The Rjr Borden Deal: Is The Investor The Odd Man Out?

When Kohlberg Kravis Roberts & Co. announced its bid on Sept. 12 to buy Borden Inc., shareholders in the struggling food giant howled. The deal calls for KKR to acquire Borden in exchange for some 275 million RJR Nabisco Holdings Corp. shares. But the transaction values Borden's stock at just $14.25--a 23% premium over the market price. That's cheap by takeover standards--especially since Borden stock hit 35 two years ago.

Now, as KKR and RJR managers try to pacify Borden investors and close the deal by yearend, a new outbreak of shareholder disaffection has erupted closer to home: at RJR Nabisco. And it's not just the potential dilution of their stakes that investors find upsetting. Many institutional holders are fearful that Borden shareholders, uncomfortable with owning a tobacco company, may dump their RJR shares, scuttling chances of a long-awaited revival in the stock.

They're also worried that the deal is merely the start of a clever strategy to allow KKR to exit RJR Nabisco at other shareholders' expense. One frequently suggested scenario: KKR could force RJR to buy some Borden brands at premium prices. "I don't want to see KKR using RJR Nabisco as a funneling tool and selling all the Borden pieces to them," says Gregory Jackson, a portfolio manager at Yacktman Asset Management Co., which owns 5 million RJR shares.

COOKIE JAR. Perhaps most frustrating to shareholders: The Borden deal and its potential aftermath come at a time when the outlook for RJR Nabisco--and its stock--is the most upbeat it's been in years. Since KKR recruited ConAgra Inc.'s Chairman Charles M. "Mike" Harper, 67, to replace Louis V. Gerstner Jr. in May, 1993, RJR Nabisco looks reinvigorated. Nabisco Foods Group has launched several successful products, including SnackWell's reduced-fat cookies and crackers. Even the tobacco business is thriving, thanks to more pricing flexibility and an upsurge in cigarette consumption among young people. Although RJR reported poor results last year, analyst Marc Cohen of Goldman, Sachs & Co. figures that RJR Nabisco's operating earnings could climb 18% this year, to $3.4 billion, as its sales rise 4%, to $15.7 billion. KKR and RJR defend the proposed Borden purchase. "KKR believes that RJR Nabisco investors will benefit by participation in RJR's direct investment in Borden," says a spokeswoman for the LBO firm. But with RJR in registration with the Securities & Exchange Commission to issue stock for the Borden deal, RJR and KKR declined to elaborate.

RJR shareholders have never been an altogether happy lot. Ever since KKR acquired RJR in a leveraged buyout in 1989, shareholders have felt short-changed. RJR has poured its cash into paying off the $25 billion in debt it accumulated in the LBO. Meanwhile, sales and profits have been erratic, while RJR's share price has languished (chart). At 67/8, it's down from earlier in the year. And RJR management, shareholders say, hasn't been too sympathetic to investors' concerns. "To Nabisco, no one is a big shareholder except KKR," gripes Jackson.

The complicated Borden deal is just KKR's latest affront to shareholders, say some investors. If the KKR-Borden acquisition goes through, KKR will exchange roughly half of its stake in RJR for all of Borden. Then, KKR will sell 20% of Borden to RJR for $500 million, with an option to buy another 10%. Rather than use cash to buy its minority stake in Borden, RJR will issue about 77 million new shares of stock.

Whether Borden shareholders hold on to their RJR stock or quickly unload it is the most immediate concern to RJR investors. Tobacco turns off many investors nowadays. "It's possible Borden shareholders will be in a selling mode when they receive their [RJR] shares," says Arthur Cecil, an analyst at T. Rowe Price Associates Inc., owner of about $20 million worth of RJR preferred stock. Such fear isn't unfounded. Robert Monks, a principal at LENS Inc., owner of 1.7 million Borden shares, already vows to dump any RJR shares he receives.

