recommendationforthe hedgefund onthe purchase of 5 per cent of Premier. Present and

motivate your recommendation based on the following questions:

1. Present an overview of Premier's swap portfolio - against the backdrop of relevant information

from itsfinancial statements. What istherationale behindthefirm issuingthese interestrate

swaps? Why do you think caps and floors are used in conjunction?

2. What is the value to Premier of its fixedforfloating short term interest rate swaps?

3. What is the value of Premier's cap? And of its floor?

Conclude with your recommendation and motivate it given your findings.

It is January 2, 2009, and you have been tasked with the responsibility of making a final recommendation to a hedge fund on whether to purchase a 5 per cent equity stake in Premier Foods Plc. Share prices for Premier Foods, which only six months prior had reached as high as 135,2 closed at 33.25 per share on January 2. In fact, from July to October of 2008, a number of mutual funds, including Aberdeen Asset Management and Franklin Mutual Advisors LLC, significantly reduced their holdings in the firm.3 However, since mid-October, following a further sharp fall in Premier's stock price, the bulk of mutual fund transactions involved share purchases in the firm. Exhibit 1 charts Premier's stock price over the previous six months. A review of Premier's latest detailed statements and reports highlights the firm's increasing trouble with its interest rate swap portfolio. Exhibits 2 to 4 reproduce Premier Foods' 2008 financial statement results. Before making a recommendation as to investment in Premier's equity, it will be necessary to understand and assess the company's swap portfolio. In this respect, the company's history of debt accumulation and its related interest rate swaps will be informative. Your most immediate objective is to consider the swap portfolio's impact, if any, on Premier's risk exposure and value.

PREMIER FOODS PLC

Premier Foods Plc (LSE: PFD) was founded by Harry Solomon and David Thompson in 1975 as Hillsdown Holdings. Over the following three decades, the firm grew in large part by acquiring other food businesses. In 2002, Premier Foods acquired Nestl's ambient food business and was subsequently floated on the London Stock Exchange with an initial market capitalization of 526 million. Following the flotation, Premier Foods pursued a strategy of organic branded sales growth and improved operating efficiency. In addition, it continued to make acquisitions. In 2005, Premier Foods acquired Bird's Custard and Angel Delight, elevating the company's desserts range. Beginning in 2006, the firm's acquisitions

became more ambitious in scale. In August of that year, Premier Foods completed a 460 million acquisition of Campbell's UK and Irish business operations. In March 2007, Premier Foods executed a

1.2 billion acquisition of RHM, a company housing many of the United Kingdom's best known food brands, including Hovis, Sharwoods, Cadbury Cakes, Bisto and Mr Kipling⁴.

The team that fuelled Premier Food's aggressive growth consisted of David Kappler, Robert Schofield and Paul Thomas, all three of whom had extensive financial qualifications and experience. Kappler, the Chairman, who had joined the company at flotation in 2004, previously held the role of finance director of Cadbury Schweppes Plc. He was a chartered management accountant and was also, at that time, a non- executive director of HMV Group Plc, Shire Pharmaceuticals Group Plc and Intercontinental Hotels Group.

Schofield was appointed chief executive in January 2002 and had previously garnered extensive manufacturing and operational experience at United Biscuits Plc, where he ultimately served as managing director of United Biscuits UK. Schofield was also the non-executive chairman of Burton's Foods Limited. Thomas, the finance director, joined the company in 2002. Prior to Premier Foods, he served as finance director of the Leisure and Brewing divisions of Bass Plc. He was a chartered accountant and a company secretary by qualification.

HEDGING ACTIVITIES⁵

Premier Foods sourced raw materials from countries around the world and exported products to various other countries. The company generated some of its profits in non-sterling currencies and had assets in non-sterling jurisdictions, principally the Euro. Premier limited its currency exposure resulting from these Euro denominated profits and overseas net assets. It entered into forward currency contracts to partially hedge against its exposure to exchange rate fluctuations in the purchase of raw materials and in its export business. This matched duration hedging helped reduce the firm's exposure to short-term volatility in exchange rates.

