General Mills’ Acquisition of Pillsbury from Diageo Plc

Outlines Background of the transaction Companies’ profile About General Mills About Pillsbury and Diageo Plc Features of the transaction Motives for General Mills Terms of transaction Recommendation to shareholders

Background of the transaction July 2000: GM’s management agreed to buy Pillsbury from Diageo Plc. 8 December 2000: GM’s Management recommended its shareholders to approve the proposed acquisition. Transaction in the form of exchange of shares of GM (Diageo becomes GM’s major shareholder). Before the transaction, Pillsbury would borrow $5 billion and pay a special dividend to Diageo. GM would receive contingent payment up to $642 million from Diageo in one year after the transaction.

This contingent payment puzzled GM’s shareholders: Would this deal create value for GM’s shareholders? Should GM’s shareholders approve this transaction?

About General Mills General Mills started in 1866 as a flour company in Minneapolis Minnesota. General Mills produces mostly yogurt and cereal. A study showed that at every American has at least one GM product when they go grocery shopping. GM had annual revenues of about $7.5 billion in the year 2000.

Products Boo Berry, Count Chocula, Cocoa Puffs, Cinnamon Toast Crunch, Franken Berry, Cheerios, Lucky Charms, Trix, Wheaties, and Reese’s Puffs.

Location General Mills is located in Golden Valley, Minnesota outside of Minneapolis. General Mills was founded in 1866. GM’s products are manufactured in 15 countries and are available in more than 100 countries.

Competition Although highly profitable, GM is facing increased competition in the food industry. Two major competitors of General Mills are Kellogg’s and Post. Both companies make cereal.

About Pillsbury and Diageo Pillsbury has been well knew in food industry. Diageo is a London-based consumer-goods conglomerate that specializes in the manufacture of premium alcoholic brands such as Smirnoff, Johnnie Walker, and Guinness. Diageo’s portfolio includes world-famous drink brands, Burger King, and Pillsbury, a producer of refrigerated dough and baked goods. Pillsbury is one of America’s best-recognized names in the food industry.

About Pillsbury and Diageo Pillsbury has successfully positioned its brand and been longstanding for success in the food industry. Pillsbury controls several other high-profile brands, such as Green Giant, Old El Paso, and Progresso. Not too far behind General Mills, in 2000, Pillsbury generated annual revenues of $6.1 billion. Although Pillsbury has shown a high potential for growth in the food industry, Diageo PLC hopes to divest the company in order to focus more on its core alcoholic beverages business.

About Pillsbury and Diageo In recent years, its beer and liquor businesses have been strong performers, yet its Pillsbury and Burger King divisions have been a drag on earnings. Thus, a deal with General Mills will allow Diageo to divest some of its unprofitable food assets and will also enable Diageo to focus more heavily on its thriving alcohol business.

Features of the transaction Transaction involves a stock-for-stock exchange that would pay Diageo over $10 billion: distributed to Diageo as a special dividend before the deal is closed. (141 million shares of common stock + $5.142 billion in debt) ($142 million of existing debt + $5 billion in new borrowings) 141 million shares of common stock Deal worth over $10 billion Equivalent to 1/3 of total GM shares $5.142 billion of debt $5 billion new borrowing $142 million existing debt

Features of the transaction After the transaction, Diageo will own 33% of GM’s outstanding shares, and Pillsbury operating as a wholly-owned subsidiary of GM. This means that Pillsbury is completely controlled by GM, and Diageo is primarily divesting its holding in Pillsbury in exchange for a substantial holding in General Mills. Diageo’s holding 1/3 of GM’s shares General Mills General Mills Pillsbury Pillsbury Diageo Diageo Before the deal After the deal

The transaction also includes a rare contingency payment, which specifies that $642 million of the transaction cost will be set aside by Diageo for one year following the closing of the deal. If GM’s 20-day average stock price is above $42.55, Diageo is to transfer the $642 million back to GM. If average stock price is below $38, Diageo will pay $450,000. If stock price falls in between, the fund will be split on a pro-rated basis. Two main constraints: First, GM does not want Diageo to own more than 1/3 of its stock. Second, GM does not want to lose its investment-grade bond rating of A-.

