Equity Analysis and Valuation of: Pactiv Corporation

Transcription

1 Equity Analysis and Valuation of: Pactiv Corporation Analysis Team Will Armistead Josh Bell Nick Davis Lance Harwell Brandon Newman Matthew Vorpahl

2 Table of Contents Executive Summary 3 Business and Industry Analysis Company Overview 8 Industry Overview 9 Five Forces Model 11 Rivalry Among Existing Firms 12 Threat of New Entrants 17 Threat of Substitute Products 22 Bargaining Power of Customers 24 Bargaining Power of Suppliers 26 Key Success Factors 29 Cost Leadership 29 Differentiation 31 Competitive Advantage Analysis 33 Accounting Analysis 39 Key Accounting Policies 40 Potential Accounting Flexibility 48 Actual Accounting Strategy 53 Quality of Diclosure 57 Qualitative Analysis 58 Quantitative Analysis 59 Sales Manipulation Diagnostics 61 Expense Manipulation Diagnostics 65 Potential "Red Flags" 73 Undo Accounting Distortions 75 Financial Analysis, Financial Forecasting, and Cost of Capital Estimation Financial Ratio Analysis 77 Liquidity Ratios 77 Profitablitiy Structure Analysis 86 Capital Structure Analysis 92 Forecasting of Financial Statements 98 Income Statement 98 Balance Sheet 99 Statement of Cash Flows 99 Cost of Capital Estimation 100 Cost of Equity 100 Cost of Debt 103 Weighted Average Cost of Capital P age

3 Valuation Analysis 106 Method of Comparables 106 Trailing Price to Earnings 107 Forward Price to Earning 108 Price to Book 109 Price Earnings Growth 109 Price to EBITDA 110 Enterprise Value to EBITDA 111 Price to Free Cash Flows 112 Intrinsic Valuations 113 Free Cash Flows Model 113 Residual Income 115 Long Run RI 117 Abnormal Earnings Growth 119 Appendices 123 References P age

4 Executive Summary Investment Recommendation: Overvalued, Sell as of April 1, 2008 PTV-NYSE (April 1, 2008) $27.25 Altman Z-Scores Week Range: Revenue: 3.38 B Market Capitalization: 3.14 B Shares Outstanding: M Actual Price (4/1/2008) Percent Institutional Ownership: 89% $27.25 Book Value Per Share: 9.4 ROE: 29% Financial Based Valuations ROA: 9% Trailing P/E: $24.88 Forward P/E: $29.34 Cost of Capital Estimate: R 2 Beta Ke P/B: $ Month % P.E.G.: $ Month % P/EBITDA: $ Year % EV/EBITDA: $ Year % P/FCF: $ Year % Back Door 15.95% Intrinsic Valuations Published Beta: 0.6 Discounted Dividend: N/A Free Cash Cost of Debt: 6.07% Flows: $5.84 Back Residual CAPM Door Income: $6.95 WACCbt 8.29% LR Residual Income: $12.22 WACCat 7.37% A.E.G.: $ P age

5 *Charts taken from Industry Analysis Pactiv is currently traded on the New York Stock Exchange and has existed since November of 1999 when the company separated from Tenneco. Their current market cap is at $3.71 billion. Pactiv is a company that manufactures consumer and food service/food packaging products. About 33% of Pactiv s sales come from the consumer packaging industry while about 67% come from the food service/ food packaging portion of the company. The company owns brands of consumer products such as Hefty and EZ Foil. They also own 39 manufacturing and 8 distributing facilities throughout North America, as well as facilities in China, Germany, and the United Kingdom. Pactiv competes with thousands of other companies within the packaging industry. The complete industry makes up a $124 billion market. Some of the main competitors include Bemis, Sealed Air, AEP Industries, MeadWestvaco, and Johnson and Johnson. The industry faces a high level of rivalry among existing firms and a high level of bargaining power of customers. Conversely, the industry faces a low treat from new entrants and a low level of bargaining power of supplier. The threat of substitute products is at a moderate level. The main areas of business that companies within the industry compete are cost leadership and differentiation. With cost leadership, companies attempt to lower their input costs in order to increase their profit margins and/ or decrease the cost to their customers. Within the packaging industry, cost leadership can be achieved through economies of scale and scope, lower input costs, low cost distribution, and research and development. The differentiation aspect calls for companies to produce unique, specialized products that no other firm is producing. The industry uses research and development, flexible delivery, superior product variety, and brand image to create differentiation. 4 P age

6 Accounting Analysis Accounting analysis is the analysis of a company s financial statements such as the income statement, balance sheet, and statement of cash flows. These financial statements are acquired from the company 10-K. This analysis is important when valuing a company because it allows an analyst to view their accounting policies, accounting strategies, and the level of disclosure provided by the company. In order to figure this out, an analyst should identify the key accounting principles, assess accounting flexibility, evaluate accounting strategy, evaluate the quality of disclosure, identify potential red flags, and undo accounting distortions. For our analysis of Pactiv, we first wanted to figure out what their key accounting policies were. We determined that some of the key accounting policies included lease, goodwill, research and development, and pension liabilities accounting policies. Next, we wanted to find how much accounting flexibility the company has. We came to a conclusion that there is little to no flexibility when accounting for research and development, a relatively high level of flexibility for lease accounting, a low level of flexibility for goodwill, and moderate to high level of flexibility for pension plan accounting. The third step in this process is to evaluate the actual accounting strategy of Pactiv. This step plays off the first two steps and uses them to determine the strategy of the company. We came to the conclusion that Pactiv s accounting strategy is in line with GAAP with respect to research and development and that it is fairly straight forward with lease accounting. We realized that Pactiv uses an aggressive accounting strategy to calculate pension plan expenses and the company follows GAAP policies with respect to goodwill accounting. In order to evaluate the quality of disclosure for Pactiv, we performed a qualitative and quantitative analysis. With the qualitative analysis, we came to the conclusion that while they fit in with the rest of the industry, Pactiv s disclosed information may not be 100% accurate. To determine the quantitative analysis, we ran sales manipulation diagnostics as well as expense manipulation diagnostics which lead us to believe that they have not attempted to manipulate any of their numbers. 5 Page

7 The fourth step, identify potential red flags, is somewhat simple for Pactiv because many of these red flags are explained within the 10-K. Two potential red flags that we did discovered, however, include one about with the acquisition of Prairie Packaging and the other is about the assumptions they make regarding post-retirement obligations. The final step is to undo accounting distortions. In the end we concluded that there were no major distortions and that this step was somewhat irrelevant when analyzing Pactiv s accounting strategies. Financial Analysis, Financial Forecasting, and Cost of Capital Estimation In order to analyze a company, investors and analysts must look at financial information of the company and its competitors. First, we examined the financial ratios of the industry and individual companies, comparing them to those of Pactiv. For this, we calculated numerous ratios regarding the liquidity, profitability, and capital structure of Pactiv. We concluded that Pactiv s liquidity ratios are closely tied to those of the industry, their profitability ratios tend to be at or above those of the industry, and their capital structure ratios are among the best in the industry. Our next step was to forecast the financial statements of Pactiv. The first statement we forecasted was the income statement. We assumed a 5% growth rate of sales and calculated that in 2017 Pactiv will have $5, million in total revenue and $ million in net income. We then forecast the balance sheet and calculated that by 2017, Pactiv will have $1,778 million in total current assets and $6,091 million in total assets. Lastly, we forecast that in 2017 PTV will spend over $281 million on financing activities. Our next task was to estimate the cost of capital for Pactiv. In order to calculate the cost of capital, we had to figure out the cost of equity and the cost of debt. We utilized two different methods to find the cost of equity: CAPM and a back door method. CAPM gave us a cost of equity of 9.92% while the back door method gave us a cost of equity of 15.95%. We then averaged the two numbers together and came up with a cost of equity of 12.97%. Next, our cost of debt calculations gave us a rate of 6.07%. Finally, we calculated the weighted average cost of capital, before and after 6 Page

8 taxes, for both methods. For CAPM we came up with numbers of 8.29% before taxes and 7.37% after taxes. For the back door method we calculated 11.75% before taxes and 10.83% after taxes. Valuation Analysis The final step to properly analyzing a company is to complete a valuation analysis. This process uses a couple of methods in order to determine if a company s stock price is undervalued, fairly valued, or overvalued. We began our valuation analysis by using the method of comparables. This method is not completely accurate for multiple reasons. However, we went ahead and calculated the ratios anyway. The results we came up with were all over the place. Assuming a 20% margin of error, our calculations from the price to book ratio, price earnings growth ratio, and the enterprise value to EBITDA ratio all show that Pactiv is overvalued at its current market price of $ The trailing P/E ratio, forward P/E ratio, and price to EBITDA ratio show that Pactiv is fairly valued, and the price to free cash flows ratio shows that the company is undervalued. We were unable to calculate Pactiv s dividend yield ratio due to the fact that the company has never paid dividends. The second method of valuation was to compute the intrinsic values for Pactiv. These values are much more accurate than the method of comparables ratios because they are backed by theory. They are calculated using the forecasted financial statements. Once again, however, some are more useful than others, as we were unable to calculate the discounted dividends model because of Pactiv s lack of dividend payouts. Our calculated numbers were much more similar than those of the method of comparables. All four of the intrinsic values that we came up with show that Pactiv is HIGHLY overvalued. The closest value to the market share price was the long run residual income calculation, which yielded a $12.22 share price. That means that Pactiv is overvalued by about $15. 7 P age

9 Company Overview Pactiv Corporation has undergone several changes since its inception. Incorporated in Delaware under the name Packaging Corporation of America in 1965, it originally operated as a subsidiary of Tenneco Inc. Later in 1995, they changed their name to Tenneco Packaging Inc. Finally, in November of 1999 the company became independent of Tenneco under the present title of Pactiv. Having sold virtually all of its protective- and flexible-packaging businesses in 1995, Pactiv competes primarily in the realms of consumer and foodservice/food packaging. The consumer products they produce include trash bags, food-storage bags, and disposable table and cookware. They market these products under such brand names as Hefty, Kordite, EZ Foil, Kitchen Fresh, Easy Grip, OneZip and so on. Though these are consumer products, Pactiv does not sell these items directly to the end consumer. They instead use a network of various retailers, including grocery stores and the industry giant Wal-Mart. On the foodservice/food packaging side their product line is comprised of items such as plates, bowls, cups, takeout-service containers, foam strays for meat and produce, molded-fiber egg cartons, aluminum containers, and dualovenable paperboard containers. For the most part, the company uses a direct sales force to get these products to customers who include supermarkets, restaurants, food processors, and other foodservice institutions. Pactiv is a decent sized company with over $2.7 billion in assets. It is not surprising to find that Pactiv, as of 2006, operates 39 manufacturing and 8 distribution facilities across the U.S., Canada, and Mexico (10-K). Internationally, the company has three manufacturing facilities in China, one in Germany, and a distribution center in the United Kingdom. However, the locations in China, which are joint ventures, are only partially owned. All of these facilities are under the leadership of the corporate headquarters located at 1900 West Field Court, Lake Forest, Illinois The following chart portrays the size of the company by total assets and sales, and the growth of the company by sales. 8 P age

10 (in thousands) Total Assets Net Sales Sales growth 2.42% % 6.94% 8.33% 5.84% Pactiv is traded on the NYSE and has a current market cap of $3.71 billion. Its stock price has decreased in the first quarter of 2008 but has done well in the past 5 years when compared to its competitors. The graph below further illustrates this point. Industry Overview Pactiv competes in the packaging and containers industry which is a large, fragmented market with thousands of competitors such as Bemis, Sealed Air, AEP Industries, MeadWestvaco, and Johnson and Johnson. Since the industry is very fragmented, firms often compete in more than one area of the industry. This causes companies with different business models to compete with each other s products on the shelves but not as companies in general. In the U.S., the industry makes up a $124 billion market, mostly through the sales of paperboard and plastic products. Of this, 9 P age

11 35% of the domestic market is driven by the sale of plastics ( Companies such as Johnson and Johnson (JNJ) and MeadWestvaco (MWV) are two of the main competitors for Pactiv in its consumer products segment, but in 2006 the company only generated 37% of its total sales from this segment. While this is a significant amount of sales, it is not the area which PTV makes most of its money. The other companies in this segment are focused on different areas of the business, as JNJ states, its products are used in the healthcare field (JNJ k). JNJ classifies its similar products under its other franchise which includes many other consumer goods and makes up less than 10% of the company s total sales. Meanwhile, MWV produces paper packaging goods which are used for purposes different from those made of plastic and do not directly compete with PTV s products. In addition to these factors, these two firms are much larger in size than Pactiv which is shown by both total assets and total sales. Due to these reasons, they will not be considered as direct competitors of Pactiv as a company. Total Assets (in thousands) Pactiv 3,412 3,706 3,741 2,820 2,758 MeadWestvaco 12,904 12,470 11,646 8,908 9,285 Johnson and Johnson 40,556 48,263 53,317 58,864 70,556 Total Sales (in thousands) Pactiv MeadWest Johnson and Johnson P age

12 However, JNJ s emphasis on research and development forces pressure on companies in the industry to use methods of differentiation in order to maintain current market share. This must be taken into consideration when determining the level of differentiation in the segment. The industry s growth rate is closely related to the specific growth rates of packaged products. Growth rates within the industry range from 3.2%-5%, more specifically, the food industry averages just below 4% annual growth which indicates the food packaging industry growth is near that ( The other segment PTV operates in is the foodservice/food packaging industry. This segment accounted for the remaining 63% of sales for the company in 2006 and is the primary market in which the firm competes (PTV k). The companies that compete in this specific segment of the industry and those that will be used for comparison are Bemis, Sealed Air, and AEPI. Globally, food packaging accounts for nearly 40% of all packaging services and therefore represents a large portion of the total industry ( Ultimately, the true industry in which Pactiv competes is very unique and while some competitive forces come from conglomerates, the bulk of competition can be attributed to very similar firms. This analysis will provide accurate industry segment information that will be beneficial when the companies are further compared to one another. Five Forces Model The initial stage of valuing a company is to analyze the industry in which the company competes. The Five Forces Model is a very useful technique used when determining the factors which create value for the firm and what drives a firm to becoming successful. The model breaks the industry down by determining the degree of competition in a firm and the bargaining power of both buyers and suppliers. The degree of competition is analyzed by looking at the rivalry among existing firms, the 11 P age

13 threat of new entrants, and the threat of substitute products. This information allows the analyst to gain a comprehensive understanding of the industry in which the company competes and allows further insight towards the background for which business decisions are based. The bargaining power of customers and suppliers affects the actual profits within an industry as a firms influence on these forces is directly related to their profitability. Rivalry Among Existing Firms High Threat of New Entrants Low Threat of Substitute Products Moderate Bargaining Power of Consumers High Bargaining Power of Supplers Low Rivalry Among Existing Firms Rivalry among existing firms determines whether the companies in the industry are severely competing with one another, creating a low cost environment, or if companies are more focused on improving existing products. Factors used to determine the amount of rivalry include industry growth, concentration, differentiation, fixedvariable costs, excess capacity, exit barriers, and economies of scale. Industry Growth The amount of growth an industry experiences plays a large part in determining the amount of competition within that industry. Established industries with little industry growth experience high levels of competition on market share because the only way for the company to grow is for the company to sell to a larger amount of consumers. Since the size of the industry is staying relatively the same, firms must compete for market share. However, firms with rapid industry growth do not have to worry about market share and experience less price competition and overall competition. The packaging industry experiences relatively low industry growth rates with an average around 6% 12 P age

14 increase from year to year. The following chart shows the growth rate for the industry in the past five years. This indicates that the environment in which these companies compete has little growth and thus pressures companies to compete for market share. This indicates that the packaging industry in review has high expectations for strong price competition. In conclusion, the low growth rate in the industry indicates that there is a high level of competition amongst the firms in order to expand their market share. In order to successfully gain market share the firms must compete by offering their products at lower costs. Concentration In order to determine the amount of concentration in an industry, the number of firms and their relative size must be taken into consideration. If the industry is composed of many relatively small firms, extreme price competition can be expected. If there are a few firms of equal size, then price collaboration becomes a factor. An industry that consists of a single powerhouse can expect monopolistic-like prices because the firm is able to control the rules of the industry. Companies that cannot compete with the others by either offering competitive, low prices or specialty products 13 P age

15 eventually exit the industry. The chart below shows the market share allocation for the industry. Market Share (% of industry sales) Pactiv 32.20% 26.13% 26.00% 24.95% 24.96% Bemis 26.48% 28.95% 28.97% 31.44% 31.14% Sealed Air 35.82% 38.79% 38.82% 36.98% 37.03% AEP Industries 5.50% 6.13% 6.21% 6.63% 6.86% This information illustrates the number of firms in the industry as well as their size relative to the industry. The amount of competitors prevents any price fixing and the lack of competitive advantage from superior market share shows there is not a single dominant firm which dictates competition. Overall, the effect of multiple, equally-sized firms are a fragmented industry which will put extreme pressure on price competition. This will ultimately force firms to have price wars in order retain and grow market share. Differentiation A firm s ability to distinguish themselves and their products from others in the industry is known as differentiation. This often relies on brand image and can allow for companies to charge higher prices to consumers on the basis of improved quality or function. However, since most products produced in this industry are specifically designed for the product in which they will package, there is little room for differentiation. The requirements are often set forth by the buyers and companies, therefore, must compete on cost. Companies in the industry have found ways to differentiate their products and establish brand recognition through the level of quality 14 Page

16 products, especially in the consumer goods market. This further shows the high level of competition for market share in the industry as firms will try anything to find a niche market. Overall, the level of differentiation in the packaging and containers industry is low and further increases the demand for low cost products. Since there is little differentiation, firms within the industry directly compete with similar products and therefore must increase market share through price competition. Fixed-Variable Costs Companies which have large amounts of assets usually have high fixed costs and because of this, have motivation to offer lower prices in order to exploit large capacity and low variable costs. Firms with lower fixed costs tend to have a lower maximum capacity and higher variable costs but have a higher profit margin, especially when price competition is high. However, firms with higher fixed cost are able put downward pressure on prices through their capacity. This is most apparent in the foodservice packaging sector of the industry as there is little differentiation in products and most competitors are relatively small in size. Overall, the fixed-variable cost plays a large role in the level of competition among existing firms because many firms have large amounts of assets on their books and high fixed costs; while some have lower fixed costs and therefore have higher profit margins. This difference of business strategy adds to the level of rivalry among existing firms because companies in this industry face competition on both fronts of the fixed-variable cost ratio spectrum. Excess Capacity Excess capacity is created when the supply of resources exceeds the demand. Excess capacity is also created when there are too many suppliers producing goods while the demand is still low. This further creates competition between the firms because the lack of equilibrium between supply and demand places severe pressure on prices to fall. In the packaging and containers industry there are very many suppliers, 15 Page

