Debt roulette: Takeover gambles

In the age of the LBO, multi-billion dollar companies can be purchased for peanuts, but each spin of the buyout wheel holds risky consequences. For investors, debt can create wealth. But a corporation's assets, employees, or long-term spending plans often are living on borrowed time. The theory of leveraged buyouts can be distilled to the most pedestrian analogies.

For instance, Popeye's pal Wimpy ("I will gladly pay you Tuesday for a hamburger today") had the idea figured out long ago. Today, when LBOs have turned traditional views of debt upside down, Wimpy could be well-heeled.

Or you can liken corporate raiders to John Belushi's "Animal House" character. Loathed by the campus establishment, he launched food fights, created chaos, and vowed, "It's not over till we say it's over," before driving off into the sunset with the best-looking cheerleader.

Strange analogies, but these are strange times. Few business transactions have created as much confusion as the billion-dollar LBOs of the 1980s.

LBOs are a peculiar Wall Street creation--one that has allowed raiders to latch onto unsuspecting and unwilling companies with not so much as a gleam in their eyes and a banker's okay.

After they bag their prey, they turn around and sell off the companies' assets piece by piece and fire thousands of employees. Once proud consumer powerhouses become debt-laden dinosaurs.

It happened to Beatrice in 1986, and now it's bound to happen to RJR Nabisco.

Or will it? Is this really what's happening?

Partly. There's no question that investors are eyeing food companies. Dealmaker and former Beatrice chairman Donald Kelly spelled it out in a December speech on corporate restructuring: "For a long period of time companies bought companies. Today investors also buy companies."

Out with synergy, in with antergy

That's one part of it. Investors don't have the same mindset as food company executives. They buy to make money, not to create "synergies."

John Connor, an agricultural economist at Purdue University, offers this explanation: "Antergy is the new theory of leveraged buyouts--take something, divide it up into little pieces, sell it off and it's worth more that way than it was as a whole."

Another component of LBOs, is, of course, debt. And a lot of it. The most blatant example is Kohlberg, Kravis Roberts' $25 billion takeover of RJR Nabisco to be financed with $1.5 billion in equity and a complex mixture of bank debt, bonds, and preferred stock.

In 1986, the same investors put down $400 million to buy Beatrice, which then had sales of $11 billion. On a smaller scale, Duncan, Cooke & Co. a Houston investment firm, took over the Southland's Corp.'s dairies group in 1988 (sales $852 million) for $25 million in equity. Other examples abound.

Beyond these similarities, LBOs rarely lend themselves to gross generalizations. Every company is different and the results of each LBO are different.

Not all LBO managers slash spending in every area. Sometimes the restructured companies--or what's left of them--are more focused and more profitable.

But invariably, there's fallout.

Wimpy's logic = Kelly's reality

Kelly, for one, shrugs off media "statements lumping all LBOs into a single category of fiscal irresponsibility" as the product of "previously unemployed fiction writers."

Said Kelly: "Yes, people have been affected. Yes, the debt load assumed in some of these transactions exceeds the prior level of so-called `prudent' financing. And yes, certain groups of people have reaped rewards substantially more than others."

"Time alone will tell the effects of all of these activities," said Kelly. "I don't think you will find the results will be either catastrophic or heroic. They will, however, require adjustments and they will have an effect on all of us."

And there you have it. Somewhere along the way, Wimpy's logic has translated into Kelly's reality.

Until a big LBO company collapses, or until Congress or a recession dampens LBO appeal, the food industry will have to learn to live with leverage.

LBOs account for a fraction of the half a million mergers and acquisitions that took place last year in the food industry.

Likewise, not all plant closings or layoffs are the result of LBO mania. Food companies have been scaling back for years in both plants and people. Purdue's Connor, who has studied the industry extensively for his book, "Food Processing: An Industrial Powerhouse in Transition," estimates that 4% or 5% of all food plants close every year.

Quips Michael Goldblatt, a former General Foods researcher who now heads new product development for McDonald's: "When major food companies hiccup, they lay off more people than the home office of McDonald's employs."

Debt and the domino theory

Hostile takeovers, though, are fueling unrest among food company executives.

With the exception of companies like Kellogg, whose stock is safely guarded by inside ownership, food companies are skittish about their undervalued stocks. This vulnerability has many food companies scrambling to buy back stock or to set up other defenses.

In January, Borden even adopted an unusual "people pill" defense, which calls for the resignation of the company's top 25 officers should the company be involved in a takeover attempt that would bring less than what the company deems a fair market value.

Debt is on the rise in the food industry. Though some of the increase can be attributed to restructuring programs and expansion plans, analysts suspect that the threat of hostile takeovers is adding fuel to the fire. Ironically, low debt can make a company an attractive takeover candidate.

"I'm not sure that managers would agree, but certainly the leverage at General Mills, at Ralston Purina, and at CPC to a certain degree, all reflects at least some defensive posturing," says Rod Rumreich, a food industry analyst for Moody's in New York.

Paralleling this trend is a decline in cash resources that leaves some question about food companies' ability to pay the piper.

A pivotal gauge of this is retained cash flow (after dividends) as a percentage of total debt (RCF/TD).

In 1987, the median RCF/TD for Moody's index of 20 food companies tumbled to 37%, 7% below the five-year median. "Debt has clearly gone up in relationship to the companies' ability to service it (through cash flow)," explains Rumreich.

Kellogg, which boasts a stellar Aaa senior debt rating, led the food group in this analysis, with 88% in fiscal 1987, and is running at a similar rate in 1988. In 1988, Quaker Oats and Sara Lee ranked in the 40% range, both below previous years. Campbell came in at 57%, a drop off from 80% in 1987. General Mills lagged behind at 29%, down from 41% in 1987. Gerber fell below that with 15%.

Beatrice is clearly the food group's underachiever in this Moody's analysis. Beatrice's RCF/TD sunk from 23% in 1986, to 2.3% in 1987, to -2.5% in 1988.

Buyouts in the supermarket industry also are contributing to the unrest. Purdue's Connor estimates that the food industry as a whole is generating a large chunk of so-called junk bonds, the high-yield, high-risk bonds that are often used to finance LBOs.

"I would imagine if you include RJR Nabisco, $40 billion to $60 billion in junk bonds exist (in the food processing and retailing businesses)," he says. "That's a large amount of high-risk capital to be floating around."

The ultimate victim

High debt also can take a toll on a company's ability to defend itself from its competitors. Cowering under a crushing debt load, a company is less likely to get involved in price cuts or promotional deals.

In the end, the consumer may be the ultimate victim. "It's very common to see episodes of price cuts or promotional dealing," says Connor. "Those are going to become less frequent. And in the aggregate, what results is a price increase."

Debt is a fickle companion, one that can help a company flourish or smother its growth.

"There is no golden rule for determining the appropriate amount of leverage," said Irwin Engelman, president of Citytrust Bancorp, and a former General Foods CFO, at the Conference Board's business outlook conference last fall. "Debt isn't bad and can create genuine value, if the capital is used productively and the debt burden doesn't swamp the company.

"Public companies that fail to use their assets to grow and don't manage their balance sheets are setting themselves up for a takeover, friendly or otherwise," Engelman predicted. "Those that reach too far may not survive a downturn in the economy or a business setback."

It's possible that LBOs--on top of the sweeping change that comes with mega-mergers and consolidation--could spur the reemergence of the small- to medium-size company.