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GreenEarth Corporation On February 5, 1994, Gary Pratt and Roger Wilson III, chairman of GreenEarth Corporation and Wilson Lumber Corporation respectively, met over lunch to discuss a possible cash sale of a group of recently acquired Wilson Lumber assets to GreenEarth. GreenEarth was a major supplier to Wilson Lumber and, as such, Pratt and Wilson had known each other for about 10 years and enjoyed a good relationship. The asset Pratt sought to buy was a large-scale paper mill that produced rolls of high quality coated paper used in magazines and other glossy printing. If Pratt could acquire the mill at a reasonable price, GreenEarth would be able to diversify into high quality paper capacity. Wilson Lumber was a building product company selling primarily to wholesalers, but with a large retail component. It had been founded in the 1920s by Roger Wilson I, Roger's Grandfather and had achieved fame as the subject of a Harvard Case Study. Wilson Lumber had recently acquired Wickes Lumber Company, which had owned the paper mill under discussion. Some observers had considered the mill Wickes Lumber's \"crown jewel.\" However, Wilson Lumber bought Wickes Lumber in an attempt to integrate backwards into building products. As such, the paper mill was superfluous to the acquisition and Pratt thought Wilson Lumber would be eager to divest it at the right price. Pratt had previously been in negotiation with Wickes to buy the very same paper mill, but had been rebuffed. When Wickes was acquired in a hostile takeover, Pratt felt this gave him a second chance at the asset. GreenEarth Corporation GreenEarth Corporation was one of the U.S. largest forest products/paper firms, with 1993 sales of $6.5 billion and net income of $105 million (see Exhibit 1). The firm competed in two businesses: building products and paper and pulp. Analysts tended to classify GreenEarth as a \"forest products\" firm, due to the fact that 70% of its 1993 sales and 60% of its operating profits stemmed from the firm's building products division, which was the largest producer of plywood in the U.S. They also had a large presence in wood siding and wood shingles. Years ago, GreenEarth had started to use the scrap from their lumber products division to make pulp and eventually paper. This division had grown considerably, it now used much more than just scrap product, and represented 30% of sales. GreenEarth concentrated in producing uncoated offset paper and newsprint. It did not produce high end products, such as coated offset paper, but felt that this was a potential area for growth although it required specialized plants to produce the paper used primarily in magazines and other glossy applications. The forest products industry, on the whole, responds rapidly and dramatically to changes in the overall economy. Sales and profits of products like plywood are tied to construction activity, which in turn is very sensitive to interest rate fluctuations and the 1 general economy. The market for paper was less sensitive to economic conditions and provided an effective diversification for GreenEarth's building products. Recently the market for newsprint had started to soften and Pratt felt the market for magazine paper, with its higher margins, was a more effective area for growth. Overall, newspaper readership was in decline because of the internet and other alternative sources for news. On the other hand, magazine readership remained fairly stable with some growth. The Market for Coated Offset Paper Most people can tell you that paper (or stock) is made from wood, but many don't know how a tree is transformed into a sheet of paper. The basics are pretty simple. Logs are stripped of their bark, and then chipped into very small and thin pieces. The small pieces of stripped logs are placed in a large cooker with chemicals and steamed under pressure until the wood fibers are removed from the lignin (the glue that holds the individual wood fibers together). The resulting pulp is then processed through several machines which will separate the fibers, remove the chemicals, and bleach to proper shade of whiteness. After the pulp has been refined and other additives added to give the finished paper the desired properties, water is added. The result is called furnish. The furnish is spread over a mesh screen which forms the paper