Case Background

Stone Container Corporation is a company based in Chicago, Illinois. Incorporated in 1926 as

JH Stone & Sons, the company thrived to become United States’ largest manufacturer of
cardboard containers and related paper products. By 1993, Stone Container Corporation
became the country’s industry leader in manufacturing containerboard, corrugated
containers, Kraft paper, bags and sacks. Additionally, they held a major position in newsprint
manufacturing and ground-wood specialty paper. Other products included building material
and wood pulp. By the end of 1992, the company owned or held interest in 136
manufacturing plants across the globe and had 31800 employees in their payroll.

Generally, most products in the paper and forest products industry exhibit a cyclical nature
in prices. The industry is very capital intensive and characterized by high fixed costs. So, high
operating leverage is characteristic of most companies involved in the industry.

Since, the late 70’s, Stone adopted a strategy of highly levered acquisitions for
diversification and capacity addition. The funds were raised generally through bank loans
and issuing junk bonds. The acquisitions were usually made during the troughs in business
cycle, where the capacity could be acquired cheaply. The subsequent upswings in the
market price enabled paying off of the debts before time. Apart from debt, the company
also resorted to issuing common stocks and selling off assets to raise funds for expansion
and operational purposes.

The recent acquisition of Consolidated-Bathurst Inc. was done by availing a $3.3 billion
credit facility. However, the subsequent recession in business and liquidity crisis in the bond
market seriously hampered the companies’ ability to meet its payment obligations.
Although Stone has met its commitments, it is now on the brink of default. This has led the
management to assess various alternatives to tackle the crisis.

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 Financial Problems

High debt Paper and forest products industry is highly capital intensive, requiring roughly
$1.30 in assets to generate $1.00 in sales. Consequently, most companies in the industry
have a high degree of operating leverage. Moreover, Stone Container Corporation, since the
late 70’s adopted a policy of capacity expansion through leveraged buyouts (LBO). The
acquisitions were usually made during the troughs in business when assets can be
purchased at below-market prices from distressed manufacturers. Stone was able to pay off
the debt during the subsequent upswing in business cycle. However, the last acquisition i.e.
Consolidated Bathurst was made during the peak of cycle. Stone paid 47% premium to buy
Bathurst. Moreover, the acquisition, valued at $2.7 billion, was the largest in the history of
company. Soon, recession in the business followed and the company’s sales prices dropped
significantly. Therefore, Stone Corporation was unable to pay off the debts quickly as it did
during previous acquisition.

Risk of default In the face of increasing financial difficulties due to high debt and low market
prices, Stone faced additional commitments. During the financial year ending March 1994,
the corporation has to continue paying $400 to $425 million interest on debt, make debt
repayments of $416 million as well as extend, refinance or replace $400 million worth of
revolving credit facilities which are scheduled to terminate soon. Additionally, Stone needed
to incur a capital expenditure of $100 million in order to meet the compliance norms of new
secondary-waste treatment regulations in Canada. So, with the continuing recession, Stone
is running the risk of defaulting on payments.

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Low credit ratings The debt-to-equity ratio of Stone Container Corporation has increased
considerably since the acquisition of Bathurst in 1989. The D-E ratio has increased from 2.79
in 1990 to 3.77 in 1992. The net income from operations has also been negative since 1991.
Additionally, the company experienced negative cash flow in 1992. All these factors have led
to lower credit ratings in the market. With lower credit ratings, Stone Corporation is unable
to issue bonds with low yields in the market to secure cash for operational and current debt
repayment purposes.

High rate of interest Since the value of debt is continuously increasing in the books of Stone
Container Corporation, it is increasingly at the risk of default. Consequently, banks and
other lending institutions are charging higher rates of interest on loans. Besides, due to low
credit ratings as mentioned above, the company cannot raise the required money (at
reasonable yield rates) from security markets either. Historically, too, the company has
relied on junk bonds in order to meet a part of its financing requirements. Junk bonds are
high yield, high risk debentures usually with a rating below BBB-. So, one fact could be that
due to inherent high operating leverages in the industry, the credit rating has typically been
low.

Low share prices and undervalued assets Due to high debt, market recession and negative
earnings per share the shares of Stone Corporation are being traded at $15.375 per share,
half of its market value in 1989. Moreover, due to recession in the business, Stone probably
cannot fetch a fair value by sale of its assets. Thus, both public offering as well as asset sale
may not be sufficient to pull the company out of the current crisis.

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 Analysis & Interpretation

The net income of Stone Container Corporation is negative due to high interest payments.
However, it should be noted that the operating profit margin (OPM) is less than its
competitors.

Operating profit margin = (Operating profit/Net revenue) X 100%

Net profit margin (NPM)= (Net profit/Net revenue) X 100%

Company Stone Chesapeake Union Camp Westvaco Willamette

Container Corporation Corporation Corporation Industries
Corporation
Revenue $5520.7 $888.4 $3064.4 $2335.6 $2372.4
Operating $193.2 $52.2 $182.3 $285.1 $197.6
Income
Net Income $(177.4) $4.7 $76.2 $135.9 $81.6
OPM 3.5% 5.9% 5.95% 12.2% 8.33%
NPM 0.53% 2.5% 5.8% 3.4%

All the figures above (except OPM) are in millions.

No competitor deals in the diverse range of products as that of Stone Corporation. All of
them have some overlapping offerings with the company. However, the operating profit
margin (OPM) of Stone Container is lower than each of the companies. So, the issue does
not lie in the portfolio. Thus it is evident that in addition to debt burden, the company has
issues with its operational activities like procurement, processing or distribution.

