FBE-560 Mergers and Acquisitions|2015 Spring

To: Prof. Gerard Hoberg

From: Team 6 (Ryan Gunawan, Di Lan, Kyunghwan Lee, Jinchul Park, Yuanye Shan, Timothy Wang)
Date: February 11, 2015
Re: Atlantic Corporation Case Report
______________________________________________________________________________

In 1984, as one of the largest US-based ‘forest product’ manufacturers focusing on paper manufacturing

businesses, Atlantic Corporation (“Atlantic”) was considering whether to strengthen its packaging box business

by acquiring linerboard mills from Royal Paper. This memo is intended to discuss the strategic value of the

acquisition, as well as the underlying economics, and possible transaction options with recommendations.

Linerboard Industry Outlook

Linerboard is the intermediate product in the goods packaging industry. The end product, corrugated

cardboard boxes, are used to pack over 90% of all good shipped in the U.S., and the demand is inelastic to the

economic cycle. Linerboard manufacturing requires high capital investment, which translate to slow growth

(1%-2% per year) in the overall industry capacity.

In 1984, the future outlook for linerboard industry was very positive due to forecasted economic

expansion. Linerboard and cardboard boxes sales were expected to rise by nearly 7%. With strong demand,

price was predicted to significantly to $320 per ton from $270, a 19% increase, and the industry-wide operating

rates were expected to reach 99% with little risk of decline in the near future. Such high utilization rates indicate

that prices would continue to rise, while maintaining a high profitability since the variable cost of producing

linerboard will be reduced due to high volumes of production.

Strategic Evaluation

The acquisition of linerboard mill from Royal Paper would be a very valuable strategic move for Atlantic,

if achieved at a desirable transaction price. Atlantic’s overall strategic goal is to enhance its firm-wide

linerboard production capacity in anticipation of greater future demand. Currently, 70% of Atlantic’s operating

profits stems from home construction material business, which is highly sensitive to the health of the domestic

economy. Enhancing linerboard production will help to offset this cyclical nature and add stability to the firm’s

sales and profits, directly affecting its stock price.

 To increase linerboard capacity, acquiring an existing facility has great advantages over constructing new

ones. Although Royal Paper’s mill would need further capital commitment to convert the kraft capacity to

linerboard capacity, the facility had already been optimized for this conversion with existing linerboard capacity

ready for immediate production. Building a new facility would cost $750 million and require two years before

generating output. The acquisition will save Atlantic significant amount of time and resources, shorten the

cycle of return on capital with an up-and-running cash inflow, thus reducing investment risk.

From a competitive and profitability standpoint, Atlantic might face serious challenges in the future

without this acquisition. From an operational perspective, Atlantic’s existing linerboard mill in Ohio can only

produce 780 ton/day, leaving a 150,000-ton gap of input for its box plants. As market demand rises, linerboard

prices are forecast increase and become increasingly unavailable, which would severely erode the company’s

operating margin. Additionally, Royal Paper’s Montecillo mill’s national footprint would enable Atlantic’s box

business to cover most of the major US markets.

Transaction Analysis

The primary assumption for the transaction analysis is that Atlantic’s acquisition move can be justified

given their limited current production levels and excess demand in the linerboard industry; more specifically,

the small market share (4%) that would be achieved by Atlantic would not hinder its ability to sell even with

price increases. Additionally, the high utilization rates (90%+) justify Atlantic’s increase in production levels to

meet consumer demand. Production levels, while growing, are forecasted at a slower pace than the previous

year (6.71% vs. 10.42%), which would balance out the additional capacity created by Atlantic’s acquisition.

One of the key assumptions of the valuation is the forecasted price increase from $270 to $320 for 1984. It

is agreed that there must be an increase in price due to the strong demand and limited supply expected in 1984.

The question centers on the rate of price increase, which is over 18%. The caution derives from the fact that the

market for linerboard sales and profits tend to respond less quickly and less directly to economic shifts. This

should cause concern given that prices have decreased over the past 6 years at rates much smaller than the

expected increase. However, given that expectations of utilization are expected to be near 100% and that box
sales are predicted to rise nearly 7%, there is evidence to support that increased demand will support a price

increase in 1984 and beyond.

