Case 1 General Mills’ Acquisition of Pillsbury from Diageo PLC 1. What are General Mills’ motives for this deal? Estimate the present value of the expected cost savings (synergies). In the spring of 1998 General Mills began studying areas where they could add to the company and advanced a strategy of acquisition-driven growth. General Mills has several motives for pursuing a deal to acquire Pillsbury. Pillsbury was identified as an ideal target due to its ability to complement General Mills’ other existing businesses and Diageo’s readiness to sell.
The potential acquisition of Pillsbury would create value for shareholders by “accelerated sales and earnings growth….. through product innovation, channel expansion, international expansion, and productivity gains. ” The addition of Pillsbury would lead to a more balanced product portfolio offered by General Mills and its existing businesses, and it the new company would be the fifth largest corporation by measure of global food sales. This diversification and growth allows General Mills to enter new markets and protect itself from losses by stabilizing its markets and adding new customers.
The amount of General Mills shelf space will increase in stores, which allows greater flexibility to advertise products and adjust their products to the demands of the consumer. The company will have access to new markets both geographically and in new fast-growing areas of food sales. Supply chain improvements in sales, merchandising, marketing, and administration through the consolidation of Pillsbury and General Mills would create pre-tax savings that are estimated at $645 million through 2003.
The acquisition would provide an array of new products that would allow General Mills to reach better economies of scope, which would create greater efficiencies in its COGS and SG&A. In terms of growth, the acquisition of Pillsbury would almost double the size of the company in terms of revenue. In 2000, General Mills had revenue of approximately $7. 5 billion and Pillsbury had revenue of approximately $6. 1 billion. Estimate of Cost Savings (See Appendix)
In estimating the present value, we began by estimating the market return by using the 2-year annualized return of the S&P 500. We used the 2-year rate yield because the 1-year yield for the S&P was negative and the 5 and 10-year rate yields were exaggerated by the tech boom. We used a 10-year treasury yield for the risk free rate. For the cost of debt we used the prime rate of lending, the interest rate that banks would charge the most creditworthy, which was 9. 50 percent on December 8, 2000 because General Mills had an investment grade credit rating.
Next, we calculated the weight of debt and equity. Because we know that after the acquisition Diageo will own ? of the General Mills we can multiply that by 3 to determine the total shares outstanding after the merger, which is 423 million shares. To find the market capitalization before the acquisition we subtract 141 million from 423 million and multiply by the stock value. We determined the stock value by using the 20-day average of GIS from November 10 to December 8, 2000, which was $40. 296 per share.
We used General Mills’ market cap and long-term Debt-to-Equity ratio, which is 6. 719 percent to calculate General Mills’ long-term debt. The weight of debt is, then, Therefore, the weight of equity is After the acquisition, General Mills will assume $5. 142 billion in debt, which changes the weight of debt to 33. 67 percent and weight of equity to 66. 33 percent. Now that we have our discount rate of 8. 27326% we can use excel to NPV the expected saving which are $25 million in 2001, $220 million in 2002, and $400 million in 2003 pretax.
The after tax saving is $16. 25 million, $143 million, and $260 million respectively. The pretax NPV of synergies is $525. 89 million and after tax NPV of synergies is $341. 83 million. 2. Why was the contingent value right (CVR) included in this transaction? How does the claw-back affect the attractiveness of the deal from the standpoints of General Mills and Diageo? The contingent value right was included in this transaction due to the conflicting perspectives of the two firms regarding the value of General Mills (GM) shares.
General Mills chose to issue shares to acquire Pillsbury from Diageo, and proposed a payment of $10 billion, whilst Diageo submitted an asking price of $10. 5 billion, which GM perceived to be too expensive. Both sides refused to negotiate as GM felt that their shares were undervalued, whilst Diageo believed that the stock price would either stay the same or decrease and the only way to solve this problem was by issuing a CVR. The fact that GM believed their shares were undervalued discouraged them accepting Diageo’s bidding price for two reasons.
Firstly, as the acquirer’s shares are undervalued, having to pay a higher price ($10. 5 billion) than the amount it has already requested ($10 billion) is no longer feasible, because as the shares are currently priced at discount to its intrinsic value, the firm would have to issue more shares than desired to pay for the acquisition, making it far too expensive. Secondly, when a firm believes the market is undervaluing its shares, then it should not issue new shares to finance the transaction, as that would penalize current shareholders.