Motives for General Mills Diversification: General Mills is motivated to acquire Pillsbury because Pillsbury has a strong presence in the food-service industry, successfully serving restaurants, school cafeterias, and vending machines that meet its desire to grow and expand, and to remain a market leader and survive against heavy competition. Growth: The acquisition gives GM the opportunity to double the size of its empire, becomes more powerful in supermarket aisles. If the acquisition is approved, GM will have more than 30 brands with annual sales exceeding $100 million (GM Annual Report, 2000).

Synergy: GM’s management believe that the two companies will grow faster together. In other words, GM hopes to increase the value of the combined enterprise through synergy, which will benefit Diageo as well as the other GM’s shareholders. This synergy is achieved through newfound economies of scope and a reduction in competitive forces. It will be able to combine the capital, resources, and technology of both firms, resulting in greater efficiencies. Strong global presence: By combining the two companies, sales of General Mills’ brands in international markets will more than double and add almost $1 billion in revenues from Pillsbury operations in Asia, Europe, and Latin America.

Industry force: Competition in food industry has been more intent Industry force: Competition in food industry has been more intent. In order to keep pace with industry rivals, GM must expand in order to give itself more power over shelf space and pricing decisions. GM’s cereal division (its core business) has shown declining sales. Therefore, if GM acquires Pillsbury, it is able to drastically reduce its dependence on cereal sales and focus on more profitable divisions.

Cost savings: GM’s management believes that if Pillsbury is acquired, it will attain pretax savings of $25 million, $220 million, and $400 million in 2000, 2001, and 2003 respectively. We use WACC (weighted average cost of capital) to compute for interest rates (8.14%), applied in the calculation of NPV of these pretax savings: NPV (8.14,0,{25,220,400}) = $527.55 million However, through the synergies of GM and Pillsbury, we believe that the cost savings will last longer than three years; therefore, the NPV of pretax savings will be much higher than $527.55 million.

Terms of the transaction Payment of shares: GM would issue 141 million shares of common stock to Diageo (33% of GM’s total outstanding shares. In July 2000, GM’s stock traded at around $34 - $37. By December, its stock traded at around $40 - $42. Assumption of Pillsbury debt: At the closing of the deal, GM agreed to assume the liabilities of Pillsbury an amount of $5.142 billion of debt: ($142 million in existing debt + $5 billion in new borrowing)

Contingent payment by Diageo to GM: at the closing, Diageo would establish an escrow fund of $642 million, which Diageo would pay to GM a certain amount depending on GMs’ share price: $642 million, if average daily share price for 20 days was $42.55 or more. $0.45 million, if the average daily share price for 20 days was $38 or less. Variable amount, if the average daily share price for 20 days was between $38 and $42.55. Some financial analysts called this a ‘claw-back’ provision, while others called this a ‘contingent value right’ (CVR). Merrill Lynch estimated that the transaction costs, borne by GM, for this deal would amount to $55 million.

Recommendation to shareholders The acquisition is expected to produce pre-tax cost savings of $527.55 million. This indicates that there is positive synergy between GM and Pillsbury. Based on the analyses by Meryl Lynch and Evercore Partners, Pillsbury is worth between $11.836 - $13.489 billion and $11.3 - $14.2 billion respectively. Thus, acquiring Pillsbury will add a significant amount of value to GM.

Recommendation to shareholders Furthermore, since GM strongly believes that its stock price will rise post-acquisition, the stock price at GM may rise well above $42.55, thus increasing GM’s value further. They will gain back $641.55 million. This deal is absolutely economically attractive from the viewpoint of GM’s shareholders. Therefore, it is recommended that GM’s shareholders should approve the deal.

Thank you for your kind attention!

Computing for interest rates, used for calculating NPV of pretax savings Cost Savings: To numerically illustrate the benefits associated with the acquisition, we calculated the present value of the cost savings that would result from the acquisition. In order to compute this number, we first had to determine the applicable interest rate to use. We agreed that WACC is the best rate to use, as it is a reliable benchmark indicator. Cost of Debt: We used the prime rate of 9.5% for the cost of debt, as this is the interest rate that banks charge its most creditworthy customers. GM is considered a creditworthy company because it is classified as a large cap organization.