Based on the above forecasts, Atlantic should be willing to pay up to $350 million less transaction costs,

depending on the level of debt financing Atlantic can raise without endangering its current BBB rating. The

level of debt financing has a positive effect of lowering the WACC for the project because of the lower cost of

debt and implied tax shield benefit. If Atlantic were confident that it could maintain its BBB rating at its current

debt percentage of book capital at 43%, the valuation range is up to c. $358 million. Value assigned after 1993

should extend for 5 years, or the remaining life of the project, with no terminal value thereafter. Key

assumptions during this extended forecast period include a 5% continued increase in unit price, no additional

Capex after 1993, and straight-line depreciation of remaining PP&E.

We valued the target assets using DCF analysis initially based on Atlantic Corp’s assumptions, with

concerns about two key assumptions that affect free cash flows: Price Per Ton and Capex. We were conscious

of the bullish price increase starting with 18.5% per year to a plateau of 5% after the first eight years. We also

assumed that the same 5% increase in price would maintain after 1993 given the 15-year economic life of the

mill and box plants, but also included a less bullish scenario starting with 10% price per ton growth to a plateau

of 3% for the lower range of our valuation.

It is unknown that if the planned Capex includes any contingency buffer for unforeseen expenditures. Also,

Atlantic assumes that no additional Capex will be necessary after 1993 for the 5 remaining years of economic

life. Any unforeseen expenditures, especially in the early years of the project, would directly impact free cash

flows, hence negatively impacting the DCF valuation.

Based on Halloran’s cash offer of $319 million, the appropriate discount rate for the bank loan plus

common equity issuance option is c. 13.78%. To protect Atlantic’s bond rating at BBB, we conservatively

assumed that the level of debt issuance as a percentage of book capital should be capped at 41%, resulting in a

debt issuance capacity of $89.5 million. The remaining amount of $229.5 million would be funded through the

issuance of 8.2 million shares with net proceeds of $28 per share. Cost of debt is estimated to be 10.75%, which
inherently assumes that Atlantic would be able to refinance at the same interest rate throughout the life of the

project. Cost of equity is estimated using the CAPM model, with the equity beta derived from the anticipated

debt-to-equity ratio and median asset beta from Atlantic and its major comparables. The market risk premium is

estimated to be 7%, and the risk-free rate is the YTM of US 30-year Treasures at 8.5%.

Analysis of the debenture option requires an APV analysis due to the 5-year grace period. According to the

APV analysis, although a 5-year grace period seems attractive on surface, it reveals that due to the accrual of

interest during that period without actual interest payments, Atlantic essentially would have to forego the tax

shield benefits for the first 5 years of the project. Because of the effects of discounting, the tax shield benefits

after Year 5 are minimized. Comparatively, the bank loan option allows Atlantic to instantly enjoy the benefits

of the tax shield; however, cash flows during the initial years of the project would be lowered due to debt

servicing.

Recommendations

Being more conservative with all the assumptions and to avoid the winner’s curse, we would recommend

to acquire Royal Paper’s linerboard and box mill operations at a price range up to $335 million less transaction

costs. In particular, it is worth noting that the assumptions are less aggressive in terms of long-term unit price

growth and ability to secure debt financing while maintaining Atlantic’s current bond rating.

In addition, since this is an asset acquisition, there are no tax concerns from an acquirer’s perspective. A

price above $319 million is viewed as sufficiently substantial to incentivize Royal Paper to sell the target assets,

despite the selling firm being liable for any gains on the asset sale.

Valuation Range: $319 $335

Debt % of book capital @ 40% - 43% $321 $358

DCF @ LT unit price growth 3 - 5% $312 $333

DCF @ WACC 13.25% - 14.25% $322 $345

$290 $300 $310 $320 $330 $340 $350 $360

Exhibit 1: 15-year DCF Analysis
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Monticello Mill

