Interstate Bakeries – Acquisitions, Merger, or Bankruptcy? Our mission is to be the market... Interstate Bakeries – Acquisitions, Merger, or Bankruptcy?

Our mission is to be the market leader in branded bakery goods, through the efficient production and distribution of high quality products, manufactured to consistent standards, as demanded by customers and consumers alike. (Interstate Bakeries Corporation, Proxy, August 25, 2003) In early August 2004 James Elsesser, CEO and Chairman of Interstate Bakeries Corporation, reviewed the draft of a press release. The press release focused on the unaudited preliminary fourth quarter results for Interstate’s 2004 fiscal year which had ended May 29. The news wasn’t good. For the 52 weeks, the company expected sales would be down 1.7%. The company would incur an operating loss of approximately $7M compared to a 2003 profit $83M and a net loss of approximately $25.8 vs. 2003 net income of $27.5M. He had already notified board members. The company had been beset with numerous issues since Elsesser took the reins as CEO in September 2002. Externally the company was dealing with a mature industry in which a major portion of the industry’s revenues, namely white bread sales, had declined during the prior year.[i] The industry faced a number of challenges including changing demographics and dietary preferences in the U.S. that did not bode well for the company’s product lineup. Retail consolidation, in which Wal-Mart was clearly the leader, put pressure on margins. Even though Interstate had grown, its downstream retailers had grown faster through consolidation. As his predecessor had put it, even with $3.6B in sales the company was tiny relative to the major retail chains with whom the firm had to deal. Competitors were active internationally, a move that Interstate had not emulated in spite of the firm’s strong brand assets. Internally the company had run into problems on multiple fronts. A continuing effort to reduce capacity by closing plants had cost more than expected or been delayed. The SEC had become involved with an internally initiated audit that had led to a $40M charge for a shortfall in the reserve for workers’ compensation claims. Problems had developed with SOAR, a significant restructuring of the firm. Part of the difficulty emanated from the implementation of SAP which was part of the recentralization process. Employee morale among the largely unionized work force continued to be difficult. Given the cash flow difficulties, the board had suspended dividend payouts in March 2004 in the spring. Seven shareholder lawsuits remained unsettled. Elsesser had taken on the role as CEO of Interstate Bakeries on November 1, 2002. The members of the board had becoming increasingly concerned about the company’s continuing stagnation of revenues, the decline in profits, and stock price performance. (See Exhibit 1 for selected financial data 1994-2003, Exhibit 2 for Third Quarter 2004 financial results, and Exhibit 3for IBC’s stock price relative to the S&P 500.) Elsesser anticipated matters would come to a crisis point in the upcoming board meeting. There was already strong support for taking the company into bankruptcy. However, a number of firms had indicated interest in acquiring Interstate in the past. Elsesser wondered if an appropriate merger/acquisition might be a better move for his beleaguered company. Company History Interstate Bakeries began in Kansas City, Missouri in 1930. Originally a wholesale operation for breads, Interstate began early on to acquire small local and regional companies across the country. Interstate Bakeries in late 2004 was the result of mergers and acquisitions with 24 companies over its history. (See Exhibit 4 for Interstate’s major mergers and acquisitions.) In the 1950s Interstate began acquiring cake-baking and confections operations in various part of the United States. In the late 1960s Interstate diversified to include a canning operation. In 1979 Interstate came under the control of conglomerate DPF which later took the company private. After incurring its first ever loss in 1983, the company continued to trim operations on into the late 1980s. In 1991 under CEO Charles Sullivan, the company went public again. During the 1990s demand for bread increased. Interstate responded to the market situation by decentralizing operations. The results of the moves in the 1980s and restructuring led to favorable financial results in the mid-1990s which, along with strong market conditions, propelled the stock price during much of the remainder of the decade. (See Exhibit 2 for stock price 1995 through mid-2004 and Exhibit 5 for Interstate’s historical timeline.) The Continental Baking Acquisition In January 1995 Interstate agreed to acquire Continental Baking Company from Ralston Purina for $330M in cash and 16.9M shares of newly issued Interstate stock valued at almost $14 per share, a total of $560M cash and stock. Ralston Purina remained responsible for Continental’s debt. After discharge of the debt, it was estimated that Ralston Purina’s shareholders would net about $140M. As an analyst at PaineWebber put it, “They (Ralston Purina) are basically giving it (Continental) away.”[ii] At the time Continental was the largest U.S. baker of fresh bread. Continental was also known as an industry innovator. For example, Continental had been first to introduced sliced bread and also enriched white bread. The company distributed Wonder bread, one of best selling and most well known brands in the country. Interstate, with $1.2B in revenues, was the largest independent baker in the United States and the country’s third largest baker of fresh pan bread. The combined company was the largest wholesale bread and cake producer in the United States. Ralston Purina had originally purchased Continental from ITT for $475M in 1985. In the process of restructuring Ralston had been trying to sell its baking subsidiary for several years. The baking firm had experienced declining sales and a high cost structure including increased prices of ingredients and high labor costs associated with a heavily unionized work force. In 1994 Continental lost $16M on sales of nearly $2B. In 1994 Ralston created a separate stock for Continental, first attempting to spin it off in the form of a special dividend to shareholders and then more aggressively shopping it. Said Charles Sullivan, then Interstate’s CEO, of the acquisition, “It is going to be a pretty tough job…This is a mature business and growth is very difficult. The only way you grow is through acquisition. It’s not just us. It’s the entire industry.”