Cost of Equity: To formulate the cost of equity, we used the CAPM model. We decided to use the expected market rate of the S&P 500, as GM is a large cap company and the S&P 500 shows the average performance of the top 500 large cap companies. We decided to use the 2-year annual return of 1999 & 2000. If we had used the 1, 5, or 10-year yields, we would have arrived at ludicrous expected returns. For example, the 1-year rate yielded negative results, whereas the 5 and 10-year rates yielded results that were too high to incorporate into our calculation. 𝑅𝑒=𝑅𝑓+𝑏 (𝑅𝑚−𝑅𝑓) =5.74+.65 11.94−5.74 =9.735% Re: estimated interest rate Rf: risk-free interest rate Rm: market interest rate

Weight of Debt & Equity: To determine the appropriate debt and equity weights, we used GM’s 20 day average stock price on November 27, 2000, which was $40.43. We also know that General Mills is offering Diageo 141 million shares for Pillsbury, which would make Diageo one of General Mills’ major shareholders. In fact, Diageo will own 1/3 of the total company. Therefore, we can calculate the total number of shares that GM has outstanding. 141∗3=423 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑠h𝑎𝑟𝑒𝑠 𝑜𝑟 .423 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 𝑠h𝑎𝑟𝑒𝑠 423 – 141 = 282 million shares or .282 billion shares before issuing new shares 40.43∗.282=$11.4 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 * $40.43 is the 20 day average price on November 27, 2000 As of November 27, 2000, General Mills’ estimated market capitalization is $11.4 billion.

GM’s long-term debt-to-equity ratio is estimated to be about 6. 719% GM’s long-term debt-to-equity ratio is estimated to be about 6.719%. Since we know both its long-term debt-to-equity ratio as well as its estimated market capitalization, we can now determine how much long-term debt General Mills has. .06719=𝐷/𝐸=𝐷/11.4 𝐷=.766=0.766 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 By using its current market capitalization of $11.4 billion and its long term debt of $0.766 billion, the weight of debt comes out to be 6.72%. 𝑊𝑒𝑖𝑔h𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡=𝐷/𝑉=.766/(11.4+.766)=𝟔.𝟑% 𝑊𝑒𝑖𝑔h𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦=𝐸/𝑉=(11.4−.766)/(11.4+.766)=𝟗𝟑.𝟕% 𝑊𝐴𝐶𝐶= 𝐸/𝑉 ∗𝑅𝑒 + 𝐷/𝑉 ∗𝑅𝑑∗ (1−𝑇) 𝑊𝐴𝐶𝐶= (.937) (9.735) + (.63) ∗9.5 (1−.35) 𝑾𝑨𝑪𝑪=𝟏𝟑.𝟎𝟏% Re: Cost of equity/ Rd : Cost of Debt

𝑊𝑒𝑖𝑔h𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡=𝐷/𝑉=(.766+5.142)/(12.17+5.142)=𝟑𝟒.𝟏𝟑% With the additional $5.142 billion in debt, the WACC changes as follows: 𝑊𝑒𝑖𝑔h𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡=𝐷/𝑉=(.766+5.142)/(12.17+5.142)=𝟑𝟒.𝟏𝟑% 𝑊𝑒𝑖𝑔h𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦=𝐸/𝑉=(16.542−5.908)/17.31=𝟔𝟏.𝟒𝟑% Modigliani & Miller Proposition II: 𝑅𝑒′=𝑅𝑜+ (𝐷/𝐸) (𝑅𝑜−𝑅𝑑) (1−𝑇) 𝑅𝑒′=9.735+ (5.908/10.634) (9.735−9.5) (1−.35) =𝟗.𝟖𝟐% The cost of equity increased because General Mills is taking on more debt, thus its exposure to bankruptcy subsequently increases. Due to this increased risk, investors will require a higher rate of return (which can be seen in the new calculation for the cost of equity). 𝑊𝐴𝐶𝐶= 𝐸/𝑉 ∗𝑅𝑒+ 𝐷/𝑉 ∗𝑅𝑑∗ (1−𝑇) 𝑊𝐴𝐶𝐶= (.6143) (9.82) + (.3413) ∗9.5 (1−.35) 𝑾𝑨𝑪𝑪=𝟖.𝟏𝟒% Back to slide # 18