Stone container Case discussion

Question 1:

What was the basis of Stone Containers 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 Stones 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 lines1. 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 depression1. 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

Conservative capital structure and retained family ownership of 57%

Its founders established a longstanding policy to not to carry any significant debt for

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

long periods of time.

Question 2: 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?
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

Rogers strategy was predicted on the notion that greater value could be created by

Initially, Rogers strategy was fairly successful as he was growing the earnings of the
business and fulfilling debt obligations.

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 Rogerss Strategy

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.

Problem started with acquisition of Consolidated Bathrust Inc (even though it enabled
integration
unsuccessful

into

the

European

community)

.:

-Rendered

Rogers

leadership

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 Rogers 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 Rogerss 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 Cascades offer to
purchase Stone in 1979 for 2X market value

Question 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.
Assume Stone Containers 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.

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
The income seems to be sensitive to the price levels.

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 Containers 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 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 (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 Stones 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 bonds 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 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

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 %. 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.

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.