[iii] Analysts expected Interstate would do a better job of marketing Continental’s brands. As one analyst put it, “The brands were mismarketed. Continental, when they did try to market their brands, just threw a lot of money out without any game plan. They spent, I am going to guess, $75 million or $80 million last year (1994) to market Wonder and Twinkies, and I think probably half of that was wasted money.”[iv] Not unexpectedly, in July 1995 the U.S. Department of Justice challenged the proposed acquisition of Continental Baking Company by Interstate Bakeries. In January 1996 the FTC (or DOJ) entered a consent decree with Interstate that permitted the acquisition, but only after Interstate agreed to divest a major brand of white pan bread in five geographic markets. The divestment would affect about five percent of Interstate’s revenues. Interstate Operations Interstate Bakeries Corporation baked and distributed bread and cake products throughout the United States. The company also distributed to military bases abroad, but had no other international presence. The firm’s Wonder Bread was the number one bread brand in the country while Home Pride was the number one seller in the wheat bread segment. Interstate also owned the Hostess brand that included such well-known products as the Twinkies and HoHos, which were among the leading snack foods. (See Exhibit 6 for the company’s products, brand names, and trademarks.) In 2003 Interstate employed almost 32,000 people 80% of whom were unionized. The company owned 55 bakeries, facilities that were automated, but varied in terms of efficiency. (See Exhibit 7 for a description of bakery operations.) The firm’s operations were spread through 27 states where the firm had approximately 1,250 thrift stores from which it sold products with close expiration dates, over 1000 distribution centers, and more than 9,300 delivery routes serving more than 200K retail providers. The retail outlets served almost 90% of the United States. Given the shelf life of bread had been about three days, the company’s extensive network of bakeries and delivery routes helped keep Interstate goods on the retailers’ shelves fresh and Interstate’s detail route sales people also worked at keeping the product on the shelves orderly and attractive for consumers. It was customary in the industry that the wholesalers or manufacturers sales force detail the retailer. Detailing meant that the route drive stocked the retailers’ shelves with non-private and sometimes private label bread as well. The route driver removed stale loaves directing the loaves to a thrift shop. If not sold by the expiration date, the bread was sold for animal feed. Interstate had begun, along with other competitors, to use electronic handheld devices to record data during shipment. The use of the devices had helped the company to lower transfer time between locations and keep inventory information up to date. In addition the electronic information assisted the company in keeping track of and responding to shifts in customer demand. Under Charles Sullivan’s leadership Interstate had initiated an Extended Shelf Life (ESL) program using new ingredient technology for its products. Company chemists had first successfully extended the shelf life of Zingers using new additives. Later the company applied the same technology to Hostess products which stayed soft and fresh looking longer without impairing taste. About the same time an industry supplier developed an enzyme that showed promise for giving bread a longer life. The process used enzymes to retain water to ensure softness. The new process required exact control of times and temperatures during mixing, fermentation, proofing, baking and cooling processes. Said Sullivan, “Everything has to be very precise or it doesn’t work well. That (has) forced us to improve our existing operation in addition to using ESL, so we have become better operators.”[v] Originally the company --- as well as competitors throughout the industry --- hoped to double the shelf life of product through Extending Shelf Life (ESL). ESL life had significant ramifications for the firm’s operations and cost structure including reduced distribution costs, a decreased need for bakeries, reduced product spoilage, and broader product selection on retail shelves. Indeed, in conjunction with ESL, Interstate had reduced the number of its direct-store-delivery routes from over 10,500 to about 9,500. Savings in fuel, labor, and equipment dropped to the bottom line. The changes allowed the company to stock more product at low-volume accounts including convenience stores. Said Sullivan, “It (ESL) allowed us to reduce routes, but it’s all on a seniority basis. Generally speaking low-volume, high-turnover routes were eliminated and we have significantly increased bread and cake route averages all across the country. That has resulted in stability with the sales force. They make more money. We make more money. We just can’t find anything wrong with it. In some cases, especially on the cake side, we have been able to combine routes and give people consecutive days off...the customer is pleased…everyone wins. It’s not just cost savings…If you look at this business, the two major costs are manufacturing and distribution. On the manufacturing side we (are addressing) that issue by upgrading existing plants and building new facilities. On the distribution side, ESL improved everything. Those two improvements have made us a much stronger company and more profitable…Two years from now, everyone will look back and realize that having a longer shelf life, whether it’s bread or cake, is a positive, no matter how you slice it. You can’t find anything wrong with it as long a your products are soft and perceived fresh by consumers. Eventually, everyone is going to be doing it.” [vi] Overall the company-wide stale rates had dropped from about 15% to about 8%. What that translated into is that if the company previously had had to bake 115 units to sell 100, it had to bake only 108 after ESL rollout. However, the program had met with snags. ” The ESL technique worked with some products, for example, Twinkies.