How Rjr Nabisco Was Bought Out in the 1980s

¶ … RJR Nabisco LBO

The players in the RJR Nabisco leveraged buyout were the management group led by CEO Ross Johnson (supported by Shearson Lehman Hutton and Salomon Brothers), whose low-ball bid on the company was viewed as something of a conflict of interest, since his role as CEO was to achieve maximum shareholder value while his role as bidder was to get control of the company at the best price possible. The bid brought out other investors, who saw the company as being undervalued. The board eventually went with the higher bid by Kohlberg Kravis and Roberts (KKR), backed by the investment banker Drexel Burnham Lambert. First Boston was also a bidder as was Forstmann Little.

What prompted the LBO was that RJR Nabisco had a stable cash flow that was not conditional to market volatility and neither RJR nor Nabisco "required major capital expenditures" (Leveraged Buyouts, p. 288). Additionally, RJR had little relative debt and its capacity to draw on more was appealing in terms of an LBO.

Thus, what prompted the buyout was CEO Johnson, first of all, who initiated a management buyout bid -- which opened the door to a bidding war (mainly because his offer of $75 per share was regarded as "embarrassing" (Leveraged Buyouts, p. 289). Soon other investors saw an opportunity to capitalize on a company that was deemed to be undervalued. Did Johnson set out with this purpose in mind in order to ultimately boost the price per share of the company by setting the ball in motion? Or did he truly believe that a lowball offer would get his team control of the company? One could speculate, of course, but what made the LBO feasible was the fact that RJR Nabisco had significant brand value even as its return on assets had been declining and that its worth had been estimated by Smith Barney at between $85-$92 per share, significantly greater than Johnson's buyout bid and much greater than the company's pre-buyout offer share price of $56.

The terms and conditions of the LBO pre- and post-buyout in terms of corporate structure were that the company was to be kept "intact and to still have some public ownership" which KKR promised to give in their LBO, whereas with the Johnson offer, the team intended to "sell off assets" in order to "pay down debt" (Leveraged Buyouts, p. 289). However, after the LBO, the return on investment that KKR anticipated did not manifest and KKR ended up liquidating its interest in the company following its underwhelming ROI. Thus, before the LBO the corporate structure was overseen by Johnson and the Board and after the LBO, KKR became the overseer until the time when it too saw fit to eliminate its position in the company. Perhaps Johnson's lowball offer, in retrospect, was not so lowball after all.

However, the story did not end there. As the offers grew, they quickly outshot even the Barney Smith estimate of the company's worth, with Johnson's management team attempting to outflank the opposition with an offer of $112 per share. KKR countered with a lower bid of $109 per share, which ended up being the offer accepted by the Board because it was "guaranteed" money, as opposed to the offer by Johnson, which was not (Greenwald, 1988).

Thus, the financial qualities of the LBO in terms of the stock value pre- and post-LBO were to cause the price per share to be inflated beyond anyone's expectations. KKR was definitely paying more than the Smith estimate deemed reasonable, by nearly $20 per share, or nearly 25% higher than the greatest value estimate. Johnson had successfully gotten KKR to up their ante, essentially, which gave him an incredibly lucrative "golden parachute" for when the sale went through: Johnson stood to gain $100 million from the purchase now. His actual compensation was around $60 million and when he left the company in 1989, Louis Gerstner took over (Tursi, White, 1999). So for Johnson, it turned out to be a very profitable financial opportunity. The stock began trading in 1991 under the ticker symbol RN and the first quarterly dividend paid. $0.835 per share, a nearly 30 cent increase from December 1988. Thus, the company stock was much more in demand post-LBO.

However, by the end of the decade, R. J. Reynolds Tobacco Holdings would be spun off and would trade under the symbol RJR on the NYSE and in 2000 Philip Morris would acquire Nabisco and RJR would merge with Nabisco Group Holdings. RJR and British American Tobacco PLC would then combine assets to form the Reynolds American Inc. company and it would trade on the NYSE under ticker symbol RAI in 2004. Today, RAI is at an all-time high share price of $49 (A Stock History -- Sequence of Events, n.d.). Thus, through a series of strategic moves, mergers, stock splits, spin-offs, and acquisitions, RJR Nabisco is now even bigger and more valuable today than it ever has been before in its entire history.

Nonetheless, when KKR sold of its investment in the company, it was done because of the perception that the company's returns were not quite as profitable as it would have liked to have seen. In one sense, however, it was a successful LBO, because Johnson was rewarded handsomely and the Board got what it wanted. In another sense, though, the LBO failed because it was felt by KKR that it overpaid for the buyout and the company had to go through a series of sell-offs, spin-outs, reverse splits and splits, mergers and acquisitions over the next fifteen years in order to get where it is today. Yet over all that time, the stock continued to climb as it is still doing today.

From the perspective of KKR, however, this case study was indicative of the "winner's curse" because the returns that KKR expected simply were not there, and though it won the bidding contest, the price it paid to win was more than it was willing to swallow with regard to the returns. The ROI was simply not efficient to warrant maintaining the position. Thus, the company was divested and turned over to other hands. Indeed, the tobacco industry underwent a period of consolidation, so there was a substantial return for investors throughout this period, but for KKR the biggest LBO in history was not all it was cracked up to be.