Despite being caught in a depressed junk market, RJR has few problems except its mountain of debt. Under chief executive Louis Gerstner Jr., the company is doing better than skeptics had predicted. Despite the drooping demand for cigarettes, RJR’s operating income jumped by 50 percent in the first quarter of this year. New food products have hit the grocery shelves–Teddy Grahams Breakfast Bears and Life Savers Holes–boosting revenues by $600 million last year. Raymond Garea, a Donaldson, Lufkin & Jenrette analyst, predicts that for the full year RJR’s cash flow will rise an impressive 24 percent. Dirk Van Doren, a bond analyst at McCarthy, Crisanti & Maffei, says, “The bottom line is it’s a good company.”
What’s not so healthy are about 56 billion worth of junk bonds that helped pay for the acquisition. Unless they can be refinanced, RJR faces huge debt payments next year. The culprit is something known as a reset provision. When Kravis was arranging financing for the takeover, his investment banker Drexel Burnham Lambert advised that to entice institutions to buy the junk bonds, RJR would have to agree to compensate holders for any decline in the value of their bonds by raising, or resetting, the interest payment in April 1991. Since then, the value of RJR’s bonds has indeed fallen. Analysts say that if the RJR bonds were reset at this week’s prices, RJR would owe a hefty 18 percent interest. And it could climb even higher if the junk-bond market worsens by next April. RJR’s junk-bond predicament was probably avoidable. Other companies have issued reset bonds, but most set a ceiling. Market pros believe RJR should have done the same.
KKR thinks it has a solution: buy back most of the troublesome bonds, using new equity from KKR’s partners and an additional $2.25 billion loan from the banks. Bank debt usually carries a far lower interest rate than junk bonds. Although lending to leveraged buyouts is out of vogue, the banks will likely look with favor on KKR’s proposal. Since the buyout, RJR has sold a number of assets–like International Nabisco Brands and Del Monte Foods–for prices higher than expected. That enabled RJR to keep businesses it intended to sell, such as Planters LifeSavers. RJR has also slashed $550 million in annual costs by, among other things, eliminating 2,300 jobs in its North Carolina tobacco factories, half the corporate staff and six corporate jets. The KKR plan still faces many hurdles. Yet Henry Kravis intends to show that debt isn’t necessarily bad–it just needs to be handled with care.