[vii] But, the results of the application of the ESL technology to bread had turned out quite differently. Bread turned out gummy and doughy, and often caved in the middle. Customers began to complain shortly after the bread was introduced and began to switch brands. In addition, with loaves on the shelf longer, displays became disorderly as customers picked through shelf stock. The unattractive displays decreased customer interest. As one observer put it, “So, product not only tasted bad, it looked worse on messy or empty shelves.” The company backed out of ESL for bread and added the driver routes it had cut. Retailers were unhappy about the results of the bread experiment. However, new technologies for extending the shelf life of baked products were under development at number of commercial laboratories that had potential to provide opportunities for the industry. Interstate Bakeries used a sole supplier for its raw materials, principally for sugar and edible oils. The company did not have a long-term supply contract with its supplier. Purchasing the major commodity requirements was done through advance purchase contracts, which did not normally run longer than a year. Prices for raw materials were dependent on a number of factors including weather, crop production, transportation costs, processing costs, and government regulation. Interstate Products Interstate intended to focus more on building its branded products with the more centralized organization. The firm was making changes in its marketing emphasis. One aspect of the changing marketing strategy was lessening the emphasis on regional or local private label products. Elsesser explained, “We have highly recognized national and regional brands with strong customer loyalty. We intend to build our brands and focus on higher-margin products in our portfolio.” [viii] In 2003 especially the company launched new advertising campaigns for branded breads and sweet goods. Interstate owned a number of well-known breads and cakes. The firm was making changes in its marketing emphasis. In the bread line were brands such as Wonder Bread, Beefsteak, Butternut, Home Pride, and Merita. In the cake line were leading brand names such as Hostess, Drakes, and Dolly Madison. Some brands were national while others were strong regional contenders. (See Exhibit 6.) Brand Names - Bread Wonder Bread. Wonder Bread was “…a brand of extremely soft white bread”. It was originally produced by Taggart Baking Company of Indianapolis and debuted on May 21, 1921 after “blind” promotion with ads that stated only “Wonder”. The brand name was chosen by Taggart Vice President Elmer Cline who was inspired by the International Balloon Race at the Indianapolis Speedway resulting in the red, yellow, and blue logo. To create more brand awareness and to market the bread line, the Taggart company had trucks deliver helium-filled balloons to children who, in turn, took letters to their mothers inviting them to try the new Wonder Bread. In 1925 Continental Baking Company purchased Taggart Baking Company. Continental took the Wonder bread brand to national prominence. Continental was the first bread company to introduced pre-sliced (Wonder) bread. At first consumers viewed sliced bread with some skepticism, but the convenience soon overcame the initial objections. During the 1970s Continental introduced nutrition information labels. In 1995 Interstate acquired the Wonder bread product line in its purchase of Continental Baking Company. At the time “Continental was described as “…the nation’s largest baker of bread and snack cakes, with nearly $2 billion in sales and brands like Wonder, Hostess cupcakes, Twinkies, Home Pride, Beef Steak Rye, and Ding Dongs.”[ix] In honor of Wonder Bread’s 80th birthday, the Wonder Bread hot air balloon toured the country in summer 2000. The balloon flew at various balloon festivals “spreading the story of how Wonder Bread earned its name, the balloon brings back childhood lunchbox memories to people from coast to coast and reminds everyone why Wonder Bread is their favorite.”[x] Beefsteak. Beefsteak was another Interstate brand acquired with Continental Baking. The company described this product as a rye bread with a “tangy, robust rye taste.” The bread was light (i.e., low fat) and known for its great taste. Butternut. The Butternut brand name had been in existence since 1902 and described as “…dedicated to providing you with the freshest, most delicious breads possible. We use only the finest ingredients to ensure a quality product that you can feel good about serving to your family. Butternut has many valuable vitamins and minerals and remains an important part of your family’s diet.” Annual sales for Butternut were about $39M. Among the products sold under the Butternut Bread brand name were: Enriched White, Honey Wheat, White Sandwich Thin, Whole Grain 100% Whole Wheat, and Country Wheat. After Interstate acquired Wonder Bread, the two main bread brands, Wonder and Butternut, encountered problems for some time. The difficulties emanated from their disparate cultures. Butternut was described as a “seat-of-the-pants” operation with each of its bakeries running as a self-contained profit center. Wonder Bread, on the other hand, was very “procedural and by-the-book”. Home Pride. This brand also came to Interstate through the Continental acquisition. The brand had been in existence for over 30 years. Interstate described this brand as “…baked with special care and pride. Each recipe calls for the finest ingredients so