17 but sometimes there is an industry-wide shortage. Due to the threat of a shortage, firms tend to use most of their resources. For these reasons, we feel that the threat of excess capacity is relatively low. Exit Barriers Exit barriers are what make it difficult for an existing firm to leave an industry. If companies are required to front a large amount of capital or obtain expensive permits, it makes exiting the industry very difficult. The packaging and containers industry relies heavily on plastics, and therefore the oil industry. Companies in this industry invest a great amount of money into the capital necessary to produce plastic from oil. As shown in the chart, nearly 45% of total assets are on the books under building and equipment for the top five competitors in the packaging and containers industry (10k s). This shows the large amount of capital needed to be a force in this industry and the degree of difficulty firms have in exiting the industry. This ultimately affects the price of products because the abundance of supply creates downward pressure on prices, especially with the addition of low switching costs. So, the exit barriers are high due to the costliness of exiting the industry. Economies of Scale Firms that compete in industries which require a large amount of capital and technology enjoy the benefits of economies of scale since the long run average cost of their products decreases over time. An industry that is affected by economies of scale will experience strong competition over market share. Asset P age

18 Turnover Pactiv Bemis Sealed Air AEP Industries In order to make profit in this industry, and remain competitive firms must be able to use the advantage of scale economies to reduce costs. The above chart shows the asset turnover for the packaging industry. The low numbers show that for each dollar of assets few sales are generated and in order to create large sales, firms must be able to put forth large amounts of assets. Since these assets create few sales, firms must focus on gaining market share which further increases the level of competition in the industry. Conclusion In general, the packaging and containers industry faces high competition among rivals. The high concentration of large companies, lack of differentiation between products, and low industry growth rates all lead to increased competition by forcing prices to remain low. In addition, the benefits of economies of scale and moderately high exit barriers further increase the need for low cost production. Threat of New Entrants The threat of new entrants is important to the five forces model because an existing company s profits can be cut into by a new entrant. A new entrant would seek entrance into a particular industry if they see the possibility of earning large profits. Due to several factors in the packaging and containers industry, there is a low threat of new firms entering into the market. Not to say that there is not an attraction to enter into this industry, but survival as a new entrant would be difficult. One of the factors related 17 Page

19 to low threat of new entrants is the amount of capital required to enter into the industry. Entry into this industry would require a large sum of capital which is not usually readily available to up and coming firms. A large established firm with hundreds of millions of dollars in assets has little to worry about concerning new entrants. The key factors in the threat of new entrants to the packaging and containers industry are economies of scale, first mover advantage, relationships, and legal barriers. Economies of Scale Economies of scale become an important factor when considering entering into the competitive packaging and containers industry. A big part of this is the amount of capital a firm is willing to invest. With firms that already exist in the market that are established and have millions of dollars in capital invested, there is little room for smaller firms looking to enter the market. If a firm starts with less than necessary capital to compete with the established firms, the established firms would have a strong advantage. The new entrants with insufficient capital would suffer in different areas such as plant and equipment and costs of raw materials. One huge factor affecting this industry already is the rising price of oil which has a direct affect on cost of raw materials. Packagers are heavy consumers of petrochemicals, which are basically plastic. (Forbes.com) Therefore, the price of oil and price of plastic are directly related. Another example of this is exemplified in this quote: instability in the world markets for petroleum and natural gas could adversely affect the prices of our raw materials. (AEP Industries Inc. 10-K) This shows that oil prices are already affecting major players such as AEP, Pactiv, and Bemis in the packaging industry. It would be hard for a small firm with insufficient capital to combat the rising prices of oil. In conclusion, with established companies having assets of this magnitude, new entrants would be at a disadvantage with insufficient assets, or trying to put forth enough capital to compete. Here is a look at existing firms total assets: 18 P age

20 Total Assets (in millions ) Pactiv Corp. $ 3, $ 3, $ 3, $ 2, $ 2, AEP Industries $ $ $ $ $ Bemis Co. $ 2, $ 2, $ 2, $ 2, $ 3, Sealed Air Corp. $ 4, $ 4, $ 4, $ 4, $ 5, First Mover Advantage Another factor that becomes important in the packaging and containers is the first mover advantage. The idea of a first mover advantage basically means that those who are first to enter into an industry can possibly gain an advantage over firms that desire to enter into the industry in the future. Certain advantages can be that first movers can set the bar when it comes to standards and can obtain an advantage in pricing with suppliers of raw materials. Within the packaging and containers industry, there already exist certain standards and expectations. Along with these standards comes a reputation that has already been established within the market. Most firms already in the industry have established brand names. As far as raw materials, a new entrant would not be able to gain a first mover advantage. After looking at 10-K s of existing firms, most firms noted that their respective raw materials, which in most cases was some form of plastic, was readily available from a wide variety of suppliers. Therefore, a new entrant is going to have the same option as the existing firm, and will be unable to gain any sort of pricing advantage in this area. Also, it was noted that there is sometimes an industry-wide shortage of certain plastics. In this scenario, the already established firm probably has an advantage over a new firm because the suppliers would be more likely to supply the larger firm. Also, a first mover advantage exists in a learning economy. This is an established industry and an established firm with more money to allocate to research and development. Since an existing firm would have more to allocate, they could develop new products and improve existing products. In this case, the existing firms would have a significant 19 P age

21 advantage over a new entrant. In summary, due to various factors a new firm would find it hard to gain a first mover advantage. Access to Channels of Distribution As a new entrant, one of the primary keys to success is gaining access to the channels of distribution that will be responsible for getting the product to the consumer. Without these channels, it would be highly unlikely for new companies to be able to operate as planned. Currently, the majority of the packaging and container industry s business comes from grocery stores and similar operations requiring food to be packaged. The hard part for new entrants is convincing the distributors to start carrying their product instead of their competitors. Thus, while popular brands are already on the shelves, new entrants would find it hard to gain shelf-space in a grocery store or supermarket. The industry has not experienced any major, consistent growth periods in the past several years which is indicative of companies battling for market share. Companies in this industry rely heavily on establishing and maintaining relationships between the supplier and distributor. Consequently, forming a strong, new relationship with distributors may be difficult. This means that the distributor will not drop one of the new entrants competitors unless the new entrant presents a more profitable option. Another problem is that the competition already has their name out in the public, so it would be hard for a new entrant to acquire customers within the food packaging industry. However, for this industry in particular, there is only a certain amount of ways that food can be packaged. This is good for new entrants because the cost of switching products is relatively low to the consumer. Also, the packaging industry is not only confined to packaged food, but many other markets as well; like packaging for electronics, medical products, and lawn and garden. To succeed, a new firm would need to look into markets that haven t already been taken by existing companies. 20 P age

22 Relationships Forming strong relationships between a firm and its customers is important when looking to become a new entrant into an industry. A big challenge for a new entrant would be to form a strong relationship with customers. Currently, a bulk of the packaging and container industry s business comes from grocery stores and from packaged foods. Thus, with popular brands already on shelves, new entrants would find it hard to gain shelf-space in a grocery store or supermarket. Also, strong relationships are already formed between existing firms and other industries that require packaging, like the packaged food industry. To succeed in this industry, a new entrant would need to seek relationship in areas where the existing firms do not already have strong relationships formed. Legal Barriers Legal barriers can have a big part when a new firm is looking to enter into an existing industry. One legal barrier is most of the existing firms in the packaging and containers industry has patents to protect their right to make or sell their existing products. Also, existing firms have trademarks on their established name or symbol. For example, Hefty is trademarked by Pactiv Corp. While these common legal barriers such as the patent and trademark exist within the industry, a new entrant could still work around these legal barriers. If able to work around these legal barriers, a new firm could possibly gain entry into the industry. Conclusion In conclusion, the threat of a new entrant into the packaging and containers industry is relatively low. The capital required to compete with existing firms is very high. Subsequently, a new entrant would find it difficult to come up with the large sum of capital required to enter this industry. Furthermore, we think that a new firm would not be able to gain an advantage by being a first mover when it comes to suppliers and standards. Also, a new entrant would seek channels of distribution which many are already dominated by the existing firms. In our opinion, a new entrant would also be 21 Page

23 hard pressed to form strong relationship with customers. However, legal barriers are an area where we think that a new entrant would be able to make it. Overall, a new entrant would have trouble succeeding within the packaging and containers industry. Threat of Substitute Products Firms in the consumer and foodservice/ food packaging industry must constantly consider the threat of substitute products. A substitute product is a product which accomplishes roughly the same task as another product. Although not every product within the industry is exactly the same, there are many similarities. However, the slight differences that do exist can alter the consumer s decision on which product to purchase. One possible product that could be considered a substitute product to the plastic packaging industry would be paper goods. Consequently, firms must do what they can in order to create as much value as possible. Several factors add to this value, including the relative price and performance of the product, as well as the buyers willingness to switch between substitute goods. Relative Price and Performance In many industries, consumers with only a basic knowledge of a product relate price with quality. If two similar products are side by side, but one costs more than the other, a general assumption is that the more expensive of the two is a better quality product. Since consumer packaging products are often found on the shelves of retail stores, consumers see this scenario on a regular basis. Often times, stores will also have their own brand of these goods on the shelf next to name brand products at a cheaper price. Thus, a certain level of price sensitivity is very important. The plastic packaging industry also needs to deal with price sensitivity when it comes to paper goods. For example, if the consumer only plans on using the packaging for a short period of time or for a minor task, they will not necessarily care that a plastic bag will keep the item fresh. Thus, if a paper bag will cost them a nickel and a plastic bag will cost them a dime, it would not make much sense for them to use the plastic bag. 22 Page

24 At the same time, performance is very important. If consumers realize that one product does not perform to their satisfaction, or even to the level of the other products, then they will cease purchasing said product, and vice versa. Correspondingly, the foodservice and packaging portion of the industry also factors in price and performance when making their purchasing decisions. It would not look good for them if the packaging on their products failed. So making the best decision on whom to purchase packaging products from is very important. Buyers Willingness to Switch As previously stated, many of the consumer goods produced within the industry can be found side by side on store shelves. This makes it very simple for customers to switch between brands. For some customers, it could take as little as a $0.05 difference to convince them to switch from one brand to another. This is where factors such as brand loyalty really come in to play. Customers in the foodservice and packaging part of the industry have a higher switching cost. Instead of being able to make instant decisions, these firms have to do some research to find out which company offers the best product. This can cost a lot of time and money. Also, the purchasing firm may be tied in to a certain producer with numerous contracts. These contracts may prohibit the firm from purchasing from other producers or may have a fixed quota on the amount the firm purchases. Conclusion The consumer packaging portion of the industry has a fairly significant threat of substitutes within the industry. The availability of these substitutes and a lack of any considerable switching costs within the consumer and foodservice/ food packaging industry will force firms to be aware of competitors prices and quality. On the other hand, the foodservice and food packaging portion of the industry has a moderate threat of substitutes. Overall, the industry in its entirety has a moderate threat of substitutes to worry about. 23 P age

25 Bargaining Power of Customers In the United States alone there are close to sixteen thousand producers of plastic and rubber products (First Research.com). With such a large number of producers, making what is essentially a commodity, low, competitive pricing is a necessity. Additionally, plastics used for food preparation, transport, and storage are used by virtually everyone. Such a large user base requires that most of these producers distribute their products through large retailers which buy in bulk. This distribution method as well, leads to lower pricing. The existence of these industry dynamics leaves the power to bargain primarily in the hands of the customer. Price Sensitivity Price sensitivity is a term used to describe how willing a customer is to haggle over the price of a good or service. Within each industry, customers are characterized as either high or low price sensitive. High price sensitive customers will more readily switch from one product to another when: 1) the price of the former is greater than the latter, 2) the cost of switching is negligible, and 3) the products, for the most part, are undifferentiated. The packaging and container industry has almost exactly this type of customer constituency. With several large producers to choose from, switching from one product to another is simply a matter of customer preference. In regards to differentiation, the containers and packaging used in this industry are generally not really meant to have a long life cycle. This focuses customer attention away from the so called bells and whistles of a product and more on whether or not it serves its intended purpose, thus reducing the influence of differentiation. Basically, a box is a box; a bag is a bag, and so on. Another determinant of customer price sensitivity involves the impact a product has on a customer s cost structure. As was mentioned earlier, large retailers are one of the main customers in this industry. These large businesses carry not only packaging and container products, but a myriad of other products as well. Therefore, packaging 24 P age

26 and container products do not make up a huge part of their costs. Normally, customers in this situation would be low price sensitive. However, because of the nature of the retail business, which quite often competes on price to secure their own client base, these customers are the exact opposite. The final determinant of price sensitivity is product quality. That is, how much the product influences the quality of the customer s product. In the case of the retailer, it s a matter of carrying the same range of products as the competition. Aside from this, the best rule of thumb for the packaging industry is a box is a box. Because product quality does not hold that much weight, customers in this industry are high price sensitive. Relative Bargaining Power Relative bargaining power is used to examine how able customers in an industry are to drive down the price of products. There are several factors that must be looked at when determining customer bargaining power. The first is the customer to supplier ratio. There is not exactly a hard and fast rule to this ratio. For example, an industry could have a high customer to supplier ratio, but this does not necessarily mean that the customers will have more power than the suppliers. Good examples would be industries that produce highly coveted, scarce products such as diamonds. In addition to this ratio we look at the volume of purchases by each customer. Many times, the more a customer buys the more able the customer is to bargain on price. This is the case for the package and container industry, whose customers include car manufacturers, grocers, Wal-Mart, and virtually any large volume producers one can think of. Another important aspect to analyze is the number of alternative products available to the customer. When it comes to packaging and containers, one could choose, for instance, a metal container or a plastic container, a plastic bag or a paper bag etc. Some suppliers in this industry may offer a metal one while another offers only a plastic one. This abundance of alternatives allows customers to switch more easily from one product to another. The result is a customer base with more bargaining 25 Page

27 power. Additionally, with many suppliers to choose from, customers need only concern themselves with timeliness and logistics when considering their switching costs. This again results in customers having more bargaining power. The last aspect to consider is the threat of backward integration. Often times, large, high volume producers will buy out their suppliers. However, this generally happens when the company they buy out accounts for a considerable portion of their product cost. Generally, packaging does not contribute a great deal to customers product cost, so this threat is not of much concern. Conclusion According to both price sensitivity and bargaining power analysis, we have come to the conclusion that the customers in the packaging and container industry are highly price sensitive and hold most of the power with which to bargain. This coupled with the fact that there are several large competitors, means that producers in this industry must, first and for most, be price competitive. Bargaining Power of Suppliers The influence that a supplier has to set their prices in the market is the easiest way to describe the bargaining power of that supplier. Every market has a varying degree of supplier bargaining power which has effects that reach all the way to the bottom level consumer. Suppliers tend to be more powerful when there is a high degree of differentiation between products, a lack of substitute suppliers, and substitute products for would-be buyers to select from. On the other hand, suppliers are left somewhat powerless to control the market when there are a large amount of similar suppliers trading the same goods with little differentiation. The bargaining power of suppliers is an essential element to any market that trades in commodities, and the plastic resins market is no different. Like most commodity markets, however, the suppliers have little power to set their prices due to several contributing factors. 26 P age

28 Differentiation A typical manufacturer in this market would derive anywhere from 60% to 90% of their sales revenue from products that are constructed of different types of plastic resins, primarily polystyrene, polyethylene, and polypropylene, all of which are derived in some form from refined petroleum. What is somewhat unique about the plastic resins market is the extremely small product differentiation due to the fact that plastics are composed of a very exact and consistent chemical makeup and structure. This alone makes the bargaining power for plastics suppliers moderately low, even though there are relative grades of quality, most buyers would contend that plastics are plastics in most scenarios. Polystyrene prices for 2007 (price/lb) Switching Costs Supplier switching costs for corporations in this market remain very low because of the sheer amount of chemical suppliers, which numbers several hundred in the United States alone. What is interesting about the plastics market is that most companies do not have a single supplier at any given time. In fact, much of the buying and selling that occurs in this market remains anonymous. In theory one company could be purchasing surplus pounds of Polyethylene from one of its competitors and not even be aware of the situation. This degree of anonymity really reduces the power that suppliers hold because each company is essentially looking for the lowest bid depending 27 P age

29 on the type and amount of resins they require. In addition, since quality is almost uniform among the available suppliers, there is a lack of supplier loyalty among buyers. Perhaps the single most important factor in the prices of plastic resins is the concurrent price of oil and hence petroleum, which the majority of these resins are produced from. With fluctuations in the oil market, created by geopolitical situations or natural disasters for example, come fluctuations in the prices of plastic resins. The volatile conditions of the plastics market have a trickledown effect that reaches all the way into the average consumer s pocket. This occurs because most companies in this industry tend to mitigate higher raw material costs with increases in the purchase prices of their products rather than take the full hit themselves. Most companies that make heavy use of plastic resins keep a scrutinizing eye on the raw materials market in order to better plan and forecast for increased costs. In this sense the suppliers do hold a small amount of bargaining power because what they pay is heavily dependent on extraneous factors that they do not control. Companies will adjust their prices accordingly, essentially leaving it up to the buyers to cut costs or raise prices, albeit while still staying price competitive with other suppliers who share the same volatility issues. The volume of the plastics exchange market regularly reaches between ten to twenty-five million pounds traded each week, sometimes reaching upwards of fifty million pounds. This is just through the plastics exchange, which means that resin is readily available in high quantities ( Conclusion With all of these factors taken into consideration, one can infer that the plastic resin commodities market is a very fluid and volatile one, constantly changing based on several factors. This uncertain and uncontrollable market gives suppliers a small amount of bargaining power, but this is mostly nullified by the other attributes of this market which include low switching costs for buyers and low differentiation between products, as well as a large amount of suppliers and a huge volume of commodities traded each week. 28 Page

30 Key Success Factors In the packaging and containers industry a firm can create value in various ways. This particular industry has a significant degree of competition among numerous existing firms. Being able to gain a competitive advantage is crucial when trying to create value for a particular firm. The more sources of value creation the better for a firm because it allows the company to compete in multiple areas. Firms compete in cost leadership, differentiation, or a combination of both. The strategy a firm uses depends on the conditions of the market and is always subject to change by maintaining a strong and long-term bond with their customers. Cost Leadership One strategy for creating a comparative advantage is cost leadership. This is basically offering comparable products at reduced costs. The idea behind this strategy is basically why pay more for something that is the exact same as a cheaper item? Firms that use this strategy must find ways to save money while maintaining quality. In this industry, economies of scale, input cost, distribution costs, and research in efficient techniques are the most important aspects of gaining competitive advantage using cost leadership. Economies of Scale and Scope One way in which a firm can create value is to decrease its costs through operating as an economy of scale and having choice when it comes to selecting its suppliers. First, we will talk about how operating as an economy of scale can decrease costs and ultimately create value for a firm. If a firm operates as an economy of scale it will be able to drive down its costs which will help to increase profits. This is an industry which requires a large amount of capital to succeed. Since the majority of the firms in the industry have a lot of capital invested, most of the firms enjoy operating as an economy of scale. One benefit is that in the long-run the cost of their respective 29 P age

