Diageo case study capital structure

Finance Case Study: General Mills’ Acquisition Of Pillsbury

This case was prepared by Professor Robert F. Bruner from public information, with research assistance by Dennis

Hall. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an

administrative situation. Copyright  2001 by the University of Virginia Darden School Foundation, Charlottesville,

VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this

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School Foundation. Rev. 12/01.

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

On December 8, 2000, management of General Mills, Inc., recommended that its

shareholders authorize the creation of more shares of common stock and approve a proposal for

the company to acquire the worldwide businesses of Pillsbury from Diageo PLC. This

transaction called for an exchange of shares of General Mills for the Pillsbury subsidiary that

would leave Diageo as the largest shareholder in General Mills. Furthermore, it was agreed that,

just before the transaction, Pillsbury would borrow about $5 billion and pay a special dividend to

Diageo. Finally, General Mills would obtain a contingent commitment from Diageo that would

pay General Mills up to $642 million on the first anniversary of the transaction, depending on

General Mills’ stock price. The proxy statement carried the opinions of General Mills’ financial

advisers that the transaction was fairly priced. Yet shareholders and securities analysts were

puzzled by the contingent payment. What was it? Why was it warranted in this transaction?

Would this deal create value for General Mills’ shareholders? In light of answers to these

questions, should General Mills’ shareholders approve this transaction?

General Mills, Inc.

Headquartered in Minneapolis, Minnesota, General Mills was a major manufacturer and

marketer of consumer foods, with revenues of about $7.5 billion in fiscal-year 2000. The firm’s

market capitalization was about $11 billion. It was the largest producer of yogurt and the second-

largest producer of ready-to-eat breakfast cereals in the United States. The firm’s segments

included Big G cereals, Betty Crocker desserts, baking and dinner-mix products, snack products,

and yogurt marketed under the Yoplait and Colombo brands. Each of these businesses in the

United States was mature and offered relatively low organic growth. The firm pursued expansion

opportunities overseas through company-owned businesses and through a cereal joint venture

with Nestlé and a snack joint venture with PepsiCo. Through a program of aggressive share

repurchases in the 1990s, the firm had increased its book value debt-to-equity ratio dramatically

compared with its peers.

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Diageo PLC

Diageo, headquartered in the United Kingdom, had been formed in 1997 through the

merger of GrandMet and Guinness, making it one of the world’s leading consumer-goods

companies. Its product portfolio consisted of prominent alcoholic-beverage brands such as

Smirnoff, Johnnie Walker, Guinness, J&B, Gordon’s, and Tanqueray, as well as the Burger King

fast-food chain and Pillsbury. Pillsbury had been acquired by GrandMet, acting as a “white-

knight” acquirer to save Pillsbury from acquisition by Sir James Goldsmith, a well-known raider.

The Pillsbury Company

Pillsbury produced and marketed refrigerated dough and baked goods under the familiar

Dough Boy character, canned and frozen vegetables under the familiar Green Giant brand, Old

El Paso Mexican foods, Progresso soups, Totino’s frozen pizzas, and other food products.

Pillsbury had been headquartered in Minneapolis, Minnesota, as an independent company, and

still had significant administrative operations there. Revenues for the company in fiscal-year

2000 were about $6.1 billion.

Origin of the Transaction

Seeking to build growth momentum, General Mills studied areas of potential growth and

value creation in the spring of 1998. This had generated some smaller acquisitions and a general

receptivity to acquisition proposals by the firm. In early 2000, the firm’s financial advisers

suggested that Diageo might be interested in selling Pillsbury, in an effort to focus Diageo on its

beverage business, and that Pillsbury would complement General Mills’ existing businesses. In

March 2000, Diageo’s chief operating officer contacted General Mills’ chairman and CEO to

explore a possible sale of Pillsbury. General Mills submitted its proposed deal terms to Diageo in

June 2000—the total proposed payment was $10.0 billion. Diageo submitted an asking price of

$10.5 billion. The two sides would budge no further, and it looked as if the negotiations would

founder. General Mills did not want to issue more than one-third of its post-transaction shares to

Diageo, and believed that its shares were undervalued in the stock market. Diageo believed it

was necessary to value General Mills’ shares at the current trading prices. In an effort to bridge

the difference in positions, the two firms agreed upon including in the terms of the deal a

contingent payment on the first anniversary of the transaction that would depend on General

Mills’ share price. James Lawrence, chief financial officer of General Mills, said, “We genuinely

believe this is a way in which they could have their cake and we could eat it, too. There’s no

question in my mind that, absent this instrument, we wouldn’t have been able to reach this deal.”