The market signaling theory states that if a firm chooses to issue an acquisition using stocks as opposed to cash, it signals to the market that the managers think that the stock is overvalued and may fall after the information is released. In order to encourage GM to take Diageo’s deal it needed some other form of payment to compromise, which is where the CVR became necessary. To bridge the gap between the differing valuations of GM’s share price, a contingent payment clause is included in the transaction. The contingent payment clause was designed so if GM was correct in its valuation and the share price rose, GM would profit.
If Diageo was correct and the share price either remained constant or decreased, Diageo would benefit. When the deal was negotiated, GM was trading at $38, and the contingent payment was designed to benefit both the buyer and the seller if the value of GM differed from this price upon the first anniversary of the closing. At the closing, Diageo established an escrow fund of $642 million, out of which it would make various payments contingent upon GM’s share price. If GM’s average daily share price for 20 days were $42. 55 or more, then GM would receive payment of $642 million.
The ‘claw-back’ affect is that when GM’s stock is 42. 55, GM can reclaim (42. 55-38=4. 55*141million=641. 55) of the escrow fund back. The closer the stock price is to 42. 55, the more money that GM can claw back. The deal is attractive to GM, because they receive the additional payment required to make the deal profitable for them. The deal also beneficial to Diageo, because they own 33% of GM, so they will profit from share appreciation. If GM’s average daily share price were $38 or less, Diageo would pay $0. 45 million to GM.
Diageo will benefit from this because it will only have to pay $450,000 to GM if the stock price is $38, and if the stock price falls below $38, then Diageo can keep $641. 55million. If the stock price falls, it is less beneficial to GM but they still receive some payment. The ideal scenario for both parties is for the stock price to rise above $42. 55, because Diageo would earn $10. 5billion or more from the acquisition, and GM would pay only $9. 8 billion ($2 million less than the original asking price) for the acquisition. Overall, the purpose of the contingent payment is to close the deal, as both parties value the GM stock differently.
If GM is right and the stock price rises in a year, they are paid adequately, whilst if Diageo is right and the stock price falls, they pay less to General Mills. 3. How does the contingent payment work? Prepare a payoff diagram (a hockey stick diagram) of the claw-back feature. Diageo must put $642 million into an escrow fund and the amount disbursed to General Mills is dependent on the General Mills’ stock price. General Mills would receive the full amount of $642 million if the stock price had an average daily moving share price for 20 days of $42. 5 or more. If General Mills’ average daily moving share price is $38. 00 or less, General Mills will receive $0. 45 million. If the stock’s average daily share price is between $38 and $42. 55, Diageo would retain the difference between the average daily share price for 20 days and $42. 55 times the number of GIS shares held by Diageo. 4. What is the contingent payment worth in early December 2000? Use a Black-Scholes calculator/spreadsheet (see options valuation. xls). Be prepared to outline your assumptions and findings.
To determine what the contingent payment was worth in early December 2000, we assumed a stock price of $40. 75 which was the recorded unadjusted close on December 8, 2000. Using the Black-Scholes model, We determined the put value both long and short using exercise prices of $42. 55 and $38. 00. The difference of the two values, which we calculated to be 3. 779 (long) and 1. 869 (short), revealed a cost of contingent value right of 1. 910. We calculated the per share cost of Diageo’s payment to General Mills by dividing $642 million by the number of shares offered coming up with a value f 4. 553 per share. This combined with the cost of the contingent value right led to the conclusion that the contingent payment is worth approximately $6. 466 per share. 5. Is this deal economically attractive to General Mills’ shareholders? Would you recommend that shareholders approve or reject this deal? General Mills acquiring Pillsbury is a horizontal transaction which will enable the newly formed company to expand into new markets such as the food-service industry. This portfolio expansion will increase GM’s customer base while solidifying itself from other industry competitors.
New synergies will arise through economies of scope because GM and Pillsbury are similar in its manufacturing methods. Therefore, by sharing technology and management’s expertise GM can reduce Pillsbury’s product costs, and increase GM’s overall profitability. As the food industry is in its mature life-cycle it is important for GM to maintain market power through external expansion. There are some costs associated with this acquisition. Successfully integrating the two companies into a single entity has underlying risks involved such as how the fit, culture, and business operations of the two companies will merge.
The main additions to General Mills are more products, greater diversification of those products, geographic growth, growth in new types of food markets, and cost-saving through greater efficiency in supply chain improvements. General Mills shareholders will be optimistic about the addition of Pillsbury due to the opportunities created by the deal, however they will want to see the growth in General Mills reflected in its stock price. Assuming General Mills correctly performed due diligence, successfully integrates, and did not overestimate synergies the stock of General Mills should see long term growth.