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Statement of Purpose: The purpose of this analysis is to determine if Reynolds Metals (“Reynolds”) should accept Nestlé’s offer of $61 million for its holdings of Eskimo Pie. The crux of the issue is whether or not the projected income from a proposed Initial Public Offering (“IPO”) by Wheat First Securities (“Wheat First”) is reasonable and will actually result in proceeds between $61 and $68 million to Reynolds, the Reynolds family and the Reynolds foundation, as projected.
To get at this question, this paper will seek to value Eskimo Pie as a stand-alone company, if the IPO option is selected.
Discount Rate: The first task is to estimate the discount rate, or the rate that investors will require on this type of investment. In 1990, the last year for which we have data, Eskimo Pie had $744,000 in long-term debt obligations and $19,496,000 in Stockholders’ equity.
This amounts to 3.67588% of their financing coming from debt and 96.32411% of their financing coming from equity.
Exhibit 9 reflects the corporate borrowing rates as of 1991. Being that Eskimo Pie is a small operation with fairly thin margins, they would not qualify for an A or AA bond rating. Thus, I am assuming that any bonds they have issued have a BB rating. The long-term bond yield for BB bonds is 11.44%.
The case does not provide any information regarding the required return on equity.
However, by imputing the data from Exhibit 8c into a spreadsheet we can calculate Beta for comparable companies. I calculate the Beta for Ben & Jerry’s to be 1.5994. I calculate Beta for Dreyer’s to be 1.2524. This averages out to 1.4259, which is the Beta I estimate for Eskimo Pie.
Using the risk free rate of 4.56% from Exhibit 9, and an expected market return of 13.99% , I calculate the expected return on equity to be 17.9968%.
Thus, calculating the Weighted Average Cost of Capital: (.0367588)(11.44%) + (.9632411)(17.9968%) = 17.7558%. The applicable discount rate is 17.7558%.
Growth Rate: There are several factors to consider in estimating Eskimo Pie’s growth rate. As measured by net sales, the growth rate fluctuated greatly between 1987 and 1991. According to Exhibit 1, half of the growth experienced in 1991 is attributable to increased prices and the assumption of advertising responsibility. I view this large increase as a one-time event. As competitors adjust, whatever advantage Eskimo Pie gained from these methods will dissipate.
One advantage that Eskimo Pie has is that they hold patents for various sugar and fat substitutes. They largely attribute their 3% increase in unit market share over a four year period to their patent on a sugar free coating. They also have a patent in the works for a fat substitute. However, any growth they see from the fat substitute will be limited because those sales will cut into their sales of the sugar-free product.
In Exhibit 6, Goldman Sachs makes very conservative growth estimates. From 1991 to 1992 they project growth, in terms of net sales, of 4.5415%, and from 1992 to 1993 they project 1.2376% growth. These projections are tempered by the fact that they underestimated Eskimo Pie’s net sales and net income in 1991.
Finally, according to Exhibit 4, the market for frozen novelties has leveled off, so most of Eskimo Pie’s growth will have to occur by grabbing market share. Eskimo Pie’s growth in the past is tied, at least to some degree, to their presence in grocery stores. Between 1987 and 1991 the presence of at least one Eskimo product in U.S. Grocery Stores grew from 76.3% to 97.9%. The fact that they are in nearly 98% of all stores in 1991 suggests that they have very little room for growth in this area, especially when you consider that the percentage change of their presence in grocery stores is related with the market share of Eskimo products, and is also related to their net sales. In considering all of these factors, and recognizing this is a low figure, I estimate that their growth rate in perpetuity, beginning in 1994, will be 5% per year.
Valuation: Valuing the company begins by estimating sales, net income and the free cash flow. As previously mentioned, net sales will be estimated beginning with the $61 million in net sales projected for 1991, then relying on Goldman Sach’s projected growth rate for 1992 and 1993, and using a 5% growth rate from that point forward. Net income is estimated for 1992 and 1993 using Goldman Sach’s estimate of the margin.
Free cash flow is then estimated from the net income by subtracting capital expenditures, which are estimated to be less than $1 million for 1992. Additionally, there are several additional expenses for 1991 that I believe are ignored by Goldman Sach’s estimate. The first is the potential clean-up costs from the spill in the New Jersey plant, estimated at $300,000. However, weighing other possible outcomes, I estimate the cost to be $374,000, occurring by the end of 1991.
Further, even in the pre-Sarbanes-Oxley era, the cost of an IPO, and the subsequent filing documents required by the SEC, is significant. I estimate the cost of the IPO to be $1 million in 1992, and $500,000 each year after for the filing requirements (or the cost of being public). These amounts are subtracted from the free cash flows in the appropriate years.
Thus, I estimate the value of Eskimo Pie, as a stand-alone company, to be $31,770,219. This is significantly lower than the $61,412,000 or $68,044,000 that Wheat First predicts the IPO will generate.
Further Analysis: This of course begs the question of why Nestlé would be willing to pay $61 million for Eskimo Pie. The most obvious answer is that they estimate the growth rate to be much higher than I do. However, such high levels of growth seem unlikely, especially when you consider that capital expenditures are minimal.
However, I believe that the answer for Nestlé’s high bid lies elsewhere, and that their bid may even be too low. The first factor is the $61 million in sales that Eskimo Pie experienced in 1991. Using Goldman Sach’s own net sales multiplier of 1.2 means the sales price should be around $70-75 million.
There are several other reasons why Eskimo Pie would have more value to a company such as Nestlé than as a standalone company. The first is that Nestlé could slash operating expenses, such as the Richmond management, advertising expenses and selling expenses, which would increase the net profits and the free cash flows. They would also be able to reduce personnel and possibly consolidate the manufacturing components of each company.
Most importantly, however, is that the acquiring company would also assume ownership of Eskimo Pie’s patents on the sugar and fat substitutes. The sugar substitute was largely responsible for Eskimo Pie’s increased market share and is thus a very valuable asset. Nestlé would be able to use those patents on all of their products and potentially see their market share grow as Eskimo Pie’s did. These patents, along with Eskimo Pie’s name, may be the most valuable parts of Eskimo Pie.
Two strong mitigating factors remain that would keep Nestlé from increasing their bid. The first is the potential litigation arising from the spill in the New Jersey plant. If Nestlé acquires the company, then they are acquiring the potential lawsuit as well, exposing their entire company. While the likelihood of litigation is small, the potential still exists. The second mitigating factor is Eskimo Pie’s licensing approach, yet Nestlé would have the opportunity to end these agreements once the current agreements expire.
Conclusion: Eskimo Pie should reject Wheat First’s IPO proposal. Their estimates of sales at $14 and $16 per share, generating $61 million and $68 million respectively, are too generous. The most they should expect to raise is approximately $32 million, the total value of the company. Even if they cannot get Nestlé to increase their offer in light of the 1991 sales figures, Eskimo Pie should accept Nestlé’s offer.