% increase in volume. For full
Income Statement details, refer to Appendix I.
5. What should be Stone Containers financial priorities for 1993? What must be
accomplished if Stone is to relieve the financial pressures afflicting it?
Even though there seemed little doubt that paper prices would eventually recover, the
accumulation of $3.3 billion in debt had left the company highly leveraged and was drawing
close to the coverage and indebtedness covenants on its various credit agreements. The
following tasks must be accomplished in order to relieve the company from its financial
crisis:
1. Avoidance of default via compliance with coverage and total indebtedness covenants in
its various credit agreements
2. 80% of the revolving credit facilities were scheduled to terminate in the first quarter of
1993. Stone would need to extend, refinance or replace those facilities
3. Find a way to finance a capital expenditure of $100 million as required by new secondary-
waste treatment regulations in Canada
Stone must find a way to keep the company afloat until an industry upswing allows the
company to reduce its debt load to a sustainable level (closer to peers 45.4% debt/total
capital) that can handle cyclicality.
6. Of the various financing alternatives described at the end of the case, which would be in
the best interest of Stones shareholders? Which would be in the best interests of its high-
yield debt (i.e., junk bond) holders? Of its bank creditors? Which of the financing alternatives
would you recommend Stone Container pursue in 1993? If you recommend more than one,
which do you view as most important and why? Which would you do first, and which later?
Make sure to call upon previous lectures when answering this question.
Best Interests
Shareholders: an outright asset sale or offering of subsidiary stock (option #1) would avoid
the negative consequences of information asymmetry related to a new equity offering and
eliminate cash flow rights of new debt with higher priority.
High Yield Debt Holders: equity issuance would bring in cash that would not dilute their
claim on cash flows and make it more likely that scheduled fixed income will be received.
The convertible offering, with an implied conversion price of $18/sh, is perhaps tantamount
to a backdoor equity offering considering Stones share price in February 2013 compared to
its historical averages. Assuming that Stone weathers its crisis and recovers with the paper
industry, convertible note holders would almost assuredly convert their bonds to common
shares to sell them on the open market if Stones market equity price returns to historical
levels.
Bank Creditors: renegotiation of bank loan agreements would result in hefty fee income with
no change to the banks arrangement as Stones senior lending group with first claim on
company assets in the event of bankruptcy
Recommendation
Pablo - I think that we should recommend 1) an asset sale that could be used to pay down
bank debt (give Stone some cushion on its credit agreement covenants) followed by 2)
issuance of the longer-term convertible notes with the lower coupon. Let me know your
thoughts.
Appendix I
FI 602
Case 6
Anonymous
I. Overview
After its first IPO, Stone was able to widen its reach demographically. The
company began acquiring even more to better diversify itself in the paper
industry. By 1987 Stone had quintupled its production capacity but had
borrowed heavily to do so. Stone Forest Industries, a subsidiary of Stone
Container, was created to relieve some of this debt and Stone Container
was able to diminish the rest. In 1989, Stone was back at it when it
acquired Consolidated-Bathurst Inc in conjunction with its $3.3 billion of
debt. Even with its high standing in the industry, in 1993 Stone Containers
future was a shaking one; one that came down to how it would avoid
defaulting on its $4.1 billion of debt.
* Industry Sales Growth- 38% revenue growth between the years of 1986
and 1992.
Not only does Stone Container have to battle repayment struggles but it is
also facing a volatile industry. In the early 1990's, the paper industry saw a
rise in recycling with a rate of 33.5% of the paper consumed could be
recovered for recycled use. An increase in recycled paper would influence
price changes in the paper industry. This could be contributed to the price
decrease in the early 1990's. Stone was facing changes in how paper was
being produced but also large swings in the industries profitability. Between
1986 and 1992 the paper and forest products industry grew from $61.6
billion in sales to $85.2 billion. Even though this was a 40% increase, the
net profit dropped from $6 billion in 1988 to $.97 billion in 1992. Such a
large decrease in a short amount of time didn't prove favorable for Stone.
These two factors could make it difficult for Stone to accurately forecast its
financials thus its ability to pay back its debt.
Issue
Having seen great success with acquisition in the past, Stone Container
Corporation hasn't seen the results it would have hoped for recently. Stone
disregarded its policy to only buy when it could pay in cash or pay their
debts back quickly. This in turn left them with the uncertainty on how to pay
back the large amounts of debt that were taken on. Because the company's
original plan to refinance their loans with high-yielding bonds went south;
they now face the problem of which of the five alternatives available to
them is the best plan of action to take to arrive at a sound financial plan.
This plan will need to relieve the immense debt that is plaguing them, help
it get through the paper pricing trough, and also restore the company to its
former glory of financial stability.
Choices
Analysis
Multiple assumptions have been made throughout the analysis of the Stone
Container Corporation case. Some of the financial assumptions include:
* A weighted average of the past three years will be used for net sales for
the year ending December 31, 1993 (Exhibit 1).
Relevant Data
Analysis
In analyzing this case one key financial theory was used, financial
leverage. This theory takes the debt of a company and reinvests the
proceeds from that debt in order to earn a greater rate of return than the
cost of interest. When leveraging is successful the firm's return on assets
(ROA) is higher than the interest on the loan, as a result its return on equity
(ROE) will be higher than if it hadn't borrowed. The negative is when the
firm's ROA is lower than the interest rate, its ROE will be lower than if it
hadn't borrowed. Leverage allows a company to see the potential for a
greater return than would have been available without it. But there is risk
involved because the potential for loss is also greater. If the chosen
investment becomes worthless, the company would still be obligated to pay
the principal on the loan and all of the accrued interest.