Annual capacity ('000 tons) 661.0 699.0 747.0 747.0 747.0 747.0 747.0 747.0 747.0 747.0 747.0 747.0 747.0 747.0 747.0
Utilization rate 95.0% 93.0% 93.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0%
Production rate('000 tons) 628.0 650.1 694.7 709.7 709.7 709.7 709.7 710.0 709.7 709.7 709.7 709.7 709.7 709.7 709.7
Price per tonb 320.0 360.0 400.0 410.0 430.0 452.0 475.0 498.0 522.9 549.0 576.4 605.2 635.4 667.1 700.4
YoY Increase 18.5% 12.5% 11.1% 2.5% 4.9% 5.1% 5.1% 4.8% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
Mill sales ($ millions) 201.0 234.0 277.9 291.1 305.3 320.9 337.3 353.6 371.3 389.8 409.0 429.5 450.9 473.4 497.0
Cash costs($ millions)b 160.3 176.1 194.2 211.3 221.5 232.7 244.2 256.4 269.2 282.8 296.8 311.6 327.1 343.5 360.6
Operating profit margin 79.8% 75.3% 69.9% 72.6% 72.6% 72.5% 72.4% 72.5% 72.5% 72.6% 72.6% 72.6% 72.6% 72.6% 72.6%
Operating profit before depreciation and taxes 40.7 57.9 83.7 79.8 83.8 88.2 93.1 97.2 102.1 107.0 112.3 117.9 123.8 129.9 136.4

Box Plants ($ millions)

Operating profit before depreciation and taxes 11.6 14.8 16.3 17.1 18.0 18.9 19.8 20.8 21.8 22.9 24.0 25.0 26.1 27.1 28.2
YoY Growth 27.6% 10.1% 4.9% 5.3% 5.0% 4.8% 5.1% 4.8% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Combined Mill and Plants ($ millions)

Operating profit before depreciation and taxes 52.3 72.7 100.0 96.0 101.8 107.1 112.9 118.0 123.9 129.9 136.2 142.9 149.8 157.1 164.6
Depreciation expensec 20.9 28.3 35.0 39.3 41.3 39.3 34.3 27.1 26.3 25.3 18.7 18.7 18.7 18.7 18.7
As % of operating profit 40.0% 38.9% 35.0% 40.9% 40.6% 36.7% 30.4% 23.0% 21.2% 19.5% 13.8% 13.1% 12.5% 11.9% 11.4%
EBIT 31.4 44.4 65.0 56.7 60.5 67.8 78.6 90.9 97.6 104.6 117.5 124.1 131.1 138.3 145.8
Tax 36% 11.3 16.0 23.4 20.4 21.8 24.4 28.3 32.7 35.1 37.7 42.3 44.7 47.2 49.8 52.5
EBIAT (NOPAT) 20.1 28.4 41.6 36.3 38.7 43.4 50.3 58.2 62.5 66.9 75.2 79.5 83.9 88.5 93.3
+ Depreciation expensec 20.9 28.3 35.0 39.3 41.3 39.3 34.3 27.1 26.3 25.3 18.7 18.7 18.7 18.7 18.7
- CAPEX (Planned) 19.2 30.5 41.7 10.2 10.2 8.2 6.2 6.2 4.2 4.2 0.0 0.0 0.0 0.0 0.0
- Δ in Net Working Capital 9.0 16.0 10.0 5.0 4.0 5.0 5.0 4.0 6.0 5.0 5.8 6.2 6.5 6.8 7.2
Free Cash Flows 12.8 10.2 24.9 60.4 65.8 69.5 73.4 75.1 78.6 83.0 88.1 92.0 96.1 100.4 104.9

WACC 13.78%

Valuation $332.97
Exhibit 2: WACC Estimate and Comparable Asset Beta Analysis

WACC Calculation
Source of funds assumptions
Total price $ 319.0
Debt $ 89.5
Equity $ 229.5

Maximum potential debt

Debt % of book capital 41.0%
Old debt BV $ 1,628.0
Old equity BV $ 2,242.0
New debt BV $ 1,717.5
New equity BV $ 2,471.5

Cost of debt 10.75%

Debt Scenario 1

Cost of equity 16.47%

Risk-free rate 8.49%
Equity beta 1.14
Market risk premium 7%

WACC 13.78%

Cap at Market
Company Name Equity Beta No. of Avg stock % debt % common Debt Equity EV Asset Beta
shares (mn) price
Atlantic Corp 1.35 107.1 27.0 35% 65% 1,557.7 2,892.9 4,450.5 1.00
Stone Container 1.15 14.1 33.0 45% 55% 380.8 465.4 846.2 0.75
Champion Int'l 1.40 67.2 25.0 40% 60% 1,120.2 1,680.3 2,800.5 0.98
Union Camp 1.10 24.4 71.0 29% 71% 707.7 1,732.7 2,440.4 0.87
International Paper 1.15 53.3 53.0 25% 75% 940.8 2,822.4 3,763.1 0.95
Royal Paper 1.25 39.3 30.0 40% 60% 785.7 1,178.6 1,964.3 0.88