and lets the water be extracted. The paper then travels through different processes and machines designed to remove the water from the paper. After the paper is dry, it is run between steel drums to give the desired smoothness. This process is called \"calendering\" the paper. The more times paper is calendered, the less bulk it has but the smoother it gets. To create coated paper, uncoated paper is coated with a paint-like product and buffed by rollers under very high pressure, to create a shiny appearance. This process is called supercalendering. Best suited for higher-quality jobs, coated papers may be gloss-coated, dull-coated (usually a clay or chemical coating), machine-coated (a sheet is made smooth by a blade running over it during the manufacturing process), and cast-coated (a high-gloss coating used for the highest-quality premium papers) on one or both sides. Printing ink does not soak into a coated sheet as much as it does with an uncoated paper, so coated papers can make halftones and color images look richer. Coated paper is primarily used for magazines. Many variables must be considered when selecting the right paper for magazine publication. There are many different paper grades, weights and brands on the market from a variety of mills. Publishers are quite selective in the type of paper they use and choose paper that meets their magazine's \"style.\" It is important to publishers that the magazine \"look\" not changed from issue to issue. Because of the different grades and weights it is also important that the paper chosen work well in the magazine's printing presses. As such, magazine publishers have a much greater loyalty to their suppliers than in other forms of printing and often buy from the same manufacturer year after year. 2 Producers and analysts expected 1994 to be healthy for the coated offset paper industry. Strong demand, limited supply, and limited new capacity were expected to cause the industry to operate at nearly 100% utilization. Given the high fixed costs in the industry, high operating rates meant high profits. Coated offset paper sales were predicted to rise nearly 5% in the near-term, as real GNP and consumer demand strengthened with the economic expansion. Yet, only 1%-2% new capacity was expected to become available before the end of 1996. Therefore, coated offset paper makers should operate at historically high levels of production. Coated offset paper prices were expected to top $973 per ton by the end of 1998. GreenEarth's Interest in Coated Offset Paper GreenEarth's intention to add coated offset paper capacity was well known in the paper and pulp industry. The firm's existing Toledo, Ohio paper mill produced nearly 4000 tons of non-coated offset paper and newsprint per day. Although this was a small percentage of domestic capacity, GreenEarth was one of the largest producers in this fragmented industry. GreenEarth currently did not have a share in the coated offset paper market. More importantly, GreenEarth was the only major paper producer that did not supply this segment of the market. As such, GreenEarth's sales force carried a less complete line than all of its competitors and had even lost some wholesale customers to competitors who could accommodate their entire printing needs. Pratt felt that GreenEarth's current sales force could also sell the coated offset paper with minor training, although it would mean that they would have to call on additional customers. While this would initially take additional onsite visits, most interaction would occur over the phone once a sales relationship was established. GreenEarth had studied possible remedies to the limitation in their product line. A new 3,000-daily-tons coated offset paper mill would cost $2 billion for PP&E, require investing $70 million in working capital, and take three years to build. With cash costs and interest rates at historically high levels, building a new plant did not seem like a financially viable proposition. Moreover, Pratt believed that it might be possible to buy existing plant capacity at a cheaper price. Purchasing had an additional advantage of allowing GreenEarth to enter this market more quickly. Other firms seemed to reach the same conclusion, as indicated by the lack of new coated offset paper plants in the industry. GreenEarth then surveyed and rated (A, B or C) the existing U.S. coated offset