David Van Benschoten, General Mills’ treasurer, added that the contingent payment was another

example of the “development of the use of [options] in the past 20 years as finance has come to

first understand, and work with, the constructs of optionality.”1

1 Steven Lipin, “First Roll out a Tool to Save Doughboy Deal,” Wall Street Journal, July 21, 2000, C1.

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On July 16, 2000, the boards of General Mills and Diageo approved the final terms. On

July 17, the two firms issued press releases announcing the deal. In the week following the

announcement, the shares of General Mills lost 8% of their value, net-of-market. But in late

August, investors began to bid upward the General Mills share price, perhaps in response to the

publication of the merger proxy statement and prospectus, and on news that the operating losses

at Pillsbury had narrowed further than analysts had expected in fiscal-year 2000. That fall,

General Mills was the subject of several “buy” recommendations. Exhibit 1 gives the recent

trading history of shares in General Mills.

Motives for the Transaction

In its proxy statement, General Mills declared that acquiring Pillsbury would create value

for shareholders by providing opportunities for accelerated sales and earnings growth. These

opportunities would be exploited through product innovation, channel expansion, international

expansion, and productivity gains. The resulting product portfolio would be more balanced. The

combined firm would rank fifth in size among competitors, based on global food sales.

In addition to growth, the deal would create opportunities to save costs. Management

expected pretax savings of $25 million in fiscal 2001, $220 million in 2002, and $400 million by

2003. Supply-chain improvements (i.e., consolidation of activities and application of best

practices in purchasing and logistics); efficiencies in selling, merchandising, and marketing; and,

finally, the streamlining of administrative activities would generate these savings.

Terms of the Transaction

The transaction proposed that an acquisition subsidiary of General Mills would merge

with the Pillsbury Company, with Pillsbury surviving as a wholly owned subsidiary of General

Mills. The agreement outlined several features:

 Payment of shares. General Mills would issue 141 million shares of its common stock to

Diageo shareholders. After the transaction, Diageo would own about 33% of General

Mills’ outstanding shares. When the board of directors approved the merger in July, the

company’s shares traded at around $34.00–$37.00. In the first week of December, the

company’s shares traded at around $40.00–$42.00.

 Assumption of Pillsbury debt. General Mills agreed to assume the liabilities of Pillsbury

at the closing, an amount expected to be $5.142 billion of debt. The Pillsbury debt would

consist of about $142 million in existing debt and $5.0 billion in new borrowings, which

Pillsbury would distribute to Diageo before closing. Terms of the new debt were

conditional upon the consent of General Mills, for which a primary concern was that it

should not lose its investment-grade bond rating.

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 Contingent payment by Diageo to General Mills. At the closing, Diageo would establish

an escrow fund of $642 million. Upon the first anniversary of the closing, Diageo was

required to pay from this fund an amount to General Mills depending on General Mills’

share price:

o $642 million, if the average daily share price for 20 days were $42.55 or more.

o $0.45 million, if the average daily share price were $38.00 or less. This price reflected

the price at which General Mills was trading at the time the deal was negotiated.

o Variable amount, if the average daily share price were between $38.00 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 General Mills shares held by Diageo.

Some financial professionals called this a “claw-back” provision because it would reclaim some

value for General Mills if its share price rose. Still other professionals referred to this as a

“contingent value right” (CVR), a kind of collar that lived beyond the closing of the deal. CVRs

were unusual corporate-finance devices that were used to give the seller confidence in the value

of the buyer’s shares.

Merrill Lynch estimated that the transaction costs for this deal would amount to $55

million.