your family can enjoy a wide variety of delicious tastes and textures.” Customers were invited to “…experience the great taste and long-lasting freshness of Home Price…you and your family will enjoy the last slice as much as the first!” Among the main products carrying the Home Pride brand were: Bread 100% Whole Grain Sugar Free, Buttertop Bread Wheat, Buttertop Bread White, Carb Action Bread White, and Wheat Bread. Merita. Interstate acquired Merita bread in 1987 from American Bakeries. The Merita bread line was distributed in the Southeastern United States. Interstate described this 100-year-old brand as “...the freshest, most delicious breads…(with) only the finest ingredients…used for the soft, premium quality that bread lovers have come to expect.” Brand Names - Cake Hostess. Continental initiated the Hostess brand in 1925 shortly after Continental acquired Taggart and the Wonder bread brand. Continental’s executives felt their company needed a cake line and set out to create a snack food that was “special, creative, and fun to eat.” The first Hostess product was a chocolate chip cake, still popular in the early Twenty-First Century. In 1930 Hostess sought to develop an inexpensive treat that the firm called Twinkies®. The company used strawberry pans that had been put away for the season. The pans were used to bake shortcake injected with a banana cream filing. On his way to St. Louis for the initial introduction of the new sweet treat, the head of the firm saw a billboard reading “Twinkle Toes”. He made the decision to call the new product “Twinkies”. The new product was introduced as an inexpensive treat at a retail price of two Twinkies for a nickel. Twinkies quickly became very popular and Hostess’ cash cow. During WWII bananas were in short supply, and the company changed the filling to vanilla crème. In the early Twenty-First Century, Twinkies became almost a generic name and retained their popularity selling over a half billion yearly. Hostess also had other treats such as Ding Dongs®, Ho Ho’s®, Suzy Q’s ®, Snow Balls®, and fruit pies as well as a wide line of Hostess brand donuts including the popular bite-sized Donette® brand. In the early Twentieth Century Interstate held the largest market share of the snack cake industry with over 45% of the revenues in this segment. This dominance was largely because of Interstate’s success with its Hostess and Drakes product lines. Drakes. Drakes had served the Northeast United States with snack cakes for over a century. The founder, Newman E. Drake, baked his first pound cake in Brooklyn, New York. Drake recognized the success of the product and decided to package it for sale by the slice. In the early Twenty-First Century, Drakes continued to be a favorite brand name in the snack cake segment. Among its products were Coffee Cake, Devil Dogs, Yankee Doodles and Ring Dings, Yodels, Funny Bones, Sunny Doodles, and Fruit Pies. Interstate bought Drakes in 1998. Dolly Madison. Interstate Bakeries founder Roy Nafziger introduced the Dolly Madison line of cakes in 1937. Nafziger described the cakes as “Cakes and pastries fine enough to serve at the White House.” He admired President Madison’s wife and focused on developing a high quality, but affordable cake fit for Madison and other First Ladies. The Dolly Madison Bakery® line of products included Zingers®, Donut Gems, Angel Food and Pound Cakes, as well as a variety of breakfast sweet items such as Sweet Roles, Dunkin Stix, and Pecan Rollers. This Interstate division had plants in Georgia, Kansas, and Indiana. In 1996 then Interstate Chairman of Board and CEO Charles Sullivan aimed at cutting expenses by streamlining manufacturing and delivery efforts. In the reorganization the Dolly Madison and Hostess operations came to share production facilities. In 1969 Dolly Madison was one of Interstate’s top three best-known products. Interstate as an Organization Interstate was undergoing significant structural and cultural change. The leadership included the board and senior executives. Executives and managers had retirement, stock purchase, and other incentive plans. Most of Interstate’s personnel were heavily unionized and the firm had been headed by two CEOs over the prior decade and a half. During their tenure the firm had formalized its mission statement, organizational values, and a code of conduct. (See Exhibits 7-A and 7-B respectively.) By far the majority of the firm was made up of unionized employees who worked in the firm’s plants. Organizational Structural and Cultural Change During the 1990s demand increased for bread. Interstate responded to the market situation by decentralizing operations. Interstate operated within three geographic divisions --- east, central, and west --- on a regionally decentralized basis until 2003. Responsibility for production, distribution, and sales was delegated to the General Manager of each facility. The General manager of each plant ran his (or her) operations as an independent profit and loss center. Each General Manager reported to one of the three Regional General Manager. The three Regional General Managers reported to Interstate’s Chief Operating Officer. In October 2003 Interstate announced the initiation of a “major, culture-changing initiative internally referred to as Program SOAR…acronym for Systems Optimization and Re-engineering…an extremely important undertaking for our company’s long-term competitiveness.”