/n CASE 14 Chestnut Foods In early 2014, stock performance at Minneapolis-based Chestnut Foods (Chestnut) had failed to meet expectations for several years running, and senior management was hard-pressed to talk about much else. CFO Brenda Pedersen, eager to reverse the trend, had begun advocating two strategic initiatives: a $1 billion investment in company growth and the adoption of a more progressive corporate identity. At a restaurant overlooking the Mississippi River, Pedersen hosted an informal meeting of company VPs to build support; exchanges had been highly spirited, but no consensus had materialized. Then, on her drive home from the restaurant, she received a call from Claire Meyer, VP of Food Products, who had attended the dinner. Given the tone of the meeting, Pedersen wasn't surprised to get a call so soon, but what Meyer shared floored the CFO. "It just came up on Twitter. My admin saw it and texted me. I'm not going to say I told you so." Meyer read her the tweet. "Van Muur buys 10% of Chestnut, seeks seats on board and a new management direction." Meyer filled in the details: based on filings earlier in the day with the U.S. Securities and Exchange Commission, Rollo van Muur, a high-profile activist investor, had quietly and unexpectedly purchased 10% of the company and was asserting the right to two seats on the board. In addition, Van Muur was recommending that the Instruments division be sold off "to keep the focus where it belongs." Pedersen drove in shocked silence and processed the information while Meyer waited patiently on the line, not sure what to expect. When Pedersen finally responded, she fell back on humor: "Well, that's one way to move the discussion along, but he could have just come to dinner with us." By the end of the night, she had spoken with CEO Moss Thornton and organized a team of lawyers and finance staff to assess the company's options. The Company Page 208 Chestnut Foods began in north Minneapolis in 1887, when 22-year-old Otto Chestnut (born Otto Kestenbaum in Bavaria) opened a bakery that made lye rolls and pretzels, then stumbled into success as a supplier of sandwiches to the St. Paul, Minneapolis, & Manitoba Railway. Six years later, on a trip to Chicago, Illinois, to visit the Columbian Exposition, Chestnut happened to come upon the Maxwell Street Market, a vibrant melting-pot community of merchants of eastern European descent. At the market, he had a chance meeting with Lem Vigoda and George Maszk, founders of V&M Classic Foods, which provided a range of meat and fish products as well as preserves and condiments. Through them he witnessed a nascent ad hoc distribution system to neighborhood groceries in the rapidly growing city. A vision of wholesale food production and distribution struck him, and he returned to Minneapolis determined to realize it. By 1920, as regional grocery chains had begun to materialize, Chestnut, since joined by his sons Thomas and Andrew, had purchased V&M among other food businesses. Their plan was for the expanded Chestnut to stock the regional grocery chains across the upper Midwest, while also continuing to supply railroad dining cars and, beginning in 1921, a Chestnut chain of automats in Chicago and Detroit. Otto Chestnut died in 1927 at age 62, but the company was well positioned to weather the Great Depression; in 1935, the Chestnut brothers sold the automat division to Horn & Hardart, then used the proceeds to purchase farmland in Florida and central California. In the postwar period, as the supermarket model emerged, Chestnut grew with it, both organically and through acquisition, going public in 1979. By 2013, the company was valued at $1.8 billion, with annual profits of more than $130 million. Chestnut sought to "provide hearty sustenance that gets you where you're going." The firm had two main business segments: Food Products, which produced a broad range of fresh, prepackaged, and processed foods for retail and food services, and Instruments, which delivered systems and specialized equipment used in the processing and packaging of food products. Instruments provided a variety of quality control and automation services used within the company. The company took increasing pride in the high quality of its manufacturing process and believed it to be an important differentiator among both investors and consumers. In recent years, Chestnut's shares had failed to keep pace with either the overall stock market or industry indexes for foods or machinery (see Exhibit 14.1). The company's credit rating with Standard & Poor's had recently declined one notch to A-. Securities analysts had remarked on the firm's lackluster earnings growth, pointing to increasing competition in the food industry due to shifting demands. One prominent Wall Street analyst noted on his blog, "Chestnut has become as vulnerable to a hostile takeover as a vacant umbrella on a hot beach." $1.80 $1.60 $1.40 $1.20 $1.00 Food Industry Machinery Industry S&P 500 Muſ Chestnut $0.80 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 EXHIBIT 14.1 I Value of $1.00 Invested from January 2010 to December 2013 (weekly adjusted close) Data source: Yahoo! Finance and case writer data. Food Products Division The Food Products division provided a range of prepackaged and frozen products related to the bread and sandwich market for both institutional food services and retail grocery distribution throughout North America, and some limited distribution in parts of Central and South America. Revenues for the segment had long been stable; the company achieved an average annual growth rate of 2% during 2010 through 2013. In 2013, segment net operating profit after tax (NOPAT) and net assets were $88 million and $1.4 billion, respectively. Looking to the foreseeable future, operating margins were expected to be tight such that return on capital for the division was expected to be 6.3%. Page 209 From its long association with the sandwich market prior to the advent of fast food, through its expansion in the 1950s and 1960s, Chestnut had consistently retained portions of the market for institutional