CASE 10–2 Altria Group, formerly known as Philip Morris Companies, is a major manufacturer and distributor of consumer products. It has a history of steady growth in sales, earnings, and cash flows. In recent years Altria has diversified with acquisitions of Miller Brewing and General Foods. In Year 8, Altria acted to further diversify by announcing an unsolicited cash tender offer for all the 124 million outstanding shares of Kraft at $90 per share. After negotiation, Kraft accepts a $106 per share all-cash offer from Altria. Assume you are an analyst with Investment Services, and that soon after the cash tender offer you are requested by your supervisor to review the potential acquisition of Kraft and assess its impact on Altria’s credit standing. You assemble various information using the following projected Year 8 and Year 9 financial data:

CASE 10–4A Determining Bond Rating ALTRIA GROUP, INC.

Projected Financial Data ($ millions)

YEAR 9 ESTIMATE Year 8 Estimate Excluding Kraft Before Kraft Kraft Only Adjustments Consolidated Selected Income Statement Data Sales Domestic tobacco................................ $ 8,300 $ 8,930 $ 8,930 International tobacco.......................... 8,000 8,800 8,800 General Foods ..................................... 10,750 11,600 11,600 Kraft.................................................... $11,610 11,610 Beer .................................................... 3,400 3,750 3,750 Total sales ............................................... 30,450 33,080 11,610 44,690 Operating income Domestic tobacco................................ $ 3,080 $ 3,520 $ 35 $ 3,555 International tobacco.......................... 800 940 940 General Foods ..................................... 810 870 870 Kraft.................................................... $ 1,050 50 1,100 Beer .................................................... 190 205 205 Other................................................... 105 125 125 Goodwill amortization ......................... (110) (110) (295) (405)

Total operating income ............................ 4,875 5,550 1,050 (210) 6,390 Percent of sales .................................. 16.0% 16.8% 9.0% 14.3%

Interest expense ...................................... (575) (500) (75) (1,025) (1,600)

Corporate expense ................................... (200) (225) (100) (40) (365)

Other expense.......................................... (5) (5) (5)

YEAR 9 ESTIMATE Year 8 Estimate Excluding Kraft Before Kraft Kraft Only Adjustments Consolidated Pretax income.......................................... 4,095 4,820 875 (1,275) 4,420 Percent of sales....................................... 13.4% 14.6% 7.5% 9.9%
Income taxes ........................................... (1,740) (2,000) (349) 493 (1,856)
Tax rate.................................................... 42.5% 41.5% 40.0% 42.0%
Net income .............................................. $ 2,355 $ 2,820 $ 526 $ (782) $ 2,564 Selected Year-End Balance Sheet Data Short-term debt....................................... $ 1,125 $ 1,100 $ 683 $ 1,783 Long-term debt........................................ 4,757 3,883 895 $11,000 15,778 Stockholders’ equity ................................ 8,141 9,931 2,150 (2,406) 9,675 Other Selected Financial Data Depreciation and amortization ................ 720 750 190 295 1,235 Deferred taxes ......................................... 100 100 10 280 390 Equity in undistributed earnings of unconsolidated subsidiaries ............... 110 125 125 Required:

a. You arrange a visit with Altria management. Given the information you have assembled above, identify and discuss five major industry considerations you should pursue when questioning management.

b. Additional information is collected showing median ratio values along with their bond rating category for three financial ratios. Using this information reported in the excerpt below along with the projections above:
(1) Calculate these same three ratios for Altria for Year 9 using:

(a) Amounts before accounting for the Kraft acquisition.

(b) Consolidated amounts after the Kraft acquisition.
(2) Discuss and interpret the two sets of ratios from 1 compared to the median values for each bond rating category. Determine and support your recommendation on a rating category for Altria after the Kraft acquisition.

Additional Information:
MEDIAN RATIO VALUES ACCORDING TO BOND RATING CATEGORIES Ratio AAA AA A BBB BB B CCC Pretax interest coverage.......................... 14.10 9.67 5.40 3.63 2.25 1.58 (0.42)
Long-term debt as a percent of L-T Debt  Equity.............. 11.5% 18.7% 28.3% 34.3% 48.4% 57.2% 73.2%
Cash flow* as a percent of total debt ..... 111.8% 86.0% 50.9% 34.2% 22.8% 14.1% 6.2%
*For the purpose of calculating this ratio, Standard & Poor’s defines cash flow as net income plus depreciation, amortization, and deferred taxes, less equity in undistributed earnings of unconsolidated subsidiaries.
Source: Standard & Poor’s.