Financial Case Study

Harvard Business School 9-296-078 Rev. September 9, 1996

 

Research Associate William DeWitt (MBA ‘95) prepared this case under the supervision of Professor Richard Ruback as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Copyright © 1996 by the President and Fellows of Harvard College. To order copies, call (617) 495-6117 or write the Publishing Division, Harvard Business School, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

1

The Chrysler Takeover Attempt

On April 12, 1995, financier Kirk Kerkorian made an unsolicited offer to buy the outstanding shares of Chrysler for $55 each, a 40% premium over the previous day’s closing price of $39.25. At closing on the 12th, Chrysler shares had risen to $48.75. Kerkorian was Chrysler’s largest shareholder, owning 10%. Lee Iacocca, Chrysler’s former CEO who was forced into retirement in 1992 by the board, was backing the Kerkorian bid. The proposed $19.5 billion deal was sketched out to include $2 billion in Chrysler equity already held by Kerkorian and Iacocca, $3.5 billion from outside equity investors, $8.8 billion in bank debt, and $5.2 billion from Chrysler’s own $7.6 billion in cash. The group planned to suspend annual dividends, totaling $650 million a year, to help finance the deal.

Chrysler had built up its cash balance from $3 billion to $7.6 billion from 1992 to 1994 with solid performances in a number of divisions. CEO Robert Eaton argued that a cash reserve of at least $7.5 billion, or $21.13 per share, should be kept as a cushion for the next downturn in the industry. But Kerkorian and Iacocca thought otherwise. In a news conference shortly after the announcement, Iacocca stated:

You just watch, it [the cash] will self-fulfill the prophecy. If you keep saying, we need $7.5 billion and it’s just a cushion, then the union — and I know them like I know my kids — will say, ‘We have a place to put that money.’ They will want part of [it] baked into the UAW contract for three years.1

Kerkorian and Iacocca argued that Chrysler needed $2.5 billion in cash and $2.5 billion in bank lines of credit to survive the next recession. Alex Yemenidjian, an executive at the Tracinda Corporation, which was Kerkorian’s wholly owned investment vehicle, summed up the position succinctly: “We understand they want a cushion, we just believe the cushion is too large.”2

After an emergency board meeting, Chrysler issued an announcement, saying it was “not for sale.” Eaton remarked, “We don’t want to put Chrysler at risk. We’ve worked hard to build this company’s financial strength, to increase shareholder value, and to build the confidence of customers, employees, dealers and suppliers. We have no desire to reverse this process.”3 Other observers were less subtle about the proposal. “It’s immoral,” said a ranking U.S. official with an Italian bank. “I believe in enhancing shareholder value, but as a long-term concept rather than a short-term grab for profits. This could only happen in this country.”4

1. As quoted in The Wall Street Journal, April 13, 1995. 2. Ibid. 3. Ibid. 4.

As quoted in The Detroit News, April 19, 1995.

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296-078 The Chrysler Takeover Attempt

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Company Background

Chrysler was incorporated in 1925 by Walter Percy Chrysler, a former vice president of General Motors (GM). Resigning from GM over policy differences, Chrysler rescued the Maxwell Motor Corporation from insolvency and designed its new Chrysler automobile. First exhibited in 1924, the car was an immediate success and before year’s end, the company had sold 32,000 cars and had earned more than $4 million. By 1940, Chrysler had acquired Dodge and Plymouth, controlled 25% of the domestic market, and surpassed Ford to become the second largest automaker in the industry behind GM. Although it lost ground to Ford and GM in the ensuing decades, Chrysler was still third among U.S. and worldwide automakers by the end of the 1960s. But the 1970s were not good to Chrysler, as the oil shocks, inflation in the economy, and increased Japanese competition all took their toll on the company.5