ready-to-bake frozen bread dough, bread and rolls, and ready-to-bake soft pretzels. Premium-quality versions of these were packaged and sold in supermarkets under both the Chestnut brand and store brands. Despite repeated efforts over the years to expand into other markets, the specialty bread and pretzel market remained Chestnut's primary driver of growth, reliant on scale, multiple outlets and packaging formats, and product innovation, most recently with Chestnut Classic Rapid-Rise Soft Pretzels, a newly formulated ready-to-bake product that produced oven-fresh pretzels in 10 minutes, including preheating. Particularly since the 1980s, after Chestnut had gone public and as demand for fresh produce, diverse ethnic cuisines, and health-conscious snacks had begun to increase, the firm made a series of moves designed to broaden its range of offerings, but the industry remained highly competitive and the returns on those alternative products modest. Nevertheless, customer surveys reflected consistently high ratings for product quality, freshness, and flavor. Chestnut was frequently referred to in popular culture, particularly in the northern states. Its well-known catchphrase "You'll make it with Chestnut,” was synonymous with warm, hearty bread for people on the move. Instruments Division Since its earliest days amid the bustling flour mills and rail lines of Minneapolis, Minnesota, Chestnut's management had maintained a shared value that technology, properly harnessed, could improve quality and efficiency across production processes, and over the years, the company had developed a strong expertise in food process instruments. The success of companies such as Toledo Scale, founded in Toledo in 1901 before merging to become Columbus, Ohio-based, Swiss-owned Mettler-Toledo in 1989, was not lost on Otto Chestnut himself, although thoughts of such diversification were repeatedly deferred. Yet as a more cyclical and diverse industry (with products providing advanced capabilities to utilities, military and aerospace programs, and industrial and residential applications in addition to food production), precision instruments seemed to complement the food industry and to present opportunities for growth overseas. In 1991, Chestnut capitalized on an opportunity to purchase Consolidated Automation Systems, a medium- sized food-processing-instrument equipment company based in Thunder Bay, Ontario, and the Instruments division was born. This proved very successful and was followed by the purchase in 1997 of Redhawk Laboratories, a small manufacturer of computer-controlled precision equipment based in Troy, New York. Although 20% of the division's revenue was derived internally from the Chestnut' Products division, the Instruments division produced equipment and automation support for a wide range of food producers in North America. Demand, much of it from overseas, was strong, but required substantial investments in R&D and fixed assets. Instruments division sales had increased by nearly 20% in 2013. Segment Page 210 NOPAT was $46 million, and net assets were $600 million. The expected return on capital for the division over the foreseeable future was 7.7%. Recent Developments Concerned above all else with the poor stock-price performance, and mindful of the importance of scale to profitability in the precision instrument industry, Pederson hoped to sustain corporate growth opportunities by raising $1 billion to invest in the expansion of the Instruments division. She had been delighted with the market's strong interest for the high-value-added offerings the division maintained and believed that funneling investment in its direction was the way forward for Chestnut. She believed that the 7.7% expected returns for this division could be maintained with additional company investment. She also believed that the tradition-laden company name failed to capture the firm's strategic direction and that the name "CF International” better reflected the growth and modern dynamism envisioned by leadership. At the dinner meeting, as over the past few weeks, her initiative had generated partisan reactions from the company's two divisions. Curiously, much of the discussion at dinner focused on the rather pedestrian topic of the company hurdle rate. Meyer had strongly contended from her perspective in Food Products that the two segments of the business were different enough that they warranted separate hurdle rates; Rob Suchecki, VP of Instruments, was ardent in his opposition. SUCHECKI: Look, Claire, to investors, the firm is just a big black box. They hire us to take care of what's inside the box and judge us by the dividends coming out of the box. Our job as managers should be to put their money where the returns are best. Consistent with this reality, our company has a long-standing policy of using a single common hurdle rate. If that hurdle rate takes from an underperforming division and gives to a more profitable division, isn't that how it's supposed to work? We're all well aware that investors consider past profits unacceptable.¹ MEYER: Rob, the question is how you define profitability. High-return investments are not necessarily the best investments, and to be fair, our investors are way more savvy than you are giving them credit for; they have a wide range of information sources and analytic tools at their disposal and have a firm grasp on what is going on inside the company. They appreciate the risk and return of the different business units, and they adjust performance expectations accordingly. So to this type of investor, different hurdle rates for the different levels of risk reflects how things really are. Page 211 SUCHECKI: But Claire, multiple hurdle rates create all sorts of inequities that are bound to create discord among the ranks. If you set the hurdle rate for Food Products lower than the firm-wide hurdle rate, you're just moving your division's goalposts closer to the ball. You haven't improved performance, you've only made it easier to score! MEYER: You've got to realize, Rob, that we are playing in different leagues. Each part of the business has to