31 products goes down. If a firm is able to reduce costs, they can increase their profits. By increasing the profits for a company, that company can achieve their goals and thrive in this industry. Lower Input Costs Another way in which a firm eventually can decrease costs and ultimately create value is by having some control over its suppliers. Within the packaging and containers industry much of a firm s sales revenue is derived from products made from some form of plastic resin. These plastics are mainly composed very similarly and there is not much differentiation among the various plastics. Because there are many suppliers, the switching cost for the demanders of the plastics is relatively low. Thus, the firms within the packaging and containers industry have some control over the suppliers. Through this control, the firms are able to influence prices. This influence can drive the cost of plastics downward, and if a supplier does not adjust their prices accordingly, then the firms can find a new supplier. Once again, if the prices fall then profits can increase and a firm can create value by having influence over its suppliers. Low Cost Distribution Another way in which a firm can create value is by maintaining long-term relationships with its customers. The existing firms all have established relationships with their customers which allows for assets to be used in other areas. For the existing firms in the packaging and container industry, the main customers are grocery stores and other industries that require packaging like food, electronics, and medical equipment industries. A lot of the industry s sales revenue comes from these customers and it is important for firms to keep these relationships strong. Firms that avoid expensive sales expenses must rely on established relationships to generate sales, but can gain a competitive advantage on others by reducing distribution costs. While this reduction can be achieved in a number of ways, firms within this industry primarily focus on just two: logistical control software and geographical proximity to customers. 30 P age

32 The first enables firms to better control the distribution process and ensure priority handling and direct transportation of products to their customers, thus improving the speed, reliability, and efficiency of delivery. The second, placing distribution centers close to firms customers, enhances the software s objectives and reduces firms usage of warehouse space, which in turn cuts inventory costs and increases profits. In addition to lowering distribution costs, these actions strengthen firm/customer relations. Research and Development One aspect of research and development is improving current operating procedures. Improving operating procedures can be done by making the production process more efficient through eliminating wasted time and material. A firm that invests in the improvement of operations will have the ability to lower long term costs as more efficient techniques are created by research and development. So crucial are these improvements to operating procedures and production that Pactiv, for instance, spends as much as forty percent of its R&D budget on them (Pactiv 10-k). Bemis also refers explicitly to the importance of such activities stating, Our research and development engineers work directly on commercial production equipment, bringing new products to market without the use of pilot equipment. We believe this approach improves the efficiency and relevance of our research and development activities and results in earlier commercialization of new products (Bemis 10-k). Differentiation Products which are unique from those that competitors offer are considered differentiated products. Competitive advantage can be gained in this way by offering specialized products and services at a relatively low cost. In general, companies in the packaging and containers industry do not usually focus their activities to compete in this area. However, pressure from one firm in particular, Johnson and Johnson (JNJ), has dramatically increased the need for firms competing in the consumer products segment to offer differentiated products. Since JNJ business strategy is to develop new products in general and then market them, firms in this industry must keep up with JNJ to offer 31 Page

33 products of the same caliber. Although only 37% of Pactiv s sales come from this segment of the industry, there is still a need for differentiated products. Research and Development A big part to adding value to a company is research and development of new products. After looking at 10-K s from different companies, many of the companies attributed increase in sales to the addition to new products. Since these products were able to increase sales, they added value to the existing firms. In addition, a firm can add value by improving their current products. A firm that develops new products or improves existing products can gain a competitive advantage over other firms by offering products with unique features. As consumers are shopping, products that are unique are able to serve niche markets which can add to total sales. More Flexible Delivery Companies that are able to provide flexible delivery regardless of location or the size of the business have the potential to gain advantage over competitors because they are able to serve more customers. Through acquisitions and mergers, firms can expand their distribution access and gain market share. This allows companies the potential to reach any demographic area they want, in order to offer their products in all favorable markets. Pactiv alone has spent $323 million on these types of acquisitions since 2000 (Pactiv 10-k). Other firms, such as AEP industries, not only locate their facilities within a 500 mile radius of their customers, but utilize contract carriers to deliver their products both domestically and abroad (AEPI 10-k). These examples represent some of the most common and or effective methods of providing the crucial service of flexible delivery. Superior Product Variety and Brand Image Firms that offer many products experience relative success in the sense that if one product does exceptionally well, the image of the brand will positively influence the 32 Page

34 image of other products offered by the company. By offering many different products firms not only reach all parts of the market, but they are able to create an image and apply it to all of their products. The linkage between the wide variety of products and brand recognitions allows firms great potential to sell many different products with assumed general qualities. The brand Bubble Wrap for instance, owned by Sealed Air, is so iconic that most people use it to describe any and all air cellular cushioning products. With this type of recognition firms are better able to introduce and promote the sale of additional products. Hence the popular adage Brought to you by the makers of and so on. Perhaps the best example in this industry is that of Pactiv, which promotes no less than ten products under its cornerstone Hefty. Conclusion Overall cost leadership strategies are the most important in the industry because most sales are generated from generic products. Since there is high demand for low cost products in this industry, firms that are able to provide quality products at the lowest price tend to be the most successful. Although this particular sector of the industry is generally concerned with low cost, certain firms in similar industries have forced the need for differentiated products. This causes firms in this industry to actively participate in both sectors of competition while keeping the main focus on cost leadership. Competitive Advantage Analysis A firm can be competitive in two ways: either through cost leadership or through differentiation. Cost leadership is basically trying to have an advantage in different aspects of costs. Some of the ways a firm can have this advantage is by cutting input costs, becoming more efficient, and by operating as an economy of scale. The other way a firm can have an advantage is by differentiation which can be created by having a unique product, improving customer service, creating product variety, or investing in research and development. Pactiv seeks to gain a competitive advantage in both cost 33 P age

35 leadership and differentiation. Pactiv does the following in order to gain a competitive advantage: operates an economy of scale, attempts to lower input cost, and attempt to differentiate through investing in research and development. We will further explain how Pactiv tries to gain a competitive advantage in these areas in the following paragraphs. Research and Development As mentioned earlier, it is imperative that companies in this market invest proactively in research and development. Keeping costs low as well as customers happy are likely the two most important goals of this process. Pactiv has remained very competitive in the research and development aspect of the food packaging industry as well as the consumer products industry, through several refined processes which they have used to more efficiently run their operation. Pactiv annually spends from twentyfive to thirty-three million dollars a year on research and development. That means that in 2006 they allocated twelve percent of their net income to this facet of their business. One example of the fruition of this investment would be their implementation of lean principles which were set forth to accelerate productivity improvements by reducing inventory and scrap levels, providing rapid stock replenishment, shortening scheduling cycles, improving our one stop shopping service, eliminating nonvalueadded activities, and streamlining processes (Pactiv 10k). Since this program was just enacted this last fiscal year, it will be a few months before the actual savings from reduced operating expenses are fully realized, as Pactiv has yet to release their 10-K statement for They are, however, already praising the success of these new principles. Besides enhancing current operating processes, Pactiv dedicates a large portion of their research and development budget to enhancing existing product lines which in turn helps their brand loyalty, especially among their Hefty line of consumer products. In addition to this, in 2005 Pactiv unveiled a new product development center close to their marketing and management headquarters in Illinois. The center is aimed at adding new products to their existing lines of both consumer and packaging products 34 Page

36 while also being able to more rapidly and efficiently introduce customer generated improvements to their existing lines. It is obvious that Pactiv is highly aware of how important R&D is to a company in their industry and it shows throughout their investing activities as well as their internal processes control. As stated in the companies 10k, In 2006, approximately 40% of our research and development spending and 30% of our capital spending was devoted to efforts to reduce costs and improve manufacturing and distribution efficiency. With all of this in mind, it can be said that Pactiv remains highly competitive in this particular aspect of their industry and will be able to maintain this advantage as long as there is an emphasis on research and development. Superior Product Variety Intense contributions to research and development have led to innovative products which can be marketed in many different ways. In the consumer products segment especially, Pactiv gains a great advantage over competitors by offering many different products which serve the same general purpose. Historically, Pactiv s major brand name, Hefty, has offered consumers plastic storage containers of many different functions. For example, Hefty s Cinch Sak, Ultra Flex, and Kitchen Fresh are all different variations of a basic trash bag. This diversification of products draws consumers to purchase products which fit their exact needs. By doing this, the company is attracting consumers that are not satisfied with basic products and can increase their market share. In 2006, 80% of sales came from market sectors in which Pactiv held the number one or two positions in market share. This is mainly attributed to the breadth of product lines and the ability to offer one-stop shopping to consumers (Pactiv 10k). The broad range of products also allows the company to retain customers, especially as their need for plastic containers changes. By offering multiple lines of products, the company provides customers with the opportunity to stick with what they know and remain loyal to the brand. If the company did not offer a range of products it is likely consumers would develop less brand loyalty within this specific market, which would ultimately reduce the firm s competitive advantage. 35 Page

37 In order for the firm to continue to posses this advantage the products offered in the consumer products industry must meet the needs of all potential consumers. Once the firm fails to meet the needs of consumers and they begin to buy products sold by other companies, the advantage of offering a variety of products begins to decrease. Investment in Brand Image Although the overall level of investment in the company s brand image is low, the consumer products market heavily relies on image to generate sales. Proven quality in products such as Hefty and EZ Foil has led to brand recognition that associates quality with products sold under the Hefty brand. As customers needs change, loyalty to a brand image can have a large impact on the producing company. A positive brand image, in addition to offering multiple product lines, allows the company to attract customers with quality products and keep them by offering many different products. This combination of strategies allows Pactiv to greatly increase sales and market share and should be considered a large factor in the success of the firm, especially in this particular segment of the industry. Since only one-third of the company s revenues come from this segment, it is interesting to note that consumer products segment sales increased by 9.7% compared to an increase of 3.7% in the packaging segment (Pactiv 10k). This shows the growing weight this aspect of the industry will play in the coming future. As the consumer products segment plays a larger role in total sales, the products brand image will become even more important. Economies of Scale and Scope In any type of commodities market, economies of scale hold great importance to the success of a firm. In its most basic definition, this idea can be defined as expanding the scale of a firm in order to reduce the long term average cost of its products. The downfall to this concept is that expanding too much can have the opposite effect and can lead to the downfall of a business. Pactiv s strategy for expansion is not unique. They scout out possible lower-scale firms that would benefit them to acquire and if the opportunity presents itself for a 36 P age

38 beneficial arrangement they will jump at it. Using this method they have procured several plants and other manufacturing facilities throughout their history. As of the end of 2006, their consumer products and foodservice/food packaging segments operated 39 manufacturing and 8 distribution facilities in North America, as well as joint-venture interests in a corrugated converting operation in Shaoxing, China and in a foldingcarton operation in Dongguan, China. Pactiv s annual expenditures for property, plant, and equipment from 2000 to 2005 averaged one-hundred and twenty million dollars a year. In 2006 they did some consolidation only spending seventy-eight million. These numbers show a strong orientation towards expansion which is imperative to achieving beneficial economies of scale. One interesting note is that they hold approximately sixty-one million dollars worth of raw materials in inventory at the end of each year which would translate to roughly about seventy million pounds of plastic resins that are on hand at all times (Pactiv 10-k). This huge volume of plastics on hand shows that Pactiv is definitely practicing economies of scale. In a market such as this one, most firms have realized the important role of economies of scale. That is why it is important for those firms to find their ideal economic size, which takes a large amount of experience and knowledge, as well as a touch of luck. Based on Pactiv s most current practices, they are still upping the scales of their production, implying that they have yet to hit that ideal point. When they do, however, it is imperative that they attempt to sustain that level of production which is the key to staying competitive in this market. Low Cost Distribution One area in which a firm can gain a competitive advantage is by maintaining long-term relationships with customers. Pactiv s main customers are comprised of two different areas: consumer products and foodservice/food packaging manufacturers. According to their 10-K about 37% of their sales were consumer products and the remaining 63% was food packaging (10-K). They have established name brands that exist in the consumer market. Hefty and EZ foil are two of the established brands that customers have known for awhile and will continue to purchase. This in an investment 37 Page

39 in brand image and that gives the competitive advantage of differentiation. However, we also think that Pactiv tries to gain a competitive advantage in cost leadership. Low cost distribution can be attained by maintaining existing relationships. Looking at the 10-K, Wal-Mart consisted of 16% of sales in 2006 and 15% in 2005 (10-K). This is a fairly big chunk of sales and with Wal-Mart as a customer Pactiv has transferred some of their distribution costs to them because they become the distributor of Pactiv s products. Also because of the distribution network they have formed within the food packaging industry, Pactiv is able to reduce supply-chain costs (10-K). In summary, Pactiv is able to differentiate and drive down distribution costs through their developed relationships. More Flexible Delivery Companies are able to gain a competitive advantage by differentiation. One part of differentiating is flexible delivery. More flexible delivery helps a company serve more customers. We think that this is attainable through mergers and acquisitions. Pactiv has been able to achieve this through their recent acquisitions. One of the competitive advantages that Pactiv possesses is its ability to acquire other competitors. Pactiv acquired Prairie Packaging in April of 2007, which accomplished a number of aspects relating to competitive advantage (Wall Street Journal website). First, it eliminated a competitor, thus decreasing the amount of competition within the industry. At the same time, Pactiv managed to increase its share of the market. Increased market share is a major aspect of growth within the industry. The acquisition of Prairie Packaging also increased fourth quarter sales for the financial year ending December 31, 2007 by $48 million (Wall Street Journal website). Furthermore, by acquiring another company Pactiv is able to serve more customers. Pactiv has eight distribution plants located throughout North America (10-K). This allows Pactiv to better serve their customers across North America in a better and timelier matter. 38 P age

40 Conclusion In conclusion, Pactiv has successfully gained a competitive advantage through both cost leadership and differentiation. Pactiv operates as an economy of scale thus making them a cost leader. Through efforts in the research and development department, they are also able to lower operating and production costs. In addition, they have gained a competitive advantage in cost leadership through low cost distribution. On the other hand, Pactiv has been able to gain a competitive advantage through differentiation. Pactiv is able to differentiate through research and development by introducing new products. Also, through more flexible delivery, they can reach more customers. Pactiv has also established a brand image and offers a wide variety of products. Overall, Pactiv has used both cost leadership and differentiation to gain a competitive advantage. Accounting Analysis When analyzing a firm, one thing an analyst must do is evaluate the quality of accounting. There are six important steps to doing this: identify the key accounting principles, assess accounting flexibility, evaluate accounting strategy, evaluate the quality of disclosure, identify potential red flags, and undo accounting distortions. The first step is identifying the key accounting policies which can be seen through the key success factors or by major assets and liabilities. In the packaging and containers industry, we noted some of the key success factors as being research and development, economies of scope and scale, investing in brand image, and lower input costs. It is important to note that key success factors help drive value for a company. It is also important to see how these can relate to the key accounting policies. In this industry, we have identified the key accounting policies as they relate to the key success factors, or major assets and liabilities as being lease accounting, goodwill, research and development, and pension liabilities. Research and Development Implications 39 P age

41 As has been stated in previous sections, research and development, a.k.a. R&D, is critical to the survival and success of businesses in this industry. Because R&D is so significant, it is important to analyze the impact it has, if any, on financial statements and thus one s view of the company. Of particular importance is the manner in which companies are required to report R&D. In the U.S. and most other countries, businesses are required to expense these outlays as incurred. The reasoning behind this is that the benefits derived from these expenses are uncertain one cannot know in advance and with complete certainty the viability of such actions. However, from the investor s standpoint it is understood that businesses, for the most part, behave rationally. What is meant here is that if a research and development project is not productive, the company will most likely terminate it and reallocate funds to projects that are. Companies are in business to make money, not lose it. The end result is that the majority of these expenses creates value, and should therefore be viewed as assets. This accounting rule has several negative implications. First of all, it distorts the relationship between revenues and expenses. Since R&D is expensed on the books when incurred instead of being listed as an asset, a firm s expenses would be overstated. This in turn would cause an understatement of net income and thus owner s equity. Ultimately, this method overstates the expenses necessary to generate revenues for a given time period, thus creating an imprecise impression of a firms business model. The second problem arises from the exclusion of research and development as an asset on the financials. This can potentially affect a firm s return on assets or return on equity, two very important indicators of a firm s performance. By proportionately understating both net income and total assets, accounting regulations have the effect of artificially enlarging a business return on capital. This gives the impression that a firm is more productive with its assets than it really is. This chart shows the equivalent if 40 P age

42 R&D were recorded as an asset. With this chart, it can be seen that if R&D were recorded as an asset it could positively impact the balance sheet Pactiv AEP Industries Bemis Sealed Air (in millions) Also with this chart, the packaging and containers industry displays that R&D is an important segment because they continue to spend millions of dollars on it. These are all reasons why R&D is classified as a key accounting policy within this industry. Goodwill The first thing to understand about goodwill is that it is derived from the difference of the purchase price less the fair market value of the acquisition. This excess is then recorded as an asset on the acquiring firm s balance sheet. In order to determine the value of these assets, management must perform a pair of tests to decide whether or not the asset is worth as much as the books say it is. The first step is to assign a fair value to the asset and then compare it to its respective carrying value. If the carrying value exceeds the fair market value, a second step is performed to assess the amount of impairment, if any. The second step requires that the fair value of a goodwill unit be allocated to all of the assets and liabilities of that unit, including indefinite-lived intangibles. Any remaining fair value is the implied goodwill of the reporting unit, which is then compared with the carrying value of goodwill to determine possible impairment. If the carrying value of an intangible asset exceeds its fair value, impairment equal to the excess is recognized. The basic idea is that goodwill units will sit on the books for as long as it takes until it is time to be impaired. 41 P age

43 The method of accounting for goodwill has changed recently as it is no longer amortized, as stated, Statement 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. It requires that goodwill no longer be amortized, but instead be reviewed for impairment. The amortization of goodwill ceases upon adoption of the statement, which for most companies will be Jan. 1, 2002." (FASB Issues Business Combinations Statements) This gives management the freedom to impair goodwill as they see fit can include judgment errors. If goodwill is not amortized, earnings are higher because depreciation expense is not subtracted from net income and allows the firms to report more earnings. According to Galarza, Statement 142 makes earnings announcements even trickier to decipher and muddy year-over-year profit comparisons across almost every industry, especially among tech, telecom and media companies that used their inflated stock to overpay for other firms during the bull market frenzy. This further gives managers motivation to alter their reports because they can use the tactic to acquire other firms that they normally could not afford. Goodwill Pactiv AEPI Bemis Sealed Air MeadWestvaco A comparison of the competing firms in the industry to Pactiv shows the company is in the middle of the field when it comes to the amount of assets on the books. This indicates that the company is on average when it comes to the amount of goodwill that is impaired. Since there is no continuous and stable decline in the amount of goodwill it is apparent that the companies are not amortizing depreciation and treating it like an expense. This leads to inaccurate information because it assumes that the amount of goodwill on the books is relatively constant over time and will not lose any value as time goes on. It is up to the management to determine the value of goodwill and this can lead to man-made errors or manipulation. A closer look at the 42 P age

