Ust Inc

Introduction

In 1998 the U.S smokeless tobacco industry generated $2 billion of retail revenue with approximately 5 million consumers of moist tobacco and 7 million consumers of chewing tobacco including loose leaf, twist, plug and dry. Moist smokeless tobacco consumption approximated 50% of the total. The factors contributing to the continuous growth of the moist smokeless tobacco was the increased prevalence of smoking bans which had led customers to switch to smokeless tobacco and the fact that smokeless tobacco was less expensive to use than cigarettes based upon an average per-week usage measurement. Additionally, consumers have been shifting over time to moist smokeless tobacco from loose leaf chewing tobacco. While the consumer base remains primarily male, smokeless tobacco is no longer confined to the stereotypical blue collar or rural users as approximately 30% of users had attended college. The overall moist smokeless tobacco market was expected to continue to grow at an annual rate of 1-3% with a larger portion of the growth expected to be in the price value segment.

UST is the dominant producer of moist smokeless tobacco, or moist snuff controlling approximately 77% of the market. UST also has other business interests such as wine, cigars and international marketing of moist smokeless tobacco. UST has been a driving force in the overall expansion of the moist smokeless tobacco market over the years, primarily through product innovations such as new forms and flavors.

UST has been one of the most profitable companies, not only in the tobacco sector but also in corporate America. UST's five-year return on capital of 9.21% was nearly 20% higher than the 2nd ranked firm. UST maintained enviable margins with average gross profit, EBITDA, EBIT and net margins of 77%, 53%, 50% and 31% respectively. Annual return on equity averaged 89% and return on assets averaged 48%. Over the same period, UST also provided a generous return on capital to investors paying $2.2 billion in dividends and repurchasing $2.0 billion in stock. UST had also maintained an A-1 credit rating for its commercial paper (a form of money market security).

In December 1998, UST Inc decided to borrow up to $1billion over 5 years to accelerate its stock buyback program. This paper analyzes whether this was a good decision, assuming that the entire debt was taken as a lump sum at one time.

Data Requirement or Sources

Exhibit-3 : Summary of financial information for UST Inc ,(in millions)

Exhibit-4 : Summary Financial Information. For UST Inc,( in millions)

Exhibit-6 Financial Ratios for Tobacco Companies

Exhibit-8 Adjusted Key Industrial Financial Ratios-Senior Debt Ratings and Formulas for adjusted Key Industrial Financial Ratios.

Problem Statement

Given such a long history of a conservative debt policy and high dividend payout , should the board of Directors of UST approve a plan to borrow a loan of $1 billion in 1998 all at one time to buyback stocks?

The following five questions help in responding to the problem statement:

f. What would be the expected impact upon their value assuming the entire one billion is done at once? (You may want to use an average effective tax rate over the last 5 or 10 years and assume that the debt is perpetual.)

g. Preparing proforma statements to analyze the impact of the interest payments and the debt on the total financial structure will help in this analysis.

h. What type of bond rating do you think UST will receive and thus what type of yield do you think will be required on the debt?

i. Their dividend payments have been uninterrupted since 1912. Will the proposed recapitalize hamper future dividend payments?

j. What are the primary business risks associated with UST, Inc.?

Key Assumptions

* Assuming that the entire loan is taken as a lump sum and not in installments.

* All other line items in the balance sheet remain the same.

* A tax rate of 40% for calculating present value of tax shield.

* 20 Year "A" rated bond yield of 7.05% for calculating EBITDA and EBIT interest coverage ratios.

* The dividend pay-out ratio remains the same.

* The shareholders are willing to sell back their shares at a price of $36.92

Methodology or Techniques

a. What would be the expected impact upon their value assuming the entire $1 billion is done at once? (You may want to use an average effective tax rate over the last 5 or 10 years and assume that the debt is perpetual.)

The present value of tax-shield is first calculated:

Present value of tax-shield Amount

Average Tax Rate 38% (Average of last 10 years)

Debt for Equity Swap $1,000.00

Present value of tax-shield $ 378.70 (Present value of additional long-term debt obtained by multiplying Avg tax rate with Debt of $1.0B)

The new value of the firm is then calculated based on the following steps:

Steps to Arrive at New Value of Firm Amount Calculation

Increase in Price of share $ 2.04 present value of tax-shield/number of shares outstanding prior debt

New Price of share $ 36.92 price prior to debt +increase in price of share post debt

No of share bought back 27.08 million shares Debt/increase in price

New shares outstanding $ 158.42 shares prior debt- shares postdebt

New Market Equity $ 5,848.94 new price of share *new outstanding shares

New Value of the Firm $ 6,227.64 New market equity + Present value of tax-shield

Taking a loan of $1 billion increases