In the late 1990’s and early 2000’s the food industry was struggling with weak sales and low inflation which caused waves of consolidation among some of the largest firms in the industry. In 1998 General Mills studied areas of potential growth and value creation for their company which lead to small acquisitions of other firms. Looking to further grow their company, in December 2000, management of General Mills made a recommendation to its shareholders that they authorize the creation of more shares of common stock and approve a proposal for the company to acquire Pillsbury Company, a producer of baked goods, from Diageo PLC.

Company Information General Mills General Mills is one of the leading food companies in the world. It is the largest producer of yogurt and the second-largest producer of ready-to-eat breakfast cereals in the United States. The company is primarily engaged in the manufacturing and marketing of branded consumer foods. General Mills also provides branded and unbranded food products to the food-service and commercial baking industries. The company owns many product lines that are marketed under high profile names such as Betty Crocker, Yoplait, Cheerios, and Big G. In 2000, General Mills annual revenue was $7. billion and their market capitalization was about $11 billion. They pursued expansion efforts overseas through joint ventures with Nestle and PespsiCo as their brands are mature and offered low organic growth. In order to stay competitive in the food industry General Mills has begun to acquire smaller firms. In acquiring Pillsbury, General Mills would rank as the 5th largest food company in the world. Diageo Diageo is one of the world’s leading companies in the branded beverage alcohol industry. It is engaged in the production and distribution of branded premium spirits, beer and wine.

Some of their major brands include Smirnoff, Johnnie Walker, Captain Morgan, Baileys Original Irish Cream, J&B, Tanqueray, Guinness, Crown Royal Canadian, Beaulieu Vineyard and Sterling Vineyards, and Bushmills Irish. The company, along with its subsidiaries, sells its products in 180 markets worldwide. In recent years, Diageo’s beer and liquor businesses have been strong performers. In selling Pillsbury, Diageo would be exiting the food business, leaving it well positioned to pursue additional beer and liquor purchases. Pillsbury

Pillsbury is a baked goods company that operates under the parent organization, Diageo PLC. Pillsbury is one of America’s best recognized names in the food industry due to successfully marketing its goods under the popular Dough Boy character. The company controls several other high profile brands such as Green Giant, Old El Paso, and Progresso. In 2000, Pillsbury’s annual revenue was $6. 1 billion and showed a high potential for growth in the food industry. If the deal is accepted, Pillsbury would operate at a wholly-owned subsidiary of General Mills. Industry Analysis Sector Analysis

The consumer foods segment is a sub sector of the consumer staples industry. Companies in this industry, such as General Mills, produce products deemed to be necessities that are purchased by the majority of the population regardless of the economic climate. Staples products include basic food and beverage items, household products, prescription drugs, and tobacco. A primary characteristic of this industry is the consistent demand for these products among consumers. They are generally not purchased in mass quantities, but rather, repeatedly and regularly to keep up with steady consumption.

As a result of this ongoing demand, companies in this sector typically do not experience a lot of stock volatility and are considered to be less risky than the market as a whole. Porter’s 5 Forces To assess the economic structure of the consumer foods industry and determine its relative attractiveness for both business and investments, an analysis using Porter’s five forces was conducted. Rivalry among Existing Competitors Rivalry among existing competitors is extremely high in this industry. This results from the fact that it is a mature segment with many well established companies vying for market share.

The industry is highly consolidated and very fragmented. To grow their businesses, companies rely heavily on mergers and acquisitions to capture additional market share. Historically, the grocery industry has been characterized by slow growth which results in strong price competition and the development of aggressive marketing campaigns between existing firms. Perceived product quality and strong brand recognition by consumers are the basis of competition among firms in the industry. The source of General Mills’ competitive advantage lies in its ability to develop innovative products and highly reputable brands.

As a result, they hold cost leadership positions across a number of grocery categories. Exhibit 1 shows the top US companies according to their sale of packaged foods globally. Market leaders include Kraft Foods, PepsiCo, Nestle, Mars, Kellogg, and General Mills, however, neither company possess an overwhelming share of global sales. This is in part due to the large degree of product diversity throughout the industry and the strong brand rivalry of each competitor’s labels. Threat of Substitutes The threat of customers finding substitute products from other manufacturers in the food industry is high.

In the ready-to-eat breakfast cereals segment, General Mills’ primary business focus, there are a variety of similar products being offered by many brand name companies and private labels. The difference lies in a company’s ability to create a brand that is highly recognizable and perceived as being of high quality. Because General Mills has a reputation of manufacturing high quality products through strong brand names, they are less likely to have loyal customers concerned with quality switch to competitors or private labels when the economy is performing well.

However, when the economy is performing poorly, there is a higher risk that brand name companies will lose consumers to lower-priced private labels. The high risk of substitutes constrains margins and forces manufacturers to compete on a price level in order to develop brand loyalty for their products. There is also the threat that consumers will substitute manufactured food products with produce and other raw food sources. However, as the pace of life continues to increase and people become more pressed for time, demand for pre-packaged, convenient products will continue to increase and the threat of substitutes will be manageable.