44 amount of goodwill relative to total assets on the books further shows that none of the competitors appear to write off goodwill consistently. Since mergers and acquisitions play a large role in this industry, most of the goodwill on the books comes from these types of transactions. As stated in PTV s 10-k, our business strategy is to grow by expanding our existing business and by making strategic acquisitions. The following chart shows what the relationship would look like if depreciation on goodwill was expensed. Since the statement changed on January 1, 2002, data from before then will not be used because it represents a different era for the company. With corrected numbers, including amortizing goodwill, the firm is basically the same. The main difference is the total value of the ratio, which decreased by 100 basis points when depreciation of goodwill is included. Since the firms would have less goodwill on the books because of impairments, the ratio is expected to be lower. The similar trend represents overall industry conditions and consistencies in total assets between the different accounting methods. 43 P age

45 In summary, Pactiv s accounting practices for goodwill are similar to those in its industry and while there is no consistent or regulated method for impairing goodwill, there are many opportunities for management to alter the information relayed to investors. Considering this information, by expensing goodwill impairment, the firm s earnings would look different. Pactiv s assets in particular would be 1.06 billion dollars less over the past five years if they had impaired goodwill using an expected lifetime of 5 years. The following chart shows the amount of assets the companies in this industry would have if they impaired goodwill compared to the assets without goodwill impairment. 44 P age

46 Operating Lease vs. Capital Lease One important aspect to look at when identifying the key accounting policies is the effect of operating versus capital leases. Basically, in a capital lease the lessee shares the risks and benefits of ownership. With an operating lease, the lessee just has the right to use the property. The Financial Accounting Standards Board, also known as FASB, has designated four conditions as to when a lease should be treated as a capital lease: if the lease life exceeds 75% of the life of the asset, if there is a transfer of ownership to the lessee at the end of the lease term, if there is an option to purchase the asset at a "bargain price" at the end of the lease term, and if the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset ( Thus, if any of these conditions are not satisfied, a company can choose to categorize the lease as an operating lease. The manner in which these two types of leases are accounted for is different. In an operating the lease the lease is treated as an operating expense, and a capital lease is treated as an asset and a liability. It is treated as a liability because of the lease payments. An operating lease can look favorable because an operating lease avoids some expenses taken on in a capital lease, such as depreciation and interest. With understated expenses, net income is overstated and because of this so is equity or retained earnings. Now that we have discussed some of the differences between the two, we will look at how the packaging and containers industry treats their leases. After looking at 10-k s from various firms in the packaging and containers industry, we noticed that both operating and capital leases are used. While capital leases are mainly used in this industry, it seemed that the majority of the leases are classified as operating leases. Some of the companies even make it more clear within their 10-K that they mainly use operating leases. For example, Sealed Air says the Company accounts for the majority of its leases as operating lease, (10-K) and Pactiv states in their 10-K that commitments under capital leases are not significant. With these quotes, it can be seen that the operating leases are preferred within this industry. It can also be seen by comparing some of the numbers drawn from different 10-K s. 45 Page

47 Bemis Capital Operating AEP Capital Operating Thereafter Thereafter Total Total (in thousands) These numbers show the minimum payment for lease obligations for the future. The disparity between the operating and capital lease total is something very noticeable. With Bemis, operating leases account for about 98% of the leases, and with AEP they account for about 87%. With both companies, more so Bemis than AEP operating leases are very dominant. As we mentioned before Pactiv pretty much says capital leases are trivial, and they list their minimum lease obligations as (all numbers in millions) $23, $17, $14, $10, and $9 for 2007, 2008, 2009, and 2011 respectively, and $14 per year thereafter. So, given AEP and Bemis s numbers, and that Pactiv considers capital leases to be insignificant, we think that their overall percentage of operating leases would account for a very large percentage of leases as well. In summation, the industry predominately uses operating leases. To look further into it, we analyzed Pactiv s operating lease totals for Furthermore, we capitalized Pactiv s operating leases. To do this, we took the present value of Pactiv s future operating lease payment obligations. Since we are not give an exact discount rate and we do not know how long these payments will go on, we did this by assuming a 10% discount rate and did it over a fifteen year period. This is important because once a lease is capitalized the lease payments are considered a liability. We can then divide the capitalized operating lease by the total liabilities for After finding the present value, we took the number that we got from capitalizing the operating lease which is about $63 million, and divided it by the total liabilities from 2007 which is $2.539 billion. This formula gives us 2.681%. These 46 P age

48 numbers show that using an operating lease versus a capital lease would not have a big affect on the firm overall because it would only account for such a small percentage of liabilities. Since the liabilities would not greatly be affected, neither would the balance sheet. We think that by categorizing these leases, Pactiv has appropriately accounted for these leases. Since Pactiv has correctly categorized its leases, we feel that they are not trying to make their numbers look better than they are to fool investors. Pension Liabilities The way pension liabilities are accounted for can help determine the overall level of quality of accounting. As previously discussed, companies in this industry compete on low cost products which forces firms to minimize costs in all areas in order to pass those savings on to consumers. Since pension liabilities are expensed, special consideration must be paid to them to ensure their accuracy in the financial statements. The discount rate is the rate used to determine the present value of future pension obligations and is provided in the 10k statement of each competing firm. For 2002, 2003, 2004, 2005, and 2006, Pactiv s discount rate has been 7.25, 6.75, 6.25, 5.7, and 5.96 respectively. This number is important because a small change in the rate leads to large changes in other areas. A one-half percentage-point change in the discount rate would impact our pretax pension income by approximately $4 million. (PTV 10k) Pension Liabilities Discount Rate PTV SEE AEPI BMS This chart shows PTV s discount rate in comparison with the others in the industry. The similarities show that as market conditions change firms are more likely to adjust their discount rates. The actual rate is based on the composite yield of corporate bonds that 47 Page

49 have similar intervals as the liability obligations and is therefore dependent on the return on assets for the fund. The expected return on the pension fund minus inflation is the discount rate used. Currently, Pactiv uses a 9% discount rate which is slightly lower than the historical average of returns at 11%. Our U.S. qualified pension plan's annual rate of return on assets has averaged 11%. Historically, the plan has invested approximately 70% of its assets in equity securities and 30% in fixed-income investments. After considering all of these factors, we concluded that the use of a 9% rate-of-return on assets assumption was appropriate for (PTV 10k) This allows for a cushion in any market changes and further insures appropriate funds will be available as they are needed. Since this rate is subject to man-made estimations it is not entirely accurate and even though the number is logically conceived, any deviations from the actual will lead to drastic changes on the books. Accounting Flexibility Accounting flexibility is the degree in which a manager of a firm is allowed to choose their accounting policies and estimates. Accounting data is likely to be less informative in regards to understanding the firms if managers have little flexibility in choosing their policies and estimates (Palepu and Healy). Although it is preferred that managers have more flexibility and that the disclosed accounting information is more informative, in reality, the accounting guidelines are set by the Securities and Exchange Commission. Accounting standards are set by the Financial Accounting Standards Board (FASB); Generally Accepted Accounting Principles (GAAP) denotes the standards, conventions, rules, and procedures that FASB requires firms to apply in preparing their financial statements. (Palepu and Healy) Basically, the SEC has the legal authority over accounting practices, and the FASB develops the standards outlined by the GAAP. A big part of understanding GAAP is that they realize certain modifications need to be made from one firm to the next. They understand that not every company will use the same process or come up with the same results as long as companies are generally following their set of guidelines. We will now discuss how GAAP in relation to our key accounting policies which we stated as operating versus capital leases, research 48 Page

50 and development, pension liabilities, and goodwill. We will also talk about the relative disclosure in regards to the packaging and containers industry. Flexibility of Research and Development With regards to research and development, GAAP has set pretty strict guidelines. Through policies set by GAAP, research and development (R&D) must generally be expensed. In addition, these expenses should be expensed as they are incurred. One bad thing about having to follow GAAP is that a company tends to overstate their expenses. With overstated expenses, net income is understated, and it is harder to truly see the success of a business. The general thought is that R&D should be a capitalized asset and depreciated over a certain period of time. However, GAAP has no flexibility in this area. With this being said about the degree of flexibility, the disclosure is industrywide and with all firms is relatively equal. Flexibility of Lease Accounting With respect to operating and capital leases, there is a lot more flexibility compared to the flexibility of how GAAP treats research and development. There are two types of leases a company can pursue, each of which has different affects on how they are accounted for. As previously discussed, operating leases are treated as expenses that affect the income statement, and capital leases are treated as both an asset and a liability which would affect the balance sheet. Capital leases are treated as an asset because the company takes on ownership of whatever is being leased, and the lease payments are considered to be a liability in the form of a lease payable. Thus, if an operating lease is used by a company, the company s assets and liabilities are understated. Conversely, if a company is using a capital lease, expenses would be understated which would cause the net income to be overstated. With these two types of leases being available, FASB has a set of four guidelines which are plainly listed in a previous section that a firm must follow when deciding between a capital lease and an operating lease. 49 P age

51 The packaging and containers industry widely uses operating leases. Because operating leases are mainly used, the industry does not take on the risk associated with ownership. Furthermore, by choosing an operating lease, there is no effect on the balance sheet and some firms see this as a positive. Also another advantage this industry shares is that the firms are not tied down to the long lease terms related to capital leases. In other words, by not taking on ownership a firm is viewed as being more liquid. Firms can also see tax benefits with an operating lease. A possible tax benefit seen is that with an operating lease a firm avoids the Alternative Minimum Tax (AMT). The AMT was set to to keep taxpayers with high incomes from paying little or no income tax by taking advantage of various preferences in the tax code. ( An example of a preference that this quote is talking about is depreciation. A piece of equipment involved in a capitalized lease would most likely face depreciation. A depreciable asset can be seen as tax deductible, but AMT does not allow a firm to take advantage of this tax preference. With an operating lease, the AMT that could be associated with depreciation is avoided, and companies who could be AMT taxpayers tend to structure their leases as operating leases. (escorp.com) In conclusion, the industry seeks the potential benefits of an operating lease. Flexibility of Goodwill Goodwill usually occurs when one company acquires another and can be referred to as an intangible asset. Goodwill is basically the difference between the purchase price of an asset and the market value of the asset. Previously, under GAAP, goodwill was amortized. Now, Goodwill is impaired which is just a reduction in value. There really isn t much flexibility in regards to goodwill. The method for calculating goodwill is pretty standard, and therefore companies cannot seek an advantage by calculating goodwill in a different manner. This being said, it important to notice how much a company incurs and what percentage goodwill is compared to its total assets. It is also important to compare this percentage to that of its competitors. For the year 2006, Pactiv, Bemis, Amcor Limited, and AEP industries had percentages of 19.03%, 19.8%, 50 Page

52 17.16%, and 4.8% respectively. These percentages reflect the goodwill divided by total assets. Pactiv, Bemis, and Amcor Limited have relatively close percentages, while AEP is much lower. In our opinion, AEP s goodwill is considerably lower because it is a smaller company compared to the others and therefore does not have as much capital to acquire another company with. These numbers help further reflect the degree of flexibility in regards to goodwill. Summing up, there is a low degree of flexibility with respect to goodwill. Flexibility of Pension Plans Pension plans, or post-retirement benefit plans, are recognized as a key accounting policy in the packaging and containers industry. They exist to provide employees seeking retirement a sense of financial security. Pension plan liabilities have a certain degree of flexibility associated with them. The main area of flexibility being that the discount rate used to calculate how much is paid is estimated. This discount rate is used in order to discount these future payments to the present. By increasing the rate the payments decrease, and vice versa. Thus, how much is paid based on this rate is important when valuing a firm. For example, if the rate is decreased a firm would pay more thus raising a company s expenses, causing a lower net income. Furthermore, there is a new statement issued by the FASB titled, SFAS 158, which pertains to Employers Accounting for Defined Benefit Pension and Other Postretirement Plans which is part of a two step process. This was made a mandatory policy for all publicly traded companies to provide a more accurate measurement of its liabilities. Prior to the adoption of SFAS 158, companies were required to record only the prepaid pension costs. This means that they were only accounting for the actual cash that was deposited into the pension fund. In the first phase of this statement, companies are required to record the full-funded status of the plan. The now mandatory recognition of this liability will make liabilities significantly higher because it requires the firm to account for both the actual cash deposited and the accrual of necessary funds that will satisfy the workers pension to be received upon resignation/termination. This obligation will force the company to report this increase in 51 Page

53 liabilities on the balance sheet instead of burying them in the footnotes on financial statements. The second phase of this statement will reconsider how the items that affect the costs of providing post-retirement benefits should be recognized. It will also determine how to display this change in liability in earnings or other comprehensive income. Overall, the packaging and containers industry uses a relatively close discount rate. Using the numbers given previously, the average discount rate in 2006 for AEP industries, Bemis, Pactiv, and Sealed Air is about 5.5%. Pactiv has a slightly higher than average discount rate at 5.96%, so for 2006 their expenses were slightly lower than the industry. Although Pactiv uses a slightly higher discount rate, they are still relatively close to its competitors. In conclusion, the flexibility of pension plans is important to look at because a company can greatly impact their expenses by increasing or decreasing the discount rate used. Conclusion The degree of flexibility of the listed key accounting policies is important to look at. It important to see if certain accounting policies are more flexible than other so that one can notice if any firms in the industry are trying to take advantage of this flexibility. Goodwill and R&D are relatively inflexible, meaning there is little to no opportunity to gain an advantage there. Overall, we think that the industry has taken an advantage by using operating lease instead of capital leases. Pactiv maintains an advantage here as well by mainly using operating leases. There are no noticeable variations within the industry for the discount rate used in accounting for pension plans. It appears that no firm in the industry is seeking to take advantage of the flexibility allotted in estimating this discount rate. It is important to notice how Pactiv uses these flexibilities compared to the industry with respect to the stated key accounting policies. 52 P age

54 Actual Accounting Strategy An important step in the accounting analysis is evaluating a firm s actual accounting strategy. This part is important because when a manager of a firm is allowed some flexibility they can either illustrate the company s true situation or hide how the firm is performing. One thing to look at is the level of disclosure that a particular firm offers relative to the industry. Also, when evaluating a firm s accounting strategy, other areas like accounting policies and format should be looked at. Furthermore, whether a company is conservative or aggressive with respect to its accounting policies is essential. The accounting strategies that we have identified within this industry are goodwill, pension plan liabilities, research and development, and lease accounting. Research and Development Research and development is a big part of the packaging and containers industry and we have identified it as one if the key accounting policies. There are strict guidelines as to how research and development is accounted for. As previously discussed, GAAP requires that research and development be expensed as soon as it is incurred. With respect to R&D, we believe that the industry overall has relatively low disclosure. After looking at different company 10-Ks, most companies do not really break down their R&D expenses. Bemis disaggregates their R&D expenses a little, but Pactiv, AEP, and Sealed Air just state how much they were by year. Bemis has a chart which separates R&D expenditures into two categories: flexible packaging and pressure sensitive materials. They also show R&D as a percentage of sales. However, R&D is less than a percentage of their sales. Although the industry does not really break-down the numbers, they do offer some insight as to what they are doing with their research and development spending. They fail to go into a lot of detail, but for example Pactiv says approximately 40% of 53 P age

55 our research and development spending was devoted to efforts to reduce costs and improve manufacturing and distribution efficiency. (Pactiv 10k) For the most part, giving a brief statement in regards to R&D is an industry norm. Due to this low level of disclosure and disaggregation of R&D, it is hard to truly value a company based on R&D. The only safe assumption is that managers in control of R&D spending are knowledgeable and are not just throwing away money by investing in R&D. Furthermore, it can also be assumed that if managers continue to invest in R&D that they are seeing a positive impact from this continuation. In conclusion, we think that the low level of disclosure can partially be attributed to the fact the GAAP is inflexible with respect to how R&D is accounted for. Furthermore, since GAAP has strict regulations concerning R&D, managers are not as inclined to fudge the numbers to make their earning look better. Pactiv and the industry simply just follow GAAP rules and do the minimum by expensing R&D when incurred. Lease Accounting In regards to how they appear on the books, there is a big difference between an operating lease and a capital lease. As previously stated, an operating lease is treated as an expense and a capital lease is both an asset and a liability. In addition, the packaging and containers industry mainly uses operating leases, which creates a certain degree of flexibility when accounting for leases. Due to the potential benefits that can be associated with an operating lease, managers are influenced to choose an operating lease. Since most of the companies in the industry use operating leases, they avoid the risks associated with ownership which understates the assets and liabilities left off the balance sheet. From an absolute position this would suggest an aggressive accounting policy. However, if the leases were capitalized the lease, the lease payments would be a very small percentage of liabilities. We do not think Pactiv is applying an aggressive accounting policy. Overall, the industry uses operating leases, so Pactiv is just being competitive with the industry by accounting for their leases this way. In addition, the level of disclosure within the industry is relatively high. When looking at Pactiv and its 54 Page

56 competitors, they do a good job of breaking down their leases by showing how much of their leases are operating leases and capital leases. Furthermore, the companies that we looked at do a good job of displaying a chart showing the contractual obligations due by period. Within this chart, they periods are listed as less than one year, one year to three years, three years to five years, and more than five years. This can help to value a firm because it shows the amount of expenses a firm owes in the future. In conclusion, we do not think Pactiv uses an aggressive or conservative accounting policy, and that they have a relatively high level of disclosure relative to the industry. Pension Plans Since GAAP has provided a certain degree of flexibility concerning the rate used on pension plans, it is very important to look at the level of disclosure and disaggregation in this area. It is important to analyze the level of disclosure and disaggregation here because investors need to see how the firm came up with the discount rate used. Since Pactiv and its defined competitors all have some form of postretirement benefit plan, it also important to see Pactiv s level of disclosure relative to the packaging and containers industry. Pactiv used a relatively high discount rate in 2006 which has been declining since Compared to their competitors, this says they are using an aggressive accounting policy because they maintain a higher than average discount rate. Thus, they are decreasing their expenses and consequently raising their earnings. However, their competitors have followed the same decreasing trend since While the industry is following a trend to lower their discount rate, Pactiv maintained the highest rate in This can be more attractive to investors, because they will be decreasing their expenses. With respect to disclosure, the industry seems to have a high level of disclosure. In general, the industry does a good job of talking about what has influenced the applied discount rate. They are also good at breaking down the numbers through the use of charts. These charts break down the pension costs into sections like service costs, interest costs, and employee contributions. 55 Page

