Executive Summary

UST Inc. is a US based company who is a dominant producer in the moist smokeless
tobacco industry. The U.S smokeless tobacco industry has become increasingly popular
due to research claiming that the use of such products does less harm to the body than
typical cigarettes. This can be reflected through the $2 billion of retail revenue the
industry generated in 1998, with moist smokeless tobacco being the fastest growing
segment of the tobacco industry over the past 17 years, growing at 3.7% per year,
compared to the 2% annual decline for cigarette companies over the same period.

In December 1998, UST’s board of directors approved a plan to borrow up to $1 billion

over five years to fund its stock buyback program, in contrary to its long-standing
history of having a conservative debt policy. There are several reasons for this including
belief that their shares are undervalued, benefits from having a tax shield, reducing
management entrenchment and positive signaling to potential investors.

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This report identifies the company’s primary business risks specifically toward its

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creditors as well as its main attributes, which combats such risks. Furthermore it will

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discuss possible reasons behind the company’s changing capital structure and how this

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new debt will impact UST’s future growth and dividend policy.
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Debt Policy at UST Inc. 1

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 Questions

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

From a bondholder’s point of view the following risks must be considered:

A) Compliance risk is related to the litigation and legislative environment. Tobacco

companies will always be main targets due to increasing concern towards customers’
health when consuming UST’s products. Although Smokeless Tobacco Companies are
involved in fewer lawsuits than cigarette companies; at the end of 1998 UST Inc. still
received seven pending lawsuits. This can be a serious problem for bondholders
because payouts to such lawsuits may restrict the company’s ability to pay their interest
or even principal payments of their outstanding debt, as seen in 1997 when UST
suspended its stock repurchase program. In combatting this, UST Inc. has taken action to
reduce youth exposure by signing the Smokeless Tobacco Master Settlement Agreement

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and complying with advertising and promotion restrictions.

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B) Strategy risk relates to engaging in ineffective plans that may hinder the company to
achieve its goals. Recently, smaller players have eroded UST’s market share by cutting

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down their prices. Instead of following suit UST opted to launch similar products to
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compete against these price-value brands whilst still aggressively partaking in annual
price increases for its main lines. This can be seen in Appendix A, where UST’s 7-year
CAGR is the lowest amongst its competitors. This ineffective counter-attack alongside
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stagnant innovation for its products may hinder the company’s long-term growth and
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profits, ultimately leading to default on its existing debt.

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C) Reputational risk may arise due to UST Inc. being dominant in the US market, but less
well known in the wider global smokeless tobacco industry. This implies that there are
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no immediate opportunities to expand the business internationally, which may

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potentially raise bondholders’ concern towards UST’s growth and expansion in the long
run. Also, there is a risk that cultural shift as well as scientific research in the near future
may jeopardise the company’s future earnings, discouraging creditors from investing.
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2. Why is UST Inc. considering a leveraged recapitalisation after such a long

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history of conservative debt policy?

A) Share repurchases often signals that a firm’s share price is under-valued because if
they are over-valued giving a share repurchase, instead of a cash dividend, is extremely
costly for current shareholders. In Exhibit 3, UST’s P/E ratio for the year ending 1998 is
13.8x compared to the 11-year average of 17.0x. This can very well signal to UST’s
managers that the company’s shares are highly undervalued in relation to their
performance and thus accelerating a share buyback can raise their EPS value.

B) UST wants to increase its firm value by benefiting from the huge interest tax shield
they will gain with a leverage position, which is equal to the increase in debt multiplied

2 Debt Policy at UST Inc.

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 by the corporate tax rate. This value in addition to the initial enterprise value of UST will
further be distributed across a smaller number of shares (due to the buyback) which
will significantly increase the value of the company’s shares. Since UST is one of the
most profitable companies, with a 10-year average ROE of 89%, it can be considered a
cash cow with excess free cash flow (FCF). Thus, servicing this new debt will not add
any financial distress to the company whilst still raising the value of the firm.

C) According to the FCF Hypothesis, by adding debt to a firm, it effectively reduces

management entrenchment. Leverage increases firm value because managers will be
motivated to run the firm as efficiently as possible, as they are commited to paying
future interest payments. This reduces wasteful spending as managers will not invest in
its non-core operations of wines and cigars and solely focusing into its tobacco products,
as seen in Exhibit 2 with gross margin returns for each of its operations.

D) By issuing more debt, UST wants to reward their current shareholders with a higher
cash dividend and signal confidence to them for positive future earnings. This will be

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discussed in Question 4.