The Iacocca Years In 1974 losses totaled a massive $52 million, and the next year’s deficit was five times that amount. After a brief respite in 1976 and 1977, Chrysler incurred net losses of $205 million in 1978 and $1.1 billion in 1979. In just one year, Chrysler’s worldwide sales of motor vehicles fell by 1.6 million units.6 It took a complex set of negotiations with creditors and unions as well as a $1.5 billion government bailout to save Chrysler from bankruptcy in 1978. Lee Iacocca, the charismatic CEO who was hired shortly after being fired from the presidency of Ford, presided over Chrysler’s comeback with a flair for communications and salesmanship. By 1981, Chrysler was on its way back. Its fleet had achieved the best corporate average fuel economy in the industry at 25.5 miles per gallon, and its Aries and Reliant models had both received the prestigious “Motor Trend Car the Year” award. By 1983, Chrysler had achieved the largest percentage increase in U.S. retail sales of any major domestic car maker (19% for cars and 11% for trucks). Earnings were positive again in 1983 and the company repaid the government loan seven years early.7

After its recovery in the early 1980’s, Chrysler diversified. It acquired Gulfstream Aerospace, Finance America, and E.F. Hutton Credit Corporation, among others. It also merged with American Motors Corporation, acquired the Italian automaker Lamborghini, and established several joint-ventures with Mitsubishi and Samsung. But at the end of 1989, Chrysler announced that it was scrapping its holding-company structure (which was created just four years earlier) to cut costs. Soon thereafter, it announced it would try to sell Gulfstream and Electrospace Systems, marking a humiliating end to the company’s diversification strategy.8

In 1991 Chrysler lost $759 million, its debt was junk rated, and its pension plans were underfunded by more than $4 billion. Domestically, Chrysler was selling only one in twelve cars, as opposed to one in every nine cars five years earlier. Critics argued that Chrysler’s financial problems were a direct result of failing to invest in new product development in the mid 1980s.9 But by 1992, new models were ready, and hopes were high for another recovery. Fortunately, sales of the higher-margin minivans (a product Chrysler virtually invented in 1984) were strong, and its other new models were earning good reviews. They were the low priced Dodge Shadow and Plymouth Sundance; the high performance Dodge Stealth; the Dodge Spirit and Plymouth Acclaim sedans; and the Jeep Grand Cherokee and Dodge Dakota V-8 trucks. Despite all this, the board thought it was time for new leadership. In 1992 they chose Robert Eaton, head of European operations at GM, to replace Iacocca.

Eaton Takes Over Eaton’s focus from the start was on transforming Chrysler into a company that could withstand downturns. Shortly after becoming chairman, he told company managers, “My

 

5. International Directory of Company Histories, Volume 1. 6. Chrysler Annual Report, 1980. 7. For further information, see “Chrysler: Iacocca’s Legacy,” Harvard Business School Case No. 493-017. 8. Ingrassia, Paul, and White, Joseph B., Comeback, The Fall and Rise of the American Automobile Industry. New York:

Simon & Schuster, 1994, p. 195. 9. Frank Washington, “LH, as in ‘Last Hope’,” Newsweek, June 29, 1992 as quoted in HBS case No. 493-017.

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personal ambition is to be the first chairman to never lead a Chrysler comeback.”10 The early results were good as the stock price soared in 1992 and 1993 on the heels of the economic recovery. New product development was accelerated even more, and good reviews came out for the LH sedans, the Dodge Neon, and the midsize Cirrus and Stratus models. Chrysler also continued to dominate the minivan segment. In one of Eaton’s first major product moves, the company invested $2.6 billion on a complete redesign of the minivan line — more than any new-vehicle development program in company history.

But as interest rates began to climb and the stock price remained flat, Chrysler was forced to take steps to mollify Kerkorian, who was the largest shareholder at 9%. Management boosted its dividend by 60%, announced a $1 billion share buyback, and diluted its poison pill so that individual investors could raise their stakes to 15%. Nevertheless, the share price continued to fall. Between mid-December and the April 12 Kerkorian bid, Chrysler’s stock price fell 16% — a drop of one-third from its peak of $53 in January, 1994 (see Exhibit 2).11

The Tracinda Group

The 77-year-old Kerkorian was the son of poor Armenian farmers from Fresno, California. He made his first millions running commercial and military flights during the 1950s and 1960s, many of them between Los Angeles and Las Vegas. He bought and sold properties in Las Vegas and eventually pioneered the notion of building huge hotels and attracting people who had never gambled before. Enticing people to “play where they stay” was a new idea which proved extremely successful.12 Another large part of his estimated $2.5 billion net worth came from timely acquisitions and disposals of Hollywood studios, among them Columbia Pictures and MGM/UA.

