Stone Container Corporation 285r26

Stone Container Corporation

1. How did Roger Stone’s management of the company compare to that of his predecessors? In general, would you judge his leadership to have been successful? Why or why not? Stone Container Corporation (“Stone”) has historically been an acquisitive company. However, in the wake of the Great Depression, its founders established a longstanding policy to “not to carry any significant debt for long periods of time”. Prior to 1979, acquisitions that served to diversify the company’s product offering and geographic presence were typically paid for with a combination of cash and loans that were repaid early. While Stone completed an initial public offering in 1947, the business remained conservatively capitalized thereafter with family ownership in the majority at 57%. Roger Stone, with highly leveraged acquisitions of distressed producers, stimulated much higher financial and equity risks with the addition of layered debt. He was able to expand capacity more than 5 times at one-fifth of the normal cost of building new plants; however the high degree of operating leverage inherent in the production of paper/ paperboard exposed the company to a greater degree of cyclicality and pricing risk. Given the high fixed-cost nature of paper manufacturing, Roger’s aggressive capacity expansion left the company particularly exposed to periods of decline where producers will cut prices before production. Further, via additional equity offerings overseen by Roger, the Company’s family ownership was diluted to 30% by the late 1980’s. Initially, Roger’s strategy was fairly successful as he was growing the earnings of the business and fulfilling debt obligations. While the acquisition of Bathurst turned Stone into an industry juggernaut with new access to the European market, a 47% purchase price was paid near the peak of the industry cycle. The Bathurst transaction was at detour from Roger’s strategy of buying depressed assets1 and added significant financial risk (evidenced by a long-term debt to capital increase from 38.9% at 12/31/1988 to 69.3% at 12/31/1989) and additional reliance on junk bonds for financing. This transition was a turning point that set Stone on a path toward financial distress (e.g. near insolvency, reliance on the sale of assets, revolver refinancing accompanied by heave fees, reluctant equity issuances likely plagued by adverse selection, LT-debt/EBITDA of >8.0x at 12/31/12) and rendered Roger’s leadership unsuccessful. Further, it is possible that Roger was illadvised to turn down Boise Cascade’s offer to purchase Stone in 1979 for 2X market value.

2. How did Stone Container in recent years finance acquisitions? How did the financing evolve after the acquisition was completed? Why might Stone Container finance acquisitions in such a manner, in the language of theories we covered in Class 2? Year Transaction description Amount 1979 Expansion of South Caroline line board $55 million 1981 Dean Dempsey Corp. equity position undisclosed 1983 Acquisition of Continental Groups. Long term debt rose to 79% of capital First equity offering (Family ownership 57% to 49%) $600 million 1985 Acquisition of Champion International Corporation Gave Champion 12 to 14% of Stone´s Stock (Less than 40% ownership) $457 million 1987 Acquisition of Southwest Forest $760 million 1989 Acquisition of Consolidated Bathurst Inc. Purchased during the peak of pricing cycle at 49% over market value. Became the World´s 2nd largest producer of pulp, paper and paperboard. Enter European market through U.K. subsidiary $2.7 billion Stone Container had grown increasingly dependent on the issuance of high yield debt in an effort to balance the benefit of the tax-shield with the costs of bankruptcy, as the “trade off” theory from MM states. In line with the pecking order theory, Roger Stone financed the sizable Bathurst acquisition with short term bank debt, which minimized information asymmetry and signaled to investors that Stone had quality inside information. Given the capital intensive nature of the paper industry, Stone had a large amount of tangible assets on its balance sheet. These assets, whether formally secured as collateral or available to senior debt holders with priority, reduced agency costs for the debt market and allowed the company to take advantage of lower cost financing. However, bank loans were eventually refinanced via the issuance of public debt with “junk bonds” (higher level of asymmetry) creating a firm more sensitive to insider information.

