Introduction

In December 2000, management at General Mills (GIS) proposed a plan to acquire

Pillsbury, a bakedgoods producer, in a stock-for-stock exchange. Pillsbury is currently

controlled by Diageo PLC, one of the world’s leading consumer–goods companies. The deal

specifies that General Mills is to create and issue additional shares of common stock to Diageo in

exchange for complete ownership of the Pillsbury subsidiary. If the deal is executed, Diageo

will become General Mills’ largest shareholder. The consideration to Diageo would include 141

million shares of the company's common stock and the assumption of $5.142 billion of Pillsbury

debt, making the deal worth over $10 billion. In addition, the agreement will contain a

contingency; up to $642 million of the total transaction value may be repaid to General Mills at

the first anniversary of the closing, depending on its (20-day) average stock price at that time.

Therefore, we must calculate and analyze the various costs and savings associated with the

transaction to determine whether or not General Mills’ shareholders should vote for the proposed

merger.

General Mills Company Profile

General Mills manufactures and markets branded consumer foods worldwide. It has a

strong presence in the United States, as it is the nation’s largest producer of yogurt and the

second largest producer of ready-to-eat breakfast cereals. General Mills has successfully tapped

into international markets, serving more than 100 countries around the globe. The company

owns many product segments that are marketed under high-profile brand names, such as Betty

Crocker, Yoplait, Cheerios, and Big G. The company has mature product lines and has pursued

numerous expansion efforts that have successfully positioned General Mills as a market leader.

Its products are manufactured in 15 countries and are available in more than 100 countries, thus

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General Mills has capitalized on overseas expansion and has benefited from broad, efficient

distribution channels. Its expansion efforts have proved successful as GM had annual revenues

of about $7.5 billion in the year 2000. Although highly profitable, GM is facing increased

competition in the food industry as rivals are consolidating and becoming more difficult to

compete against. Therefore, GM must be able to recognize and act on potentially high-yielding

investments that will allow the company to expand despite the slow-growth food industry.

Diageo PLC/ Pillsbury Company Profile

Pillsbury is a baked goods company that operates under the parent organization, Diageo

PLC. Diageo is a London-based consumer-goods conglomerate that specializes in the

manufacture of premium alcoholic brands such as Smirnoff, Johnnie Walker, and Guinness. Its

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. Marketing its goods under the popular Dough Boy character, Pillsbury has

successfully positioned its brand and has created a longstanding platform for success in the food

industry. The company also 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.

Origins of the Deal

In the spring of 1998, on a quest to build growth momentum, General Mills studied areas

of potential growth and value creation. This generated some smaller acquisitions and a general

receptivity to acquisition proposals. Financial advisors suggested that Diageo might be

interested in selling Pillsbury. Although Pillsbury has shown a high potential for growth in the

food industry, Diageo PLC hoped to divest the company in order to focus more heavily on its

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core business – manufacturing premium alcoholic beverages. In recent years, its beer and liquor

businesses have been strong performers, yet the 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.

In June of 2000, General Mills submitted its proposed transaction terms to Diageo; the

total payment proposed was $10 billion. Diageo submitted an asking price of $10.5 billion. The

two companies reached a stalemate. General Mills did not want Diageo to own in excess of 33%

of its stock. They also believed that their shares were undervalued in the stock market. In an

effort to move forward with the deal, the two firms agreed upon including a contingent payment

on the first anniversary of the transaction that would depend on General Mills’ share price in the

terms of the deal.

Deal Structure

The deal proposed that an acquisition subsidiary of General Mills would merge with the

Pillsbury Company. Pillsbury would survive as a wholly owned subsidiary of General Mills.

The agreement included payment of shares from General Mills to Diageo, the assumption of

Pillsbury’s debt, and a contingent payment by Diageo to General Mills.

Payment of shares:

The payment of shares from General Mills to Diageo included 141 million shares of its

common stock to Diageo shareholders. This would result in Diageo owning about 33% of

General Mills outstanding shares making them the majority shareholder. In July, when these

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terms were approved by the board, the company’s shares traded between $34.00 and $37.00. By

the first week of December, the shares had jumped to between $40.00 and $42.00.

Assumption of Pillsbury debt:

The assumption of Pillsbury’s debt consisted of General Mills agreement to take on

Pillsbury’s liabilities of about $5.142 billion upon closing. Of the $5.142 billion, $142 million

made up existing debt and $5 billion made up new borrowings that would be distributed to

Diageo before closing. This new debt had to be approved by General Mills before it was

incurred for which a primary concern was that it did not want to lose its investment-grade bond

rating.

Contingent payment by Diageo to General Mills:

The contingent payment or the “claw-back” provision by Diageo to General Mills

contains three conditions. First, Diageo would set-up an escrow fund of $642 million dollars.

The amount of money that General Mills would receive out of this account would depend on the

average daily price of General Mill’s shares. If the average daily share price for 20 days was

$42.55 or more than General Mills would receive the complete $642 million dollars of the

escrow fund. If the average daily share price were $38.00 or less than General Mills would

receive $0.45 million of the fund. Now if the average daily share price were between $38.00 and

$42.55 then Diageo would keep the amount by which $42.55 exceeds the average daily share

price over 20 days times the 141 million General Mills shares that Diageo owns.

Benefits of the Acquisition

General Mills is motivated to acquire Pillsbury because it has a desire to grow and

expand. In General Mills proxy statement, they declared that acquiring Pillsbury would create

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value for the company’s shareholders by providing opportunities for accelerated sales and

earnings growth in the near future. These opportunities would be through the exploitation of

product innovation, channel expansion, international expansion and productivity gains.