Kerkorian owned all of the Tracinda Corporation, which was the holding company for his Chrysler stock. He began purchasing Chrysler in 1990 in the middle of the recession for $12.37 per share. By 1995, he had spent about $676 million accumulating his stake. At the closing market price of $48.75 the day of the announcement, Kerkorian’s 36 million shares were worth nearly $1.8 billion.

Many analysts wondered whether Kerkorian was serious about his intent to buy control of Chrysler. Ownership of a heavy manufacturing entity was not characteristic of his long investment history.13 For his part, Iacocca, 70, stated that he would serve only as an advisor to Chrysler if the deal went through, saying, “after 47 years in Detroit, I don’t want to go back.”14 But others were more suspicious of his motives. One reporter commented: “It’s impossible to believe Mr. Iacocca’s current protestations that he doesn’t want to run Chrysler again. He never wanted to stop running it, and at the very least a Kerkorian victory would leave him in charge of all the major strategic decisions at the company.”15

The Auto Industry Cycle

Supply In the volatile auto industry, car companies can quickly shift from making a lot of money to posting big losses when sales drop. One reason for this is that traditionally, auto companies built enough production capacity to supply everyone who wanted a car in a boom year. This maximized profits in boom years but led to excess inventory problems in bad years. Also, in good times they received payments for cars as soon as they were assembled, and did not have to pay parts suppliers for

 

10. As quoted in The Wall Street Journal, April 14, 1995. 11. The Economist Newspaper, April 15, 1995. 12. The Washington Post, April 14, 1995. 13. Los Angeles Times, April 14, 1995. 14. As quoted in The Wall Street Journal, April 13, 1995. 15. Paul Ingrassia, “What’s Driving the Chrysler Deal,” The Wall Street Journal, April 19, 1995.

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296-078 The Chrysler Takeover Attempt

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up to 45 days. When sales sagged, however, auto makers ended up paying for parts before the cars were sold, straining cash reserves.16

To cover their high fixed costs when sales were flat, auto makers cut their prices to move existing inventory. These cuts, typically in the form of rebates and dealer incentives, often escalated into industry “incentive wars.” Thus earnings would be more variable than actual vehicle sales. For example, from 1989 to 1990, Chrysler’s vehicle sales fell 16.8% from 2.38 to 1.98 million units. In that same period, pretax income fell 74%, from $565 million to $147 million. Likewise, when vehicle sales increased 11.5% from 1993 to 1994, pretax income rose 51.9% in the same period.

Demand Interest rates had a large impact on demand. As with most companies, higher rates increased the cost of capital and squeezed margins. But with auto manufacturers, rising rates also had a dramatic impact on consumer demand because buyers who financed their auto purchases would have higher monthly payments. Federal Reserve interest rate policy was thus a key variable affecting the auto cycle. Other key demand indicators were employment, real income growth, the underlying age composition of the motor vehicle fleet, and the strength of the dollar relative to the currencies of Japan and Europe.

The consensus among analysts in early 1995 was that new vehicle sales would be sluggish because of the recent Federal Reserve rate hikes and an overall slowing of the economy. Some believed that the auto cycle had already peaked, predicting that 1994 volumes would be very difficult to match. A downturn was inevitable, they argued, and it was more likely to come sooner rather than later. But others believed that slower demand growth (rather than an actual decline in demand) would lead to a longer, flatter cycle for the auto companies. In this scenario, Chrysler’s sales volumes would be maintained by the pent-up demand still lingering from the last recession.

Chrysler’s Cash

When the 1989-1991 recession ended, management established the goal of building up $5 billion in cash to weather the next downturn. But when revenues increased, Chrysler raised the target to $7.5 billion. As one official put it, “$7.5 billion would be prudent. If you run the company with less cash, you run a greater risk of having to cut product spending and pension funding in the next downturn.”17 But in 1995 Chrysler’s pension was fully funded for the first time in almost 40 years, and its credit rating had just been upgraded to single-A by the major credit agencies.