Conclusion

In evaluating this proposal, analysts considered current capital-market conditions (see

Exhibit 2). Exhibit 3 presents a calculation of the historical share-price volatility of General

Mills from the past year’s weekly stock prices, ending December 8, 2000—this volatility was

0.248. Using the same method to estimate the historical volatility for the year ending July 17,

2000 (the date of announcement of the deal) yielded an estimate of 0.249. Analysts knew that it

would be possible to estimate the implied volatility from traded options on General Mills’ shares

(prices on these options are given in Exhibit 4). Exhibit 5 presents the volatilities and financial

characteristics of General Mills’ peer firms. Contingent payments of the sort used in this

transaction were rare; Exhibit 6 outlines some prominent transactions where they had been used

previously, mainly in combinations of pharmaceutical firms.

Analysts wondered why the contingent payment was used in this deal, and why it would

be attractive to either side. Most importantly, they puzzled over the implications of the

contingent payment for the cost of the deal to General Mills’ shareholders. Finally, they sought

to determine whether the total deal was fairly priced from the standpoint of shareholders of

General Mills. The financial advisers of General Mills presented valuation analyses of Pillsbury

and General Mills as a foundation for an assessment of the deal terms (see Exhibit 7 for a

summary of the valuation analyses). Nevertheless, some securities analysts remained uncertain

about the deal:

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The deal is dilutive … we are concerned with the company’s expectations that the

acquisition will be dilutive to earnings until fiscal 2004. GIS notes the deal will

be accretive to EBITDA by fiscal 2002, suggesting the investment community

focus on this metric. However, we prefer to monitor traditional earnings growth in

order to track a company’s progress.2

The sizable jump in debt concerns us. After the merger is complete, GIS will have

borrowings totaling more than $8.5 billion. To help manage the high leverage, the

company will likely suspend any share repurchases, using the funds expected to

be received [from asset sales] … to work down the large debt load.3

Ultimately, these analysts sought to make a recommendation about how General Mills’

shareholders should vote on the proposed merger: for or against?

2 Value Line Investment Survey (August 11, 2000): 1477.

3 Value Line Investment Survey (November 10, 2000): 1476.

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Exhibit 1

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

Source of price data: Bloomberg Financial Services.

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Exhibit 2

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

Current Capital-Market Conditions at December 8, 2000

December 8, 2000

Equity Market Indexes

Dow Jones Industrial Average

S&P 500 Index

NASDAQ OTC Composite Index

10,373

1,315

2,645

Change in Equity Market Indexes over Last 12 Months

Dow Jones Industrial Average

S&P 500 Index

NASDAQ OTC Composite Index

−5.6%

−5.8%

−21.1%

U.S. Treasury Yields

Bills (90 days)

Bonds

1 year

2 years

5 years

10 years

20 years

30 years

6.09%

5.22%

5.43%

5.32%

5.43%

5.74%

5.64%

Corporate Benchmark Rates

Prime rate of lending

LIBOR

9.50%

6.45%

Sources of data: Wall Street Journal (December 8, 2000); Value Line Investment Survey.

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Exhibit 3

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

Comment: In this table, stock prices are converted into price relatives (which are simply the ratio of today’s price to yesterday’s price). Then the price relatives are transformed into logarithmic values (in order to normalize the distribution). In the right- most column, the squared deviations of the logarithmic values are computed from their mean value (0.002). The weekly variance is computed by dividing the sum of the right-most column (0.060218) by the number of price relatives (52) and then multiplying by a correction factor (52/51) to adjust for sampling bias. The annual variance is obtained by multiplying the weekly variance by 52. The standard deviation is the square root of annual variance. For a more detailed discussion of this estimation procedure, see J. Cox and M. Rubinstein, Options Markets (Englewood Cliffs, NJ: Prentice-Hall, 1985), 255–58.