draw on capital differently, because the rules for each unit are different. If Food Products was on its own, investors would be happy with a lower return because Food Products' risk is so much lower. Stability has its perks. And likewise, if Food Products could raise capital on its own, we'd surely get that capital at a cheaper rate. SUCHECKI: Different leagues? The fact is that we don't raise capital separately; we raise it as a firm, based on our overall record. Our debt is Chestnut debt and our equity is Chestnut equity. It's a simple fact that investors expect returns that beat our corporate cost of capital of 7.0%. It is only by growing cash flow company-wide that investors are rewarded for their risk capital. In fact, being diversified as a company most likely helps reduce our borrowing costs, letting us borrow more as a unit than we could separately. MEYER: Rob, you know very well the kind of problems that thinking creates. If 7.0% is always the hurdle, the company will end up overinvesting in high-risk projects. Why? Because sensible, low-risk projects won't tend to clear the hurdle. Before long, the company will be packed with high-risk projects, and 7.0% will no longer be enough to compensate investors for the higher risk. By not accommodating multiple hurdle rates, we are setting ourselves up for all sorts of perverse investment incentives. The Food Products division is getting starved for capital, penalized for being a safer bet, while the Instruments division is getting overfed, benefitting from a false sense of security. SUCHECKI: Hold on, I object! The reason Food Products is not getting capital is because there's no growth in your division. Instruments is coming on like gangbusters. Why would investors want us to put additional capital into a business that is barely keeping up with inflation? MEYER: With a plot of risk versus return, the dashed line is our current corporate hurdle rate based on the average risk of the company. The solid line is a theoretical hurdle rate that adjusts for the risk of businesses within the company. Food Products is marked with an "F." It is expected to earn 6.3% on capital, which doesn't clear the corporate hurdle rate, but if you adjust for risk, it does clear it, and it is profitable! Instruments is the opposite. It's marked on the graph with an "I." It can expect 7.7% returns, which clears the corporate hurdle. But since it is inherently riskier, the risk-adjusted hurdle rate exceeds 7.7%. Unless we are careful to adjust for that risk, it remains a hidden cost, and we are fooling ourselves. Page 212 SUCHECKI: Claire, I believe it is pure speculation to claim that the risk adjustment line you've sketched out is anywhere close to that steep. Second, even if you are theoretically correct, I believe there is practical wisdom in maintaining a single, simple, consistent, and understandable performance criterion. A single measure of the cost of money makes NPV results consistent, at least in economic terms. If Chestnut adopts multiple rates for discounting cash flows, the NPV and economic-profit calculations are going to lose their meaning, and business segments won't be able to make comparisons. At this point, pens and paper napkins were procured for Meyer, who presented the group with a diagram illustrating her argument (Figure 14.1) before continuing. Rate of Return Risk-adjusted hurdler Corporate hurdle rate Food Products F Instruments FIGURE 14.1. I Meyer's diagram of constant versus risk-adjusted hurdle rates. Source: Created by case writer. At this point, Pederson had finally managed to rein in the heated debate and redirect the conversation to matters that were less controversial. Risk Level/n Chestnut Foods Lecture Outline: Professor Rahman This is not a WACC estimation case, but more of an investment decision case, i.e., knowing the right hurdle rate! How can WACC be used in measuring value creation? • Economic Value Added (EVA) = Total Divisional Capital x (Expected ROC - WACC) Should WACC be used as a hurdle rate for project selection? WACC is the opportunity cost of the investors. As such, it serves as a hurdle rate, i.e., the minimum return expected from the project funded. Should WACC and FCF reflect inflation adjustment? • Recall that Nominal Return is approximately = Real Return + Inflation Rate • • • To be consistent, nominal cashflow should be discounted by nominal discount rate, and real cash flow by real discount rate. WACC is estimated as a nominal rate, i.e., expected inflation rate is already included in the required rate of return for equity and debt. So, FCF should be estimated as a nominal rate, i.e., include inflation adjustment. That way, FCF may be discounted by WACC. Should the cost of debt and cost of equity reflect business risk and financial risk? • Bond rating reflects the underlying risk associated with the bond issued. Stock beta includes both financial and business risk estimate. • So, WACC is a risk-adjusted opportunity cost of funding. Should the equity and debt reflect appropriate market-value-based weightings? • • Market value, and not book value of the long-term securities are relevant for weightings in WACC. The weightings should ideally be based on target or optimal mix, rather than the actual financing used. Should the WACC be the same for all divisions, i.e., single company wide WACC be used? • Every division has its own unique business and financial risk exposure. So, it is appropriate to estimate WACC for each division separately. Corporate WACC measures the overall opportunity cost and risk of the investments made by the firm. It may be used for valuation of the entire corporation, but not appropriate for any division. Should the WACC be based on projects, or be the same for all projects within a division? • WACC should be estimated to properly capture the underlying risk of a project. • There's a difference among project-specific, divisional, and companywide hurdle rates. Approaches to estimating WACC: Based on the cost of the firm's own securities (KD, Ks) financing mix (D/E) • Based on the average WACC of comparable firms within the industry