Company plans called for an aggressive capital expenditure program, projected to cost $3.2 billion in 1995 and $3.1 billion annually thereafter. Other projected cash outlays included the $1 billion stock buyback in 1995 (subject to “market conditions”), and increasing the dividend payment from $1.00 to $1.60 per common share, adding about $200 million to the annual cash outlay for dividends. In addition, Chrysler’s stated goal was to lower its debt-to-capital ratio from 18% to 10%. This would cost approximately $1 billion, although the timing of the debt pay-down was unknown.

On the product side, Chrysler was aggressively rolling out its new models and predicting that profit margins would improve as the product mix changed. But some external factors were creating uncertainty. Inventories for the Neon and the LH full-size sedans were running above normal in the first quarter. For the minivans, Chrysler was projecting the loss of approximately 65,000 units during the model changeover. Also, Ford was building its inventories to uncomfortable levels, and all manufacturers were adding capacity to the sport utility line which included Chrysler’s high-margin Grand Cherokee. The concern was that this could lead to price cutting, followed by reduced margins.

 

16. The Wall Street Journal, April 17, 1995. 17. As quoted in The Wall Street Journal, April 17, 1995.

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The Chrysler Takeover Attempt 296-078

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Finally, the crisis in Mexico was depressing sales there and creating some uncertainty about the market for the T300 pickup and the Cirrus/Stratus lines which were manufactured in Mexico.

Deal Structure and Financing

For Tracinda, the structure of the deal would have an impact on two key issues related to Chrysler’s cash position. First, the amount of cash they were going to use from the company’s balance sheet would directly affect its ability to weather a future downturn. Second, the deal structure itself could have cash flow implications depending on the amount and type of leverage used for the buyout.

Using $5.2 billion of Chrysler cash to finance the deal would leave approximately $2.4 billion on the balance sheet. Depending on projections of additional cash build-up in the short term, Chrysler would have anywhere from $2.5 billion to $4 billion to weather the next downturn. As for the cash flow implications of adding $8.8 billion of leverage, it appeared that the after-tax cost of the additional interest would be almost offset by the elimination of dividends.

Chrysler’s finance subsidiary might also be available to support some of the leverage in the deal. Chrysler Financial (CFC) was a well-managed company with earning assets to equity of roughly 4.5 times. This was much lower than GMAC (GM’s finance unit) which was at 9.0 times, and Ford Financial Services which was at 9.6 times. Increasing leverage at Chrysler Financial might provide an additional $2 billion in capital for the deal.

At the time of the announcement, Kerkorian had not yet obtained financing for the deal. A Tracinda spokesperson cited the need for secrecy as the reason no banks had been contacted. But there was some uncertainty about whether it could be raised at all. One reason was that more than 150 banks – – ranging from small local lenders to some of the world’s biggest banks — were already tied up in Chrysler credit agreements.

Reactions

As both sides in the deal stepped up the rhetoric on the proposed takeover, Chrysler’s analysts remained mixed in their opinions. Summarizing the pro-management stance, one analyst observed: “It’s really uncertainty in the economy that drove the stock down and put Chrysler in play. And that is completely out of Chrysler’s control.”18 These analysts were convinced Chrysler represented a great buying opportunity, with an inherent value in the range of $70 to $90 per share. David Cole, Director of the Office for the Study of Automotive Transportation, was even more bullish: “Wall Street has undervalued the [auto] industry,” he said, placing the value of Chrysler at $100 per share.19 But others suggested that the large cash hoard and weak stock price were signs that Chrysler wasn’t handling its finances properly. “The market is the ultimate arbiter on how Chrysler is being run, and the market is saying it’s sorely mismanaged.”20

Public reaction to the Tracinda group was mostly negative, as many were calling the deal a flashback to the excesses of the 1980s. The Tracinda team was unmoved. Yemenidjian summarized the group’s attitude: “We are the owners of the company. We are not some outside intruders who came in to spoil the company. The lack of respect is abominable.”21

 

 

18. John Casesa of Wertheim Schroder, as quoted in The Wall Street Journal, April 14, 1995. 19. As quoted in William J. Cook and Linda Grant, U.S. News & World Report, April 24, 1995. 20. Analyst Nicholas Lobacarro of S.G. Warburg & Co., as quoted in The Wall Street Journal, April 17, 1995. 21. As quoted in USA Today, April 27, 1995.