[xi] The cost of the three-year program was expected to be approximately $55M with most of the costs related to hardware and consulting fees. SOAR changes to take place over the three-year period from 2003 to 2006 included: Re-engineer business processes Move to become more efficient and develop a more focused, company-wide direction Carefully consider investments in production, distribution, and administrative functions Reduce infrastructure costs Look for market opportunities and adjust the company’s brand portfolio to better respond to demographic shifts and changing consumer preferences. The SOAR program resulted from a consulting engagement with Accenture. Under SOAR the General Managers of each facility would be responsible for production and distribution at each facility while sales and the support divisions (e.g., marketing, finance, and accounting) would report to the CEO. Human resources, sales, and manufacturing facility operations policies were to be standardized across the company. As CEO Elsesser put it, “Fiscal 2004 will be an exciting year as we implement our action plan and build our long-term strategy…Program SOAR…will mean a change for all of us at IBC. At the very least, it will involve a culture change. IBC has prided itself on its decentralized management model, but more centralization is called for today in all of our strategic decisions.”[xii] The reorganization was initially rolled out at a two-day Kansas City meeting of 150 company managers. In announcing the change, Elsesser said to the management cadre, “Said Elsesser, “This is a new IBC. Our entire management team is committed to this restructuring plan. Its purpose is to make us more nimble, more consumer and customer focused, more cost conscious and, we hope, more profitable…You are present at the creation of a new IBC. We know that change is difficult, but the market is telling us that the time is right for making changes that will enhance our ability to compete in an evolving market for baked goods. We anticipate this reorganization will produce long-term benefits for our Company, our customers, our stakeholders, and our employees and their families.”[xiii] However, internal problems had arisen. To implement the SOAR program the firm had spent already $32M targeted at improving profitability, for example, new computer hardware, software and management programs to increase efficiency, centralize administration, and shorten its decision-making processes. However, major difficulties arose. Among the problems were difficulties with the new SAP system that Interstate had switched to June 1, 2004. Data entry, training deficiencies, and system problems had contributed to the company’s difficulties. Leadership Officers and Directors. Interstate Bakeries had 45M shares of stock outstanding and 2,335 shareholders. Interstate’s officers and directors owned 2.5M (5.5%) of outstanding shares. The two largest investors were Barclays Global Investor N.A. with 12.1% of shares and Merrill Lynch Asset Managements, Inc. with 8.4%. The Interstate Bakeries senior governance group consisted of a board of eight external members and an eight-member executive team. (See Exhibits 8 and 9 respectively.) The board had taken some significant actions in recent years. For example, in 2000 when several firms indicated significant interest in making a bid for Interstate, the company adopted a poison pill provision. The board made it clear that the move wasn’t intended to block a takeover, but rather that the board wanted the poison pill to require a suitor to negotiate with the board first. Charles Sullivan. Sullivan was named CEO and President of Interstate Bakeries in 1988, Director in August 1988, and Chairman of the Board in 1989. Prior to his appointment as CEO and President, Sullivan had been president of Merita, the company that Interstate had acquired from American Bakeries in 1988. Sullivan stepped down as Interstate’s CEO and Chairman in September 2002, but remained a member of the board. As he stepped down as CEO Sullivan reflected on his 14 years heading the country’s largest baking company. The two most significant milestones in his tenure, he felt, had been going public and buying Continental. Sullivan had taken Interstate public in 1991 and in the process converted debt into equity, debt that had kept the company hamstrung for a number of years. Through the acquisition of Continental he had fulfilled a dream of owning “powerhouse national brands” including Wonder and Hostess. In 2002 Interstate was profitable and growing as he turned the reigns over to James Elsesser. The stock had fluctuated from the 30’s in the late 1990s to as low as $11 a share in late 2000. At the time he stepped down it was trading in the mid-20s. However, the prior two years had been a roller coaster. Energy prices skyrocketed, plant start-ups were difficult, and aggressive price hikes had decreased sales and profits. “We (had) a hell of a master plan,” said Sullivan as he laughed and then went on, “Master plan my foot. We stumbled our way through it.”[xiv] Sullivan’s strategy had included commitment to consistent capital investment to upgrade manufacturing operations to improve product quality and lower costs. In the eight years between 1994 to 2002, the company had closed 13 plants and spent about $500M to build five new facilities for a net of 62 plants in 2002. Capital expenditures in 2003 were about $90M while the expected expenditures for FY2004 were in the more usual $75M range. There were new production lines or significant upgrades in process for four plants, upgrades driven by the ESL process. Some startups had gone smoothly. Others didn’t. In addition, Sullivan had stressed rolling out new products. One product line was a premium line of soft breads under the brand name Home Pride Selects that Interstate distributed nationally, except in the south where the new products sold under the Merita name. Sales of the product line were impressive. With regard to the product line Sullivan pointed out that Interstate’s new CEO would need to “…introduce more new products --- not at the rate others (i.e., competitors) do, but certainly more so than in the past, especially on the cake side.” [xv] In summing up the challenge for the company in 2002, Sullivan said, “The real issue with this company is where do we go from here. The largest part of the rebuilding of our plants is done. They’re still working on it, but the heavy lifting has been completed. We have good brands, and we know our customers are getting bigger. It’s all about where we go from here. The day-to-day operations are in good hands with (President and Chief Operating Officer) Mike Kafoure and his people. It’s the next chapter that’s on the table.” [xvi] James Elsesser. Elsesser picked up the challenge as Interstate CEO to take the company to the next level in September 2002. Elsesser had served on the company’s Board since the mid-1990s. He had served as a financial consultant to Interstate from March 2002 until his appointment as CEO. As a consultant to Interstate, among other issues, he had helped Interstate with the purchase of shares from Ralston in April 2002. Beginning in May 2002 he had visited with institutional investors to encourage them to buy the shares coming into the open market. Regarding Elsesser, Sullivan said, “A couple of years ago, one of our other board members said, ‘Why shouldn’t we look at a guy like Jim running the company?’ That was sort of the beginning of the process for my successor. We did a national search, and we felt that we ended up with the best choice. I think it’s not so much ironic as helpful because he knows the players and he knows the business.” [xvii] Prior to his employment at Interstate, Elsesser had served as Chief Financial Officer of Ralston Purina Company for 16 years. He had been a key player in the Interstate’s acquisition of Continental Baking Company from Ralston Purina and joined Interstate’s board after the 1995 acquisition of Continental. He had also served as CFO of Carlson Companies, Inc., a privately held firm. In 1991 Institutional Investor Magazine named James Elsesser one of the nation’s 10 best CFO’s. At the time Elsesser took on the challenge as Interstate’s CEO, the company’s senior executives promised analysts that Elsesser, known as a “legendary cost-cutter” at Ralston Purina, would lead Interstate in “cost cutting as never before.”[xviii] At the time of his appointment Elsesser acknowledged that more acquisitions might be in the offing. Sullivan noted Elsesser’s ideal background to think about mergers and acquisitions and said, “Most of our growth historically has been mainly through acquisition. It’s very difficult to grow the company without acquisitions. I would say the next level is either making a major acquisition or becoming part of a larger food company. I don’t know what the future holds, but we need to be a larger supplier because our customers are consolidating and they’re becoming larger.” [xix] Retirement and Stock Purchase and Incentive Plans. Interstate had four types of retirement plans. Union employees were covered by multi-employer pension plans. For employees not covered by union plans Interstate maintained a defined contribution retirement plan with contributions based upon a percentage of annual compensation plus a percentage of voluntary employee contributions. The company had also established a Supplemental Executive Retirement Plan (SERP) as of June 2, 2002 as a means of retaining executives and selected senior managers. The plan provided benefits to these selected employees. Benefits were 1.8% of the participant’s final average salary multiplied by the number of years the individual had served with a maximum of twenty years. In 2003 Interstate formed a rabbi trust[xx] to protect the assets of the employees who were participants in the plan. In 1991 Interstate had formed a non-compensatory Employee Stock Purchase Plan for eligible employees. As of May 31, 2003 232K shares remained to be issued under the plan. In addition in 1996 the company adopted a Stock Incentive Plan that permitted the company to grant employees and directors stock awards, including stock options. The options were granted at prices not less than the fair market value at the date the grant was made. On May 31, 2003 three million shares (17.2%) remained to be awarded. The stock options generally vested in one to three years from the date of grant and were granted for a term not to exceed 10 years. (See Exhibit 10 for summary of Interstate’s retirement plans.) Interstate’s Unionized Employees Of the 32,000 Interstate employees approximately 80% belonged to unions. The company managed approximately 550 union contracts with two unions --- the International Brotherhood of Teamsters and the Bakery, Confectionery, Tobacco workers and the Grain Millers International Union. A typical union employee did not have a post-secondary education, but union employment offered opportunity to earn above average wages, participate in a company-paid retirement plan, and receive a paid medical benefit. Typically, union contracts were renegotiated every three to five years. Regarding its contracts the company said, “None of the individual collective bargaining agreements is material to our consolidated operations. However, because our union groups are concentrated in the two organizations…contract negotiation with any local unit can involve the threat of strike by other union members at other IBC facilities.”[xxi] Further, the company noted that its labor costs were higher than non-unionized competitors and “…our ability to implement productivity improvements is lower than in many nonunion operations as a result of various restrictions specific in our collective bargaining agreements.”[xxii] The firm described its relations with its union and nonunion employees as “generally good.” However, thousands of disgruntled Interstate Bakeries had written letters to management complaining about their low pay and under-appreciated work. Employees had established a website www.twinkies.org. Site managers made clear that the “site was not affiliated in any way, nor sponsored, supported or endorsed by Interstate Brands Companies.” And that they had “…decided to create this Web Site to give others an opportunity to present their views and tell their own stories.” A “messboard” on the site gave people opportunity to do so. Postings were identified as coming from a variety of people including employees (not all disgruntled), customers, shareholders, students (where can I get information for a case assignment?), and members of the general public. The first postings occurred in April 2001. One of the earliest postings came from a person, who identified himself as working at the Wayne NJ Interstate facility.

That posting said: When is the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sic).