By 1992 junk bonds represented 35% of the total public bond issues in the U.S. When this line of financing was exhausted and no other options were available, Stone Container chose to make the use of equity as it did in 1991 when it had to sell 9 million shares of stock for $175 million to raise cash. Eventually, Stone refinanced and restructured its debt using complex securities such as convertible exchange preferred stock, interest rate swaps, and high yield subordinated debentures. 3. How sensitive are Stone Container’s earnings and cash flow to the paper and linerboard pricing cycle? Estimate the effect on earnings and cash flow of a $50 per ton industry-wide increase in prices. How about a $100 per ton industry-wide increase in prices? Assume Stone Container’s sales volume approximates its 1992 production level of 7.5 million tons per year, and costs, other than interest expenses, remain the same. Also assume a 35% tax rate. Single variable regression analysis shows that there is noteworthy correlation between: i) the price of linerboard and Stone’s net income; and ii) the price of paper and Stone’s EBITDA (utilized as a cash flow proxy), while there is weak correlation at the other two crosssections. As indicated by F-tests with significance levels above 95%, the multi variable regression results below indicate that movements in paper and linerboard pricing as a group have a statistically significant impact on the Net Income and EBITDA of Stone Container. When assuming: i) the 1992 production level of 7.5 million tons per year; ii) 1992 costs (with the exception of interest expense) iii) interest expense of $400 million as implied by the case2; and iv) a 35% tax rate, earning and EBITDA are highly sensitive to price increases of $50 and $100 as illustrated below. For full Income Statement details, refer to Appendix I. 4. What would be effect under both these pricing scenarios if production and sales volume increased to full capacity of 8.3 million tons per year (for simplicity, assume costs per ton remain constant)? Of note, the calculated EBITDA forecast for 2013 of $1,241 million with a pricing change of $100/ton (see question #3) resembles EBITDA of $1,212 million forecasted for a production increase to 8.5 million tons, holding pricing flat. Therefore, EBITDA resulting from a 13.6% isolated increase in pricing is comparable to an isolated 13.1% increase in volume. For full Income Statement details, refer to Appendix I. 5. What should be Stone Container’s financial priorities for 1993? What must be accomplished if Stone is to relieve the financial pressures afflicting it?

Even though there seemed little doubt that paper prices would eventually recover, the accumulation of $3.3 billion in debt had left the company highly leveraged and was drawing close to the coverage and indebtedness covenants on its various credit agreements. The following tasks must be accomplished in order to relieve the company from its financial crisis: 1. Avoidance of default via compliance with coverage and total indebtedness covenants in its various credit agreements 2. 80% of the revolving credit facilities were scheduled to terminate in the first quarter of 1993. Stone would need to extend, refinance or replace those facilities 3. Find a way to finance a capital expenditure of $100 million as required by new secondarywaste treatment regulations in Canada Stone must find a way to keep the company afloat until an industry upswing allows the company to reduce its debt load to a sustainable level (closer to peers – 45.4% debt/total capital) that can handle cyclicality. 6. Of the various financing alternatives described at the end of the case, which would be in the best interest of Stone’s shareholders? Which would be in the best interests of its highyield debt (i.e., junk bond) holders? Of its bank creditors? Which of the financing alternatives would you recommend Stone Container pursue in 1993? If you recommend more than one, which do you view as most important and why? Which would you do first, and which later? Make sure to call upon previous lectures when answering this question. Best Interests Shareholders: an outright asset sale or offering of subsidiary stock (option #1) would avoid the negative consequences of information asymmetry related to a new equity offering and eliminate cash flow rights of new debt with higher priority. High Yield Debt Holders: equity issuance would bring in cash that would not dilute their claim on cash flows and make it more likely that scheduled fixed income will be received. The convertible offering, with an implied conversion price of $18/sh, is perhaps tantamount to a backdoor equity offering considering Stone’s share price in February 2013 compared to its historical averages. Assuming that Stone weather’s its crisis and recovers with the paper industry, convertible note holders would almost assuredly convert their bonds to common shares to sell them on the open market if Stone’s market equity price returns to historical levels.

Bank Creditors: renegotiation of bank loan agreements would result in hefty fee income with no change to the banks’ arrangement as Stone’s senior lending group with first claim on company assets in the event of bankruptcy Recommendation Pablo - I think that we should recommend 1) an asset sale that could be used to pay down bank debt (give Stone some cushion on its credit agreement covenants) followed by 2) issuance of the longer-term convertible notes with the lower coupon. Let me know your thoughts. Appendix I