Because the companies originated in the same area they have the advantage of geographic

efficiencies starting with strong ties with local communities. The companies also have similar

corporate structures, ambitions, strategic objectives and long-term goals. Pillsbury has also been

under Diageo’s control over seas and this merger would not only bring the company back to its

roots but also help make the integration process a more manageable and smooth one. The more

obvious fact is that the two companies deal with the same types of products.

Both Pillsbury and General Mills started off in the flour milling business and this by no

means is the only thing they have in common. The acquisition could benefit General Mills

because both companies offer the same products, which are priced at a premium and perceived

by the public as premium brands. The company had some previous unsuccessful diversification

attempts and this one would help them sharpen their product focus on a much bigger portfolio for

a clearer strategic focus. It only makes sense for the company to merge with another that shares

almost the same products, production systems and technologies. General Mills has products like

the Betty Crocker line that would complement the Pillsbury products very well causing better

cost reductions and economies of scale. At the same time Diageo could concentrate on what they

do best, which are alcoholic beverages (higher margin for them) and getting those products out to

the public. There are also fine transaction benefits that General Mills would be benefiting from

with the acquisition of Pillsbury as well.

General Mills gets many opportunities to save costs from this acquisition. Within a three

year period alone the company management could expect to save pre-tax cost savings of over

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five hundred million dollars. Another benefit for this deal to General Mills is that the funding

used to finance the deal ($5 billion) given to Diageo is coming from debt rather than equity. Not

only is debt a cheaper option for a company to finance with but the interest payments would be

tax deductible. Through the issuance of the new shares the company also only losses 33% of its

ownership of their company through the deal. Finally General Mills has the chance to earn a lot

of funding at the end of the transaction from the projected returns they could earn in just a year

from now. At the same time it is important to remember that Diageo is also getting some

advantages for the Pillsbury deal. The acquisition is mostly paid for in the form of stock (stock-

for-stock exchange), therefore, the deal is then treated as an exchange rather than sale for tax

purposes (less capital gains tax). Diageo is going to be a GM stock holder and they will benefit

from synergistic gains produced by the merger. As always there are some topics of the merger

that are not necessarily considered to be the best.

Starting with increased interest payments and right through debt the General Mills

Company will be experiencing new obstacles they will need to overcome. By acquiring Pillsbury

the company will be doubling their debt as a payment and increasing their leverage and hurt its

investment grade bond-rating. Fixed costs will also increase just as the fixed asset spending to

support the additional business coming in. There may also be some minor configuration costs

associated with the deal such as issues with integration problems, regulatory processes and a lack

of experience with new business lines. The cost of doing business for General Mills will also

increase with its size due to rising costs such as labor rates or commodity prices. Not easily as

measurable the opportunity costs could also be figured in as a drawback. With the process that

this deal involves GM will be losing time, funding and resources that could have been used for

new products. Finally there is the issue of the $55 million that is associated with this transaction

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that GM will have to deal with and if it does not turn out the positive way they are hoping for;

the company will be looking to get out of dangerous waters.

Cost Savings Analysis

As stated above, in General Mills proxy statement, acquiring Pillsbury will provide

General Mills with an opportunity for accelerated sales and earnings growth. Pillsbury would

complement General Mills’ existing product lines and make its product portfolio more balanced.

In addition, General Mills estimates that the deal will generate a minimum of a three years pretax

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 the Cost

of Equity derived from the CAPM model is the best rate to use because the equity shareholders

are the ones getting value from the cost savings.

Cost of Equity:

To formulate the cost of equity we were given a risk-free rate of 5.7%, an equity risk premium of 5.5%, and a beta of 0.65. From these figures we were able to calculate the cost of equity using the CAPM model.

Re = Rf + b(Rm – Rf).

Equity Beta 0.65Rf 5.70%Rm 11.20%Rm-Rf 5.50%Cost of Equity 9.28%

Present Value of Cost Savings:

General Mills’ management team 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. These savings will result from supply chain improvements and greater efficiencies in selling, merchandising, and marketing its goods. If we calculate the present value of these

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pre-tax savings, we will be able to give General Mills an estimate of the cost of savings it will likely occur.

AssumptionsInflation Rate 2.74%Cost of Equity 9.28%

YearExpected Pretax Savings

(millions) Adjusted for InflationPresent Value of

Savings

2001 $ 25.00 $ 25.69 $23.50

2002 $ 220.00 $ 226.03 $189.27

2003 $ 400.00 $ 410.96 $314.90

Total $

662.67 $527.68

However, through the synergies of General Mills and Pillsbury, we believe that the cost savings will last longer than three years. For instance, through the acquisition, General Mills may cut down part of its work force today to add to the cost savings. We believe that the cost savings will last at least five more years with savings of $400 million in 2004 and 2005. The calculations for the terminal value are as followed:

AssumptionsInflation Rate 2.74%Tax Rate 35.00%Cost of Equity 9.28%

YearExpected Pretax

Savings (millions)Adjusted for

Inflation

Present Value of Pre-Tax Savings

Present Value of After-Tax Savings

2001 $25.00 25.69 $23.50 $15.282002 $220.00 226.03 $189.27 $123.032003 $400.00 410.96 $314.90 $204.692004 $400.00 410.96 $288.16 $187.312005 $400.00 410.96 $263.69 $171.40

$1,079.53 $70

1.69

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Terminal Value $1,093.58

Contingent Payment Analysis

Acquisition Cost

Recommendation

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