Employees charged that Interstate management replied to their concerns in a confrontational manner and did not try to rectify any of the employee complaints. There were several employee lawsuits filed. One was a racial discrimination suit filed in San Francisco in which the plaintiffs claimed that management created a hostile working environment, that there was discrimination in promotions, and that there had been there were racial slurs at the San Francisco, Oakland, and San Jose facilities. The court awarded a total of $11 million in compensatory damages to 21 Bay Area employees and $121M in punitive damages to 19 of the plaintiffs. Under appeal the judge reduced the compensatory damages to $3M and the punitive damages to $24M. Financial Results Over the ten years 1994 to 2003 Interstate Bakeries’ revenues rose from $1.1M to $3.5M in 1999 and remained at approximately that level through 2003. The company was profitable every year until 2004. Net income rose from $16M to a high of $128M in 1998 and generally decreased thereafter to $27M in 2003 to the loss in 2004. Meantime, long-term debt had increased almost steadily from $201M to $529M. (See Exhibit 1 for selected financial data.) Partly because of the company’s purchase of treasury stock (See Exhibit 11 for Interstate’s cash flows from operations, investment, and financing activities.), stockholders equity had fallen from a high of $604M in 1999 to $326M in 2003. The company’s available cash had dropped to zero in 1996 and remained there as the company struggled through the next eight years. The company’s production and distribution facilities were high fixed cost operations. In 2004 the company experienced net sales and unit volume declines. In addition to fixed costs, the company’s product costs included ingredients, packaging, energy, and labor. Ingredients and energy had been subject to rapid and difficult to predict changes while the company could adjust its prices much more slowly. The largest cost for the company was labor. Benefits were a significant portion of labor costs. However, as the firm put it, “social welfare costs have been rising more rapidly than inflation…such costs are likely to continue to outpace inflation.” The company had changed its non-union retiree health care costs by revising the contribution levels (effective January 1, 2004). The firm expected the change in policy to save approximately $10M to $12M annually in pre-tax post-retirement benefit expense. Along with its competitors, the company had adopted industry innovations in logistics and computerized inventory control. The financial savings resulting from SOAR were uncertain, although expected to be significant. Even before initiating SOAR, IBC had begun to restructure. For example, during 2003 the company had closed five bakeries and 96 thrift stores in addition to restructuring some of its other facilities. The results of the 2003 restructuring moves were estimated to be pre-tax annual savings of $10M to $12M, a result of reductions of: $6.5M to $8M cost of product $3M to $3.5M selling, delivery, and administrative expenses $450K non-cash depreciation However, the moves had not been sufficient to overcome the company’s languishing profitability. To date in fiscal year 2004, Interstate had announced the closing of an additional three plants (Grand Rapids, MI; San Pedro, CA; and Milwaukee, WI). The continuing benefits from these moves, although promising, were uncertain. The company had suspended its dividend in March 2004 citing a number of factors including the growing popularity of low-carbohydrate diets as a significant reason, and concerns that the auditors would include a paragraph in their report saying, “There may be substantial doubt about the company’s ability to continue as a going concern.”[xxiii] In addition, the company was undergoing an internal investigation focused on the $40M shortfall in the reserve for workers’ compensation claims. As a result of the accounting difficulties, the firm had just announced that its year-end financial statements due at SEC in early August would be filed late, possibly by September 24. In addition, the company’s new CFO, appointed in July, was reluctant to file the certification for the year-end financials. The Sarbanes-Oxley Act required officers certify the filing. Given the uncertainties it was not clear when the company would be in a position to actually submit the filling. [xxiv] [xxv] The FTC had also filed deceptive advertising charges against Interstate. Interstate ran an ad that claimed that Wonder Bread’s calcium content improved children’s brain functions and memory capabilities. However, the FTC found no information or proof backing up these claims. As a result, Interstate was barred from making certain types of health benefits claims on behalf of products unless the firm could provide adequate substantiation. In addition, shareholders had filed seven class action lawsuits. Two of the lawsuits charged that Interstate executives misrepresented material facts about the business, its operations, and its products during a conference call with analysts on September 17, 2001. The lawsuits alleged that the misleading statements led shareholders purchase millions of dollars of stock at inflated prices that had had declined sharply shortly thereafter. The Ralston Purina Stock Holding After Ralston Purina sold Continental to Interstate in 1995, Ralston owned 45% of Interstate’s shares. Under the terms of the deal, Ralston Purina had until September 2000 to reduce its share of Interstate’s stock holdings to 20%. In late July 2000 the two firms renegotiated the agreement. Interstate had previously purchased some of the shares at market price. During summer 2000 Interstate repurchased sufficient shares to reduce Interstate’s stake to 29.5%, and the two firms agreed that Ralston would be required to cut its stake to 15% by Aug. 1, 2004 and to 10% by Aug. 1, 2005.