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Stone Container Corp FI 602 Case 6 Stone Container Corp Case Analysis Write-up Anonymous I. Overview J.H. Stone & Sons, a cardboard container and paper products manufacturer was founded by Joseph Stone in 1926 and after World War II

reincorporated as Stone Container Corporation. Early on in its conception Stone was able to grow significantly by way of acquisition. The company had a policy of paying for its acquisitions either entirely in cash or borrowing funds with early repayment. Continuing to grow, the company became publicly-owned when it issued its first 250,000 shares of stock in 1947. After its first IPO, Stone was able to widen its reach demographically. The company began acquiring even more to better diversify itself in the paper industry. By 1987 Stone had quintupled its production capacity but had borrowed heavily to do so. Stone Forest Industries, a subsidiary of Stone Container, was created to relieve some of this debt and Stone Container was able to diminish the rest. In 1989, Stone was back at it when it acquired Consolidated-Bathurst Inc in conjunction with its $3.3 billion of debt. Even with its high standing in the industry, in 1993 Stone Containers future was a shaking one; one that came down to how it would avoid defaulting on its $4.1 billion of debt. II. Condition of the Industry Summary of the Paper & Forest Products industry: * Industry Niches and relevant competitive leaders: * Paper and Wood- Georgia Pacific * Sanitary Tissue Products- Scott * Softwood Timber- Weyerhae * Containerboard/Corrugated Containers- Stone Container Corporation * Industry Sales Growth- 38% revenue growth between the years of 1986 and 1992. * 1986 Revenue- $61.6 billion * 1992 Revenue- $85.2 billion

* Industry Net Profit - Declined by 65% between the years of 1986 and 1992. * 1986 NP- $2.85 billion * 1992 NP- $.97 billion * High degrees of price cyclicality due the operating leverage inherent in the Industry's capital intensive schema. * Highly competitive Containerboard/Corrugated Containers niche with Stone facing 5 direct competitors. III. Condition of the Company Due to heavy acquisition, Stone Container Corporation has put themselves in a tight financial situation with debt and interest payments. Stone's plans to finance its large acquisitions such as the one of Consolidated-Bathurst, went awry when its plan to refinance its loans with high-yield bonds was eliminated. This was partially due to regulators forcing many saving and loans banks to dump their junk bonds. Stone found a way to relieve some of its financial pressure by refinancing and restructuring its debt using securities such as interest rate swaps and convertible exchangeable preferred stock. An interest rate swap would allow Stone to exchange a stream of interest payments for another party's stream of cash flows. This would alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations. Convertible exchangeable preferred stock is stock that can be exchanged at the issuer's option for convertible debt that has the same yield and conversion . Both of these options could be problematic for Stone because it leaves them open to interest rate risk. Not only does Stone Container have to battle repayment struggles but it is also facing a volatile industry. In the early 1990's, the paper industry saw a rise in recycling with a rate of 33.5% of the paper consumed could be recovered for recycled use. An increase in recycled paper would influence price changes in the paper industry. This could be contributed to the price decrease in the early 1990's. Stone was facing changes in how paper was being produced but also large swings in the industries profitability. Between

1986 and 1992 the paper and forest products industry grew from $61.6 billion in sales to $85.2 billion. Even though this was a 40% increase, the net profit dropped from $6 billion in 1988 to $.97 billion in 1992. Such a large decrease in a short amount of time didn't prove favorable for Stone. These two factors could make it difficult for Stone to accurately forecast its financials thus its ability to pay back its debt. IV. Issues, Choices, and Analysis Facing the Company Issue Having seen great success with acquisition in the past, Stone Container Corporation hasn't seen the results it would have hoped for recently. Stone disregarded its policy to only buy when it could pay in cash or pay their debts back quickly. This in turn left them with the uncertainty on how to pay back the large amounts of debt that were taken on. Because the company's original plan to refinance their loans with high-yielding bonds went south; they now face the problem of which of the five alternatives available to them is the best plan of action to take to arrive at a sound financial plan. This plan will need to relieve the immense debt that is plaguing them, help it get through the paper pricing trough, and also restore the company to its former glory of financial stability. Choices Debt Relief Avenues Available to Stone Container Corporation: 1. The on the bank loans could be renegotiated to extend their maturities and ease some of the binding covenants. Fees for this transaction would range from $70 to $80 million. 2. Assets or equity interest in a Stone Container Corporation subsidiary could be sold for a cash flow of $250 to $500 million. 3. The bank debt could be repaid by selling intermediate-term senior notes to the public. $300 million of 5-year notes bearing a coupon in from 12% to 12 ½% could be sold.

