Kraft and Philip Morris

Be Acquired or Restructure?
The Stock Market Reaction
110.00

95.00

80.00 Important
65.00 dates
Share Prices
50.00
03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct 18 Oct.
PM bid. Kraft’s price
Kraft Philip Morris doubles, excess return of
51% following the offer at
90$

170.00 20 Oct.

Relative Share Prices Nabisco MBO

announced. Kraft’s price
150.00 falls by 5%, market starts
doubting the merger

130.00

24. Oct
110.00
The share price rebounds
thanks to Kraft
announcing the
90.00 restructuring plan and
03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct KKR bidding on Nabisco

Kraft Price Philip Morris Price S&P price

Share Price
Market Value after restructuring announced

Value after restructuring

Market Price after PM offer Company

PM offer price by company
Market price before offer

0.00 20.00 40.00 60.00 80.00 100.00 120.00

S&P500
Share price High Yield Dividend
No major moves in the index,
that averages return of 0.5%
across the period
15.00%
Effective Excess return on Kraft restructuring
announcement day 51% announcement
10.00%
Kraft
After the price jump on
announcement date, Kraft’s
5.00% returns mirror the SP, but on
the day the Nabisco MBO is
announced and when the
restructuring is made public
0.00%
03 Oct 08 Oct 13 Oct 18 Oct 23 Oct 28 Oct
Philip Morris
-5.00% The price moves along with
the SP500,with two
Nabisco MBO exceptions: -5% on
announcement announcement day and +3%
on Nabisco MBO
-10.00% announcement

Excess return Kraft Excess Return PM

Can Philip Morris afford it?

Net Income Revenue growth 5%

Assumptions
EBIT margins 14% adjusted to account for previous acquisitions

Debt The interest will be paid on the average amount of outstanding debt
Repayment Historical cost of debt at 9.5%
Assumptions
Acquisition price of $11b will be financed by 1.5b excess cash and 9.5b debt

FCF We assume all FCFE will be used to repay the principal

Assumptions Historical ratios of Capex, Depreciation and NWC to sales

Historical Tax rate at 44%

Acquisition financing
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.

3,500

3,000

2,500

2,000

1,500

1,000

500

-
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Interest FCFF
Assumptions
Projections

Revenue Margin Interest Payment

Trust Management Do not trust Management Do not trust Management
projections projections projections

6% 25% 3%
2%
5% 20%
1%
4%
15% 0%
3% -1%
10%
2% -2%

5% -3%
1%
-4%
0% 0%

1989
1990
1991
1992
1993

1995
1996

1998
1994

1997
Average Average Average Average
Historical Management Historical Management
Difference Mngmt and own
Revenue Growth EBIT Margin projections
Our Assumptions

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

The EBIT margin increases considerably from the historical average of 9% to 20%. This
14% cannot be justified even accounting for the retention of higher margin activities. We
EBIT margin 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

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

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.

12,000

10,000

8,000

6,000

4,000

2,000

-
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Existing Debt Bank Debt Debt High Yield

Discount rates
R0

14.2%
• βasset = 0.65
• Market premium = 8%
• Rf = 9%

Re

• 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
58.2%
year
• We use Rf and Market premium to calculate Re for every
18.1%
year

WACC

• We assume that the cost of debt stays constant throughout 12.9
the period. We use the previously calculated Re and Rd to
compute the WACC 13.6%
Cash Flows
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
-442 -368 -423 -353 -409 66 72 77 83 63 720
NWC
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
CASH FLOWS

32.06 28.12 26.95 24.93 14.75 11.21 7.66 4.11 0.57 -

Shield
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
-442 -368 -423 -353 -409 66 72 77 83 63
NWC
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
subjectively
We compute
select a range,
Min, Max,
basing our We calculate
Median and
selection on the enterprise
Average
the previously value using the
values for all multiples.
calculated
comparable
values and the
transactions
overall value
of the deal
Valuations Summary

Multiples Valuations We obtain valuations

ranges that are
consistent with Kraft’s
EV/Book projections, but only
when the more
optimistic
P/E assumptions are
used.

P/S If we use our own

assumptions, the
valuation looks very
DCF Valuations fragile, with Net
Income being
negative for the
CFF better part of the
following decade,
due to the burden of
APV interest rates
expenditure.

WACC In comparable
transactions, we
disregard the P/S
FCFE multiples, since it is
often inaccurate.
50 60 70 80 90 100 110 120 130 140 150
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
Undervalues the
company
Accept Philip
Morris Offer 90$
Lower than
current Stock
price

High risk
implementation
Possible Course of Proceed with the
action Restructuring Plan
Management
Incentive

Use restructuring
to force PM to
pay more
Wait for Philip
Morris to increase
their offer price
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

Kraft • Find an alternative bidder (White Knight)
• Stress the importance of being independent
How to increase the
Price • Release private information (Business strategy,
growth forecasts,…)

• Expose fragility of Kraft’s proposed restructuring

Philip Morris • Tender offer directly to Shareholders (premium of
50% over undisturbed share price)
How to Keep the Price • Offer more than 90$ but less than 110$ to initiate
talks
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
 Restructuring Assumptions
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
Average Average Own
Sell businesses 2.1
Historical Management Assumption
Structure % Revenues 55%
Revenue Growth 3% 5% 5%
% Profits 81%
Bank borrowings 6.8
EBIT Margin 9% 23% 14%
Bank debt Dep/Sales 1% 1%
Interest 12%
Debt 3.00 Capex/Sales 2% 2%
Interest low 12.50% NWC/sales 5% 5%
Debt
Interest high 14.75%
Average 13.63%
Debt repaid 2.1
Existing Debt retained 0.904
Interest on retained 8.65%
high Yield interest 15.25%
High Yield Effective 7.63%
No payment (years) 5.00
Number of shares 1987 131
Shares
Number or shares 1988 121.7
Debt Schedule
Existing debt

. 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 - - - - - - - - - -
DEBT

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
 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%

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

Lower range Difference Upper Range Lower Range

. .
FCFE 101 16 116 g 4%

WACC 72 33 106 Ebit Margin 14%

DCF

APV 113 23 136 Stock value 12$

CFF 127 25 151 Upper Range

0
P/S 71 19 90 g 5%
Multiple

P/E 126 19 145 Ebit Margin 23%

EV/Book 113 9 122 Stock Value 12$