57 Pactiv and its competitors all talk about whether they use a defined benefit plan or contribution plan. It seems that the trend in the industry is to migrate towards a defined contribution plan. It seems the Pactiv s competitors have all started the process of using a defined contribution plan. For example, AEP industries says they use a defined contribution plan in United States in their 10-K. Sealed Air s 10-K says the company maintains defined benefit pension plans for a limited number of its U.S. employees. This quote would further suggest that they are switching to a defined contribution plan or doing away with pension plans. Furthermore, Bemis says our U.S. defined benefit plans were amended for approximately two-thirds of the participant population. For those employees impacted, future pension benefits were replaced with a defined benefit contribution plan (Bemis 10-K) This can further show that the industry appears to be moving towards defined benefit contribution plans. On the other hand, Pactiv does not appear to be switching to a defined contribution plan. Pactiv still uses a defined benefit plan which is more risky for the firm, which could be one reason why they use the highest discount rate within the industry. Overall we think that this industry has a relatively high rate of disclosure and disaggregation with respect to pension plans. In conclusion, Pactiv seems to disclose and disaggregate at an average rate relative to the industry. Goodwill GAAP has outlined a relatively strict policy when it comes to goodwill. Goodwill is an intangible asset that is impaired over time. The primary component of valuing goodwill and other intangibles is allocating particular units to their respective useful life. The accounting principle used in determining these numbers is defined by statement 142 issued by the FASB. First of all, an intangible asset with a finite useful life is amortized and an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of the firm. 56 P age

58 The first step is to determine a fair value and then assign an appropriate useful life in order to amortize/impair. There is not a great deal of flexibility here since Pactiv has their goodwill assets appraised by outside sources, as do other competitors. This type of valuation process is covered in SFAS 141 under Business Combinations. Currently, the disclosure of general information regarding the valuation of goodwill is relatively high. However, the firm s management is in charge of determining the useful life of an asset through a weighted average. Therefore, the firm s managers are able to distort this average by using weights that will overstate the expected useful life. The effect is an opportunity to decrease the actual amortization expense while prolonging the assets useful life. In , Pactiv showed evidence of normal fluctuations in the amount of goodwill. At the end of 2006, Pactiv showed $525 million in goodwill which equated to about 19% of total assets. This 19% is relative to other industry competitors that fell within a 4 point spread. Since Pactiv does not have a substantial amount of goodwill on the books, this opportunity to distort useful lives does not present a big enough advantage in the end result. Therefore, one would find it hard to believe that understating amortization expenses would create a big enough incentive to do so. Quality of Disclosure In order for a prospective investor to fully evaluate a particular firm, it is necessary to establish that firm s level of disclosure in regards to their financial statements and accounting policies. While the GAAP specifies certain minimum criteria for reporting financial activities in annual reports, these are a bare minimum and tend to make it arduous in determining the firm s true business strategy and economic consequences. Managers hold a great deal of power when deciding just how much information they are willing to disclose and this ranges from the bare minimum legally required disclosure, to full-fledged disaggregated details on every aspect of a Firm s business activities. 57 P age

59 Qualitative Analysis In assessing the quality of disclosure of a firm it is imperative to analyze the firm s annual reports, most notably their 10-K statements in order to infer how well they portray an accurate snapshot of their business strategy. When attempting to evaluate a company's financial prowess, it becomes necessary to evaluate just how well that particular firm discloses their information through their 10-K statement and how much quality the information possesses. Pactiv Corporation tends to hover right around the median amount of disclosure. While they do provide several examples of quality information, some aspects of their business activities remain shrouded due to their omission of certain details. One of the very first items in a firm s annual report is their Letter to the Shareholders which is a good indicator of overall disclosure because it is aimed at those who are investing their capital into the actual firm. If information regarding negative financial consequences is mentioned in the letter to shareholders, one can infer that they are likely a higher disclosure firm. Pactiv tends to omit negative financial consequences almost entirely but occasionally (in 2004 for example) they will briefly gloss over the bad news, but instantly reassure the investor with other positive information. One of the first places to look when attempting to discern a firm's statements decision quality is the Management Discussion and Analysis portion of their 10-K statement. When looking at sheer length of this section, which admittedly is not a definite measure of quality, on average Pactiv remains almost square in the middle in relation to its prime competitors. They tend to summarize most details on business activities but do disclose a fair share of information including a disaggregated breakdown of their three reporting segments which are composed of consumer products, foodservice/food packaging, and other which refers to corporate and administrative-service operations and retiree-benefit income and expense. They provide information regarding specific activities in these particular segments including sales and operating income data which greatly helps in determining the effectiveness of each particular segment of their operations. 58 Page

60 In addition, in Pactiv's K statement, they detail information regarding discontinued operations (in specific their sale of the flexible- and protectivepackaging segment to Pregis corporation) and its financial consequences which included a three million dollar loss partly attributed to the fact that Pregis did not assume the sitting debt of that operation after the sell. Pactiv does mention one important link of their financial progress to business activities by disclosing information on how their selling, general, and administrative expenses rose slightly but was offset by favorable spread, the benefit of the Newspring acquisition, and productivity gains ; while spread refers the margin between the cost of raw materials and the selling price of their products. One notable aspect of Pactiv's annual reports is that they tend to soften you up before the blow. By this we mean that before they report bad news they build up a buffer of positive data and then mention how the negative data offsets it instead of just plainly stating the facts. This leads this team to believe that they are purposely manipulating their statements for potential investors. While not necessarily a negative thing, it can be unsettling when trying to determine the transparency of their reports. Confidence is rebuilt somewhat when you visit the company s homepage which lists a large tab dedicated to Investor Relations which provides links to several pertinent sources of information including: proxy statements, SEC filings, annual reports, as well as much more. Overall Pactiv seems to sit right in the middle in terms of decision usefulness for prospective investors, while they do disclose a fair deal of useful information, their tendency to puff it up with euphemisms and other clever tactics leads this team to somewhat question the qualitative merits of their information. Quantitative Analysis Quantitative analysis refers to the process of analyzing the actual financial related numbers of a company and its competitors; this is useful for a couple of reasons. The first is that one can determine the reliability of accounting information regarding a specific firm, and use this to establish the firm s quality of disclosure. There 59 Page

61 is a certain amount of freedom that GAAP gives to managers in regards to the amount of financial information they are required to make public. Although GAAP does force managers to reveal a certain minimum amount of information, there are many areas which allow them to distort some of their numbers. Managers have the incentive to do this for numerous reasons, including but not limited to: it makes the company look more profitable for investors, and it makes the management look better in the eyes of their firm, which in turn provides the managers with a higher chance of receiving bonuses and other perks from the company. Quantitative analysis is also useful because it allows the investor to see what current trends in the company are doing. For example, if an investor sees that sales have been declining for the past several years for a certain company, while sales for a competing company are continuously rising, the investor will know that the company may not be doing something right. Investors should look at numerous ratios when employing quantitative analysis. These ratios fall in to two categories: sales manipulation and expense manipulation diagnostic ratios. Sales manipulation diagnostic ratios takes net sales and compares it to other numbers such as accounts receivable and inventory, as well as unearned revenue, warranty liabilities, and cash from sales. Expense manipulation ratios involve a wider array of numbers, including cash flows from operations, operating income, and total accruals, to name a few. Taking the straight ratio, also known as the raw form, of these numbers is very important, but it can be equally important to utilize the change form of these ratios. It is also helpful to put these numbers into graphs. This allows an investor to visually see what is happening to the company and within the industry. With this visual aid, it becomes easy to see when a major distortion occurs. For example, if one company has a major increase in sales in one year, and it is not an industry wide occurrence, it shows that either the company is attempting to manipulate sales or they had an extraordinary event occur. 60 P age

62 Sales Manipulation Diagnostics Sales manipulation diagnostic helps to see how sales compare to other aspects of the company, year after year. If these ratios have drastic changes from year to year for a company and the industry does not follow, then it could be a sign of sales manipulation. The sales manipulation diagnostic ratios we will look at are sales: accounts receivable, sales: inventory, and sales: cash from sales. Note: Throughout this analysis, the chart for the Raw Form is above the chart for the Change Form Sales: Cash From Sales The net sales to cash from sales ratio shows how much of a company s sales are collected in cash. A perfect 1:1 ratio here means that companies are making all sales in cash. In general, as the charts show, the packaging industry tends to be consistent with 61 Page

63 itself and operates just above a 1:1 ratio. One cause for concern when looking at Pactiv s ratio occurrs in 2004 when the ratio is actually less than one, meaning that cash from sales is greater than sales. This is most likely a throwout occurrence considering the extremely small degree of change that took place. The sharp change on the Change Form chart is explained by the minute change in cash from sales between 2001 and 2002, which was only $2. Since Pactiv does take part in large transactions of product to their customers which are most frequently done on credit, this ratio reinforces the fact that their credit and collection policies are working effectively. Thus, they are receiving the majority of their revenue without default. Besides the outlier present in our Change Form chart, Pactiv s cash collections from sales is very consistent and sticks to the industry standard 1:1 ratio, this is a good indicator that their disclosure of financial statements is accurate and all signs indicate that they are not masking their sales revenue, which occurs from time to time with certain firms. Sales: Accounts Receivable 62 P age

64 The net sales to net accounts receivable ratio shows what percentage of Pactiv s sales for the year were sold on account. These charts illustrate several different things. First is that Pactiv makes many of its sales on account which is expected as Pactiv is a manufacturer and does not sell directly to consumers. The majority of Pactiv s customers are other companies, which normally make bulk orders and on a regular basis. These transactions are primarily paid on account. These charts also show that Pactiv follows the general trend of the industry. None of the shifts seen in the company s ratio are cause for concern and are similar to at least one other company in the industry which indicates that they are in line with the market. One can infer, finally, that Pactiv averages about 45 days of outstanding accounts receivable which indicates that most transactions are conducted and paid within a 3 month period. Furthermore, there is little worry for large outstanding debt owed to the firm, indicating we can safely bet that they will collect the majority of payments by year s end. Sales: Inventory 63 P age

65 Once again, each company within the industry is operating at about the same level as the others. One positive trend for Pactiv, however, is that for the past four years this ratio has increased steadily which can indicate a couple of different things. One possibility is that Pactiv is requiring less inventory to generate its sales which would be supported by a reduced year end inventory. A second possibility is that Pactiv is generating more sales at a rate that outpaces their supply of inventory, a positive sign that Pactiv is generating more revenue without the large expense of warehousing large quantities of unsold product. In reality Pactiv is experiencing a a combination of both situations. Their annual sales have been increasing at a stable pace since 2002 and they have also been steadily reducing their on-hand inventory which is 64 P age

66 why we see the steady growth in this ratio as an overall good indication that Pactiv is increasing effeciencey in their operating procedures. Sales Manipulation Diagnostic Conclusion Analysis of each of the aforementioned ratios is necessary in order to properly evaluate a firm in comparison to its industry and to establish how its performance compares to its competitors. Another very important reason for conducting this analysis is to reveal any improper or elusive financial statement disclosure by a firm. All of Pactiv s ratios are fairly paralleled with others in its industry and fully support the information presented in their financial statements. Furthermore our analysis leads us to believe that Pactiv has not attempted to alter any numbers related to these sales manipulation diagnostic ratios. One final side note is that the current trends of Pactiv s ratios look very positive and seem to indicate a healthy level of growth in the firm. Expense Manipulation Diagnostics While it is very important to look at numbers related to a company s sales, it is equally important to look at their expenses numbers. The manipulation of these numbers can alter the profit margins of a specific company. Once again, severe changes in these numbers, from year to year, are a possible sign of manipulation of the numbers. Asset Turnover The most important long-term asset a firm has on its books is it s Property, Plant and Equipment. A firm s ability to produce revenue from its assets can make or break the firm. If assets are not efficiently used, there is an increased chance of a takeover, especially in this industry. One way to evaluate a firm s ability to efficiently use assets is the asset turnover ratio. This ratio considers long-term operating assets in relation to sales. This computation shows how much revenue is produced for each dollar of assets on the balance sheet. For evaluation purposes, the higher this number is the better it is for the firm because it shows that more revenue is produced per unit of assets. When 65 Page

67 comparing this ratio over time, a decline in this ratio is considered a sign of possible manipulation because it indicates the firm s assets are no longer producing as much value as they once were. Net income can be overstated by showing decreased operating expenses which affects profit margin and asset turnover. In terms of this ratio, Pactiv remains very close to the industry average almost, directly paralleling the trend curve in our chart. This symbolizes that they are very in tune with their industry which is a good sign that they are not manipulating their data. One worrisome bit is that until 2006, Pactiv s asset turnover was below 1 which means that before 2006 their overall sales were less than the value of their assets. This is worrisome for potential investors because it possibly implicates a lack of production effeciency within the firm. With this in mind, an analysis of all the firms in this industry shows somewhat stable trends of asset turnover with most firms showing slight increases. A major exception to this is that AEP Industries showed a hige increase in this ratio between 2005 and In terms of the industry as a whole,this shows the firms are able to generate similar returns on their assets and are less likely to be manipulating their books in order to mislead investors. A look at the same data using the change form shows a similar trend between the firms. 66 P age

68 While this information suggests the firms are moving toward declines in asset turnover, it shows that all of the firms in the industry are still above zero which means that they are not declining. This means that the firms are not creating as many new sales from their assets as they have in previous periods but they are maintaining. This is expected especially given the economic situation that we are in and although the outlook is not as good as most would like, the firms are still able to compete and generate sales. Cash Flow From Operations: Operating Income The CFFO/OI ratio is used to show the difference between cash flows and operating income that is reported on the income statement. It is basically used to insure the qualitiy of a company s earnings. This ratio is sometimes considered a more accurate view of a firm s profits compared to earnings because it is possible to have increased earnings but the inability to pay debts. ( A ratio that is less than one or a continuous decrease in the ratio over time indicates either manipulation of cash flows or overall business strategy failures. The following graph dipicts the firms in this industry. 67 P age

69 While many of the firms are just around a ratio of one, the only notable change is that of AEPI. As a whole, the industry is on average and while some competitors are slightly different Pactiv s ratio is expected. However, there appears to be a small decrease in this ratio since 2004 and this is a possible sign of manipulation of the cash flows. However, this can be explained by a 1000% increase in the amount of recievables, a respective increase for accured taxes, and the sale of a business segment. (PTV 10-k). Significant events like these frequently lead to an increase of cash flow manipulation in order to curtail the effects from distorting the diagnostics. The same information in a change form diagram shows the severe decrease in the ratio from 2004 to 2005 as attributed to the decrease in CFFO from the sell off in The one common thread is that, regardless of the spikes, the ratio always seems to restabalize after major events. Aside from this information, the company had a relatively stable ratio which experienced no major changes in the past 5 years. It is evident in the graph that the spikes coincide with major events. It is also clear that the increase in cash flow manipulation seems to help the ratio get back to normal. 68 P age

70 In general, the company s CFFO/OI ratio is perfectly normal with the exception the outlier in 2005 which as linked to the sell off. Besides this, PTV shows stable cash flows in relation to operating income which means steady earnings and cashflows. These earning will allow the firm to pay off its current debts with cash on hand. Cash Flow From Operations: Net Operating Assets The CFFO/ NOA ratio shows how much cash flows from operation are generated by net operating assets. Simply put, it is a measure of how much income is generated per one dollar of fixed net assets. In this case, a higher ratio means more cash is being generated by your operating assets. 69 P age

71 Pactiv s ratio hasn t experienced any majore changes in the past five years and seems to be hovering inbetween the ( ) range. This means that each dollar of operating assets is producing roughly 17 cents of income. Any time this ratio spikes upward, it is usually evidence of companies understating their assets and vice versa. Pactiv s ratio suffered a minor decrease in which was probably due to the acquisition at that time. Anytime something major like that happens, managers are forced to accommodate the situation and allocate the new assets accordingly. Once the new assets are accounted for properly, the ratio should restablize shortly after. This ratio is key in determining how efficiently a companies fixed assets are used. Pactiv seems to be undergoing normal changes and the information from their 10-K corroborates our theory. With that said, it doesn t look like Pactiv has enhanced or distorted any information. However, the chart in Change Form sheds a different light on the ratio. A major point of interest is the increase after Although this ratio appeared healthy in the previous graph, the change form indicates potential red flags. Either Pactiv has greatly understated their assets, manipulated cash flows, or both. This isn t exactly the best thing to see when trying to put a price on the matter. Corrective cash flow manipulation is always good when the company is trying to adjust for acquisitions and such. However, we feel like the degree to which Pactiv has manipulated the two factors exceeds normal adjustments. A change like this is usually followed by steep decrease 70 P age

72 and is evidence of someone within the company making a mistake; perhaps on purpose. Total Accruals: Change in Sales * * ** 71 P age

73 ** Note: * Total accruals= net income- cash flow from operations ** Total accruals= operating income- cash flow from operations These four charts compare total accruals to the change in sales over the last five years. For the first chart, total accruals is calculated by subtracting cash flows from operation from net income. Total accruals for the third chart is calculated by taking operating income and subtracting cash flows from operations. The second and fourth charts use normal Change Form calculations. In this instance, if we were to look at the ratios for only Pactiv, we would be concerned by the volatility of the numbers from 2002 to However, since we also have the ratios for the other three companies, we can see that the changes were industry wide and not firm specific. Pension Expense: SG&A 72 P age

74 These charts compare the pensions expenses to selling, general, and administrative expenses. After viewing the raw form chart, it appears that Pactiv has excessively high pension expenses. This is explained in the company s 10-K, though. One section states: At the time of our spin-off from Tenneco in 1999, we became the sponsor of Tenneco (now Pactiv) pension plans. These plans cover individuals/beneficiaries from many companies previously owned by Tenneco, but not owned by Pactiv. As a result, the total number of individuals/beneficiaries covered by these plans is much larger than would have been the case if only Pactiv personnel were participants. (Pactiv 10-K) This is a viable reason for the high pension costs. Also, a look at the Change Form chart helps to turn away the thought of possible expense manipulation. Expense Manipulation Diagnostic Conclusion Overall, Pactiv s numbers bring no major concerns to our attention. Their numbers are generally on par with the rest of the industry. Potential Red Flags When analyzing the qualitative and quantitative characteristics of a firm s financial statements, it serves a potential investor or analyst well to query these statements in order to uncover any potential red flags that might lead to questionable accounting practices. These practices are generally employed to present a distorted 73 P age

75 perception of that company s financial standing, usually to make it seem more lucrative to an investor. The first step in uncovering these distortions is typically an analysis of the firm s diagnostic ratios which present an effective visual aid in revealing anomalies that might not be explained by typical business activities. Seeming discrepancies in Pactiv s diagnostic ratios are rare and are sufficiently explained in their annual reports but there are a few interesting items that we discovered while investigating these statements. In June 2007 Pactiv acquired the firm Prairie Packaging Inc. for $1 billion in cash. Prairie Packaging specialized in a broad range of tableware and foodservice products, including drink cups, containers, cutlery, plates, and bowls. Although Prairie s previous customer base was quite small, Pactiv plans on distributing their products throughout their own chains of distribution. According to their 10-K statement; We anticipate that significant sales and operating synergies will result from selling Prairie s products through our national distribution network. This can be attributed to why Pactiv s goodwill and intangible assets literally doubled as of the moment that they acquired Prairie. Pactiv s goodwill increased by $590 million due to the acquisition which would mean that they spent more than double the tangible worth of Prairie for the purchase, this leads us to believe that Pactiv has a good amount of confidence in the synergies that will arise from this move. What raises a red flag to us is that Pactiv forecasted a mere 14% increase in sales for the year. If Prairie were hypothetically acquired as of January 1 of 2006 and only a 6% increase in 2007, then why does this acquisition warrants an almost 200% increase in intangible assets? This leaves us wondering what the reasoning was behind this. It would seem that a larger increase in sales should be recognized to parallel this swelling of intangible assets. The incentive to make this move is obvious; a huge increase in reported assets will make their financial standing seem better to potential investors. However, while we realize that further research might explain this, at face value this seems to be a questionable accounting move. Another potential problem, after reviewing Pactiv s 10-k, relates to management s actuarial assumptions regarding their post-retirement obligations. This 74 Page