"THAT STINKS." The potential dilution of their holdings has also fueled investor angst. True, the new shares issued by RJR would represent only 5.5% of the outstanding common. At most, analyst Cohen estimates, it might knock a penny off this year's expected earnings per share of 37 cents. But only last April, RJR issued 250 million shares, or roughly $2 billion worth, of preferred equity redemption cumulative stock (PERCS). Each PERCS will be convertible into a share of RJR common stock in three years. And another class of PERCS, issued in 1991, comes due this November.

All told, RJR's outstanding common could increase 40% by 1997. Harper "is diluting the hell out of our stock, and I really think that stinks," complains Robert Kleinschmidt, president of Tocqueville Asset Management, which owns 576,000 RJR shares.

Still, the speculation about subsequent Borden-RJR deals has shareholders most fired up. One large RJR shareholder says Harper has assured her that RJR won't be "disadvantaged" if RJR buys Borden brands from KKR. But other investors aren't so sanguine. They doubt KKR has any grand ambitions to resuscitate Borden. So selling off assets at exorbitant prices to RJR makes sense, they contend. It could also allow KKR to salvage some returns at RJR's expense as the LBO firm quietly retreats from RJR. Such leading Borden brands as ReaLemon juice, Cracker Jack, and Creamette pasta could fetch a total of $1 billion.

And if RJR does pay a stiff price for Borden brands, Harper and his management team might not devote as much time to building Nabisco's brands. For now, Harper will sit on Borden's board and won't take a direct hand in managing its brands. But RJR investors fear he may end up playing a greater role at Borden.

For the time being, however, shareholders are pleased with Harper's performance. In contrast to Gerstner, a financial engineer who spent much of his RJR tenure selling assets and cutting costs, Harper gained a reputation as a brand-builder at ConAgra. And he has already shifted RJR's focus away from downsizing. In RJR's 1993 annual report, Harper wrote that RJR's "top three priorities [are] earnings...earnings...earnings." And that message has spread through management ranks. Senior RJR executives sport "E3" pins in their lapels.

But it's not just the atmospherics that's exciting institutional holders. After several lackluster years, Nabisco Foods is humming. In addition to SnackWell's cookies, Nabisco's flavored fruit Newtons and Chunky Chips Ahoy are hits. The news is also better on the tobacco front. After last year's painful price wars, R.J. Reynolds is bounding back. Thanks to price reductions, sales of RJR's premium Camel and Winston brands have climbed. And analysts widely believe that the company will raise premium cigarette prices by as much as 3% to 4% in November.

STAGE SET. Despite all the apprehension surrounding the Borden deal, shareholders say they are confident that the anticipated spin-off of Nabisco Foods won't be delayed. Ironically, the Borden deal makes the spin-off more likely. After all, a giant food company with both Nabisco and Borden brands could be far more appealing to investors, or perhaps to an acquirer such as Nestle, Grand Metropolitan, even Philip Morris.

Analyst Gary Black of Sanford C. Bernstein & Co., which owns 19 million RJR shares, believes November could mark the beginning of end for the combined RJR Nabisco. That's when the Borden transaction is likely to close--and when KKR will want to enhance the value of RJR stock and so reduce the number of shares it must exchange for Borden. To do that, Black figures, RJR may raise $1 billion by spinning off an initial 15% to 20% of Nabisco Foods and then sell the rest in two to three years. Federal tax laws require a two-year delay between spinning off a portion of a company and then selling the remainder. Also in November, 210 million of RJR's PERCS convert to common stock. PERCS holders have been receiving an 84 cents annual dividend, and Black thinks RJR will announce a long-awaited 30 cents to 35 cents dividend to keep the former PERCS holders from dumping the common. RJR wouldn't comment on the likelihood of this scenario. "We look at all kinds of options, ranging from doing nothing to doing a whole lot of things," says an RJR spokesman.

Ultimately, the split could set the stage for KKR's final exit from RJR, since a breakup could enhance the value of its RJR investment. True, the Borden deal may seem scary to investors now. But if it hastens KKR's departure from RJR in a few years, shareholders just may change their minds.

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