Premier Foods' numerous acquisitions between 2005 and 2007 significantly increased its balance sheet debt. The company sought to use derivatives to both manage its exposure to fluctuations in interest rates and, where possible, to acquire a lower overall interest rate than the company would have otherwise been able to obtain. In particular, the company planned to hedge against interest rate exposure by reducing the uncertainty of future cash flows. It also sought to use swaps to revise its debt contracts so as to take advantage of current and/or expected future market conditions.

By the end of 2008, Premier Foods' net borrowings had increased to 1,766.8 million. By that time, the company had interest rate hedging contracts in place for the majority of its borrowing. At this stage in your analysis of the swap portfolio, you should focus on (i) the firm's 465 million short-dated fixed rate swaps and (ii) the 350 million of debt that was hedged by an interest rate cap and floor structure.

The firm's swap portfolio details, with respect to their short-dated fixed rate swaps and interest rate collar (cap and floor), are provided in Exhibit 5 and are current as of December 31, 2008. The floating rates applicable to Premier's interest rate swaps were reset quarterly based on the prevailing LIBOR market rate at the reset date. The last reset date was January 2, 2009.

As Exhibit 5 indicates, the cap and floor structures had a nominal value of 350 million (in 2007, 700 million) with caps set at an average of 6.1 per cent and floor rates at 4.3 per cent. The cap and floors applied from April 2, 2009 until July 2, 2012. As per these swaps, when the reference rate exceeded the cap rate, Premier was to be compensated. However, when the reference rate fell below the floor rate, Premier was to compensate the counterparty. As for the fixed rate swaps, your analysis can assume an average annual rate of 4.9 per cent (average of the range of rates, 4.4 per cent to 5.4 per cent) on the entire amount of short-term fixed rate swaps. The notional value of 340 million matured in exactly one year, and 125 million matured in exactly two years. The day count convention for sterling interest rates is actual/365. The number of days in the period is taken as 365, regardless of whether it is a leap year and with no adjustment for weekends or holidays.

THE CHALLENGE

Aggressive acquisitions in recent years had put Premier Foods in a position of unprecedented high leverage. By the end of 2008, there was a growing risk that greater than anticipated levels of cash flow may be required to service its debt (particularly with the growing mismatch between fixed and floating rates) and that its debt level may limit its ability to react to changes in industry and market conditions. Moreover, there was an increasing possibility that, in certain circumstances, Premier Foods may even be unable to meet its debt obligations when they fall due and/or may be unable to replace existing credit facilities should they be withdrawn.

Furthermore, 2008 was a year of global financial turmoil hundreds of companies, big and small, experienced large hits not only to their market equity values, but also to the market value of their debt holdings. The uncertainty and hesitancy in the money market put constant pressure on LIBOR rates to decrease (Exhibit 6). Given the growing financial tensions worldwide and the firm's highly leveraged capital structure, Premier Foods was likely to feel the ramifications of its past financing decisions.

Notably, earlier in the year, a string of U.S. hedge funds had picked up significant stakes in Premier Foods, including Och-Ziff (4.3 per cent) and DuPont Capital Management (2.3 per cent). In order to properly assess a proposed 5 per cent stake, it is necessary, among other things, to correctly evaluate the risks associated with Premier Foods' debt and swap portfolio.

You should first evaluate the firm's short-term fixed rate swaps, caps and floors. Clearly, the value of these latter securities depended on the probability that the LIBOR rate will reach the contracted cap and floor rates during the life of the security. To a get a handle on this, you will need the current LIBOR swap curve rates for different maturities as well as the historical curve rates for the last year. The information ispresented in Exhibit 7. The volatility of the three month LIBOR rate was 1.5 per cent on an annualized basis.

Premier's motivation for issuing short-term fixed rate swaps at least seemed clear. But what motivated its issuance of caps? Floors? What was the state of Premier's financial health? What was the impact of the various derivative securities on Premier's value?

Answer rating: 100% (QA)

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