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296-078 The Chrysler Takeover Attempt

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Exhibit 1 Chryslerís Board of Directors

Name Age Occupation Director Since Lilyan H. Affinitok 63 Former Vice Chairman, Maxxam Group 1982 Robert E. Allen 60 Chairman and CEO, AT&T 1994 Joseph E. Antoninik 53 Former President and CEO, Kmart Corp. 1989 Joseph A. Califano, JR. k 63 Secretary of Health, Education, and Welfare (1977-79) 1981 Thomas G. Denomme 55 Chrysler Vice Chairman 1993 Robert J. Eaton 55 Chrysler Chairman and CEO 1992 Earl G. Graves 60 Chairman and CEO, Earl G. Graves Ltd. 1990 Kent Kresa 57 Chairman and CEO, Northrop Grumman 1989 Robert J. Lanigan* 66 Chairman Emeritus, Owens-Illinois 1984 Robert A. Lutz 63 Chrysler President and Chief Operating Officer 1986 Peter A. Magowan* 52 Chairman, Safeway 1986 Malcolm T. Stamper 69 Former Vice Chairman, Boeing 1984 Lynton R. Wilson 54 President and CEO, BCE Inc. 1984

kAlso a director of Kmart Corp. *Both Lanigan and Magowan headed companies that were acquired in leveraged buyouts by KKR.

Source: annual report.

Exhibit 2 Big Three Closing Stock Prices and the S&P 500 Index, 1/3/95 to 4/12/95 (1/3/95 = 100)

77.00 79.00 81.00 83.00 85.00 87.00 89.00 91.00 93.00 95.00 97.00 99.00

101.00 103.00 105.00 107.00 109.00 111.00

1/ 3/

95

1/ 6/

95

1/ 11

/ 95

1/ 16

/ 95

1/ 19

/ 95

1/ 24

/ 95

1/ 27

/ 95

2/ 1/

95

2/ 6/

95

2/ 9/

95

2/ 14

/ 95

2/ 17

/ 95

2/ 23

/ 95

2/ 28

/ 95

3/ 3/

95

3/ 8/

95

3/ 13

/ 95

3/ 16

/ 95

3/ 21

/ 95

3/ 24

/ 95

3/ 29

/ 95

4/ 3/

95

4/ 6/

95

4/ 11

/ 95

S&P 500 GM Ford Chrysler

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Exhibit 3 Geographical Sales Breakdown for the Big Three (in millions) (1)

United Other Latin U.S. as % States N. America Europe America All Other Total of Total

GM (excluding GMAC) 1994 101,186 8,377 24,850 5,305 1,456 141,174 0.72 1993 89,868 7,312 21,847 4,595 1,248 124,870 0.72 1992 79,783 7,509 26,291 3,311 1,236 118,130 0.68

Ford (automotive) 1994 73,008 21,784 12,345 107,137 0.68 1993 61,559 18,507 11,502 91,568 0.67 1992 51,918 21,579 10,910 84,407 0.62

Chrysler (consolidated) (2) 1994 45,655 3,877 2,692 52,224 0.87 1993 37,847 3,349 2,404 43,600 0.87 1992 31,529 2,906 2,462 36,897 0.85

Sources: annual reports.

1) Note classification differences in accounting for sales other than in the U.S. 2) Chrysler does not break its geographical sales out on an equity basis. See footnoe on equity method in Exhibit 8 .

 

 

Exhibit 4 Geographical Unit Sales Breakdown for the Big Three (in thousands)

United Outside U.S. as % States U.S. Total of Total

General Motors 1994 5,016 3,312 8,328 60.2% 1993 4,729 3,056 7,785 60.7% 1992 4,381 3,304 7,685 57.0%

Ford 1994 4,276 2,363 6,639 64.4% 1993 3,824 2,141 5,965 64.1% 1992 3,361 2,403 5,764 58.3%

Chrysler 1994 2,254 508 2,762 81.6% 1993 2,022 454 2,476 81.7% 1992 1,730 445 2,175 79.5%

Sources: annual reports.

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