Even if Stone has an OPM equal to 5.9% (that of Chesapeake, the 2 nd lowest OPM among its
competitors) it will generate an additional cash flow equal to 2.4% of $ 5520 million =
$132.5 million.

The average NPM for Stone’s major competitors is approximately 3.05%. Now, let us
assume that the entire long term debt bears the same interest rate.

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Therefore, effective rate of interest= (Interest payment/long-term debt) X 100%

= (386.1/4539) X 100% = 8.51%

To have a NPM of 3.05%, Stone would require a net income = (8.51%/100%) X 4539 = $386
million. However, in the current market scenario, this is not achievable even with zero
interest expense.

Current obligations include 1. interest expense ($425 million), 2. debt repayment ($416
million) and 3. capital expenditures for waste-treatment compliance ($100 million) in
addition to 4. refinancing, replacing or extending $400 million revolving credit facility. Let us
look at the alternatives to assess which part of the obligation they are able to address.

Alternative 1 speaks of negotiating with the bank for extending their maturities and relax
some of the covenants attached.

a) This alternative addresses 2. Debt repayment as well as 4. Extending revolving credit

facility.
b) If we go for alternative 1, then there will be an incurred expense of $70-80 million in
place of current expense of ($416 +$400) = $800 million. Due to the extension, the
company, hopefully, should not face any difficulty in repaying the debt once the
recession is over.
c) As of now, the credit rating of the company will not be degraded (due to avoiding
default).

Alternative 2 suggests sale of assets or interests in subsidiaries for cash and projects an
expected return of $250 to $500 million.

a) This alternative addresses all the current issues (although doesn’t cover the
expenses fully).
b) However, sale of assets would reduce the manufacturing capacity of Stone. Once the
recession cycle is over, this would lead to lost sales for the company.
c) Additionally, during recession period in the industry, the company would not able to
fetch a fair price of its assets.
d) Furthermore, ownership stake of the promoter family will also be diluted to under
30%

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Alternative 3 looks for repaying the bank debt by issuing $300 million worth of 5-year senior
notes with a coupon in 12% to 12.5% range.

a) It partially addresses 2. Debt repayment. This will provide short term relief from the
risk of default. Thus the credit rating will not be degraded.
b) However, based on our above calculation, the effective interest rate on long-term
debt is 8.51% (subject to our assumptions). By accepting this offer, Stone will be
liable to pay an additional interest of = 4% of $300 million = $12 million every year
for 5 years.

Alternative 4 suggests issue of $300 million worth of convertible subordinated notes bearing
a coupon of 8.75% with a maturity of 7 years.

a) This addresses 2. Debt repayment issue partially. The current credit rating shall be
unaffected. However, ownership of stake will be diluted.
b) The conversion price is set at 20% of the market price at the time of offering and
kept fixed. The bearer shall opt for conversion only when the shares trade above the
conversion prices. Since, the business is in the recession phase, and the shares are
trading at 50% of the 1989 rates, they have a high probability of being traded at
prices significantly above the conversion price 7 years from now. So, these bonds will
most likely be converted and will lead to dilution of promoter stake.

Alternative 5 suggests the issue of $500 million worth of common stock through public
offering.

a) Considering the current market price of shares to be $16, number of shares issued =
$500 million/$16 per share = 31.25 million shares. Current number of outstanding
shares is 71 million. Thus the total shares outstanding shall increase to 71 + 31.25 =
102.25 million shares. Considering the ownership stake currently to be 30%, no. of
shares owned by the company = 30% of 71 million shares = 21.3 million shares. After
the public offering the percentage stake shall go down to = (21.3/102.25) X 100% =
20.83%
b) The credit rating will not be harmed. However, due to the current financials, there is
a slight risk that the public offering will not be successfully subscribed.

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 Recommendation
It is evident from our analysis that none of the alternatives has the potential to resolve all
the issues single-handedly. The company’s major goal should be re-structure the debt to
avoid defaulting on liabilities. At the same time, Stone Container Corporation also needs to
ensure seamless supply of operational funds to continue business.

Looking at the trends in Exhibit 5, we see that the unbleached Kraft linerboard price follows
a 3-years alternative recession and expansion cycle. The price cycle for unbleached Kraft
Paper is less predictable. The prices surged steadily for five years frim 1985-90 and
subsequently in the decline trend. So, we can conservatively assume that the prices of both
the commodities shall experience an upswing beginning in 1994. As the margins will
improve, so will the repayment capacity of the company.

Going by our analysis a combination of alternative 1 and 5 could be employed to resolve the
crisis. Alternative 1 will extend the repayment date of $416 million loan as well as $400
million revolving credit facilities. Alternative 5 will take care of $425 million interest
repayment and $100 million capital expenditure (for compliance with secondary-waste
treatment regulations).

Alternative 2, i.e., sale of assets is out of question because once the commodity prices start
to climb, Stone will lose out significant business revenue. Similarly, alternative 3 calls for
issuing bonds with 12-12.5% yield, significantly higher than the average rate of interest
(8.51%) that Stone Container pays on its debt.

However, as shown in the analysis, even if the company is able to improve its operational
margin to 5.9% in the short run, alternative 4 will be a better option than alternative 5. This
is so because issuing $300 million of convertible bonds shall lead to lesser dilution of
promoter family stake than issuing $500 million common stock.

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 Stone Container Corporation

FM1 Assignment

Kaustav Dey

B18088

01-11-2018

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Kaustav Dey B18088