[xxvi] In January 2001 Ralston agreed to an acquisition by international food giant Nestle. Nestle had indicated it didn’t want to retain its IBC holdings. The expectation was that Nestle would offer its 29.5% stake in the market or elsewhere. Part of the difficulty was that Nestle was already encountering difficulties its new acquisition for which it had paid a premium. The Challenge As Elsesser well knew, the challenges facing Interstate were tremendous. He had said, “We have great brands. Our brands give us confidence that the journey will be worthwhile. Hostess, Wonder, Merita, Dolly Madison, Home Price and Drake’s are among the most recognizable brands in the country…The ability to develop and maintain a positive, meaningful, brand image is a major point of difference between IBC and the competition. Brand power is the competitive advantage that we are counting to drive our marketing strategy.”[xxvii] However, he wondered if the time had come to take a different approach to Interstate. Bankruptcy was certainly one option. However, there had been interest in Interstate as a merger/acquisition target in the past. For example, Unilever’s agreement to buy Bestfoods for $24.3B in mid-2000 had triggered heavy buying in Interstate’s stock. At that time Interstate was expected to be a target. Indeed Unilever reportedly considered making a bid for Interstate. In mid-2001 Sara Lee announced its acquisition of Earthgrains at a significant premium. At that time Interstate’s stock took a strong upturn because the rumor mill again had the company pegged as an expected takeover target. At that time a Mexican firm had indicated interest in some quarters about making a bid for Interstate. So, thought Elsesser, which should it be --- bankruptcy or merger/acquisition with another firm. RE: Interstate Bakeries Case Study. Interstate Bakeries is a company facing a number of major issues. The CEO, James Elesser has asked you to provide a recommendation on what his course of action. Addresses the below questions and provides Elesser with a recommendation of what Interstate Bakeries should do. Make sure you look at the financials. You will need to provide some evidence of analysis, by using the data provided in the case, What is the CEO, Elesser trying to achieve with his decisions and actions? Identify what Interstate was trying to do in its restructuring after all the acquisitions?Were they successful? Identify what factors would impede the restructuring. What resources and competences does a Value Chain analysis suggest Interstate has to confront its multiple challenges? Using a Value Chain analysis identify Interstate’s core competences.

Using a SWOT analysis, identify Interstate’s current challenges. Use the Space Matrix to plot strategic options for Interstate Bakeries. What are the relative advantages and disadvantages of merger/acquisition on one hand and bankruptcy on the other? What do you think Interstate Bakeries should do? Exhibit 3 Interstate Bakeries Corporation - Consolidated Statement of Operations Income Statement (000, except per share data) (unaudited) Sixteen Weeks Ended Forty Weeks Ended ---------------------- --------------------- March 6, March 8, March 6, March 8, 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Net sales $1,019,711 $1,045,574 $2,664,524 $2,707,761 Cost of products sold 505,032 522,543 1,309,574 1,320,992 1,022,283 1,044,130 2,620,958 2,626,926 Operating income (loss) (2,572) 1,444 43,566 80,835 Interest expense - net 10,925 12,140 28,172 30,094 Income(loss) before income taxes (13,497) (10,696) 15,394 50,741 Net income (loss) $ ( 6,607) $ ( 6,749) $ 11,710 $ 32,018 Earnings (loss) per share: Basic $ (0.15) $ (0.15) $ 0.26 $ 0.72 Diluted $ (0.15) $ (0.15) $ 0.26 $ 0.71 Average shares outstanding: Basic 44,903 44,783 44,878 44,537 Diluted 44,903 44,783 45,211 45,337 Notes: FY04 3rd quarter included restructuring charges of $1.5M related to the closures and restructurings of bakeries and thrift store locations initiated during fiscal 2004 and 2003. (Year-to-date: $4.2M) Also included a charge of $3M related to a potential settlement of a securities class action. FY03 3rd quarter included restructuring charges of $5M related to the fiscal 2003 closures and restructurings. (Year-to-date: includes $6.5M.) Other charges of $3.6M were related to a common stock award. Consolidated Condensed Balance Sheets (In thousands) (unaudited) March 6, May 31, 2004 2003 Assets ---------- ---------- Current assets 331,504 349,895 Property and equipment-net 815,656 853,473 Total Assets $1,597,351 $1,645,691 Liabilities and Stockholders' Equity Total current liabilities 422,180 425,581 Long-term liabilities 811,745 904,353 Stockholders' equity 333,426 325,757

QUESTIONS:

1. What is the CEO, Elesser trying to achieve with his decisions and actions?

2. Identify what Interstate was trying to do in its restructuring after all the acquisitions?Were they successful? Identify what factors would impede the restructuring.

3. What resources and competences does a Value Chain analysis suggest Interstate has to confront its multiple challenges? Using a Value Chain analysis identify Interstate’s core competences.

4. Using a SWOT analysis, identify Interstate’s current challenges.

5. Use the Space Matrix to plot strategic options for Interstate Bakeries.

6. What are the relative advantages and disadvantages of merger/acquisition on one hand and bankruptcy on the other?

7. What do you think Interstate Bakeries should do?