FIN 5204Managing Corporate Capital Investment and Capital Structure

Fall 2007

Debt Policy at UST Inc.

1. What are the primary business risks associated with UST Inc.? What are the attributes of UST Inc.? Evaluate from the viewpoint of the bondholder.

Over the years, UST has been a dominant producer in the tobacco industry, specifically the moist tobacco industry. Even though the past strategy with UST has entailed raising the prices of its products on a regular basis, the company still shows signs of positive growth. Additionally, there have been recent issues with smokeless tobacco products, such as lawsuits. However, there remains a constant consumer demand for UST products. When evaluating the business risk of a company, one of the primary drivers of its business risk stems from the price elasticity of its products. Thus, these are a few reasons that illustrate that the smokeless tobacco industry (UST’s most dominant EBIT contributor) has a relatively steep demand curve and should be considered as having an inelastic consumer demand. Also, it is important to note that UST has products outside of its core operations in the wine and premium cigar market. Also, UST has introduced products in the price value market as consumer demand has increased.

Brand name and market position - superiorCash flow generating capacity- superiorCyclicality of revenues - superiorProduct diversification - poorGeographic diversification - goodAsset tangibility - goodLitigation Risk – poor

Obviously, the two most troubling business risks associated with UST are its litigation and product diversification risks. The smokeless tobacco industry will always face potential lawsuits because of the ongoing health concerns. Also, even though UST has diversified into other markets (wine and cigars), these products are very minimally attributing to UST’s EBIT. Nevertheless, UST products have a steady demand for their products, they produce positive cash flows year-to-year, and the company has a dominant market position and brand name with regard to their core business. For these reasons, it is determined that UST has a relatively low business risk.

2. Discuss UST’s past financial performance. Is the past performance expected to continue in the future?

UST Historical Financial Performance

5-year CAGR 10-year CAGRNet Sales 5% 9%EBIT 6% 11%EPS 9% 13% 5-year Average 10-year AverageGross Profit Margin 79.7% 77.3% Net Margin 32.7% 31.3%ROE 122.8% 89.1%Dividend Payout 61.6% 57.8%

The historical financial data indicates that that compound annual growth per year has been declining in the past five year compared with the past ten years in Net Sales, EBIT, and EPS. Obviously, this is a sign of UST slowing down its financial performance due to factors such as an increase in competitors, less consumer demand, etc... Nevertheless, it is comforting that within the past five years, the operating data is generally not moving backwards and is still growing (at a much slower rate). When analyzing the 5-year and 10-year averages, the data indicates that UST financials are still steady and increasing. Exhibit 2 suggests that the market share of UST has been slowly decreasing over the past 7-years.

Due to the fact that there has been increased competition in the premium smokeless tobacco market, UST is losing market share with products in its core operations. Furthermore, the price value products in the industry are showing a dramatic increase in market share, yet UST only shows a 0.6% market share in 1998 (late mover). For these reasons, UST needs to focus their efforts on attracting the growing demand with the price value smokeless tobacco products in order to strengthen their long-term financial performance. Thus, because of the increased competition in the smokeless tobacco industry, UST has to constantly look for innovative ways in order for them to be a driving force in the smokeless tobacco industry.

3. (a) Compare UST’s financial performance and capital structure to other tobacco firms.

Exhibit TN-3 Summary Financial Information for UST and other Tobacco Companies

UST

Phill

ip

Mor

ris

Nor

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Atla

ntic

RJR

Nab

isco

Dim

on

Stan

dard

Co

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Uni

vers

al

Med

ian

(exU

ST)

Gross Profit Margin (%) 80.1 41.7 65.4 46.2 12.3 9.7 14.3 28Net Margin (%) 32.9 10.3 1.1 3.5 2.4 1.8 3.0 2.7ROE (%) 103.4 49.3 NM 8.4 12.5 22.5 25.6 22.5ROA (%) 53.8 13.2 0.4 2.4 2.7 3.4 6.5 3.1Debt/Book Cap (%) 17.6 47.5 90.0 54.4 71.9 72.3 59.4 65.7Debt/Market Cap (%) 1.5 10.1 NA 52.1 68.3 70.4 39.2 48.0EBITDA/Interest coverage(x) 105.6 12.7 1.6 3.7 3.3 5.4 4.4 4.1Corporate Credit rating A B+ BBB- BB+ BB- A- NM

USTs margins were far superior to all of its competitors; its growth margin was 2.9x the industry median and its net margin was12x the median. USTs ROE was an astonishing 103.4% and its ROA is equally impressive at 53.8% compared to a 3.1% median. Its debt/book capitalization and debt/market capitalization is 3.7x and 32x lower than the median respectively. Its interest coverage of 105.6 xs is 25 xs more than the industry median.

(b) Why is Wall Street concerned about USTs future prospects leading to a “neutral rating” on the company?

Wall Street felt that the company’s management was content with its dominant market share and was being too lax and slow in responding to smaller competitors particularly in the value segment of the market. Analysts were also concerned about the softening smokeless tobacco market where unlike cigarette companies lack the option of fighting declining domestic consumption with international growth; UST had no immediate opportunity for expanding internationally. Finally, the public and political sentiment was negative regarding the tobacco industry.

