May 02, 1993

The Corporation

SECONDHAND SMOKE AT RJR NABISCO

The chief products of RJR Nabisco are cigarettes, food, and high drama. In Act One of an epic that premiered in 1988, the corporation and its luscious cash flow were prizes in a titanic takeover battle won by Kohlberg Kravis Roberts & Co. Two years later, in Act Two, RJR’s megadebt almost destroyed it. But in the nick of time, a KKR refinancing rescued the company.

Now, as the curtain opens on Act Three, the drama continues at RJR Nabisco Holdings Corp. There’s management turbulence as CEO Louis V. Gerstner Jr. exits to head IBM. Further thickening the plot: A cigarette price war and a proposed tobacco tax hike threaten the cash flow it needs to handle its still mountainous debt.

Even though the New York-based tobacco and food giant has made steady progress in trimming the $24 billion in long-term debt that blighted its balance sheet after the 1988 leveraged buyout, RJR is still weighed down with $13.5 billion in debt. And now, the company’s cash flow could dip by 17%, to $3.4 billion in 1993 (chart), predicts Ellen G. Baras, a vice-president at Duff & Phelps/MCM Investment Research Co. RJR has less of a margin for error these days, she says.

RJR hardly faces disaster. Its cash flow will still cover interest payments by a comfortable three-to-one. But RJR’s flexibility may be reduced. At worst, RJR would have about $950 million left over in so-called free cash flow this year after paying interest, scheduled debt maturities, capital spending, and other vital costs. That’s down from $1.6 billion left over at the end of 1992. Further debt redemptions must come from free cash flow. So must extra capital expenditures, which RJR must make to challenge rivals with new products and rejuvenated old ones. RJR last year boosted capital spending 13%, to $519 million—and has told analysts that to stay competitive it will increase that by another 15%, to $600 million, in 1993.

In addition, the new cigarette plants it’s building or buying and renovating for its emerging markets in Europe cost a lot of money (page 132). The same is true for marketing campaigns at home. Analysts predict the company will hike its $1.8 billion U.S. marketing budget for tobacco by $500 million this year. Moreover, competitors enjoy lower debt and higher credit ratings, which translate to more favorable capital costs. Philip Morris Cos. and American Brands Inc. for instance, have single-A credit ratings from Standard & Poor’s Corp. By contrast, RJR has a triple B-minus. The smaller cash stream comes at a time when RJR needs all the financial might it can muster to do battle in the looming tobacco price wars. Under pressure from discount brands, RJR archrival Philip Morris unleashed the first salvo in what promises to be a brutal battle by announcing on Apr. 2 that it would issue coupons that drop the price of a pack of Marlboros by 40, to about $2.00. RJR will likely respond by cutting prices on its own premium brands. James W. Johnston, RJR’s tobacco chief, has already vowed: We will not allow competitors to take significant volume away from us.

FRESH FOOD. Unfortunately for RJR, that assertion spells almost certain strain on the company’s finances. Analyst Leigh Ferst of Prudential Securities Inc. reckons that U.S. operating profits from its R.J. Reynolds tobacco division could fall by 6%, to just under $2 billion. Sales are expected to be roughly unchanged at $6.2 billion. Some analysts say overall company earnings could drop by 10%, to $2.6 billion, while sales may grow by 3% to 4%, to $16.4 billion.

Until recently, RJR’s financial forecast was starting to look sunny. Since 1988, the largest LBO in history has made great progress paring debt. Last year, credit-rating agencies elevated most of RJR’s bonds from junk to investment-grade. Largely by selling off several food companies, such as Chun King and Shredded Wheat, RJR raised enough cash to reduce its debt to almost half the scary amount of four years ago. That and refinancing high-coupon paper at current low rates has sent the interest tab plummeting. Last year, it totaled $1.1 billion, down from $3 billion in 1990.

RJR aims to lighten the debt burden even further with a May stock offering. Trying to take advantage of the relatively brighter prospects for its food division, the company planned to issue a separate class of stock for RJR’s Nabisco Foods Co. In effect the offering would split its stock into distinct food and tobacco shares. By issuing 93 million shares, RJR hopes to raise $1.5 billion to $1.7 billion in fresh capital. The proceeds would go to redeeming some of its highest-interest bonds, most likely ones paying 13.5% and 15%, saving an additional $200 million or so in interest.