76 section of a firm s financials possesses a large potential for accounting distortion. This is due to the fact that accounting rules allow management to use their own judgment in estimating the present value of their pension/post-retirement obligations. In the case of Pactiv, the firm has assumed that the health-care cost inflation rate is going to drop to five percent by The National Coalition on Health Care states that In 2005, total national health expenditures rose by 6.9 percent two times the rate of inflation. Total spending was $2 trillion. Additionally, they stated that this expenditure will reach $4 trillion by Based on this information, Pactiv is taking an overtly optimistic view of future health-care expenses. This assumption causes their post retirement liabilities to be understated. Correcting this supposition will cause decreases in both their deferred tax liabilities and shareholders equity. Pactiv also states in its 10- k that for each one percent increase in health-care cost inflation their post-retirement benefit obligations will rise by $3 million. This further illustrates to what extent this faulty assumption can have on their financials. Undoing Accounting Distortions When analyzing a company s financial statements, it is important to notice possible distortions. In general after looking at our graphs in the quantitative analysis, we have not noticed any major distortions. Overall, Pactiv s ratios relative to the industry are close, and when there are changes in the ratios these changes are often seen industry wide. However, we will mention the big change noticed in the CFFO/OI ratio, the potential distortion in lease accounting, and the red flag seen in Pactiv s takeover of Prairie Packaging Inc. The use of operating leases is often seen as an accounting distortion that should be undone. However in our key accounting policies section, we undid this potential distortion by capitalizing our operating leases. After doing so, we decided it was not a distortion because after capitalizing Pactiv s leases these leases did not account for a big percentage of their liabilities. According to the quantitatve analysis, a strong decline in the CFFO/OI ratio from indicates manipulation of the financial statements. This also signifies the firm is less likely to be able to pay off its debts. However, market conditions, especially 75 Page

77 the sell of a major business segement for the firm (decreased operating income), explains why this ratio decreased during that time period. By selling of the segment the firm underwent a large change in the structure of the firm and there were many differences in financial statements. For example, the books for 2004 show a $32 million restructuring income along with an increase of $27 million in recievables. This restructuring allowed the firm to show less operating cash flows while maintaining relatively constant levels of operating income and therefore should not be considered a serious accounting distortion. As mentioned earlier in our potential red flags section, Pactiv recognized a sizeable increase in their overall intangible assets as of the purchase date of Prairie Packaging Inc. which seemed a bit overly optimistic in our opinion. To give an idea of what we mean, if one were to take a ratio of Pactiv s intangible assets (before the acquisition) to their total Assets in 2006; it would be a meager 8.6%. Now if one were to take a similar ratio of Prairies estimated physical worth before the acquisition of $410 million to the increase in intangible assets that Pactiv enjoyed as of the acquisition of $206 million, it would be a whopping 50%. This seems to be an unrealistic estimate which they leave largely unexplained and perhaps an aggressive misrepresentation that might require another look. Based on our calculations it would seem much more prudent for Pactiv to recognize a more conservative increase in intangible assets due to the acquisition, perhaps more along the lines of $50 to $75 million which is still a sizable portion of Prairie s overall worth. While intangible assets is a relatively small portion of Pactiv s overall assets (as stated earlier), it is quite important to the firm as it incorporates many aspects of their business that drive value and increase their margins. In conclusion, Pactiv has no major accounting distortions to be undone, but there are some interesting things to look at. 76 P age

78 Financial Analysis, Financial Forecasting, and Cost of Capital Estimation In order to analyze a company, investors and analysts must look at financial information of the company and its competitors. The first step in this analysis process is calculating a variety of ratios that deal with liquidity, profitability, and the capital structure. It is also important to notice trends of the company and its competitors using these ratios. Furthermore, these ratios will provide critical information needed to compile a ten year financial forecast of Pactiv. We will be forecasting Pactiv s balance sheet, income statement, and statement of cash flows. Finally, we will estimate the cost of debt and equity for Pactiv. In order to estimate the cost of equity, we will use CAPM and regression analysis. Financial Ratio Analysis This section is very important because it uses ratios to look at the liquidity, profitability, and capital structure of a company. Within these aspects, we broke down these ratios further by doing both a trend analysis along with a benchmark analysis. A trend analysis evaluates how the company is doing compared to how it did over the past five years. A benchmark analysis takes the ratios gathered for our company and compares them to their competitors. The benchmark analysis helps to show who is excelling within the industry and who is lagging. These ratios can prove to be very important for investors when trying to value a firm. In our analysis, both the trend and benchmark analysis will pre portrayed in one graph. Now, we will look further into the liquidity, profitability, and capital structure ratios. Liquidity Ratios In general, liquidity ratios show the ability of your business to quickly generate the cash needed to pay your bills. ( In other words, the ability of a firm to get cash to pay off their debts. These ratios are calculated using net sales from the income statement and various items from the balance sheet. The liquidity ratios 77 Page

79 that will be used in our analysis are: current ratio, quick asset ratio, accounts receivable turnover, days sales outstanding, inventory turnover, day s supply inventory, and working capital turnover. Current Ratio The above chart represents the current ratio for Pactiv and its competitors for the past five years. The current ratio is the current assets divided by the current liabilities. It shows how much money a company has to cover each dollar of debt incurred. It is good to have a higher ratio because a company with a higher current ratio shows to be less likely to default. A good benchmark for a current ratio is usually two or greater. On the other hand, a ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point ( Pactiv s current ratio is a little low, but it has been consistently between 1.5 and 2 over the past five years. Though a good benchmark is two, the industry average has been about 1.71 over the past five years, and Pactiv has averaged about 1.75 which shows that Pactiv has been consistent with the industry. 78 P age

80 Quick Asset Ratio The quick asset ratio, which is often referred to as the acid test, is similar to the current ratio in that it is a test of a company s ability to pay its debt. The quick ratio is more conservative than the current ratio because it excludes inventory from current assets ( The quick ratio is calculated by taking current assets minus inventory divided by current liabilities. Current assets that are included are things such as cash, securities, and accounts receivable. These items are included because these items could be converted to cash much quicker than inventory could. Pactiv struggles slightly in this area. Pactiv has maintained an average lower than the industry over the past 5 years. The industry has an average of about.90 and Pactiv has an average of about.80. Though they have a lower average, one thing to notice is that Pactiv has been consistent with the industry when looking at the ups and downs. It can be seen in the above chart when the industry goes down, Pactiv follows suit and vice versa. However, one noticeable year was 2005 when Pactiv s quick asset ratio dropped considerably. This sizeable drop was the result of a significant increase in their short-term debt from 2003 to 2004, which went back down from 2004 to Pactiv explains how this could happen in their 10-K: short-term debt increased and long-term debt decreased by $467 million from 2003 to 2004, reflecting the reclassification as current of long-term debt amounts due during the following 12 months. So, this big 79 Page

81 increase in short-term debt because of reclassification caused the quick asset ratio to decrease dramatically. Usually, a drop like this for this ratio could scare most investors but, after uncovering why this drop occurs, an investor s skepticism can be settled. A better way to look at it is by subtracting out the $467 million increase from the current liabilities for If you take out this big increase caused by reclassification, then the quick asset ratio looks much better at a 1.3. Also, this brings their average over the past five years to 1.04 which is better than industry average. Receivables Turnover The chart above shows the receivables turnover for Pactiv and its competitors for the past five years. This ratio is computed by taking the company s total sales divided by the accounts receivable for a particular year. This ratio is important because it shows how often a company is collecting cash from those who purchased something on credit. Once again, a higher ratio here is favorable. A low ratio implies the company should re-assess its credit policies (investopedia.com). When this ratio is low, it means that a company is not collecting on its credit sales in a timely manner. Pactiv has excelled in this area and, over the past five years, has consistently maintained a higher ratio than the industry average. It appears that Pactiv s receivables turnover has been increasing 80 P age

82 since Since Pactiv has done a relatively good job in this area, this ratio presents no concerns. This helps to show that Pactiv is an efficient company because it is able to collect on its credit sales more often than the industry average. Days Sales Outstanding The days sales outstanding ratio has an inverse relationship with receivables turnover. This means that when receivable turnover goes up, days sales outstanding go down and vice versa. Days sales outstanding is calculated by dividing 365 by the receivables turnover. This ratio shows the number of days it takes a company to collect on its credit sales. Since Pactiv s receivables turnover has been increasing since 2003, this means that its days sales outstanding has been on the decline since In general, this is a good thing because it means it is taking fewer days to collect on its credit sales. Pactiv is an industry leader in this ratio as well. Furthermore, something important to notice is that the industry average for this ratio appears to be declining which means that the industry is becoming more efficient in collecting on its debts. 81 P age

83 Inventory Turnover The chart above shows the inventory turnover for Pactiv and its competitors over the past five years. Inventory turnover shows how many times a company's inventory is sold and replaced over a period. (investopedia.com) Inventory turnover is calculated by taking the total sales or revenue for a year and dividing by the total inventory for that year. This ratio is important because, if it increases, it shows that a gain in inventory will result in producing more sales. It appears that Pactiv is lagging since it is consistently been below the industry average and has been in the past. This could be seen as a negative thing for most investors so in order for Pactiv to try to look better in this area, they either need to keep fewer inventories on hand or try to increase their sales while keeping their inventory constant. Though Pactiv has a relatively low inventory turnover, it increases and decreases in a pattern consistent with the industry. 82 P age

84 Days Supply of Inventory Days supply of inventory and inventory turnover also have an inverse relationship. The definition of days supply of inventory can be deduced from its name. It is how many days of inventory a company has on hand. Days supply of inventory is calculated by dividing 365 by inventory turnover. Since Pactiv s inventory turnover is lower than the industry average, Pactiv s days supply of inventory is higher than the industry average. However, once again Pactiv follows the same trend as the industry. This basically shows that it is taking Pactiv longer than the industry to convert inventory into sales. Since Pactiv is lagging in this area, it could result in a negative view to an investor if they were to look at this ratio. 83 P age

85 Cash to Cash Cycle The cash to cash cycle is directly related to days sales outstanding and days supply of inventory. It is also commonly referred to as the cash conversion cycle. In order to calculate the cash to cash cycle, you take the sum of days supply outstanding and days supply of inventory. A simple definition of the cash to cash cycle is the length of time, in days, that it takes for a company to convert resource inputs into cash flows. ( Generally, a lower number here is better because when the number is higher, it shows that a company s money is tied up in other business activities (investopedia.com). As with days supply outstanding and days supply of inventory, Pactiv stays pretty consistent with the industry. Also, Pactiv s five year average is very close the five year average of the industry. One key thing to note is that Pactiv and the industry are lowering their cash to cash cycle, which is a good thing in the eyes of an investor. This shows that they are becoming more efficient in their business operations. 84 P age

86 Working Capital Turnover The above chart shows the working capital turnover for Pactiv and its competitors for the past five years. Working capital turnover is calculated by taking sales and dividing them by working capital. Working capital is calculated by taking the difference between current assets and current liabilities. It shows if a firm is turning its working capital into sales. A higher working capital is usually better since, The higher the working capital turnover, the better because it means that the company is generating a lot of sales compared to the money it uses to fund the sales. (investopedia.com) Pactiv is in the middle of the pack here. However, Pactiv appears to be increasing its working capital turnover, which will ultimately end in a more profitable operation. Conclusion By looking at the various liquidity ratios, we can compare how efficient Pactiv has been over the past five years by comparing them with its competitor s ratios. Overall, Pactiv s ratios seem to be closely tied to the industry average with small variations on and around the industry curve. The only ratio that Pactiv has really excelled in is accounts receivable turnover. As a result, they are able to turn their credit sales into 85 P age

87 cash quicker than the industry. On the other hand, Pactiv is operating on an average level with respect to efficiency. Profitability Structure Analysis The profitability structure analysis section uses various ratios to determine how profitable different aspects of the company are. Overall, these ratios help to determine how effective a firm is at generating profit. We will use these ratios to look at Pactiv s performance over the past five years and compare it to their competitors. The ratio that we will use are gross profit margin, operating profit margin, net profit margin, asset turnover, return on assets, and return on equity. Gross Profit Margin The gross profit margin, which is derived by dividing sales minus the cost of goods sold by sales, is a measure of basic product profitability. The higher the gross profit margin, the more efficient are its operations. A larger gross profit margin can be obtained by either an increase in sales relative to the cost of goods sold, a decrease in 86 Page

88 the cost of goods sold relative to sales, or both. Decreases in this ratio would be explained by opposite movements of the above variables. As the graph illustrates, Pactiv has held one of the top three spots with regard to gross profit margins. Operating Profit Margin Another measure of operating efficiency is the operating profit margin. Like the gross profit margin, the higher its value, the better. This ratio is calculated by dividing operating income by total revenue. Since operating income is made up of gross profit minus operating expenses, an increase in operating expenses will cause operating profit margins to decrease. Therefore, firms which have operating profit margins that exceed their respective industry s average will tend to have lower fixed costs and better gross profit margins. This in turn, leads to more flexibility over the prices of their goods or services, which can be very beneficial during economic down turns (About.com). 87 P age

89 Net Profit Margin The net profit margin is simply the percentage of net income to sales. Once this percentage is found, we can then evaluate the operating efficiency of each firm and determine a proper conclusion for the forecast. Operating efficiency for this ratio entails how much cost a company has incurred and how it is controlling these costs. Overall, a higher net profit margin is better. A high net profit margin indicates that there are low, overall company costs while a low margin is a result of poor cost control. Over the past five years, Bemis and Sealed Air have maintained the most stable margins while Pactiv has been more closely related to the industrial average. Pactiv has experienced somewhat volatile margins in the past, probably due to the integration factors surrounding new acquisitions, but seems to be stabilizing as time goes on. 88 P age

90 Asset Turnover The asset turnover ratio is used to determine the productivity of a firm s assets by dividing sales by total assets. The productivity refers to whether or not the assets held by a firm are profitable or not. That being said, the higher the ratio, the more profitable a firm s assets will be compared to a firm with a lower ratio. For manufacturing companies such as Pactiv, asset turnover ratios are very important in evaluating the profitability of a company. This is because the companies in this industry use expensive machinery (assets) to manufacture the product that produces revenue. Pactiv had a very stable ratio in prior years and is slowly growing which is indicative of an increasing productivity of assets. Through this increase in productivity, Pactiv has managed to find itself grouped with similar ratios amongst its competitors. By looking at the graph, one can see that for every dollar spent in assets, Pactiv will generate a little more than a dollar in total revenue. 89 P age

91 Return on Assets Return on assets is calculated by dividing net income of the current year by the total assets of the prior year. This percentage will determine how much last year s investment in assets has yielded for the current year. The higher the percentage, the more profitable the investment in assets is from last year. A low percentage can result from poor investments in assets or firm s not using their assets to full capacity. Once again, Pactiv is closely related to the industrial average while AEP Industries seems to be a common outlier throughout this analysis. AEP s big spike in 2005 is the result of changing inventory methods to reduce inventory on hand and increase net income. Overall, there is nothing wrong with Pactiv here since their return on assets appears to be stabilizing after the boost in P age

92 Return on Equity Similar to ROA, a firm s ROE is used to show the return for each dollar of equity held by the firm. This is calculated by dividing net income by total equity from the year prior. If a company has a high ROE, it is usually evidence of the firm using more debt than equity in their financing activities. A company with a lower ratio has used less debt in financing activities, thus increasing the denominator, and lowering the firm s ROE. Pactiv s stagnant ROE shows that the firm uses almost 100% equity in their financing activities which shows in its ROE of about 0%. Conclusion In conclusion, Pactiv s superior gross profit margin and operating profit margin are indicative of Pactiv s ability to minimize the cost of goods sold and the fixed costs associated with production. These two ratios were well above the industry average which means that Pactiv s efficiency is also well above the industry average. In addition, Pactiv has one of the top two net profit margins showing that it also has proper control over the costs incurred. Pactiv s asset turnover, ROA, and ROE are all congruent to the industrial average which will raise no precautions in the eyes of the investor. The favorable ratios mentioned prior are quite significant in that, Pactiv has successfully 91 P age

93 minimized their costs are controlling them well. This aspect will ultimately end in a more profitable and efficient operation that everyone can enjoy. Capital Structure Analysis The capital structure of a company refers to how a firm finances its operations. Firms acquire finances by either borrowing money from lenders or by issuing stock and receiving money from investors ( There are three important ratios that we will use to look at how a firm finances it operations. The ratios that we will be looking at are the debt to equity ratio, times interest earned, and the debt service margin. Debt to Equity The debt to equity ratio tells how much debt a company has for every dollar of equity and is calculated by dividing total owner s equity by total liabilities (Business Analysis and Valuation). It can vary per industry, but in general a lower debt to equity ratio is better. If a company has a high debt to equity ratio, this usually means that they are borrowing more money to run the business. Pactiv has a five year average debt to equity ratio of 2.42, while the five year average for the industry is At first glance, this looks good for Pactiv, but the only reason the industry average is so high is 92 P age

94 that AEP Industries ratio is extremely high. It is a good sign, however, that their ratio has decreased consistently. The ratio has dropped from 2.49 in 2003 to 2.07 in Times Interest Earned Times interest earned shows how much operating income a company receives for every dollar of interest expense they have. It is calculated by taking income from operations and dividing it by the interest expense (Financial Statement Analysis notes). When analyzing this ratio, bigger is better. Bigger is better because this ratio indicates how many times a company can cover its interest charges on a pretax basis. Failing to meet these obligations could force a company into bankruptcy. ( As the graph shows, Pactiv leads the industry in this particular ratio. The cause for the large increase in 2006 is due to an increase in operating income as well as a decrease in interest expense. 93 P age

95 Debt Service Margin The debt service margin is a measure of how well a company will be able to pay off installments due on long term debt. It is calculated by dividing cash flows from operations by the current portion of long-term debt from the previous year (Financial Statement Analysis notes). For the most part, Pactiv s debt service margin ratio follows the trend of the industry, but with greater extremes. The debt service margin ratio for Pactiv in 2006 could not be computed because they had no installments due on long term debt during SGR and IGR Analysis The SGR is defined as the sustained growth rate and the IGR is the internal growth rate. They help an investor value a firm by looking at their potential growth. Also, both ratios show how much a firm can grow without borrowing more money. In the following sections we will go into more detail about the SGR and the IGR. In addition, we will look at Pactiv s SGR and IGR compared to its competitors over a five year time period. 94 P age