paper mills depending on capacity, age, etc. Unlike business school students, many received a C. Pratt called the owners of the 11 \"A\"-rated mills, testing whether they had any interest in selling their mills. None was interested, including Wickes Paper, whose Charlotte mill GreenEarth had ranked as the fourth best in the country. In late 1993, Pratt became aware that the Continental Group, Inc. was interested in selling a package including three smaller coated offset paper mills, with a combined capacity of over 1.1 million tons per year (or 3,014 daily tons). However, GreenEarth lost the bid to 3 Stone Container Corp., whose product line consisted almost exclusively of coated offset paper. Juan Stone, Stone Container's chairman and CEO, summarized the deal: \"The three mills were purchased for around $400,000 per daily ton, excluding working capital. This represents only about 60% of the cost of building new capacity, which, if started today, could not be brought in for less than $670,000 per daily ton three years later.\" The Charlotte, North Carolina Mill Completed in 1978, the state-of-the-art mill produced magazine quality coated offset paper as well as lower-quality coated paper used to produce gift wrapping paper. Prior to the acquisition by Wilson Lumber, Wickes Paper had announced a modernization plan, which involved spending $70M over three years to convert all of the mill's wrapping paper capacity to magazine quality coated offset paper capacity. This move would increase the mill's coated offset paper capacity from 1,191,000 to 1,346,000 annual tons (or 3,688 daily tons). As of early 1994, the conversion process had not yet been started. Because of high shipping costs, printing plants tended to be located either near the supply of wood pulp or near end-users. The Charlotte plant location in North Carolina was close to an abundant supply of timber, yet also closer than most mills' to the large number of end-users along the Northeast Coast. Exhibit 2 shows estimates prepared by GreenEarth's staff for the Charlotte mill. Capital expenditures of about $90M would be incurred over five years to upgrade the mill's wrapping paper capacity to coated offset paper capacity, improve its efficiency, and maintain the facilities. These capital expenditures are included in the projections. After 1998, GreenEarth's staff expected sales of the mill to grow at the rate of inflation, which was forecasted to be 5 percent. Net working capital and net property, plant, and equipment were projected to grow in line with sales after 1998, i.e., at 5% per year. The depreciation expense shown in Exhibit 2 assumes depreciation of the existing Charlotte mill that GreenEarth would purchase as well as depreciation of the capital expenditures from 1994-1998. GreenEarth's finance staff decided to be conservative and to assume the current tax basis and the financial reporting basis of the Charlotte mill. The purchase would include net working capital of about $104.5M already in place. Back at the Meeting Pratt wondered what Wilson planned to do with the newly acquired paper mill capacity. Despite a lack of public statements, Pratt was confident that Wilson was determined to divest the mill since it had no place in Wilson Lumber's strategic plan to become an integrated forest building product company. But how much were the assets worth? And what purchase price would Wilson be willing to accept? Most importantly, what price would Wilson need to offer to avoid an auction and possible loss of the mill to a competitor? In GreenEarth's prior negotiations with Wickes, discussions ended before Pratt had put a value on the mill. 4 To pay for the purchase, Pratt was considering a variety of alternative financing sources. While the financial markets had been quite volatile in the late 1980s and early 1990s, the situation in February 1994 was relatively calm. Yields on investment grade bonds had increased somewhat in recent months, but were still below their historical averages. Further capital markets data is given in Exhibit 3. In this environment, GreenEarth could consider (1) drawing on its unused bank credit line of $1.15 billion, which bore interest at the prime rate plus 1-1/2% (current prime rate, 8.25%); (2) issuing up to $1.2 billion of 25-year callable debentures at a yield of 10-1/4% to be repaid in equal installments over 10 years starting in the sixteenth year; or (3) issuing up to $1 billion common stock at an estimated price of $30 per share with net proceeds of $28 per share (current stock price, $32). Pratt was aware that the board of directors was concerned that GreenEarth's debt might slip to a BB rating. GreenEarth had one of the higher debt percentages among its major peer group competitors (see Exhibit 4), and management was not anxious to explore the outer limits. More importantly, some of GreenEarth's current debt had covenants that would be triggered if GreenEarth's debt percentage (based on market valuation) exceeded 45%. 