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Question Description

I’m working on a finance case study and need an explanation to help me understand better.

Document attached below. What is the Optimal capital structure for Hill County Snack
food and how large are the payoffs associated with a change to more leverage
capital structure?

BRIEF CASES
9-913-517
OCTOBER 22, 2012
W. CARL KESTER
CRAIG STEPHENSON
Hill Country Snack Foods Co.
The Chief Executive Officer of Hill Country Snack Foods had never enjoyed analyst conference
calls, but in late January of 2012, Howard Keener was yet again asked about the company’s cash
balances, capital structure, and performance measures. One analyst complained that Hill Country’s
growing cash position, absence of debt finance, and large equity balance made it difficult for a
company in a mature industry to earn a high rate of return on equity, and recommended a more
aggressive capital structure. “Maybe I don’t
fully understand capital structure theory and practice,”
replied Keener, “but I have observed that companies don’t get into trouble because they have too
much cash; they get into trouble because they have too much debt.” Hill Country had seen its sales
and profits grow at a steady rate during Keener’s tenure as CEO, and at the end of 2011 the company
had zero debt and cash balances equal to 18% of total assets and 13% of market capitalization.
Having just celebrated his 62 birthday, Keener was approaching retirement, creating speculation by
investors and analysts that the company might change to a more aggressive capital structure in the
near future.
Company Background
Hill Country Snack Foods, located in Austin, Texas, manufactured, marketed, and distributed a
variety of snacks, including churros, tortilla chips, salsa, pretzels, popcorn, crackers, pita chips, and
frozen treats. Although many of its products had a Southwestern flair, it also offered more
traditional snack foods, which were purchased by end consumers thousands of times every day in
supermarkets, wholesale clubs, convenience stores, and other distribution outlets. The company’s
growth and success was driven by its efficient operations, quality products; strong position in a
region that was experiencing both population and economic growth, and its ability to expand its
presence beyond the aisle into sporting events, movie theaters, and other leisure venues where
consumers were more likely to purchase snack foods. Many of Hill Country’s products were also
sold through school systems, which required the company to reduce the fat and sugar content of its
products. This was just one example of the company’s continual work to solicit, collect, analyze, and
internally distribute customer feedback so the company could quickly react to customer requirements
or preferences, and reinvent and expand its products as required to succeed in the rapidly changing
marketplace.
HES Pror W. Carl Kester and Babson College Professor Craig Stephem prepared this case solely as a basis for de discussion and not as
an endorsement, a source of primary data or an illustration of effective or ineffective management. Although based on real events and despite
small remas to actual companies, the came back and any emblance to actual pe care cuncidental.
Hill Country’s Corporate Culture
Hill Country was a well-managed company, where all decisions were made according to one
criterion will this action build shareholder value? This singular management focus came directly
from Howard Keener, the company’s CEO for over fifteen years, who strongly believed that
management’s job was to maximize shareholder value. This philosophy was applied at every level of
the organization and in all operating decisions. Many managers talk about shareholder value, but
Keener was proud of the fact that, at Hill Country, shareholder value was a way of life, not just a
talking point. Keener and other management insiders also held a significant proportion of the
company’s common stock, approximately one-sixth of the 33.9 million shares outstanding, so this
focus on building shareholder value was also personally beneficial to the members of the
management team.
Another important component of company culture was a strong commitment to efficiency and
controlling costs. The snack foods industry was very competitive, with Hill Country facing off
against industry giant PepsiCo and smaller companies like Snyder’s-Lance every day. Efficient
operations and tight cost controls were necessary conditions for success; the company could not rely
on price increases in this high rivalry industry. Operating and capital budgets were lean and
aggressive, and Keener himself was actively involved in both the budget approval process and in
ensuring the business was managed to the numbers in the budget. Unfavorable cost variances
resulted in management action to bring costs back into line with plans, even when the cost increases
were due to external factors. Management didn’t always have a solution to unfavorable variances,
but they did all they could to keep costs under control.