Mean 0.91
Median 0.91
Exhibit 3: APV Analysis of Both Debt Scenarios

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Free Cash Flows $ 12.8 $ 10.2 $ 24.9 $ 60.4 $ 65.8 $ 69.5 $ 73.4 $ 75.1 $ 78.6 $ 83.0 $ 88.1 $ 92.0 $ 96.1 $ 100.4 $ 104.9

Risk-free rate 8.49%

Equity beta 0.91
Market risk premium 7%
Cost of equity 14.87%

PV of FCF $308.98

Scenario 1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Beginning debt $ 89.5 $ 86.7 $ 85.7 $ 82.2 $ 78.3 $ 74.0 $ 69.3 $ 64.1 $ 58.3 $ 52.0 $ 45.0 $ 37.3 $ 28.9 $ 19.7 $ 9.8
Interest payment 10.75% $ 9.5 $ 9.3 $ 9.0 $ 8.6 $ 8.2 $ 7.7 $ 7.2 $ 6.6 $ 5.9 $ 5.2 $ 4.4 $ 3.6 $ 2.6 $ 1.6 $ 1.1
Amortization $ (12.3) $ (10.2) $ (12.5) $ (12.5) $ (12.5) $ (12.4) $ (12.4) $ (12.3) $ (12.3) $ (12.2) $ (12.1) $ (12.0) $ (11.8) $ (11.5) $ (10.9)
Ending debt $ 89.5 $ 86.69 $ 85.74 $ 82.22 $ 78.34 $ 74.05 $ 69.31 $ 64.09 $ 58.32 $ 51.97 $ 44.99 $ 37.32 $ 28.91 $ 19.75 $ 9.85 $ -

Assumes bank loan can be refinanced at same interest rate for life cycle (15 years) of project

Tax shield 36.0% $ 3.41 $ 3.34 $ 3.25 $ 3.11 $ 2.95 $ 2.77 $ 2.58 $ 2.37 $ 2.13 $ 1.88 $ 1.59 $ 1.28 $ 0.94 $ 0.57 $ 0.38
Cost of debt 10.75% $ 3.08 $ 2.72 $ 2.39 $ 2.07 $ 1.77 $ 1.50 $ 1.26 $ 1.05 $ 0.85 $ 0.68 $ 0.52 $ 0.38 $ 0.25 $ 0.14 $ 0.08

PV of tax shield $ 18.73

EV of levered firm $327.71

Scenario 2 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Beginning debt $ 89.5 $ 99.2 $ 109.9 $ 121.7 $ 134.9 $ 149.5 $ 139.7 $ 129.0 $ 117.2 $ 104.3 $ 90.1 $ 74.6 $ 57.7 $ 39.4 $ 19.6
Interest payment 10.25% $ 9.7 $ 10.7 $ 11.9 $ 13.2 $ 14.6 $ 14.8 $ 13.8 $ 12.6 $ 11.3 $ 10.0 $ 8.4 $ 6.8 $ 5.0 $ 3.0 $ 2.0
Amortization $ - $ - $ - $ - $ - $ (24.6) $ (24.5) $ (24.4) $ (24.3) $ (24.1) $ (23.9) $ (23.7) $ (23.3) $ (22.8) $ (21.7)
Ending debt $ 89.5 $ 99.2 $ 109.9 $ 121.7 $ 134.9 $ 149.5 $ 139.7 $ 129.0 $ 117.2 $ 104.3 $ 90.1 $ 74.6 $ 57.7 $ 39.4 $ 19.6 $ -

Tax shield 36.0% $ 5.34 $ 4.96 $ 4.54 $ 4.09 $ 3.59 $ 3.04 $ 2.44 $ 1.79 $ 1.09 $ 0.73
Cost of debt 10.25% $ 2.97 $ 2.50 $ 2.08 $ 1.70 $ 1.35 $ 1.04 $ 0.76 $ 0.50 $ 0.28 $ 0.17

PV of tax shield $ 13.35

EV of levered firm $322.33