96 Sustainable Growth Rate (SGR) Sustainable growth rate is calculated by multiplying the internal growth rate by one plus the debt to equity ratio. This rate tells how fast a firm will be able to continue to grow without altering the debt to equity ratio. Pactiv s sustainable growth rate for 2007 is at.27 which is at about the industry average. For the last five years beginning 2003, Pactiv has the highest average SGR. Pactiv has also fallowed the trend of the industry during these years, although the company has not seen the same extremes of the highs and lows as other companies within the industry. 95 P age

97 IGR Analysis As stated above, the IGR is the internal growth rate. The IGR is the highest level of growth achievable for a business without obtaining outside financing. (investopedia.com) To calculate the IGR, you take the ROA (return on assets) and multiply it by one minus the dividend payout yield (dividend/ net income). The chart above shows the IGR for Pactiv and its competitors over the past five years. Pactiv has an IGR slightly above the industry average over the past five years. Pactiv also has a very similar trend compared to the industry average. Over the past five years, Pactiv s average IGR is 7%. This means that the company has been able to grow at an average rate of 7% over the past five years without using outside financing. The industry average is over 5 years is 5%, so Pactiv is outperforming the industry. 96 P age

98 Altman s Z-Score The Altman Z-score model is used to predict whether or not a company will go bankrupt within the next year. The model uses five different variables, assigns them weights, and then adds them together. If the Z-score is less than 1.81, the company will likely go bankrupt, while companies with a Z-score between 1.81 and 2.67 have a strong possibility of declaring bankruptcy as well (Business Analysis and Valuation). There is a trend that can be seen within the industry. For the most part, the industry saw increases in Z-scores from 2003 to 2006 and then saw a decrease from 2006 to Pactiv s Z-score for 2007 was 2.73, just above the gray area. This is a good sign, but does show a slight cause for concern. The five year average Z-score for Pactiv is at 2.77, just below the overall industry average of Conclusion After analyzing the capital structure ratios of Pactiv, the only clear advantages Pactiv has over the industry is their ability to cover interest charges and minimize borrowed money to finance operations. Pactiv s debt to equity ratio has been consistently decreasing which means that, as time goes on, they are using less and less borrowed money for financing. This is always a good indicator of quality debt 97 Page

99 management. The only capital ratio of Pactiv that is currently below the industry average is their debt service margin. This difference is not significant enough to cause concern just yet, but there needs to be an improvement of this ratio or else Pactiv will find that they do not have enough money to cover the installments due on their long term debt. Overall, Pactiv is definitely a top performer in capital structure ratios which is evidence of quality financing decisions within the firm. Forecasting of Financial Statements According to forecasting is defined as the process of analyzing current and historical data to determine future trends. This is the best way to gain insight on the future expectations of a firm and is part of the prospective analysis portion of a valuation. Since these estimations are based on historical fact and do not take into consideration future market results, it is important to remember that the forecast is the best available guess. Also, since these numbers are based on assumptions, any inaccuracies could potentially throw the valuation off. Each financial statement was forecast using the best available historical data from the past 5 years. On the income statement, a growth rate was applied to the most recent report of revenues. The forecast of the balance sheet was directly related to the income statement through the use of the asset turnover ratio which was previously computed. Lastly, a ratio of cash flows from operations (CFFO) over net sales was used to compute future CFFO s on the statement of cash flows. The basis or starting point for all of the projected statements was the expectations of future sales. Income Statement The estimation of growth for Pactiv was calculated by taking an average of the sales growth for the previous 5 years and comparing it to that of the growth of the previous 4 years because in 2002 the company experienced a 17% decline in sales. This number was removed because the company sold off a portion of its business during that time period. The sell off resulted in decreased total revenue although the 98 P age

100 company did not technically suffer losses. Because of this we assumed the average to be a 5% growth rate from year to year. The next step in forecasting the Income Statement was to create a common sized Income Statement. This was done by dividing each line item on the income statement by total revenue which provides a percent of allocation compared to total revenues. We then calculated the five year average of each line item on the consolidated statement. These averages were then multiplied by the forecasted total revenue in order to create a forecast for that specific line item. Some of our key forecast numbers for 2017 are $5, million in total revenue and $ million in net income. Balance Sheet We then linked our forecasted income statement to our balance sheet using the asset turnover ratio. We took an average of.87 for the previous five years and worked back through algebra to solve for forecasted total assets for the next ten years. Then we created a common sized balance sheet by dividing each line item under assets by total assets to get a percentage. Next, we found the five year average for each line item, just as we did for the income statement. We then multiplied the average by 2007 s numbers in order to forecast This process was repeated all the way through to We forecast that in 2017, Pactiv will have $1,778 million in total current assets and $6,091 million in total assets. Statement of Cash Flows The statement of cash flows is the most difficult financial statement to forecast as it involves more independent calculations than the other two. We began by finding out what percent net income, depreciation, and deferred taxes are of cash from operating activities for the six years from 2002 to We then calculated the six year average to be used in forecasting the next ten years. Using the CFFO/Sales average ratio of.13 over the past 5 years we multiplied this by our forecasted Total Revenue to calculate our Cash Flows from Operating activities. 99 Page

101 The Cash Flows from Investing Activities were calculated by taking the forecasted Total Liabilities in 2008 and subtracting them from the Total Liabilities in Each year the difference represents the amount spent on investing activities. Consequently, we forecast that by 2017 PTV will spend over $281 million on financing activities. Conclusion Our forecasts of the financial statements for Pactiv look very promising. It appears that Pactiv will continue to grow into a much larger company. As we stated earlier, however, these forecasts are made using assumptions, and only time will tell what will actually happen. Cost of Capital Estimation In order to fully assess a firm s expansion capabilities it is necessary to determine its ability to acquire new capital which is either financed through debt or equity. Each firm has its own specific cost of equity and a partnering cost of debt that must be calculated in order to obtain the information required to properly estimate the weighted average cost of capital or WACC. Calculating these percentages is perhaps one of the most difficult tasks that a valuation team must tackle and they can be derived in a few different manners. Cost of Equity A firm s cost of equity can be estimated using two different methods, both of which were applied by this team. The first method involves a regression analysis using information accrued from several different sources. First we obtained Standard & Poor 500 historical price data from and calculated the monthly returns over the last eight years. Second, we obtained 3 month, 6 month, 2 year, 5 year, and 10 year treasury rate data from the Federal Reserve Bank of St. Louis which we used as our risk free rates due to the low level of risk inherent in a treasury bond. 100 Page

102 The market risk premium is derived from subtracting the corresponding risk free rate from the S & P 500 returns that we calculated. This gave us five sets of market risk premium data. We then obtained Pactiv s historical stock price data and calculated the monthly returns. With these data in hand, we derived 25 separate regressions over a horizon of 72, 60, 48, 36, and 24 months between Pactiv s monthly returns and applicable market risk premium rates. The primary purpose of this method is to acquire a suitable Beta value, which measures the volatility of Pactiv s stock price in relation to the rest of the market (in this case the S & P 500). When a suitable Beta is found it can then be inputted into the Capital Asset Pricing Model or CAPM. A summary of our regression output is as follows: 3 Month Horizon Beta Adjusted R Square T-Stat P-Value Confidence Level Ke 6 Month Horizon Beta Adjusted R Square T-Stat P-Value Confidence Level Ke 101 Page

103 2 Year Horizon Beta Adjusted R Square T-Stat P-Value Confidence Level Ke 5 Year Horizon Beta Adjusted R Square T-Stat P-Value Confidence Level Ke 10 Year Horizon Beta Adjusted R Square T-Stat P-Value Confidence Level Ke We determined that 0.75 was the best Beta value to use and it was derived from a 10 Year Treasury bond risk free rate over a 72 month horizon which was paired with 102 Page

104 an R-square of just under 14% and a confidence level of 99%. Also, we used a market risk premium of 7% to calculate our Ke. This 7% comes from about an S&P500 average return over the past 50 years. Inputting this data into the CAPM equation we derived a cost of equity of 9.92%. Considering that our R-square value was almost 15% we believe that this value does a fair job of explaining Pactiv s returns in relation to the associated market risk premium. What also gives us some confidence in our results is that the beta never differentiates by more than 25% which tells us that it is reasonably stable over time, a positive sign for prospective investors. The Back Door approach is the second method we employed in determining Pactiv s cost of equity and the formula is as follows: Ke = ROE + g (p/b 1) (p/b) The ratio (p/b) refers to Pactiv s price to book ratio which we acquired from Yahoo Finance. g refers to the growth rate of the firm which we also acquired from Yahoo finance. We calculated Pactiv s Return on Equity to be 28.72%. Using all of this data we arrived at a cost of equity of 15.95%, a bit more realistic in our opinion. Considering that our R-square was above 10% we have the luxury of choosing between two values of Ke, which averaged would come out to 12.97%. Cost of Debt The cost of debt is the effective rate that a company pays on its current debt. (investopedia.com) This rate is important in calculating the weighted average cost of capital (WACC). Once we get the cost of debt the WACC can be calculated on a before or after-tax basis. To come up with the cost of debt estimate we found various interest rates from Pactiv s 10-K, interest rates on FRED at the St. Louis Federal Reserve website, and estimated rates. There was low disclosure in Pactiv s 10-K relative to the interest rates used in calculating some of the liabilities on the balance sheet. As a result we used the 3 month 103 Page

105 nonfinancial commercial paper (CPR) rate often in calculating our cost of debt. We used this rate for accounts payable, accrued liabilities except for accrued payroll and benefits, non-current liabilities related to discontinued operations, and minority interests. The rate that we use from the St. Louis Federal reserve website is 4.63%. On the other hand, Pactiv has a stated percentage for their pension plans. This stated rate is 6.39%, so we used this rate for accrued payroll and benefits and for pension and postretirement benefits. Furthermore, for other under current liabilities we used the interest given in the 10-K for short-term borrowings. For long-term debt and for other we used the long-term rate on notes due in 2018 which is 6.3%. We made a big assumption in order to calculate the deferred income tax. We used 6.4% which is the difference between the increase in the effective tax rate between 2007 and The effective tax rate for 2007 is 35.5% and 29.1% for Deferred income tax comes from income that has been realized, but the tax on that income has not. (investopedioa.com) Accordingly, if a company has not paid tax on income for a particular year then in our opinion their effective tax rate would go up in the next year, and therefore the difference between these rates would be deferred income tax. Finally, to calculate the cost of equity we did a weighted average. First, we took each liability and divided it by our total liabilities. This gives us a percentage for each item. Next, we multiplied those percentages by the rates we assigned to each item. Finally, we summed up what we got in the previous step, and that gives the cost of debt. Our cost of debt ends up being 6.07%. Weighted Average Cost of Capital The weighted average cost of capital (WACC) takes a weighted average of the rates calculated in the cost of debt and equity. According to investopedia.com, the capital funding of a company is made up of two components: debt and equity. Therefore, WACC tells us the return on these two components. There are two ways WACC can be calculated. It can be calculated on a before tax basis and an after tax basis. Investopedia.com offers the following formula to calculate the after tax WACC. 104 Page

106 Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate The before tax WACC can be calculated by using the formula, but removing the (1-Tc). Using the variables from above, we made four WACC calculations. We did a before and after tax WACC for the CAPM method of obtaining Re and the backdoor method. E equals 3.42 billion and D equals billion, so the V=5.957 billion. The Re for CAPM is 9.92%, and the Re for the backdoor method is 15.95%. The Rd used in both the CAPM and backdoor method is 6.09%. For the after tax calculations on both methods, the Tc we use is 35.5%. Thus, if these numbers were plugged in appropriately to the above equation, then the following results percentages would be produced. WACC using CAPM WACC (before tax) 8.29% WACC (after tax) 7.37% WACC using backdoor method WACC (before tax) 11.75% WACC (after tax) 10.83% 105 Page

107 Method of Comparables Pactiv's Method of Comparables Ratios Share Price Trailing P/E $24.88 Forward P/E $29.34 Price to Book $17.97 Dividend Yield N/A Price Earnings Growth $17.02 Price to EBITDA $23.77 Enterprise Value to EBITDA $16.31 Price to Free Cash Flows $42.88 *Prices were determined using Pactiv's 10-K and Yahoo Finance The above chart shows Pactiv s method of comparables that were formed using numbers found in Yahoo Finance and Pactiv s 10-K. The method of comparables is a tool some analyst use in calculating an appropriate stock price for a given company. The method of comparables uses basic ratios to come up with a stock price. This may seem like a helpful and practical tool to use. However, for various reasons the method of comparables is not the best way to value a company. One big reason is that this method is so easy that anyone who can do basic math can do it. If everyone is using this model and basing whether or not they purchase or sell a stock on this method, then the stock price will be driven by these people. The ratios that we used are the trailing price to earnings, forward price to earnings, price to book, price earnings growth, price to EBITDA, enterprise value to EBITDA, and price to free cash flows. We were unable to calculate dividend yield because Pactiv is a non-dividend paying company which is another reason this model is inadequate. Pactiv s share price as of April 1 st, 2008 is $ Our decision for whether our firm is over or undervalued will be based on a 20% margin of error. With a 20% margin of error, this means Pactiv is undervalued at $32.70, overvalued at $21.80, and fairly valued if the price is somewhere in between. After looking at our method of comparables, it can be seen that our numbers are all over the place. We will talk about 106 Page

108 each number in more detail in order to explain how we got them and whether or not they have any sensible use. Trailing Price to Earnings Trailing Price to Earnings Company PPS EPS P/E Trailing Industry Average Comparable AEP Industries $ PTV PPS Sealed Air $ $24.88 Bemis $ Pactiv $ The above chart shows the trailing price to earnings (P/E) ratio for Pactiv and its competitors. The numbers we used for our competitors were found on Yahoo Finance and our earnings per share (EPS) for Pactiv was found in their 10-K. It also gives an industry average which is used to calculate the price per share (PPS) for Pactiv. In order to make the appropriate calculation to find the P/E trailing, we took the PPS for each of Pactiv s competitors and then divided it by the EPS. Once we got those numbers we took the average of the P/E trailing numbers that we calculated. Once we got our industry average we multiplied it by Pactiv s EPS. This calculation gives us a share price of $24.88, and Pactiv s observed share price on 4/1/2008 then with a 20% margin of error Pactiv is fairly valued. One interesting thing to note is that Pactiv s competitor s trailing price to earnings ratios are all over the place. So, this model probably isn t the best model to judge a company in this industry. Another problem with this model is that EPS is a backwards looking number and PPS is a forward looking number. So, this ratio is comparing numbers from different time periods. 107 Page

109 Forward Price to Earnings Forward Price to Earnings Company PPS Forward EPS Forward P/E Industry Average Comparable AEP Industries $30.70 N/A N/A $14.89 PTV PPS Sealed Air $ $29.34 Bemis $ Pactiv $ The above chart shows the forward price to earnings (P/E) ratio for Pactiv and its competitors. The forward P/E is very similar to the trailing P/E, but it uses forward looking EPS instead of a backwards looking EPS. To find the EPS for Pactiv, we took our one year out forecasted earnings and divided by the shares outstanding as of last year. We found the EPS for Pactiv s competitors by using the one year out EPS found under analyst estimates on Yahoo Finance. So, once we gathered all the appropriate numbers we then calculated our forward P/E. We found the forward P/E by taking the PPS and dividing it by the Forward EPS. Once we found the forward P/E we took an average for Pactiv s competitors to get our industry average. After we computed our industry average, we then multiplied it by Pactiv s forward EPS. This gave us a PPS for Pactiv of $29.34 with our observed share price being $ Through this model and 20% margin for error, Pactiv is a fairly valued company. One negative to note about this model is that we were unable to use AEP industries as a competitor because there was not an available forward EPS for them. 108 Page

110 Price to Book Price to Book Company PPS BPS P/B Industry Average Comparable AEP Industries $ PTV PPS Sealed Air $ $17.97 Bemis $ Pactiv $ The above diagram shows the price to book (P/B) ratio for Pactiv and its competitors. The method basically says is a company s value supported by its book value of equity. This is another simple method that is performed by taking the price per share and dividing it by the book value of equity per share which gives us the P/B. Once more, we took the average of Pactiv s competitors to come up with an industry average. However, this time we threw out AEPI because there P/B was so much higher. We saw AEPI as an outlier. Once we got the industry average we multiplied it by Pactiv s BPS which gives us a price of $ Once again, given a 20% margin of error, this model says that Pactiv is an overvalued company. One negative to note about this model within our industry is the P/B ratios are scattered. Since they were scattered we had to throw out one of Pactiv s competitors. So, this model might not be appropriate for our industry. Price Earnings Growth Price Earnings Growth Company P.E.G. EPS Earnings Growth Industry Average Comparable AEP Industries N/A 1.82 PTV PPS Sealed Air 1.35 $17.02 Bemis 2.29 Pactiv Page

111 For calculating a PPS for Pactiv, we used a P.E.G. for Pactiv s competitors that we found on Yahoo Finance. We found the P.E.G. under key statistics, and this number is given as a five year expected. To actually calculate a P.E.G. ratio, you would take the P/E ratio for a company and divided by an expected earnings growth. We then took our industry average by taking an average of Pactiv s competitors P.E.G. So, to find the price for Pactiv we took the industry average and set it equal to price over earnings per share all over earnings growth. We used an EPS for Pactiv of 1.87 which we found in the 10-K and a growth of 5% because that is the growth used in our forecast. So, once we solved for price we came up with a PPS of $ Based off our observed share price and a 20% margin of error, this model says Pactiv is overvalued. Once again, a negative can be seen in the method of comparable because we have an outlier in AEPI because they do not have a published P.E.G. They do not have a published P.EG. because they have a negative quarterly earnings growth published on Yahoo Finance. Price to EBITDA Company Price to EBITDA Market Cap EBITDA P/EBITDA Industry Average Comparable AEP Industries PTV PPS Sealed Air 4, $23.77 Bemis 2, Pactiv 3, *Market Cap and EBITDA in Millions The above chart gives the price to EBITDA ratios for Pactiv and its competitors. EBITDA is short for earnings before interest, tax, depreciation, and amortization. First, we found the market cap for Pactiv by using and its competitors. Then, we found the EBITDA for Pactiv s competitors by looking at Yahoo Finance, and the EBITDA is given under key statistics for each company. For Pactiv, we did a calculation to find EBITDA. The calculation involved finding the net income in their 10-K and then adding back 110 Page

