Stone container Case discussion

Question 1: What was the basis of Stone Container’s successful growth during its first fifty years? What was
its product market strategy? What was its financial strategy?

Industry: Cyclical nature of the industry along with high degree of operating leverage, capital intensive
industry. Machines run close to full capacity. When demand fell, prices were cut

Basis of Stone’s successful growth (snapshot of the marketing and the financial strategy as given below)

 Growth by acquisitions
 Acquisitions paid by the combination of cash and loan which were repaid early
 Conservative capital structure with debt repaid early
 Retained family ownership
 Expansion of product lines and more specialized products
 Expansion of various geographical locations internationally. Widened geographically by buying and
building regional plants

Market & Financial Strategies:

 High quality product at reasonable prices with minimal capital tied up to its inventory during initial
stages
 Introduction of new products and expansion of product lines-
1. Shifted its focus away from ordinary cardboard containers towards the production of more
specialized containers that provided advertising on the exterior as well as simply a means
of conveyance
2. Expansion into containers made from Kraft linerboard.
 Expansion of various geographical locations internationally. Widened geographically by buying and
building regional plants.
 Great depression-
1. Changed stone from jobbers to manufacturers. The National recovery Act outlawed price cutting
2. Previously, Stone had acquired the merchandise at a discount and passed on the savings to their
customers.
 Growth by acquisition. Went for IPO in 1947
 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
 Conservative capital structure and retained family ownership of 57%
 Its founders established a longstanding policy to “not to carry any significant debt for long periods of time”.
Question 2: 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?

Highly leveraged strategy, growth by acquisitions, and increase in capacity. Took more debt. The company
saw tremendous growth under his leadership. The company was able to repay the debt initially since the
prices rose and through IPO. Later the debt levels became tooo high upon acquisition of Bathrust Inc.
Wanted to refinance the loan with the high yield debt but that market posed liquidity problems which
prevented Roger from doing it. Had to sell assets, pay a lot of fees for refinancing tis revolving credit and
had to sell shares too. By that time, it had accumulated $400 million debt.

So his leadership was successful during the earlier years which was dependent on the favorable market
conditions but later his leadership was a failure since the company had accumulated lot of debt by then and
it was struggling to repay the same during the later years

The relevant discussion points related to the success and the failure of his strategy are given below

Success of Rogers’ Strategy:

 Highly leveraged strategy, continued to increase the capacity rapidly

 Initially, Roger’s strategy was fairly successful as he was growing the earnings of the business and fulfilling
debt obligations.

 Roger’s strategy was predicted on the notion that greater value could be created by buying up capacity
from distressed producers during troughs in the industry cycle. This would enable Stone to acquire assets
at favorable prices while avoiding the additional expensive new capacity to the industry. Acquisitions were
a faster means of expansion, as construction of the new facility could take 3 years to complete. As a resukt
be 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.

Failure of Rogers’s Strategy

 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.
 Problem started with acquisition of Consolidated Bathrust Inc (even though it enabled integration into the
European community) .: -Rendered Roger’s leadership unsuccessful
1. Added significant financial risk by increase in debt and additional reliance on junk bonds for
financing.
2. 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, refinancing) rendered Roger’s leadership unsuccessful.
 Effect of increase in the debt due to strategy and company struggling to repay the same posed failure of his
strategy
 1. Over the years, become highly dependent on high yield debt. (ie, junk bonds) to financed its large
acquisitions. Wanted to refinance the loan with high yield debt. Unfortunately the high yield debt
market had developed serious liquidity problems. This depressed Rogers’s intentions of
refinancing them into high yield debt.
2. Had to pay a lot of fees to refinance its revolving credit agreement with the bank
3. Had to sell its assets to meet its debt obligations. Had to sell shares to take care of debt obilgations
4. Refinanced its debt with complex convertible exchangeable preferred stock and interest rate
swaps
5. Accumulated lot of debt to the extent of $4.1 billion
 Further, it is possible that Roger was ill-advised to turn down Boise Cascade’s offer to purchase Stone in
1979 for 2X market value

Question 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.
Assume Stone Container’s sales volume approximates its 1992 production level of 7.5 million tons per year,
and costs, other than interest expense, remain the same. Also assume a 35% tax rate.

The income seems to be sensitive to the price levels.

Retaining the present volume of 7.517 million and
increasing the price per ton from $734.43 to $784.43 and assuming the same costs, interest costs of
$400 million and tax rate of 35%, the new net income was arrived as $211.5 as compared the present
net income of ($177.4). The net income seems to increase by more than 2 times as compared to the
previous level

Question 4: What would be the effect of a $100 per ton industry-wide increase under the same assumptions
given above (in Q3)?

The income seems to be sensitive to the price levels. Assuming tax rate of 35%, and assuming other costs
being the same and borrowings as $400 million, the net income seems to increase by more than 5 times as
compared to the previous level

Question 5: What would be the effect under both these pricing scenarios (per Q3 & Q4) if production and
sales volume increased to full capacity of 8.3 million tons per year (for simplicity, assume costs per ton
remain constant)?

The income seems to be sensitive to the price levels. Assuming tax rate of 35%, and assuming other costs
being the same and borrowings as $400 million, the net income seems to increase by more than 13 and 16
times respectively for $50 and $100 increase as compared to the previous level

Question 6: What should be Stone Container’s financial priorities for 1993? What must be accomplished if
Stone is to relieve the financial pressures afflicting it?

Financial priorities
  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

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 below tasks based on a high level analysis must be accomplished in order to
relieve the company from its financial crisis before taking into account the in depth analysis of financing alternatives
as listed in the case

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 (with more focus on refinancing of debt) to a sustainable level closer to peers so that it can handle cyclicality.

Question 7: 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 high-yield debt (i.e., junk
bond) holders? Of its bank creditors?

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. Safety to the shareholders. Can received high returns when the company is performing well.
Option to cash at the end and the value of the bond cannot fall below the par value

In general, though, they offer investors the advantages of a bond’s relative reliability with the option to
convert to equity and realize an even greater yield.

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 greater ROE 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
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.

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. 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

Question 8: 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?

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.

Evaluation of the different options

 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 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.

 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.

Renegotiation of loan or restructuring the debt is the best option

 Renegotiation of loan: 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.

 Option 4: 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 higher ROE 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. 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. And they provide issuers a chance to
raise capital at a lower interest rate and delay the dilution of their common stock

So option 1 and option 4 are the best options.

If Stone Corporation wants to stay out of bankruptcy it needs to restructure its debt first. 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. The company should restructure its loan terms first and then issue $300 million in convertible
notes, in order to relieve the immense debt and also help restore the company to its former glory of financial
stability.