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Exhibit 4

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

Prices of Call and Put Options on General Mills Shares

Option Call Put

July 19, 2000

Stock Price = $35.00

Expires July 22, 2000, Strike = $35

Expires October 21, 2000, Strike = $40

$0.25

$0.50

$0.375

$5.375

December 14, 2000

Stock Price = $39.9375

Expires January 20, 2001, Strike = $45

$0.50

None traded

Note: The 90-day T-bill yield at December 14 was 5.92%. In mid-July, the 90-day T-bill yield was 6.14%.

Source of data: Wall Street Journal (July 20, 2000, and December 15, 2000).

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Exhibit 5

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

Financial Data on Firms Comparable to General Mills

Company and Business

P/E

Previous

Year’s

Food Sales

($bn) 1

Previous

Year’s

Sales

($bn) 1

Beta

Exp.

Sales

Growth 2

Exp.

Earnings

Growth 2

Expected

Dividend

Yield (%) 2

LT

Debt-to-

Equity

Ratio

Total

Debt-to-

Equity

Ratio

Sigma 3

General Mills, Inc.

Cereals, desserts, flour, baking

mixes, dinner and side dishes,

snacks, beverages, and yogurt

products.

19.8 10.9 16.7 0.65 8.5% 11.5% 1.10 6.719 12.048 0.248

ConAgra Foods, Inc.

Packaged foods (shelf-stable

foods, frozen foods);

Refrigerated foods; Agricultural

products.

20.7 17.1 25.4 0.80 4.5% 12.5% 0.90 1.287 2.391 0.398

PepsiCo, Inc.

Snack foods, beverages, and

juice

30.6 7.9 20.4 0.85 5.5% 11.0% 0.56 0.383 0.399 0.287

Unilever Plc

Foods, detergents, personal &

home care products

N/A 7.2 43.6 0.75 1.5% 8.5% 0.76 0.160 0.326 0.425

Sara Lee Corporation

Packaged meats, frozen-baked

goods, coffee and tea, shoe care,

body care, insecticides, air

fresheners, intimates.

11.2 6.9 17.5 0.75 3.0% 8.5% 0.58 2.951 5.266 0.388

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Exhibit 5 (continued)

H. J. Heinz Company

Ketchup, condiments and

sauces, frozen food, soups,

beans and pasta meals, tuna and

seafood products, infant food.

22.9 5.1 9.4 0.70 4.5% 9.0% 1.57 2.163 2.365 0.311

Campbell Soup Company

Soup and sauces, biscuits and

confectionery, and foodservice

19.7 4.8 6.3 0.80 3.0% 1.0% 0.90 9.050 23.850 0.375

Kellogg Company

Cereals, cereal bars, toaster

pastries, frozen waffles, bagels,

and other products

18.8 4.4 7.0 0.70 5.5% 7.0% 1.10 0.699 2.164 0.365

Hershey Foods Corporation

Chocolate and non-chocolate

confectionery, pasta and grocery

items

25.2 4.0 4.0 0.65 6.0% 9.0% 1.12 0.600 0.790 0.361

Quaker Oats Company

Hot and cold cereals, pancake

mixes and syrups, grain-based

snacks, cornmeal, hominy grits,

rice products, and pasta.

37.0 2.4 4.7 0.65 5.0% 11.5% 1.14 1.539 1.730 0.337

1Sales for fiscal year ending before July 17, 2000. PepsiCo’s next earliest fiscal year ended in December 1999. 2Expected sales, earnings, and dividend yield for the five years from 2000 to 2005. 3Sigma (volatility) was estimated for the 54 weeks before and including July 17, 2000.

Source of data: Value Line Investors Services and case writer analysis.

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Exhibit 6

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

Terms of Other Contingent-Payment Schemes in M&A

Deal Eli Lilly and Company Buys 100%

of Equity in Hybritech, Inc.

Rhône-Poulenc Acquires 68% of Equity in Rorer Group, Inc.

Dow Chemical Acquires 67% of

Equity in Marion Laboratories

Roche Holding Ltd. Acquires 60% of Equity

in Genentech

Closing Date February 1986 July 1990 July 1989 February 1990 Total Est. Payment (US$)

$412.8 million

$1,600 million

$5,700 million

$1,295 million

General Structure

One-stage exchange per each Hybritech share: (1) $22.00 cash or par value of 10- yr. conv. notes paying 6.75%. Conversion price $66.31 per share. (2) 1.4 warrants to buy Lilly common stock at $75.98 per share. (3) One contingent- payment unit (CPU) paying up to $22.00 in dividends over 10 years.

