"This transaction was courageous when it was first announced; it is even more courageous now," said Dr Michael Smurfit. Dangerous or foolhardy? Is there not a thin line between the two?
Dr Smurfit was expressing his views on the proposed $2 billion (£1.3 billion) merger of Jefferson Smurfit Corporation (JSC) - Smurfit's US affiliate - and Stone Container Corporation which will be decided by the shareholders of the two companies at tomorrow's meetings in the US. Credit agencies have been quick to express their views. Moreover, they are negative for JSC. Moody's has lowered its rating for JSC and has warned of further downgrades if the merged group (SSCC) does not dispose of $2 billion worth of assets, as planned.
Significantly, Moody's has left its rating for Stone's debt unchanged. Also, Standard & Poor has removed Stone from its credit watch as that company's outlook is considered to be stable.
Whatever about the pros and cons for such a merger, it is clearly much more in Stone's interests than in JSC's. Indeed, it has all the hall marks of a Stone bail-out. Stone has been in breach of some of its debt convenants and was facing more. It has incurred losses every year (with the exception of 1995) since 1992. The merger document made it quite clear that unless Stone achieves significant price increases and sustains such levels in the future, it will continue to incur net losses and a deficit in net cash from its operating activities.
"Without additional cash generated by operations and funds from SSCC, Stone may exhaust all or substantially all of its cash resources and borrowing availability under its revolving credit facilities," according to the stark words in the merger document.
One of the covenants requires Stone to maintain a net worth of $500 million, otherwise it could face interest rate penalties of up to 200 basis points on the $594 million debt. In December 1997 Stone's net worth was only $378 million. Against that background, could JSC not have forced better terms on Stone? The offer is 0.99 of a JSC share for every one Stone share. Independent valuations - based on historic data, premiums paid analysis, selection comparable transactions, segment valuations and discounted cash flow - have been made. These vary considerably.
However, based on average quarterly share prices, it appears that JSC shareholders are not getting a fair deal. Taking the average prices in 1995 and 1996, the Stone shareholders could have argued for a better deal because its average share prices were higher than JSC's.
However, that position has been reversed since the first quarter of 1997. And that was certainly true in the second quarter of 1998 when the deal was arranged. That, and Stone's deteriorating financial position with the breach of some covenants, should have given JSC the upper-hand. It did not. Nor does the Jefferson Smurfit group appear to have had the upper hand with Morgan Stanley (MS). It is buying half MS's 36 per cent shareholding in JSC for $500 million, or $25 a share. Having purchased the shares at $13 per share four years ago, MS is making a fine profit. While the $25 per share looked generous when compared with the then JSC share price of $21, it looks decidedly giddy compared with the current price of just over $12. "It is a price that has to be paid to get the deal done," is how Smurfit's chief operating officer, Mr Paddy Wright, justified that deal. The merger is likely to be approved, following the withdrawal of a proposed injunction by some Stone shareholders on Friday. So what does it mean?
Apart from the share swap, JSC will borrow $500 million and contribute $300 million to Stone as an equity contribution from SSCC. And the Jefferson Smurfit group will have a 34 per cent stake in SSCC. According to Moody's, interest cover will remain weak for the foreseeable future with SSCC, at or below a breakeven level, through the end of 1999, and Stone below breakeven until 2000. Significantly, the pro-forma debt of SSCC will exceed $7 billion or more than 10 times the 1997 earnings before interest, tax and depreciation. Much play has been made of the asset disposal programme which is so essential to bring down the debt and create a more cost effective unit. However, SSCC will be at a great disadvantage because competitors are less leveraged and will have greater resources to deal with the continuing problem of weak linerboard prices.
The success of SSCC will depend on the way prices go and on how quickly it can effect meaningful cost savings. Mothballing a lot of the older capacity should, in theory, address the demand/capacity problems. And International Paper, which has exceeded its cost cutting goals, should help. However, as any JSC watcher knows, there are always corporations willing to bring on extra capacity if the demand increases. This is clearly Michael Smurfit's riskiest project. The group's record in the 1990's would not breed much confidence. Earnings per share either moved sideways, or downward, up to 1994. A brief surge in 1995 was short-lived and the group has not been going anywhere since then. That is reflected in the depressed share prices. Just where has that Smurfit hunger, and resultant magic, of yesteryears, gone?