4. The company could sell up to $300 million of convertible subordinated notes. The notes would have 7 year life, bear a coupon of 8 ¾%, and be convertible into Stone's common stock at a 20% over the market price of Stone's common stock at the time of the offering. 5. Common stock of up to $500 million could be issued to the public which would produce net proceeds for the company of 95% of the offering price. Analysis Multiple assumptions have been made throughout the analysis of the Stone Container Corporation case. Some of the financial assumptions include: * •A weighted average of the past three years will be used for net sales for the year ending December 31, 1993 (Exhibit 1). * •Selling, general, and istrative expenses are last year's expense plus the average of the change in expense over the past three years (Exhibit 1). * Depreciation and amortization expense is calculated the same as selling, general, and istrative expenses (Exhibit 1). * Sales tax rate of 35% (Exhibit 2). Relevant Data In order to fully analyze Stone Container Corporation's financial situation some relevant data was needed in order to get a better picture of what it was facing. During the year of March 1993 to March 1994, the company would: * • continue to pay $400 to $425 million in interest on its debt * • make debt repayments of $365 million * • extend, refinance, or replace another $400 million in revolving credit that was scheduled to terminate * • be required to make $100 million of new capital expenditures

* • face pre-tax losses of $450 to $500 million Analysis In analyzing this case one key financial theory was used, financial leverage. This theory takes the debt of a company and reinvests the proceeds from that debt in order to earn a greater rate of return than the cost of interest. When leveraging is successful the firm's return on assets (ROA) is higher than the interest on the loan, as a result its return on equity (ROE) will be higher than if it hadn't borrowed. The negative is when the firm's ROA is lower than the interest rate, its ROE will be lower than if it hadn't borrowed. Leverage allows a company to see the potential for a greater return than would have been available without it. But there is risk involved because the potential for loss is also greater. If the chosen investment becomes worthless, the company would still be obligated to pay the principal on the loan and all of the accrued interest. With a wide assortment of avenues Stone Container Corporation could take to improve its debt ratio, each one had to be carefully considered. Option number one was to renegotiate the of its loans. The effects of this would be $70-80 million in fees. This option is the only solution that doesn't involve the Stone's family's interest in the company to lessen but doesn't have an upside of taking in money. Option number two was to sell off some assets or equity interest in the company that could raise $250-500 million. This option would decrease the Stone family's interest in the company but would still bring in the funds needed to help decrease the company's debt. Option number three was to sell a senior intermediate-term note with a 5year term and a coupon of 12 to 12 ½%. This is a bond that takes priority over the other debt securities sold by the company. If Stone were to go bankrupt, this debt must be repaid before other creditors receive payment. Option number four was to $300 million in convertible subordinated notes with a life of 7 years and a 8 ¾% coupon. These options would allow the company to receive funds up front with coupon payments paid in the future. A financial leverage analysis was compared between option three and four (Exhibit 3 & 4). Option number five was to issue up to $500 million in common stock with net proceeds equaling 95% of the offering price. This option could potentially allow the company to put $475 million towards its debt.

V. Recommendations After analyzing each alternative Stone Container Corporation could implement in order to relieve its debt pressures, the best option would be to take a two sided approach. If Stone were to renegotiate the of its loans as in option one, they could take a smaller hit than if they were to pay out the interest payments outlined in option three (Exhibit 3). Renegotiating these will also allow the company more time to restructure its debt portfolio and give them a chance to depend less on an alternative that decreases the family's share in the company. This option outweighs the alternative to sell equity in the company or its subsidiaries because there is no loss of family stake in the company. If the company were to also go with option number four they could see a good return on their equity. With this option the company would see a ROE of 41.46% and only pay interest of $175 million over the seven year life. This alternative outweighs the option to issue senior notes because the ROE is higher and the total interest paid is less (Exhibit 3 & 4). The longer life of this option would allow Stone to spread out its default risk farther than any of the other options. This option would also keep the Stone family's interest in the company the greater than compared to option number five. If Stone Corporation wants to stay out of bankruptcy it needs to restructure its debt. The company had a long time standing of not needing debt or paid it off quickly but that changed and it quickly got in over its head because large acquisitions. Five debt reducing alternatives were presented to the company with two options deeming the biggest rewards. The company should restructure its loan and issue $300 million in convertible notes, in order to relieve the immense debt that is plaguing them, help it get through the paper pricing trough, and also help restore the company to its former glory of financial stability.