This tidy scenario suffered a setback after Gerstner’s departure and the Marlboro price cut. On Apr. 13, RJR was forced to reduce the proposed dividend payout it had planned to accompany the stock offering. Many analysts believe the move was designed to preserve cash and enable RJR to respond to Philip Morris with its own cigarette price reductions. RJR, which hasn’t paid a dividend since its LBO, had planned to pay 32 a year for a tobacco share and 12 for its food stock. Now, it has decided to ax the planned tobacco dividend. It also scrapped the idea of issuing food shares to existing RJR stockholders so it won’t have to send them the 12 payout. The dividend would remain intact for new investors who participate in the offering. The stingier dividend outlay saves RJR about $300 million annually.

All this turmoil means the new stock offering could be a tougher sell. RJR had hoped to price the offering at $17 to $19 a share. Now, Wall Street sees a share price of $16 to $17 at most. That could mean that RJR would fall short of its initial goal by $100 million to $280 million. Complicating the offer is the battering tobacco and food-company stocks have received since Philip Morris made its pricing announcement. RJR’s shares have tumbled by 28% since Apr. 2, to 534, a lot lower than the initial offering price of 1114 in 1991. Making matters worse, Ellen R. Marram, the highly regarded chief of RJR’s cookie division, left Apr. 14 for a top job at Seagram. I don’t see any compelling reason to get involved in the new stock, says Arthur Cecil, an analyst at mutual fund giant T. Rowe Price Investment Services Inc. which owns a big stake in RJR.

RJR says the offering is still scheduled for May. But the company won’t give specifics. Gerstner’s successors, co-CEOs Lawrence R. Ricciardi and Karl M. von der Heyden, declined to comment for this article, citing the upcoming offering. KKR, which owns 46% of RJR stock, also refused to comment.

QUITTERS. Even before Philip Morris issued its call to arms, RJR’s lush revenues from tobacco were under pressure. Health-conscious Americans continue to give up smoking. Overall, U.S. cigarette sales are dropping about 2% a year. And RJR’s efforts to expand abroad are still overshadowed by Philip Morris’ more extensive international presence.

Still, the biggest blow to RJR’s tobacco business has been the U.S. consumer shift to lower-margin discount cigarettes. First introduced 10 years ago, brands priced at as little as half of premium smokes now account for one-third of cigarette sales. RJR is clearly the industry leader when it comes to discount cigarettes. Cheap brands account for 42% of RJR’s product mix, up from 28% in 1991. Still, most of the tobacco division’s revenue comes from premium brands, such as Winstons and Camels. Winston alone accounted for one-third of the U.S. tobacco division’s $6.2 billion in revenue last year.

And if that isn’t bad enough, RJR must cope with the likelihood of a federal tobacco tax that would further depress cash flow. To help pay for the Clinton Administration’s pending health-care plan, most industry insiders foresee a federal tax of 75 or more per pack. That’s in addition to an existing 24 levy. And states are steadily boosting their tobacco taxes. Massachusetts now charges the most—51.

RJR’s Nabisco division is in better shape. It dominates almost all of the food businesses it’s in. But the food business doesn’t generate anywhere near enough cash flow to offset the sag on the tobacco side of the company. RJR has had to spend heavily on marketing to maintain its market share. That’s why Nabisco Foods’ operating profits rose only 3% last year, to $947 million, while revenues rose 4.4%, to $6.7 billion.

So what does all this mean for RJR’s all-important cash flow? Last year, it hit $4.1 billion. The company estimates that a tobacco price war will slice off $250 million. Some Wall Street analysts fear it will be as bad as $700 million. On top of that, higher cigarette taxes could zap sales by as much as $150 million per year. In a declining market, RJR has few places to look to replace those revenues.

Given the bumpy road ahead, it’s not a good time for cash flow to be stanched. Of course, the price war may be short-lived. And radical tax hikes that the industry fears may not happen. But in light of RJR’s penchant for drama, look for an exciting Act Three.Larry Light and Laura Zinn in New York, with Maria Mallory in Atlanta