In early March 2014, stock performance at Minneapolis-based Chestnut Foods (Chestnut) had failed to meet expectations for several years running (see Exhibit 1), and now the company was facing the arrival to the board of Rollo van Muur, a high-profile activist investor. Just over a month before, van Muur had quietly and unexpectedly purchased 10% of the company and had asserted his right to two seats on the board.
CEO Moss Thornton was highly concerned about van Muur’s arrival and his impact on the company’s long-term viability. Over the past months, CFO Brenda Pedersen had advocated two strategic initiatives: a $1 billion investment in company growth in the Instruments division and the adoption of a more progressive corporate identity. Van Muur had made it very public that he was strongly opposed to additional investment in the Instruments division and in fact had recommended that the Instruments division be sold off “to keep the focus where it belongs.”
Next week would be the board’s first meeting with van Muur. In preparation for the meeting, Thornton had gathered select members of the executive team to solicit their perspectives on the future of the Instruments division, and the arguments to be made to save it.
The Company
Chestnut Foods began in north Minneapolis in 1887, when 22-year-old Otto Chestnut (born Otto Kestenbaum in Bavaria) opened a bakery that made lye rolls and pretzels, and then stumbled into success as a supplier of sandwiches to the St. Paul, Minneapolis, & Manitoba Railway. Six years later, on a trip to Chicago to visit the Columbian Exposition, Chestnut happened to come upon the Maxwell Street Market, a vibrant melting-pot community of merchants of eastern European descent. At the market, he had a chance meeting with Lem Vigoda and George Maszk, founders of V&M Classic Foods, which provided a range of meat and fish products as well as preserves and condiments. Through them he witnessed a nascent ad hoc distribution system to neighborhood groceries in the rapidly growing city. A vision of wholesale food production and distribution struck him, and he returned to Minneapolis determined to realize it.
By 1920, as regional grocery chains had begun to materialize, Chestnut, since joined by his sons Thomas and Andrew, had purchased V&M Classic Foods among other food businesses. Their plan was for the expanded Chestnut to stock the regional grocery chains across the upper Midwest, while also continuing to supply railroad dining cars and, beginning in 1921, a Chestnut chain of automats in Chicago and Detroit. Otto Chestnut died in 1927 at age 62, but the company was well positioned to weather the Great Depression; in 1935, the Chestnut brothers sold the automat division to Horn & Hardart, then used the proceeds to purchase farmland in Florida and central California. In the postwar period, as the supermarket model emerged, Chestnut grew with it, both organically and through acquisition, going public in 1979. By 2013, the company was valued at $1.8 billion, with annual profits of more than $130 million.
Chestnut sought to “provide hearty sustenance that gets you where you’re going.” The firm had two main business segments: Food Products, which produced a broad range of fresh, prepackaged, and processed foods for retail and food services, and Instruments, which delivered systems and specialized equipment used in the processing and packaging of food products. Instruments provided a variety of quality control and automation services used within the company. The company took increasing pride in the high quality of its manufacturing process and believed it to be an important differentiator among both investors and consumers.
In recent years, Chestnut’s shares had failed to keep pace with either the overall stock market or industry indexes for foods or machinery (see Exhibit 1). The company’s credit rating with Standard & Poor’s had recently declined one notch to A−. Securities analysts had remarked on the firm’s lackluster earnings growth, pointing to increasing competition in the food industry due to shifting demands. One prominent Wall Street analyst noted on his blog, “Chestnut has become as vulnerable to a hostile takeover as a vacant umbrella on a hot beach.”
On Wall Street there was some enthusiasm for the arrival of van Muur. In recent weeks the stock was up 12%. Several research analysts saw great potential in his impact on the company and expected there to be wholesale changes in corporate strategy and leadership at Chestnut. Other analysts were apprehensive about the short-term nature of van Muur’s horizon and, like Thornton, shared concern over his long-term impact on the company. Analysts estimated the equity beta for Chestnut at 0.90. Chestnut’s debt totaled $0.46 billion.
Instruments division
Since its earliest days amid the bustling flour mills and rail lines of Minneapolis, Chestnut’s management had maintained a shared value that technology, properly harnessed, could improve quality and efficiency across production processes, and over the years, the company had developed a strong expertise in food process instruments. The success of companies such as Toledo Scale, founded in Toledo in 1901 before merging to become Columbus, Ohio–based, Swiss-owned Mettler-Toledo in 1989, was not lost on Otto Chestnut himself, although thoughts of such diversification were repeatedly deferred. Yet as a more cyclical and diverse industry (with products providing advanced capabilities to utilities, military and aerospace programs, and industrial and residential applications in addition to food production), precision instruments seemed to complement the food industry and to present opportunities for growth overseas. In 1991, Chestnut capitalized on an opportunity to purchase Consolidated Automation Systems, a medium-sized food-processing-instrument equipment company based in Thunder Bay, Ontario, and the Instruments division was born. This proved very successful and was followed by the purchase in 1997 of Redhawk Laboratories, a small manufacturer of food filtration material using computer-controlled precision equipment, based in Troy, New York.
Although 20% of the division’s revenue was derived internally from the Chestnut Food Products division, the Instruments division produced equipment and automation support for a wide range of food producers in North America. Demand, much of it from overseas, was strong, but required substantial investments in R&D and fixed assets. Instruments division sales had increased by nearly 20% in 2013. Segment NOPAT was
$46 million, and net assets were $600 million. Based on the marginal tax rate of 37%, the expected return on capital for the division over the foreseeable future was 7.7%.1 Exhibit 2 provides financial data for the Instruments division.
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