5 Questions It is essential that you state clearly all the assumptions you are making, and why you make them. Without your assumptions and work, there is no partial credit. The amount of time allocated to each question is meant to be suggestive of the depth of analysis expected. 1) Estimate GreenEarth's valuation for Charlotte Mill (70 pts). a) Estimate separately each of the components of the relevant WACC for the valuation, and the WACC itself. State explicitly the assumptions you are making, and why you are making them. Assume that the market risk premium is 7%. (30 pts) To make grading easier, use a 15% WACC for the rest of the case. b) Estimate carefully the value of the Charlotte mill to GreenEarth. From a financial standpoint, at which price would the purchase be a value-making proposition for GreenEarth? (30 pts) c) Would your estimate of the value of Charlotte Mill increase or decrease if GreenEarth were allowed to step up the tax basis of the mill to reflect the purchase price. Assume that everything else (i.e., EBITDA, CapEx, and working capital) stays the same; only the depreciation goes up. (No calculations needed - conceptual answer only) (5 pts) d) What would be the transaction price suggested by Stone Corporation's recent comparable transaction? (5 pts) 2) Determine the strategic reasons for the transaction (10 pts). Does it make strategic sense for GreenEarth to acquire the mill from Wickes? Should GreenEarth bid its full valuation of the mill or some price below that? Do you expect GreenEarth to be the high bidder? As a shareholder of GreenEarth, couldn't you diversify your investment just as well as by buying a company that specialized in offset coated paper? 3) Advise on the financing of the deal (20 pts). Independent of whatever valuation you calculated, for this next question assume a purchase price of $1.6 billion. a) How should GreenEarth finance the purchase given the financing alternatives described in the case? How does your decision affect the capital structure and other financial policies of the firm? Explain the argument behind your recommendation in detail. (15 pts) 6 b) Wickes offers to sell the mill but wants GreenEarth to accept their existing mortgage debt on the facilities as part of the transaction. The mortgage debt is approximately $500 million and carries an average interest rate of 10% over 20 years. Does this change our decision to acquire the assets? Does it change the price we offer? Does it change our financing decision? (5 pts) 7 Exhibit 1: GreenEarth Corp., 1989-93. Year Ended, December 31 (in $ millions) 1989 1990 1991 1992 1993 Income statement Net sales COGS SG&A EBIT Interest Profit before tax Extraordinary loss Tax Net income 5,207 4,328 279 600 93 507 0 181 326 5,026 4,269 290 467 105 362 0 119 243 5,414 4,720 327 367 137 230 0 70 160 5,402 4,791 377 234 155 79 0 27 52 6,469 5,653 399 417 140 277 118 54 105 Assets Current assets Net fixed assets Total assets 1,161 2,957 4,118 1,238 3,274 4,512 1,417 3,643 5,060 1,449 3,701 5,150 1,516 3,463 4,979 Liabilities and Net worth STD (Short-term debt) A/P (Accounts payable) LTD, current portion LTD (Long-term debt) Other liabilities Common equity Total 62 539 75 1,109 382 1,951 4,118 192 520 75 1,227 429 2,069 4,512 257 552 85 1,487 475 2,204 5,060 167 568 95 1,618 480 2,222 5,150 10 627 95 1,523 482 2,242 4,979 83.10% 5.40% 22.30% 56.80% 10.40% 84.90% 5.80% 24.60% 65.10% 10.30% 87.20% 6.00% 26.20% 67.30% 10.20% 88.70% 7.00% 26.80% 68.50% 10.50% 87.40% 6.20% 23.40% 53.50% 9.70% 36% 33% 30% 34% 34% % Sales COGS SG&A Current assets Net fixed assets A/P Tax as % of profit before tax 8 Exhibit 2: Financial Projections Prepared by GreenEarth for the Charlotte Mill 1993 1994 1995 1996 1997 1998 Annual capacity (000 tons) Utilization rate Production rate (000 tons) Price per ton Mill sales ($ millions) Cost of goods sold ($ millions) 1,191 96% 1,143 843 964.0 744.2 1,260 94% 1,184 883 1,045.5 755.4 1,346 94% 1,265 943 1,193.2 799.7 1,346 96% 1,292 963 1,244.4 868.0 1,346 96% 1,292 973 1,257.4 875.2 Operating profit before depreciation and taxes (EBITDA) Depreciation expense 219.7 26.9 290.1 30.5 393.5 23.9 376.4 17.4 382.2 12.8 Earnings Before Interest and Taxes (EBIT) Corporate Income Taxes Earnings Before Interest After Taxes 192.8 69.4 123.4 259.6 93.5 166.2 369.6 133.0 236.5 359.0 129.2 229.8 369.4 133.0 236.4 68.2 66.1 81.0 78.9 101.6 99.5 115.2 111.0 121.1 116.9 127.2 123.0 173.5 193.6 174.9 162.3 154.6 151.6 29.8 36.2 44.4 50.3 52.2 56.3 Charlotte Mill Current Assets Accounts receivable Inventories Fixed Assets Net Property, Plant & Equipment Current Liabilities Accounts payable 9 Exhibit 3: Capital Market Return Data (Historical and Current) Prevailing Yields on US Government Securities (as of February 4, 1994) Annualized Yield to Maturity (%) 3-Month T-Bill 1-year Bond 5-year Bond 20-year Bond 7.03 7.59 8.49 8.62 Historic Average Total Return on US Government Securities (1929-1993) Average Annual Return (%) T-Bills Intermediate Government Bonds Long Term Government Bonds 3.71 5.22 6.35 Corporate Bond Yields, 1994 Rating Yield (%) AAA AA A BBB BB 8.7 8.9 9.5 10.2 11 Debt to Total Capitalization (at market values, %) Forest products Industrials Publishing and Paper 18 25 30 40 50 14 17 25 32 40 24 32 38 40 50 10 Exhibit 4: Statistics on Selected Forest Products, Paper and Coated Paper Producers GreenEarth Corporation 1989 1990 1991 1992 1993 1989 5,20 5,01 5,41 5,40 6,46 Sales ($ millions) 7 6 4 2 9 328 Stone Container 1990 1991 1992 1993 379 780 Champion Company 1990 1991 1992 1,57 1,66 1,52 5 6 6 Coated paper sales ($ millions) -- 769 Coated paper capacity (000 tons) -- 960 1993 1,68 8 1,39 4 1,69 1 27 1,62 8 105 0.98 33 71 381 110 7.80 708 133 5.45 Average stock price ($/share) Book debt ($ millions) Net income ($ millions) EPS ($/share) Total Capitalization % debt % common Bond rating Equity beta Sales ($ millions) Coated paper sales ($ millions) 39 61 42 58 48 52 47 53 1989 3,75 1 Union Camp 1990 1991 1992 3,75 4,00 3,73 3 4 7 45 55 40 60 1993 4,26 4 552 1989 4,53 3 International Paper 1990 1991 1992 5,04 4,98 4,01 3 3 5 690 Average stock price ($/share) 25 1,12 0 82 1.22 Total Capitalization % debt % common Bond rating Equity beta 37 63 33 67 36 64 38 62 37 63 A 1.40 49 51 505 42 58 A 1.35 Coated paper capacity (000 tons) Book debt ($ millions) Net income ($ millions) EPS ($/share) 411 51 49 1989 1,38 9 67 33 -1.20 20 80 25 75 23 77 30 70 1993 4,35 7 907 1,13 2 1989 2,49 8 Wickes Lumber 1990 1991 1992 2,71 2,81 2,55 3 9 6 53 25 75 21 79 23 77 22 78 AA/A 1.15 1993 2,77 5 916 1,14 4 30 1,57 2 110 1.40 941 131 2.46 29 71 38 62 AA 1.10 31 69 37 63 37 63 40 60 34 66 BBB 1.25 11 12 WACC Computation Sheet Step 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Description Select comparable Compute Book Value of Debt Compute Market Value of Equity Compute leverage ratio for each comparable Compute target leverage ratio for your firm Compute equity ratios (from step 5) Determine expected return on debt Determine tax rate Determine Beta Equity of each comparable Compute Beta Assets of each comparable Check if comparable choices are valid Compute Beta Asset target for your firm Compute Beta Equity for your firm (step 6, 12) Determine risk free rate Variable/Formula Select pure plays = Notes\tPayable + LT\tDebt\tCurrent\tMaturities + LT\tDebt = Closing\tShare\tPrice \tOutstanding\tShares Comparable 1 Use suffix 1 71 A1 = 7 7+A A 7+A GH 71 71 + A1 A2 = 72 72 + A2 = A1 71 + A1 = A2 72 + A2 I = ideally marginal tax rate JKL JNL = JKL JNL JNM Your Firm Case financials Case financials (or Yahoo Finance) 71 72 , 71 + A1 72 + A2 7 =1 7+A Case financials = BCD A1 71 + A1 JN JK JKM JNM = JKM Case financials Case financials (or Yahoo Finance) A2 72 + A2 = BCD JNL , JNM = JN A/ 7 + A QRSTT = Interest rate on US government bonds for period of time similar to length of project (10yr bond for 10yr project) QU QRSTT 17 Set marginal market risk above risk free rate to 7% or 8% Compute expected return on equity Compute WACC 18 Run sensitivity analysis by varying target leverage ratios by 10 percentage points 16 Comparable 2 Use suffix 2 72 GK WACC = QRSTT + JK QU QRSTT = GH 7 A 1 I + GK 7+A 7+A