Hill Country Snacks Food Company Co.

Hill Country Snacks Food Company Co.

Financial  Management |Case Study #3
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Case Background

Hill Country Snacks Food Co. (HCSFC) located in Austin, Texas manufactured, marketed and distributed variety of snacks, including churros, tortilla chips, salsa, pretzels, popcorn, crackers, pita chips and frozen treats.

HSSFC focused on improving shareholder’s worth. They managed their operations well and controlled costs and thus even when operating in food industry with immense competition from PepsiCo and other companies managed to keep its 5 year compounded annual growth rate at 5.8% and 5-year compounded annual growth rate for net income margin at 8.6%.

However, Hill country’s culture and managerial philosophy was caution and risk aversion. The company invested in new capacity and new products only when attractive opportunities were identified and it did not make high-risks bets in its product markets. This strategy produced growth rates that were steady but not spectacular compared to competitors. Same was apparent in its cash balances, capital structure, and performance measures. Company’s growing cash position, absence of debt financing and large equity balance made it difficult for it, a company in mature market to earn high returns on its equity. To remain favorite investment option, hill country needed to take advantage of low interest rate environment and to signal to market its strength, which will boost its share value.

Problems

1) Hill country had significant focus on maximizing shareholder value. The philosophy was applied at every level of the organization and in all operating decisions. Also, Company’s CEO and other management insiders had held a significant proportion of the company’s common stock, approximately 1/6th of total outstanding shares. Thus, focus on building shareholder value was also personally beneficial to the members of management team. However, this also lowered their risk appetite. As their own money was at stake, they approached all business opportunities cautiously and often missing on early opportunities. They only decided to pursue them when they seemed to be viable and profitable. This ensured consistent but mediocre growth rates for sales and profit margins for a company.

2) Hill country’s culture and managerial philosophy was caution and risk aversion. The company invested in new capacity and new products only when attractive opportunities were identified and it did not make high-risks bets in its product markets. Growth was low risk and incremental, driven by extensions of existing products and the acquisitions of smaller specialty companies. This strategy produced sales growth rate that were steady if unspectacular but also increased the likelihood that customers would favorably respond 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 a cost efficiency, would quickly contribute positive operating profits.  However, this risk averse attitude didn’t allow company to take advantage of opportunities at first and no first movers advantage.

3) Company’s culture of risk-avoidance was also manifested in its financing decisions. The CEO had strong preference for equity finance and against debt financing. The company was managed with same philosophy. Thus even when all of its competitors had debt financing company had none. All investments were internally funded. Thus cost equity wasn’t taken in picture of all the decisions. In 2012, Debt investment was its lowest interest rates point still Hill country, had not adopted for it. Thus, company was not making optimum utilization of its financial instruments.

4) The biggest problem company is facing wrath from investor and analyst communities. Company’s capital structure is equity focused with zero debt opted for currently. Thus company has high WACC level. Also company is not performing on up to par with other companies because of no debt component in its capital structure. Thus, how much debt to be raised is problem that company is trying to find out. Company works in staple food industry which is very secured business. Business is not cyclical and also stable with not much variation in earnings level. Company has steady income thus they can maintain high interest coverage ratio. Also asset quality of a company is very high with cash, Accounts receivables, inventory and PPE accounting for almost 70% of total assets of a company. Thus, company also has got lots of asset to put up for collateral. Because of this both reasons company can get very high rating for its debt securities and issue it at very low rate. Thus, all factors are in favor of debt issue for a company. The only problem for company is to explain benefits of debt to senior management and get them onboard plus once they decide to raise capital, total how much capital to be raised.

5) Company has hoarded lots of cash with it. They have mentioned reason for it being it increases both safety and flexibility. However, that’s am inefficient use of money.  As mentioned in a case, short term interest rates are very low, for example, 0.17% on one month CDs. Thus, company is wasting investors’ money by not putting money to its optimum use. Thus company needs to chalk out plan to put to use that excess cash for correct usage.

Analysis and assessment

Now Mr. Howard Keener, CEO of the company for last fifteen years, who has is chiefly behind the current corporate culture of being risk averse and conservative in terms of the company’s financial structure is due to retire soon, major speculation is that a more aggressive capital structure might be implemented in the near future. And the major question under contemplation is “What is the optimal capital structure for Hill Country Snack Foods, and how large are the payoffs associated with a change to a more leveraged capital structure”

Thus, in the current assessment we have tried to answer the above question.

Now, first we have tried to calculate Cost of Capital at three different Debt to Capital Ratios: (1) 0%, (2) 20%, (3) 40%, (4) 60%.

Following data is made use of:

1. Yield to maturity on 10 year maturities: 1.8%
2. At 20% Debt to Capital ratio the assumed bond rating is AAA/AA and the interest rate is 2.85%, at 40% Debt to Capital ratio the assumed bond rating is BBB and the interest rate is 4.4%, and at 60% Debt to Capital ratio the assumed bond rating is B and the interest rate is 7.7%. The debt issued has a maturity of 10 years.
3. The effective income tax rate is 35.5%
   Here, for calculation purpose, exhibit 4 is used where Income before income taxes for 2011 is  given as $151.3 and income taxes is given as $53.7. Thus, effective income tax percentage is 35.5%