Buyer Power The buyer power of consumers in this industry is moderate. On the one hand, consumer buying habits determine the success of products and their manufacturers. There are many companies offering similar products, and as a result, consumers are not subject to large switching costs. Because of the consumer’s ability so switch products easily, they are able to play suppliers against one another which works to keep prices competitive. On the other hand, their power to switch products based on cost diminishes as product prices are increased by manufacturers of competing labels at the same time.

For example, in the cereal industry, as input costs increase, all manufacturers will feel the effects and pass the increase onto the consumer. This decreases the buying power of customers in the sense that, if they want to consume cereals, they will still purchase food from these companies regardless of price increases. When considering the power of manufacturer’s other buyers – the grocery companies, the buying power is high. Because the grocery industry is becoming increasingly consolidated, large retail customers can use their position to dictate price and volume conditions to food manufacturers.

For example, as General Mills’ largest retail customer and its powerful position in the industry, Wal-Mart can force suppliers to provide products at certain prices. Failing to do so could result in them ceasing to carry the manufacturer’s products which would negatively impact the sales and profits of the targeted company. Supplier Power Supplier power in this industry is low to moderate. Agricultural products, such as wheat, are primary inputs in many of General Mills’ products. Wheat is bought and sold through commodities markets.

As a result, manufacturers are impacted by the fluctuation of commodity prices and have to raise their prices if commodity prices increase. However, commodity prices are competitive and are influenced by supply and demand metrics. Because there are many suppliers of grains, sugars, flavourings, and other ingredients, their power over manufacturers is fairly low. However, since supplier’s products are very important to the success of the manufacturing process and product quality, they have a moderate level of power over manufacturers since they could theoretically cease production.

However, as it is assumed they want to remain in business and generate profit, this is not considered to be a high threat for the industry. Threat of New Entrants The threat of new entrants in this industry is low as it is a mature market and barriers to entry are very high. There are high costs associated with starting up a company in this industry. Not only would manufacturing facilities need to be purchased, but a substantial investment would have to be made to develop a customer base and promote brand loyalty. There is not a lot of room for growth and innovation in this industry.

Existing competitors are very influential and have established a high degree of customer loyalty which makes it difficult to compete for market share. Although there is the chance for companies to open targeting niche markets, the major players have the means to buy them out if they become a significant threat. Because there are large fixed costs associated with consumer food manufacturing, new entrants are typically unable to lower prices to compete with existing players. Summary An industry analysis has shown that the threat of new entrants is low, supplier power is not overbearing, and the power of buyers is moderate to high.

Although rivalry and threat of substitutes in the industry is high, the sector can be viewed as attractive for established players because of the stability of demand for food products. The low volatility of the industry should allow existing firms to leverage their positions to expand product lines and grow through future merger and acquisitions. Acquiring Pillsbury Problem The primary problem facing GM, and reason behind the consideration to acquire Pillsbury, is the slow growth of the food industry.

Each of GM’s brands is in the mature phase of the product life cycle, and as a result, the company is having difficulty building growth momentum, expanding its product offerings, and remaining a leader in its highly competitive industry. GM’s management team is looking for a way to grow the company and increase the value of the firm for shareholders. Proposal The transaction between Diageo and General Mills would involve a stock for stock exchange valued at $10. 5 million. This would consist of 141 million shares of GM’s common stock valued at $38 per share according to a July 17 press release issued by GM.

It would also include GM assuming $5. 142 billion in debt from Pillsbury. This includes Pillsbury’s existing debt of $142 million and $5 billion in new borrowing that would be distributed to Diageo in the form of a special dividend before the deal is closed. If approved, the acquisition would result in Pillsbury operating as a wholly-owned subsidiary of GM and Diageo would own 33% of General Mills outstanding shares. The proposal also includes a contingency payment worth a potential $642 million depending on GM’s share price one year following the closure of the deal.

Details of the contingency payment are outline in the following section. Contingency Payment The contingency payment was developed to give Diageo confidence in the value of GM’s shares and help GM reclaim some of the cost of the transaction if its share price increased in the year following the acquisition. GM believes their shares are undervalued and the stock price will increase within one year. Diageo believes that the stock price will either stay the same or decrease within the year. To close the gap between their expectations, they incorporated a contingency payment into the deal. The terms of the contingent payment are as follows: $642 million paid to General Mills by Diageo if the average daily share price for 20 days is great than or equal to $42. 55. * $0. 45 million paid to General Mills by Diageo if the average daily share price for 20 days is less than or equal to $38. * A variable amount if the average daily share price is between $38 and $42. 55. Diageo would retain the amount by which $42. 55 would exceed the average daily share price for 20 days times the number of GM shares they held. If GM is correct in believing that its current market price is undervalued and the stock price rises to more than $42. 5 in one year, it will receive $642 million from Diageo. Although Diageo makes the $642 million payment, they cannot lose in this deal unless the value of GM’s stock crashes. Even if they have to pay out the full contingency, they will make up the difference and benefit from an increased GM stock value. The clawback provision of this deal is the variable amount that gets paid depending on whether stock prices are between $38. 00 and $42. 55. If stock prices rise, the return that Diageo earns over $38. 00 per share would be equal to the partial amount of the escrow fund that Diageo must pay back to GM.