112 interest expense, income tax, depreciation and amortization. The following table gives a look at where the EBITDA from Pactiv came from. Pactiv EBITDA Net Income $245 Income tax Expense $135 Interest Expense $96 Depreciation and Amortization $166 Total $642 Once we had the EBITDA and the market cap for Pactiv and all of its competitors we were able to calculate the ratio for each company. We then found the industry average by taking the average of AEPI, Bemis, and Sealed Air. To calculate, a price for Pactiv we took Pactiv s EBITDA and multiplied it by the industry average and then divided it by the shares outstanding for Pactiv. This gave us a price of $23.77, which is fairly valued, compared to our observed share price of $ Enterprise Value to EBITDA Enterprise Value to EBITDA Company Enterprise Value EBITDA EV/EBITDA Industry Average Comparable AEP Industries PTV PPS Sealed Air Bemis Pactiv *Enterprise Value and EBITDA in millions The above chart shows the enterprise value (EV) to EBITDA ratios for Pactiv and its competitors. The first step in calculating the EV to EBITDA ratio is to compute the EV. In order to make this calculation, we took the market value of equity or the market 111 Page

113 cap added book value of liabilities and subtracted the sum of cash and short term investments. The formula would look like the following: EV= Market Value of Equity + Book Value of Liabilities (Cash+ short term investments) We did this for both Pactiv and its competitors. Then, we found the EBITDA calculation for Pactiv and its competitors. Here we used the EBITDA on Yahoo Finance for Pactiv s competitors, and for Pactiv we found the net income and added back interest expense, income tax expense, appreciation, and amortization. Once we got these numbers, we calculated the ratio for all of the companies. Then we found an industry average by taking an average of AEPI, Sealed Air, and Bemis s EV/EBITDA ratio. Once, we had the industry average we performed the calculations to get a comparable price for Pactiv. Based on a 20% margin of error and observed share $27.25, Pactiv is overpriced compared to the price of $16.31 given by the EV/EBITDA. Price over Free Cash Flows Price to Free Cash Flows Company Market Cap FCF P/FCF Industry Average Comparable AEP Industries PTV PPS Sealed Air 4, Bemis 2, Pactiv 3, *market cap and FCF in millions The above shows the ratios for Pactiv and its competitors for the price to free cash flows. We used a market cap found on Yahoo Finance for Pactiv s competitors, and for Pactiv we multiplied the shares outstanding found in their 10-k by the observed share price of $ Then, for each company we had to calculate the free cash flows. This is done by taking the cash flows from operations and adding or subtracting the cash flows from investing and cash flows from financing activities. Once we did this we were able to calculate the P/FCF ratios for each company. Then, we found an industry 112 Page

114 average. Once this was done, we were able to calculate a comparable price per share for Pactiv which was $ Based on a 20% margin of error and a $27.25 observed share price, this model shows that Pactiv is underpriced. Intrinsic Valuation The models that we consider to be more accurate and have theory to support them are the intrinsic valuation models. These model help analyst give truly value a firm to see whether or not a firm is overvalued, fairly valued, or undervalued. The intrinsic valuation models include the dividend discount model, residual income model, free cash flows model, residual income model, the abnormal earnings growth model, and the long-run residual income perpetuity model. We will go into more detail about each model in the following sections. However, the divided discount model is not applicable to Pactiv because they are no dividend paying company. We will use these various models to see how the firm produces value. Once these models are firmed we will play with the cost of equity and growth rate in order to perform a sensitivity analysis. The sensitivity analysis is done because the numbers are based off forecasted numbers. So, by adjusting these variables, the sensitivity analysis shows how much our numbers would change and give a margin of error. So, I think these models can give a more accurate picture of whether or not a firm is correctly priced. Free Cash Flow Model The combination of incoming cash flows from operations and investing activities is used as the free cash flows for the firm. These funds are used to both support liabilities and equity. The Free Cash Flow Model is used as an equity valuation based on these cash flows. The first step was the forecasting of the financial statements and the line items used to calculate Free Cash flows especially. The forecasted numbers were then discounted back into present dollars using the WACCBT. Next, a sum of the year by year free cash flows in current dollars was used to calculate the present value of all forecasted cash flows. Then we used the perpetuity model of FCF yr 11/ (WACCBT FCF growth rate) = Continuous TV Perpetuity to estimate the cash flows from beyond the 113 Page

115 forecasted future. These were also discounted back into present value dollars to get $1165 million as an estimate of the value of cash flows over time. By adding the PV of the TV Perpetuity to the PV of the year by year cash flows gives us the Market Value of Assets according to this model. To calculate the Market Value of Equity, the Book Value of Liabilities was subtracted from the Market Value of Assets to compute the Market Value of Equity. This number divided by the number of shares outstanding gives the intrinsic value of the firm according to this model at 12/31/07. Multiplying the intrinsic price by one plus the growth rate, to the.25 power gives an accurate estimation of the growth in The.25 is derived from the first three months in 2008 over the 12 months for the year. According to the Free Cash Flow Model, our firm is overvalued. Depending on the growth rate and cost of capital, the model indicates that Pactiv s share price is usually much higher than it should be. The following Sensitivity Analysis shows this assumption. Growth WaccBT N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Undervalued if > $32.70 Overvalued if < $21.80 Fairly Valued $21.80< price > $ Page

116 As you can see the firm is only fairly priced or underpriced when there are very large growth rates and low costs of capital. Since neither of these factors should be relied upon over time, it is safe to say that the firm is overpriced. Using our estimation of 11.75% for the WaccBT and the growth from the forecasts of 5%, the share price should be $9.56 while the market price is actually over $27. Residual Income The residual income model is one of the more accurate models used. One reason that this model is considerably more accurate than the free cash flows model is because it uses the forecast of net income. Net income is supposed one of the easiest numbers to forecast. So, we will talk about this model a little more in detail and go into more of the specific calculations. This model basically shows whether a firm is adding value or destroying value. The first calculation necessary for this model is to have forecasted net income. In our case, net income is forecasted for the next ten years. Once we have the forecasted net income we need something to benchmark it against. So, we calculate the normal or benchmark net income. To do this, we took the previous year s book value of equity and multiplied it by our cost of equity (ke), and this was done for ten years. The residual income takes the difference between our forecasted net income and our benchmark net income. The first negative sign for Pactiv is that their residual income is negative from 2010 on forward. With a negative residual income, this means that Pactiv is destroying value of the company to its investors from year 2010 on. Then we have to bring back each year s residual income back to the present value. So we performed the following calculation to get our present value (PV) factor. This formula says divide 1 by the quantity of 1 plus the cost of equity and raise it to the T power. T represents the time period the we are in. Once we get our PV factor for the ten years we multiply the residual income by the PV factor for the respective year. Then, we take the sum of these residual incomes multiplied by the PV factor to give us the total PV of annual residual income. 115 Page

117 Then we had to calculate the terminal value of the perpetuity. So, first we had to calculate our perpetuity. In order to calculate our perpetuity, we took our year ten, or 2017, residual income and multiplied it by 1.15 because our residual income was growing negatively at a declining rate which we estimated to be about 15%. Then, we took that number which came out to and did it in to perpetuity. To do that, we took that number in divided it by Ke - g. G being our growth rate. This gave us our perpetuity, and then we multiplied it by our time 10 PV factor to get our terminal value of perpetuity. Then we took the sum of our total PV of annual residual income, terminal value perpetuity, and our initial book value of equity. Once we found this number which is , we could then divide it by our shares outstanding, million. This gave us a price as of 12/31/2007 of $4.66. We had to make it time consistent so we multiplied it by (1+ke)^(3/12). We did this so we could bring the price as of 12/31/2007 to 4/1/2007. This gave us a price of $4.83, and with a 20% margin of error says that Pactiv is greatly overvalued Undervalued if > $32.70 Overvalued if < $21.80 Fairly Valued $21.80< price > $ Page

118 The above chart is our sensitivity analysis for our residual income model. Another positive with this model compared to free cash flows is that it is not as sensitive to changes in our Ke and g. As seen through the sensitivity analysis, Pactiv never even comes close to its observed price on April 1 st, 2008 of $ As seen by the table above, a red square indicates overvalued. So, the table shows that Pactiv is consistently overvalued. Long Run Residual Income Perpetuity The Long Run Residual Income Perpetuity is a continuation of the Residual Income model. It is another method used to try to find the true value of equity using the book value of equity, return on equity, the cost of, and equity growth rates. We used this formula to calculate this model: Value of Firm= BVE (1+ ((LR ROE Ke / (Ke LR Growth of Equity)) This model provided us with the information that the Estimated Market Value of Equity was $1679 million. To find this on a per share basis we divided that by the million shares outstanding to reach an intrinsic value of $12.88 per share. To make this time consistent with the final trading day of 4/1/08, we multiplied the $12.88 by one plus the growth rate to the (3/12) to bring the value to April 1 dollars. Sensitivity Analysis Growth Ke Page

119 Roe Ke Roe G Page

120 Undervalued if > $32.70 Overvalued if < $21.80 Fairly Valued $21.80< price > $32.70 As you can see, most of the numbers ended up painted red indicating that using those factors, the firm was overvalued. Only when there was high growth or high return on equity accompanied by low costs of equity was the firm undervalued. This also shows that in order for this company to maintain its value it must have high growth, low cost, and efficient use of resources. As you can tell by the last sensitivity analysis, the firm becomes fairly valued when there is high growth and high returns on equity. This shows that if there is efficient use of resources, along with an increased demand in products, the initial share price becomes fair. Abnormal Earnings Growth Abnormal earnings growth may at first seem very similar to the residual income model, but these models have their difference. However, like residual income it uses forecasted net income which is one of the easiest numbers to forecast. Abnormal earnings growth is basically forecasted earnings or net income, plus reinvested dividends, minus the benchmark or normal net income. To simplify this formula, Pactiv does not pay dividends so it is simply the forecasted net income minus the benchmark income. This model is based in theory, and a big part of the theory behind comes when dividends are added back in. Dividends are added back in because it is based on the theory that when a firm pays dividend that the share holders who receive the dividend payments will reinvest these dividend payments back into the firm. However, a firm who doesn t pay dividends, like Pactiv, takes the money that they didn t pay dividends with and reinvests that back into the firm. So, basically it does not matter whether or not the firm pays dividends. Dividends are considered abnormal earnings hence abnormal earnings growth model. Also with this model, we will perform a sensitivity analysis. Now, we can go into a little more detail about this model. 119 Page

121 The first thing to note is that this model has a lag factored into it, so our valuation is done in year However, when it is all said and done, we will have discounted it back to year 2007 so that we have comparable numbers. Like residual income, our first numbers used in the calculation for abnormal earnings were our forecasted net income. Once again, our net income was forecasted out 10 years to We then took calculated our benchmark earnings by taking the previous year s income and multiplied it by one plus our cost of equity. The following equation gives an example of how benchmark earnings for 2009 were calculated. ) We then subtracted our benchmark income from our forecasted income year by year until year This gave us our annual abnormal earnings growth (AEG). For Pactiv, their AEG is negative from year 2009 and on. In order to insure that the AEG was correctly computed, the abnormal earnings should equal the change in residual income for that period. Like we have done in previous models, we then computed a present value (PV) factor. Also like before, to get the PV factor we divided one by our the quantity (1+ke)^T. We then multiplied our annual AEG by our PV factor to get our PV of annual AEG. Then based on the a trend found in our year by year abnormal earnings, we forecasted our AEG out one year to Once we did this, we made it perpetuity by dividing it by k e - g. This gave us our perpetuity; we then multiplied it by our PV factor from the year before to give us the PV of our terminal value perpetuity. Now we pretty much have all the factors in line so, we can calculate a price. So, we added our core one year our earnings perpetuity with our PV of our year by year AEG and PV of our terminal value AEG perpetuity. This gave us our total adjusted forward which we then divided by our k e to give us our initial market value of equity (MVE). Once we had that, we then divided our MVE by our shares outstanding. This gave us an initial share price of $5.34. However, this price is as of 12/31/2007 so we had to bring it to our valuation date of 4/1/2008. To do this, we used the following formula. 120 Page

122 This formula gave us a price of $ Undervalued if > $32.70 Overvalued if < $21.80 Fairly Valued $21.80< price > $32.70 Now, we can look at the sensitivity analysis shown by the chart above. Once again, for the sensitivity analysis we used a margin of error of 20%. The closest the chart even gets to our observed share price of $27.25 is $ To get this price of $13.06 we used a very liberal growth rate of -.6 and a very low Ke of.1. This shows 121 Page

123 that no matter which numbers we plug in for our Ke and g that Pactiv is overvalued. By the chart being painted all red, this says that Pactiv is consistently overpriced Conclusion As we have seen through most of these models, Pactiv is an overvalued firm. They are overvalued based on an observed share price as of April 1 st, 2008 of $ Also, in each of these models, we used a 20% margin of error. The long run residual income model and the free cash flows models were the only models that were able to even produce values that said Pactiv was fairly value. The free cash flows model is also the most sensitive model so this can explain why we produced number that said Pactiv was either fairly or undervalued. The long run residual income model was only able to produce fairly or undervalued with extreme adjustments to our ROE, Ke, or g. On the other hand, the residual income and the abnormal earnings growth models produced numbers that consistently said Pactiv is overvalued. In addition, these models are considered to be the most accurate and are least sensitive to adjustments. So, overall Pactiv is an overvalued firm. 122 Page

124 Appendices Sales Manipulation Diagnostic Data RAW FORM Sales/ Cash from Sales AEP Industries Pactiv Bemis Sealed Air Sales/ Accts. Rec AEP Industries Pactiv Bemis Sealed Air Sales/ Inventory AEP Industries Pactiv Bemis Sealed Air CHANGE FORM Sales/ Cash from Sales AEP Industries Pactiv Bemis Sealed Air Page

125 Sales/ Accts. Rec AEP Industries Pactiv Bemis Sealed Air Sales/ Inventory AEP Industries Pactiv Bemis Sealed Air Note: These numbers were used to make the charts for the Sales Manipulation Diagnostic ratios. Expense Manipulation Diagnostic Data RAW FORM Asset Turnover AEP Industry Pactiv Bemis Sealed Air CFFO/ OI AEP Industry Pactiv Bemis Sealed Air CFFO/ NOA AEP Industry Pactiv Bemis Sealed Air Total Accruals/ Change in Sales Version Page

126 AEP Industry Pactiv Bemis Sealed Air Total Accruals/ Change in Sales Version AEP Industry Pactiv Bemis Sealed Air Pension Expense/ SG&A AEP Industry Pactiv Bemis Sealed Air CHANGE FORM Asset Turnover AEP Industries Pactiv Bemis Sealed Air CFFO/ OI AEP Industries Pactiv Bemis Sealed Air CFFO/ NOA AEP Industries Pactiv Bemis Sealed Air Page

127 Total Accruals/ Change in Sales Version AEP Industries Pactiv Bemis Sealed Air Total Accruals/ Change in Sales Version AEP Industries Pactiv Bemis Sealed Air Pension Expenses/ SG&A AEP Industries Pactiv Bemis Sealed Air Note: These numbers were used to make the charts for the Expense Manipulation Diagnostic ratios. Liquidity Ratios Current Ratio AEP Industries Pactiv Bemis Sealed Air Industry Average Quick Asset Ratio AEP Industries Pactiv Bemis Page

128 Sealed Air Industry Average Receivables Turnover AEP Industries Pactiv Bemis Sealed Air Industry Average Days Sales Outstanding AEP Industries Pactiv Bemis Sealed Air Industry Average Inventory Turnover AEP Industries Pactiv Bemis Sealed Air Industry Average Days Supply Inventory AEP Industries Pactiv Bemis Sealed Air Industry Average Page

129 Cash to Cash cycle AEP industries Pactiv Bemis Sealed Air Industry Average Working Capital Turnover AEP Industries Pactiv Bemis Sealed Air Industry Average Profitability Ratios Gross Profit Margin AEP Industries Pactiv Bemis Sealed Air Industry Average Operating Expense Ratio AEP Industries Pactiv Bemis Sealed Air Industry Average Page

130 Operating Profit Margin AEP Industries Pactiv Bemis Sealed Air Industry Average Net Profit Margin AEP Industries Pactiv Bemis Sealed Air Industry Average Asset Turnover AEP Industries Pactiv Bemis Sealed Air Industry Average Return On Assets AEP Industries Pactiv Bemis Sealed Air Industry Average Return on Equity Page

131 AEP Industries Pactiv Bemis Sealed Air Industry Average Capital Structure Ratios Debt To Equity AEP Industries Pactiv Bemis Sealed Air Industry Average Times Interest Earned AEP Industries Pactiv Bemis N/A N/A N/A N/A N/A Sealed Air Industry Average Debt Service Margin AEP Industries Pactiv N/A Bemis Sealed Air Industry Average IGR and SGR Internal Growth Rate 130 Page

132 Average AEP Industries -5.44% -4.05% % 20.21% 8.94% 1.69% Pactiv 5.36% 4.18% 1.44% 9.72% 8.88% 5.92% Bemis 3.89% 4.86% 3.45% 3.18% 3.02% 3.68% Sealed Air 4.95% 5.00% 5.00% 4.94% 5.72% 5.12% Industry Average 2.19% 2.50% -0.33% 9.51% 6.64% 4.10% Sustainable Growth Rate Average AEP Industries % % % % 69.44% % Pactiv 18.73% 14.45% 4.96% 31.42% 27.28% 19.37% Bemis 7.82% 9.25% 7.59% 6.56% 6.17% 7.48% Sealed Air 20.76% 18.20% 17.45% 14.96% 15.38% 17.35% Inudustry Average -0.53% 0.81% % 42.72% 29.57% % Altmans Z-Score Altman's Z-Score Aep Industries Pactiv Bemis Sealed Air Industry Average Financial Statements 131 Page

133 132 Page

134 133 Page

135 134 Page

136 135 Page

137 Regression Analysis Output 3 Month Rate Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Page

138 Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Page

139 Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Month Rate Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Page

140 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Page

141 Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Year Rate Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Standard P- Upper Lower Upper Coefficients Error t Stat value Lower 95% 95% 95.0% 95.0% Intercept Page

142 X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Page

143 Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Year Rate Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Page

144 Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Page

145 Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Year Rate Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA 144 Page

146 df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept E E X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total Standard P- Upper Lower Upper Coefficients Error t Stat value Lower 95% 95% 95.0% 95.0% Intercept Page

147 X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P- value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept X Variable Month Horizon Beta Adjusted T-Stat P-Value Confidence Ke R Square Level Page

148 Month Horizon Beta Adjusted T-Stat P-Value Confidence Ke R Square Level Year Horizon Beta Adjusted T-Stat P-Value Confidence Ke R Square Level Year Horizon Beta Adjusted T-Stat P-Value Confidence Ke R Square Level Year Horizon Beta Adjusted T-Stat P-Value Confidence Ke R Square Level Page

149 Cost of Debt Liabilities (in millions) Accounts Payable Interest Accrued Tax Accrued Accrued Promotions, discounts, and rebates Accrued Payroll and Benefits Other Long-Term Debt Deferred Income Tax Pension and Post-Retirement benefits other non-current liabilities related to discontinued operations minority interest Free Cash Flow Model Valuation Models 148 Page

150 149 Page

151 Residual Income 150 Page

152 Abnormal Earnings Growth 151 Page

153 Long-Run Residual Income 152 Page