The final component of Hill Country’s culture and managerial philosophy was caution and risk-
aversion. The company invested in new capacity and new products when attractive opportunities
were identified, but it did not make high-risk bets in its product markets. Growth was low-risk and
incremental, driven by extensions of existing products and the acquisition of smaller specialty
companies. This strategy produced sales growth rates that were steady, if unspectacular, but also
increased the likelihood that customers would respond favorably to the company’s new products.
Management avoided great leaps in its product markets, instead believing a series of small but
successful product launches, combined with the company’s operating and cost efficiencies, would
quickly contribute positive operating profits.
Hill Country’s culture of risk-avoidance was also manifested in its financing decisions. The CEO
had strong preferences for equity finance and against debt finance, and the company was managed
consistent with these beliefs. Debt was avoided, investments were funded internally, and the balance
sheet was strong. The company also held large cash balances to increase both safety and flexibility
Some members of the analyst and investment communities questioned these policies, but CEO
Keener believed they were appropriate for the company.
Financial Performance
The combination of good products, efficient and low-cost operations, and all-equity funding had
produced consistently strong financial results, as presented in Exhibit 1. Sales had increased at a
steady rate, and except for the difficult economic years of 2007 and 2008, net income had followed a
similar growth pattern. The company had experienced a decrease in earnings in 2007, and struggled
to increase profitability in 2008, but growing sales and continued attention to costs drove large
increases in net income since the recession ended in 2009. Return on asset and return on equity
numbers had similarly increased in the past few years, with return on assets reaching 10%, and
return on equity exceeding 12% in 2011. Hill Country’s cautious growth strategy also allowed the
2
BRIEFCASES I HARVARD BUSINESS SCHOOL
company to pay continuous and growing dividends; carefully considered and controlled growth
meant the company’s cash flow was sufficient to fund both capital investments and dividend
payments to shareholders. The dividend payout ratio had been just below 30% of net income in each
of the past five years, and management planned to maintain this distribution ratio.
The company’s cash position and conservative capital structure, however, had a negative impact
on its financial performance measures. Retum on assets was reduced by Hill Country’s large cash
balances in two ways. The interest rate earned on invested cash was barely over 0%, contributing
almost nothing to net income, and more cash meant more total assets. Return on equity was similarly
reduced by the avoidance of debt and complete reliance on equity capital. Hill Country’s common
stock was widely held by investors
and covered by analysts, reflecting the stock market’s favorable
opinion of the company’s products, prospects, and management. Many members of the investment
community were also frustrated by the company’s excess liquidity and lack of debt finance. Even
modest reductions to cash, increases to debt, and reductions to owners’ equity would significantly
increase retum on equity. There was no clear consensus about this issue, however, as others worried
about the wisdom of
demanding changes from a successful company.
Capital Structure
Cash holdings of US. non-financial corporations had increased to record levels by the end of
2011; thus Hill Country’s large and growing cash balances were not unusual. The company’s capital
structure with zero debt finance, in contrast, was fairly unique, particularly within its industry. Both
PepsiCo, the giant in snack foods, and Snyder’s-Lance, a competitor of similar size and scope utilized
debt finance, as shown in Exhibit 2. PepsiCo’s debt-to-capital ratio was 49.6%, but it earned bond
ratings of “Aa” from Moody’s and “A” from Standard & Poor’s, due to its strong interest coverage
and low level of business risk. This ratio was lower for Snyder’s-Lance, but debt still provided nearly
one-fourth of the company’s investment capital. None of their debt was publicly held, however, so
Snyder’s-Lance was not rated by any credit agency.