If the stock price rises, GM benefits from having a higher valued company in addition to the contingency amount. Again, Diageo benefits from higher stock prices as they would own 1/3 of outstanding shares of GM. The contingency payment terms were necessary to gain the approval of the company’s respective boards since GM was only willing to pay $10 billion for Pillsbury while Diageo was asking for $10. 5 billion. It worked to bridge the gap between the two company’s different perceptions of GMs’ value. Financial Analysis Benefits of the Acquisition

GM would benefit in many ways from the acquisition of Pillsbury. For starters, it would almost double its annual revenue to approximately $13. 6 billion (annual revenue in fiscal year 2000 was $7. 5 billion and $6. 1 billion for GM and Pillsbury respectively). It would also create shareholder value by providing opportunities for increased sales and earnings growth. This would be obtained through: * Product innovation * Channel expansion * International expansion * Productivity gains A qualitative benefit is the ease with which the cultures of the two companies are expected to come together.

Since they are both headquartered in Minnesota, it can be assumed that the two companies would have an easier time integrating that two firms with different heritages would. Present Value of Cost Savings To illustrate the benefits associated with the acquisition, we calculated the present value of the cost savings that would result from the acquisition. First, to determine the applicable discount rate we used the weighted average cost of capital (WACC), which equals E/V * Re + D/V * Rd * (1-TC). We then determined the cost of equity through use of the Capital Asset Pricing Model where cost of equity = Rf + B (Rm-Rf). The variables were as ollows: Rf: Obtained by using a long maturity government bond yield. The 10 year US Treasure Bond Yield as of December 8, 2000 was 5. 43% B: General Mills beta in 2000 was 0. 65. Rm: The S&P Index experienced significant growth between 1990 and 2000 which can be attributed, in part, to the rapid growth of the technology industry. Because the market slowed and generated negative returns in 2000, with the Dow Jones Industrial Average and S&P 500 indices down 5. 6% and 5. 8% respectively, we computed the average annual return of the market by averaging the returns in the past three years to generate a more realistic return.

The average return on common stock in the market was therefore 11. 8%. The resulting cost of equity was 9. 6% [5. 43% + 0. 65 (11. 8% – 5. 43%)] Cost of Debt (Rd): As of December 8, 2000, the prime lending rate for corporations was 9. 5%. Market value of firm equity (E): The market value of a firms’ equity is the total cash value of the fully diluted outstanding shares. If the deal is approved Diageo would own 141 million shares which is 1/3 of the company. So, 141 * 3= 423 million shares outstanding, since the deal has not yet gone through, there are only 282 million shares outstanding (423M-141M).

In July of 2000, shares were trading around $34-$37, the average price being $35. 50. The market value of the firms’ equity is 282 million shares * $35. 50/share = $10. 011 billion. Market value of firm debt (D): The case presents GMs’ debt-to-equity ratio as 12. 048. Using this and the market value of the firms’ equity we can determine the market value of the firms’ debt. 12. 048 = D/E 12. 048= D/$10. 011 billion $10. 011billion (12. 048)=D $1. 206 billion =D Enterprise Value (V): The enterprise value is the sum of debt and equity. V= E+D V= $10. 011 billion + $1. 206 billion V= $11. 217 billion

Percentage of financing that is equity (E/V): The percentage of financing that is equity is determined by dividing the market value of the firms’ equity by the enterprise value. E/V= % of financing that is equity $10. 011 billion/$11. 217 billion = 89. 2% of financing is equity Percentage of financing that is debt (D/V): The percentage of financing that is debt is determined by dividing the market value of the firms’ debt by the enterprise value. D/V= % of financing that is debt $1. 206 billion/$11. 217 billion = 10. 8% of financing is debt Corporate Tax Rate (Tc): The corporate tax rate in 2000 was 40% WACC= E/V * Re + D/V * Rd * (1-TC)

WACC= 89. 2% * 9. 6% + 10. 8% * 9. 5% * (1-40%) WACC= 9. 2% With the use of the WACC and a time value of money equation, we were able to calculate the present value of the cost savings to be generated by the acquisition of Pillsbury. The total present value of the expected cash savings would be $515 million. Refer to Exhibit 2 for a breakdown of the present value of the cost savings over the next three years. Assumption of Pillsbury’s Debt By assuming Pillsbury’s debt of $5. 142 billion, the percentage of financing through debt and equity changes to 38. 80% (5. 142 + 1. 206/16. 362) and 61. 20% (10. 011/16. 362) respectively.

 

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