4. Why is UST considering a leveraged recapitalization after such a long history of conservative debt policy?

UST is considering a leveraged recapitalization as a mean to enhance the firm’s value. First, UST will benefit from the interest tax shield (roughly the increase in debt multiplied by the corporate tax rate), in addition; this value plus the initial enterprise value will be distributed across a small number of outstanding shares significantly increasing the value of each share. Moreover, servicing this debt should not add any extra risk of financial distress due to the highly cash generative nature of USTs business plus the predictability of their future cash flows with a high level of confidence.

Second, this debt will help discipline managers from investing in projects that earn returns below the firms cost of capital where UST have historically performed poorly. USTs investment in non-core operations of its wine business and cigars business generated operating profit margins of 14.9% and 5.9% respectively compared to its tobacco operating profit margin of 57.9%. By adding interest payment obligations into the framework excess cash will be better utilized instead of being invested into underperforming operations and projects.

5.) Should UST undertake the $1 billion recapitalization?

(a) Prepare a pro-forma (1999) income statements to evaluate UST’s ability to make interest payments.

Exhibit TN-4: Income Statement Projections

Actual 1998

Pro-forma 1999 (I)

Pro-forma 1999 (II)

Pro-forma 1999 (III)

Pro-forma 1999 (IV)

Sales 1423.2 1494.36 1494.36 1494.36 1494.36 5% Annual GrowthEBIT 753.3 792.01 792.01 792.01 792.01 53% of salesInterest Expense -2.2 0 70.5 78.2 87 Pre-tax earnings 755.5 790.52 721.51 713.81 705.01 Taxes 287.6 300.40 274.17 271.25 267.90 38% tax rateNet Income 467.9 490.12 447.34 442.56 437.11 Net debt 0 0 1000 1000 1000 Interest Rate - - 0.0705 0.0782 0.087

Interest Coverage - - 11.2 10.13 9.10EBIT/Interest Expense

Debt Rating - - A BBB BB

When examining UST’s ability to make interest payments, it is important to focus on the interest coverage ratio under each of the different pro-forma scenarios. The interest coverage ratio illustrates the ability of the company (in this case, UST) to make interest payments on the outstanding debt. As the interest coverage ratio approaches 1, the ability of the company to make these interest payments becomes problematic. From a bondholder’s perspective, the bondholder wants to be sure that the company is always able to make the interest payments. For UST, in this case, as the debt rating of UST decreases from a bond rating of A (Scenario II) to a debt rating of BB (Scenario II), the interest coverage ratio is decreasing. However, from the bondholder’s perspective, the decrease does not warrant a cause for alarm just yet. The 9.10 coverage ratio is still a quality measure, and shows that UST is able to meet the demand for the interest payments as of the current projection.

(b) Calculate the valuation impact of the recapitalization plan by estimating the value of the interest tax shields, assuming a corporate tax rate of 38%. What other factors, beyond the corporate interest tax shields, should UST consider in assessing the valuation impact of the plan?

Exhibit TN-5: Valuation Model

Status Quo

$1 Billion Recap Plan

PV Tax Shields (tD) 0.00 380.00 38%*$1000Value of UST (S = Vu) 6,469.00 6,849.00 $380 + 6469Net Debt 0.00 1,000.00 Stock Price 34.88 36.92 6849/185.5Shares Repurchased n/a 27.08 Shares 185.50 158.42 Market Equity 6,469.00 6,849.00 Debt/Market Equity 0.00 0.15 1000/6849

There are other factors, beyond the corporate tax shield, that UST should consider when assessing the impact of the $1 billion dollar recapitalization plan. Some of these factors include the signal that UST will be sending to investors with this recapitalization plan. The effect that the recapitalization will have on the value of the firm; due to the change of the capital structure. Since the firm will be adding debt, and incurring tax savings, this will have a positive effect on the stock price (Yes, it is true that the number of shares will also be decreasing, leading to a higher E.P.S). Another factor that should be considered is the fact that this recapitalization will have a negative effect on the firm’s liquidity. Since the debt/equity value of the firm will be increasing, the leverage of the firm is increasing, and consequently the riskiness of the shares of common stock will also be increasing. It is important for UST to consider these factors as the firm implements and follows through with the recapitalization.

6.) UST Inc. has paid uninterrupted dividends since 1912. Assess the impact of the plan on UST’s $ dividend and dividend per share, assuming it continues to payout 64% of its earnings as dividends.

Exhibit TN-6: Impact of Recapitalization on Dividends

Debt = $1 Billion Actual 1998

Pro-forma 1999 No

debt

Pro-forma 1999 Rd =

7.82Net Income 467.9 491 442.56Shares 185.5 185.5 158.42Earnings per Share 2.52 2.65 2.79 NI/SharesDividend Payout 301.1 314.2 283.24 NI*.64Dividends per Share 1.62 1.69 1.79 EPS*.64

When assessing the impact of the plan on the $ dividend and the dividend per share, it is clear that the recapitalization plan reduces the total dividend payout from $314.2 to $283.24; however, the dividend per share value increases from $1.69 to $1.79. This is caused in part by the reduced number of shares outstanding as a result of the recapitalization. These assumption are based on the fact that UST continues its’ policy of paying out 64% of earnings as dividends. It is important for UST to continue to uphold this tradition of this dividend payout ratio in order to keep the stockholder’s happy, and to not signal any negative ideas to the stockholders and to Wall Street.

FIN 5204Managing Corporate Capital

Investment and Capital Structure

Fall 2007

Debt Policy at UST Inc.

Guillaume Laffitte-SmithLeonard Webb

Khalid Al-Sarabi