Caso 32: National Brands vs A-1 Holdings

Hamilton Products
Andre Weatherby, an aspiring artist, had just sold his fifth painting of the year and now had $5,000 in cash to invest. His first inclination was to place his money in a federally insured savings and loan, but was disappointed to find out that his annual return would be less than five percent.

Knowing little about investment alternatives, he knew he must seek advice from a pro. He recalled that at his 10-year high school reunion he had run into Carol. Upshaw, a University of Southern California finance major, who was now a stockbroker with Merrill Lynch.

Early Monday morning he called Carol and she said she would be able to provide Andre with help. During the course of their conversation, Andre indicated that he wanted to invest his funds in a stock or bond that provided a good annual return and also had the potential to increase in value. Beyond that, he was able to stipulate little else.

Carol considered a number of alternatives, but decided on Hamilton Products. She was particularly interested in the firm's convertible securities which paid 6.5 percent annual interest, and were also convertible into 27 shares of common stock. The bonds had a maturity date 20 years in the future. She explained to Andre that not only would he receive a good annual return, but could enjoy appreciation in value if the common stock did well.

The bonds were to be issued at a par value of $1,000 on the day that Andre called. The common stock of Hamilton Products was currently selling for $32.75 per share. Straight, non-convertible bonds of equal risk and maturity to those of Hamilton Products were currently yielding 8 percent. Carol said that because the bonds paid 6 1/2 percent interest, they should hold up well in value even if the stock did poorly. The initial pure bond price value was $853.17.

Prospects for the Firm

Hamilton Products produced hot asphalt and ready mixed concrete and was located in California. The Transportant Act passed by Congress in late 1995 provided California with $12 billion dollars for highway and mass transit projects over the next six years. California already had matching funds from a special use tax now in place. Although the design and approval of new projects was taking longer than expected, by late 2007 competitive bidding on projects was starting and Hamilton Products stood to be a major winner in process. For this reason Carol thought the firm's stock price could well increase in the future.

Andre's Decision

Andre decided to buy the convertible bonds. Since his expertise was in painting and not investing, he wanted to get back to his main endeavor as quickly as possible.

Fortunately the stock did well over the next two years increasing in value to $45.50. The bonds also increased in value to $1,250. It was at this point that Carol called Andre and warned him that a major state investigation into highway construction contracts might be undertaken by a subcommittee of the California legislature. She thought Hamilton Products could be a target of the investigation and suggested that he take his profits and look elsewhere for an investment.

However, Andre was now intrigued by his high returns and decided to hold on to his bonds (somewhat to Carol's disappointment). As it turned out, Hamilton Products was found in violation of state regulations on a number of major contracts and the stock plummeted to $29.75 per share in the next year. During the same time period, a combination of a downgrading of the firm's credit rating and an increase in interest rates caused the yield on straight, non-convertible bonds of those of equal risk and maturity to Hamilton Products to go to 10 percent. Hamilton Product' s bonds had 17 years remaining to maturity.

Although Andre was disappointed in the drop in the firm's common stock price, he thought he could take some comfort in the fact that the convertible bonds were an interest paying security, which gave them a basic value below which they normally would not fall.

Required

1. At the time that Andre purchased the bonds, what was the conversion value? What was the conversion premium?
2. When the bonds got up to $1,250, what was the conversion premium?

1. Assume there is a conversion premium of $98 when the common stock price fell to $29.75. What is the price of the convertible bond?

1. What is the pure bond value after interest rates have gone up to 10 percent? You will need to determine the pure bond value based on the annual valuation technique presented in Chapter 10 of the textbook under the "Valuation of Bonds" section. The yield to maturity (required rate of return) is 10 percent and there are 17 years left to maturity. The bonds are continuing to make annual interest payments of 6 ½ percent ($65). The principal payment at maturity is $1,000.

1. How much comfort should Andre take in the pure bond value computed in question 4?

National Brands vs. A-1 Holdings

At 5:30 on Friday afternoon, January 22, 2010. Bill Hall, the chairman and CEO of National Brands, lnc., was clearing up the last of the papers on his desk and looking forward to a relaxing weekend. It had been a good week. The company's annual results were in, and they showed that 2009 had been the best year in the company's history. Sales and net income were up over 8 percent from last year, and there was over $1.1 billion dollars in the cash and equivalents account to invest in the coming year.

The phone rang. It was Maria Ortiz, his secretary. "Did you hear the latest on the newswire?" Maria asked.

"No, what's up?" Bill replied, with a suspicious feeling that his evening wasn't going to be so relaxing after all.

"Kelly O'Brien, head of A-l Holdings, just announced that he's bought 5 percent of our outstanding shares, and now he's making a tender offer for all the rest at $55."

"I knew it!" Bill spat out. "He was in here just a few weeks ago, talking about whether we would sell the company to him. We turned down his offer because we want to stay independent, and he left after implying we weren't looking out for our stockholders. He's got some plan to restructure the company around a six member board of directors instead of the 15 we have now. Now he's trying to do it anyway, whether we like it or not!"

"Looks like it," Maria agreed, "so what do you think we should do?" "OK, get ahold of Tom Straw, the chief operating officer, and Doris Faraday in finance, and tell them to get up here for a meeting right away," Bill directed. "Oh, and have Stan Lindner from public relations come, too; we're sure to have a press release about this, and-oh, wait--call my wife, too, and tell her 1won't be home until late tonight."

After about half an hour, those that Bill had called began arriving, armed with pencils, papers, and ca1culators in anticipation of the coming session. Bill, in the meantime, had managed to compile some financial data about A-l Holdings, which he had summarized on a sheet of paper along with comparable data on his own company, National Brands, (see Figure 1). He passed the sheet around among the others.

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