Stone Container Corporation

1. How did Roger Stones 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 companys 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, Rogers 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 Companys family
ownership was diluted to 30% by the late 1980s.

Initially, Rogers 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
premium was paid near the peak of the industry cycle. The Bathurst transaction was at
detour from Rogers 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 Rogers leadership unsuccessful. Further, it is possible that Roger was ill-
advised to turn down Boise Cascades 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 Stones 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 Worlds 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 Containers 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
Containers 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 Stones net income; and ii) the price of paper and Stones EBITDA
(utilized as a cash flow proxy), while there is weak correlation at the other two cross-
sections.

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 Containers 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 secondary-
waste 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 Stones shareholders? Which would be in the best interests of its high-
yield 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 Stones share price in February 2013 compared to
its historical averages. Assuming that Stone weathers 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 Stones 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 Stones 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

From another paper

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- Weyerhaeuser

* 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 upcoming 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 terms. 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 terms 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 % 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 %, and be
convertible into Stone's common stock at a 20% premium 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 administrative 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 administrative 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 terms 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 5-
year term and a coupon of 12 to 12 %. 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 % 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 terms 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 terms 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 terms 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.