The question posed to Keener in the January analyst conference call reflected the opinion of many
shareholders that the company would benefit from a more aggressive capital structure policy. Debt
was less expensive than equity due to its contractual nature and priority claim, and interest payments
were deductible for income tax purposes. In addition, interest rates were at unprecedented levels in
early 2012: market yields on 10-year treasury bonds were under 2% and publicly-traded 10-year
bonds issued by “A rated corporations were trading at 3.8% yields to maturity. These data and
other current information about interest rates and bond ratings are presented in Exhibit 3.
A pro forma financial analysis is presented in Exhibits 4 and 5, which was prepared to address
speculation about how a change to Hill Country’s capital structure would affect its financial results.
Exhibit 4 shows the company’s actual 2011 financial results and pro forma restatements of 2011
results under three alternative capital structures: 20% debt-to-capital: 40% debt-to-capital; and 60%
debt-to-capital. Exhibit 5 presents the details and assumptions of the recapitalizations that produce
the alternative pro forma capital structures, in every case assuming the company issued debt and
used the proceeds, plus $55 million of excess cash, to repurchase common stock at the end of January
2012 The pro forma analysis also assumes the repurchase premiums paid above the current market
price of $41.67 per share increase as the stock repurchase increases in size. Other alternatives exist to
significantly increase the proportion of debt in the firm’s capital structure-issuing debt to fund a
large specially designated dividend, for example—but Exhibits 4 and 5 present an analysis that
1 Largest Public Companies Continue to Hoard Cash at Record Level 1000 of the Largest Now Hold $850 Billion in Cash on
Hand,” REL Research, December 2011
HARVARD BUSINESS SCHOOL I BRIEFCASES
913-517 Hill Country Snack Foods Co.
estimates the financial impact of increasing debt and decreasing equity in Hill Country’s capital
structure through a stock repurchase.
Given the company’s culture of caution and risk-aversion, it would be unrealistic for analysts and
external shareholders to expect a major and immediate change in the use of debt finance, no matter
how attractive the pro forma results presented in Exhibits 4 and 5. The recent birthday and pending
retirement of CEO Keener, however, whose personal preferences had a substantial influence on
company culture, created speculation that a more aggressive capital structure might be implemented
in the near future. The questions being considered by many members of the investment community
were, “What is the optimal capital structure for Hill Country Snack Foods, and how large are the
payotts associated with a change to a more leveraged capital structure?”
Exhibit 1
Selected Financial Information for Hill Country Snack Foods Company, 2006 to 2011
(millions of dollars, except for per share data and financial ratios)
2006
$1,027.0
$97.4
$64.6
$1.91
$0.45
2007
$1,059.9
5791
$52.6
$1.56
$0.45
2005
$1,099.5
$82.8
$83.8
$1.50
$0.45
2009
$1,180.4
SIOS 2
S681
$2.01
$0.60
2010
$1,261.7
$126.7
$79.9
S216
$0.70
2011
$1,3646
$151.3
$97.6
$2.88
$0.85
$106.4
$770.4
Sales
Operating income (EBIT)
Net income
Eamings per share
Dividends per share
Cash & cash equivalents
Total assets
Debt
Owners’ equity (book value)
Common shares outstanding (in millions)
Annual growth rate of sales
Annual growth rate of E.P.S
Dividend payout ratio
Net profit margin
Return on assets
Return on equity
$108.1
$668.5
SOLD
$529.7
33.7865
$1076
$727.3
SOLO
$567.4
33.8076
SOD
56063
$139.8
$824.9
50.0
$654.6
33.8581
$164.8
$994.7
SOLO
$710.9
33.8633
$181.1
$979.9
$0.0
$780.1
33.8834
33.8278
n/a
n/a
23.6%
1.9%
7.4%
26.4%
6.9%
17.4%
22.0%
29.5%
28.8%
5.0%
7.2%
9.3%
4.9%
7.0%
8.9%
5.8%
8.3%
10.4%
8.9%
11.2%
72%
10.0%
12.5%
12.2%
Return on assets and return on equity are calculated as net income divided by end of year total assets, and end of year owners’ equity, respectively.

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