Ust Recommendation

Recommendation:

United States Tobacco (UST) should increase the leverage in its capital structure by incurring $1 billion in debt. Debt financing will increase the value of the firm by creating a tax shield and allow UST to repurchase approximately 25 million shares, which in turn, will enable UST to increase the amount of dividends per share without increasing the total amount of dividends paid. UST needs to re-gain industry analysts' confidence by using the entire $1 billion to repurchase shares, and in 2-3 years it should consider increasing its leverage up to $1.5 billion.

Assumptions:

The following assumptions were critical for the recapitalization analysis:

* The $1 billion in debt is constant and perpetual, however only the incremental debt ($900 million) was used for analysis purposes.

* UST currently has a AAA debt rating, and even though they will be downgraded if they take on the $1 billion debt, UST wants to maintain investment-grade ratings.

* UST will use the entire incremental debt amount to repurchase stocks

Analysis

Industry attributes

UST currently holds the majority of the smokeless tobacco market share (77%), and has seen consistent increases in sales and earnings in the profitable industry. Federal advertising restrictions has limited competitors from entering the market because they cannot compete with UST's premium product and strong brand recognition. UST can rely on continued sales growth even with product price increases, given the inelastic demand and lack of substitutes for tobacco products. In addition, UST will benefit from recent trends in public smoking bans across the United States and they face less litigation risk than cigarette makers due to the nature of the smokeless tobacco product (i.e. no second-hand smoke lawsuits). UST is also the only smokeless tobacco company to sign the Master Smokeless Tobacco Agreement with 45 states, settling state Medicaid lawsuits.

Industry Risks

Though the smokeless tobacco industry it is less volatile and politically charged than the cigarette industry, UST still has significant business risks. The recent emergence of low-end value competitors in the smokeless tobacco market has infringed on UST's margins and threatened its market share. UST's historically rigid and perhaps over-confident corporate culture prevented it from responding quickly enough to the threats and as a result its competitive position has been somewhat compromised. UST has also realized increased skepticism from industry analysts as a result of their substantially less profitable non-core products such as wine and cigars. And despite the government legal settlement, there are still litigation risks, as well as risks of additional government rules and regulations in the tobacco industry. Finally, UST currently faces an antitrust lawsuit from one of its competitors that could set the stage for similar litigation in the future.

Leverage re-capitalization

UST's traditionally conservative debt policy has not allowed them to take advantage of tax shields. Now that the Master Smokeless Tobacco Settlement has been signed and the risks of state Medicaid litigation is reduced, it is an optimal time for UST to restructure its capital policies in response to recent market share erosion. By increasing debt to repurchase shares, UST is creating a valuable tax shield thereby increasing the value of the firm, while at the same time increasing their lagging dividend payments to shareholders without increasing the actual amount they are paying out (Table 1).

Table 1. UST: Current and Post-Recapitalization 1999

Current Post-Recapitalization

Value $6,470.80 $6,812.80

Price per Share $34.88 $36.73

Shares Outstanding 185.5 161.0*

Dividends Per Share $1.62 $1.87

*After repurchase

Pro forma analysis shows that UST should