Stone Container Corporation

1. 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?
Stone Container Corporation (Stone) has historically been an acquisitive
company. However, in the wake of the Great Depression, its founders
established a longstanding policy to not to carry any significant debt for
long periods of time. 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. While Stone
completed an initial public offering in 1947, the business remained
conservatively capitalized thereafter with family ownership in the majority at
57%.
Roger Stone, with highly leveraged acquisitions of distressed producers,
stimulated much higher financial and equity risks with the addition of
layered debt. He was able to expand capacity more than 5 times at onefifth 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.
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.
Initially, Rogers strategy was fairly successful as he was growing the
earnings of the business and fulfilling debt obligations. While the acquisition
of Bathurst turned Stone into an industry juggernaut with new access to the
European market, a 47% purchase price premium was paid near the peak
of the industry cycle. The Bathurst transaction was at detour from Rogers
strategy of buying depressed assets1 and added significant financial risk
(evidenced by a long-term debt to capital increase from 38.9% at
12/31/1988 to 69.3% at 12/31/1989) and additional reliance on junk bonds
for financing. 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, revolver refinancing accompanied by heave fees, reluctant equity
issuances likely plagued by adverse selection, LT-debt/EBITDA of >8.0x at
12/31/12) and rendered Rogers leadership unsuccessful. Further, it is
possible that Roger was ill-advised to turn down Boise Cascades offer to
purchase Stone in 1979 for 2X market value.
2. How did Stone Container in recent years finance acquisitions? How did
the financing evolve after the acquisition was completed? Why might Stone
Container finance acquisitions in such a manner, in the language of
theories we covered in Class 2?
Year Transaction description Amount
1979 Expansion of South Caroline line board $55 million
1981 Dean Dempsey Corp. equity position undisclosed
1983 Acquisition of Continental Groups.
Long term debt rose to 79% of capital
First equity offering (Family ownership 57% to 49%) $600 million
1985 Acquisition of Champion International Corporation
Gave Champion 12 to 14% of Stones Stock (Less than 40% ownership)
$457 million
1987 Acquisition of Southwest Forest $760 million
1989 Acquisition of Consolidated Bathurst Inc.
Purchased during the peak of pricing cycle at 49% over market value.
Became the Worlds 2nd largest producer of pulp, paper and paperboard.
Enter European market through U.K. subsidiary $2.7 billion
Stone Container had grown increasingly dependent on the issuance of high
yield debt in an effort to balance the benefit of the tax-shield with the costs
of bankruptcy, as the trade off theory from MM states. In line with the

pecking order theory, Roger Stone financed the sizable Bathurst acquisition
with short term bank debt, which minimized information asymmetry and
signaled to investors that Stone had quality inside information. Given the
capital intensive nature of the paper industry, Stone had a large amount of
tangible assets on its balance sheet. These assets, whether formally
secured as collateral or available to senior debt holders with priority,
reduced agency costs for the debt market and allowed the company to take
advantage of lower cost financing. However, bank loans were eventually
refinanced via the issuance of public debt with junk bonds (higher level of
asymmetry) creating a firm more sensitive to insider information.
By 1992 junk bonds represented 35% of the total public bond issues in the
U.S. When this line of financing was exhausted and no other options were
available, Stone Container chose to make the use of equity as it did in 1991
when it had to sell 9 million shares of stock for $175 million to raise cash.
Eventually, Stone refinanced and restructured its debt using complex
securities such as convertible exchange preferred stock, interest rate
swaps, and high yield subordinated debentures.
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. How about a $100 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 expenses, remain the same. Also assume a 35%
tax rate.
Single variable regression analysis shows that there is noteworthy
correlation between: i) the price of linerboard and Stones net income; and
ii) the price of paper and Stones EBITDA (utilized as a cash flow proxy),
while there is weak correlation at the other two cross-sections.
As indicated by F-tests with significance levels above 95%, the multi
variable regression results below indicate that movements in paper and
linerboard pricing as a group have a statistically significant impact on the
Net Income and EBITDA of Stone Container.
When assuming: i) the 1992 production level of 7.5 million tons per year; ii)
1992 costs (with the exception of interest expense) iii) interest expense of

$400 million as implied by the case2; and iv) a 35% tax rate, earning and
EBITDA are highly sensitive to price increases of $50 and $100 as
illustrated below. For full Income Statement details, refer to Appendix I.
4. What would be effect under both these pricing scenarios if production
and sales volume increased to full capacity of 8.3 million tons per year (for
simplicity, assume costs per ton remain constant)?
Of note, the calculated EBITDA forecast for 2013 of $1,241 million with a
pricing change of $100/ton (see question #3) resembles EBITDA of $1,212
million forecasted for a production increase to 8.5 million tons, holding
pricing flat. Therefore, EBITDA resulting from a 13.6% isolated increase in
pricing is comparable to an isolated 13.1% increase in volume. For full
Income Statement details, refer to Appendix I.
5. What should be Stone Containers financial priorities for 1993? What
must be accomplished if Stone is to relieve the financial pressures afflicting
it?
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 following tasks must be
accomplished in order to relieve the company from its financial crisis:
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 to a sustainable level (closer to
peers 45.4% debt/total capital) that can handle cyclicality.

6. 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? 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? Make sure to call upon previous lectures when answering this
question.
Best Interests
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.
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 considering Stones share price in February 2013 compared to its
historical averages. 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
Recommendation
Pablo - I think that we should recommend 1) an asset sale that could be
used to pay down bank debt (give Stone some cushion on its credit
agreement covenants) followed by 2) issuance of the longer-term
convertible notes with the lower coupon. Let me know your thoughts.