Three-stage transaction: (1) Cash tender offer for 50.1% of stock in Rorer. At $36.50 for 43.2 million shares, the initial cash outlay is $1,577 million. (2) RP transfers its worldwide HPB to Rorer. Rorer pays RP $20 million and assumes $265 million of RP debt. Rorer issues 48.4 million new common shares to RP. (3) RP issues 41.8 million CVRs (for terms of payment, see text of case).

Two-step transaction: (1) Dow acquires 38.9% of Marion through a cash tender offer at $38 per share. (2) Dow contributes its pharmaceutical subsidiary, Merrill- Dow, and 92 million CVRs in exchange for new Marion shares.

Two-step transaction: (1) Roche purchases a 20% interest in Genentech through the purchase of newly issued shares at $22 per share. (2) All non-Roche common shares are exchanged for $18 cash and 1/2 share of redeemable common stock. Following the transaction, public shareholders will own 40% of voting stock; Roche will own 60%.

Contingent Terms

Annual dividend of CPU equal to: [6% of sales + 20% of gross profits – ($11 million × (1.35

t )]

divided by number of Hybritech shares. t = years since 1986. Sales and gross profits are for Hybritech.

CVR entitles holders to receive from RP the amount by which $98.26 a share exceeds either a $52.00 floor price or the average market value of Rorer’s share price 60 days before the rights’ maturity date of July 31, 1993. Maximum payout $46.26 per share. RP has the right to extend maturity of CVRs for an additional year to July 31, 1994. In that event, the ceiling rises from $98.26 to $106.12. Maximum payout increased to $54.12.

Similar to RP CVR: a put spread guarantees shareholder returns within a predetermined range of stock prices through 1992.

Redeemable common stock entitles Roche to redeem the shares at predetermined prices until June 1995. Thereafter, these shares will automatically convert into an equal number of regular common shares. Redemption price starts at $38.00 at closing and rises $1.25 per quarter to the maximum of $60 per share in April–June 1995.

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Exhibit 7

GENERAL MILLS’ ACQUISITION OF PILLSBURY FROM DIAGEO PLC

Valuation Estimates by General Mills’ Financial Advisers

Valuation Based on

Comparable Firms

Valuation Based on

Comparable Transactions

Valuation Based on

Discounted-Cash-Flow

Analysis

Analysis of Pillsbury

Analysis by Evercore

Partners

LTM EBITDA: $8.6–$12.11

billion

LTM EBIT: $8.97–$12.87

billion

LTM EBITDA: $10.59 billion

LTM EBIT: $13.21 billion

Without synergies: $8.4–$10.5

billion

With synergies: $11.3–$14.2

billion

Analysis by Merrill Lynch $8.598–$10.78 billion based on

LTM EBITDA and LTM EBIT

$9.553–$12.44 billion based on

LTM EBITDA and LTM EBIT

Without synergies: $9.184–

$11.204 billion

With synergies: $11.836–

$13.489 billion

Analysis of General Mills

Stock price at July 14, 2000 $36.31/share

Analysis by Evercore

Partners

LTM EBITDA: $34.60/share

LTM EBIT: $37.17/share

LTM price/earnings:

$41.17/share

Comparable transactions are

not an applicable basis for

valuation of General Mills

because the firm is not a target

in this transaction.

$34.69–$42.15/share

Analysis by Merrill Lynch $31.75–$42.25/share $38.50–$46.75/share

Note: Evercore’s analyses were expressed in terms of valuation multiples rather than dollar figures. To permit easier comparison with the Merrill Lynch figures

and to simplify student analysis, the Evercore multiples were converted by the casewriter into dollar figures using several simplifying assumptions.

Source of information: General Mills Definitive Merger Proxy Statement and Prospectus, filed with the U.S. Securities and Exchange Commission (August 22,

2000).

DardenBusinessPublishing:239766

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