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3. Should UST Inc. undertake the $1 billion recapitalisation? Calculate the

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marginal effect on UST’s value, assuming that the entire recapitalisation is

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implemented immediately (Jan 1999).
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a) Assume a 38% tax rate.

b) Prepare a pro-forma income statement to analyse whether UST will be able to make
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interest payments.
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Exhibit 3 shows the key financial information, highlighted in red, needed to determine
whether or not UST will be able to make interest payments. Based on these we can
calculate the free cash flows and compare them to the interest payment amounts to see
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if it can be paid off.

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Debt Policy at UST Inc. 3

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By taking on a conservative approach where sales growth remains to grow at 1.5%
annually, and assuming EBIT margins, working capital and net capital expenditures, we
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can calculate the free cash flows of UST Inc. We make the variables of free cash flow, in
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other words, EBIT, tax rate, depreciation and amortization, change in net working
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capital and capital expenditure, all a percentage of sales in this percentage of sales
approach. From this, we can compare it to the interest payments, and we can see that
the free cash flows are much greater than the interest payments. Yes, UST Inc. will be
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able to generate enough free cash flows to meet interest payments.

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4 Debt Policy at UST Inc.

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By conducting sensitivity analysis on sales growth rate, where it declines to 0.5% from
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1.5%, and keeping all other factors of free cash flow constant, we can see that free cash
flows generated is less than the free cash flows when growth rate was 1.5%. However,
even at 0.5% annual sales growth, UST Inc. still generates enough to make interest
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payments.
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Debt Policy at UST Inc. 5

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 4. UST Inc. has paid uninterrupted dividends since 1912. Will the recapitalisation
hamper future dividend payments?

Appendix 4 compares the effect of earnings on dividend decisions. In the middle section,
around three-quarters of dividend-paying companies increased their dividend payments
in periods where earnings have increased. In contrast, when earnings fell as seen in the
right section, many companies still sought to keep or increase dividends from the
previous period. This seems to be the case for UST as in 1997 when net income growth
decreased by 4.3%, UST still increased their payment of dividends, highlighting the
extreme reluctance of the company to decrease their dividend regardless of whether
their earnings may have been affected by the recapitalisation.

John Lintner’s research also reinforces this, suggesting that:

1. Management believes that investors prefer stable dividends with sustainable

growth

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2. Management desires to maintain a long term target level of dividends as a
fraction of earnings.

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Applying the Dividend Signalling Hypothesis, we also come to the conclusion that it will

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be very unlikely for UST to cut its dividends. UST currently employs a dividend
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smoothing strategy and if UST decides to cut its dividend rate, it may send a negative
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signal to its investors that UST is under a weakening financial position with declining
earnings for the future. Dividend cuts are also costly for managers in terms of their
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reputation and induces a negative stock price reaction that is proportionately higher
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than dividend increases. So although UST may find it more difficult to stick to its
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dividend smoothing strategy, due to the debt arising from the recapitalisation, the
negative effects of dividend cuts may greatly discourage UST to lower its dividends in
the future, and only do so as a last resort.
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Assuming that UST does continue with its policy of consistent dividend increases, and
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that UST’s net income growth and dividend growth continues its downward trend, we
will assume that the dividend grows at the same rate as sales, at a conservative rate of
1.5%, after the recapitalisation, to ensure that UST’s dividend growth is sustainable.
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According to the forecast in Appendix 5, the recapitalisation should not affect the
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payment of future dividends. Even after net interest has been paid, there will still be
sufficient cash flows to continue paying uninterrupted dividends.

The firms will be willing to use these free cash flows to pay dividends due to the agency
costs associated with retaining it. This is due to managers using the funds inefficiently
for executive perks or to avoid financial distress costs that may threaten manager job
security. However, due to the managerial entrenchment theory of payout policy,
managers only pay out cash when pressured to do so by firms’ investors.

Appendices

6 Debt Policy at UST Inc.

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 Appendix 1

7-Yr CAGR from 1991-1998

4.2 1.6 3.9 UST

Conwood
Swedish Match
Swisher
14.3 Other
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Source: Case Material
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Appendix 2
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Operating Profit
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Margin of UST’s 1996 % 1997 % 1998 %

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major operations
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Tobacco 63.9 59.3 57.9

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Wines 14.6 19.4 14.9

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Other 0.1 -1.7 5.9

Source: Case Material

Appendix 3

Debt Policy at UST Inc. 7

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Appendix 4
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Source: Morningstar, RBA

Appendix 5

8 Debt Policy at UST Inc.

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 Free Cash Flow, Interest & Dividend Projections (millions)

1998 1999 2000 2001 2002 2003 2004 2005

Dividend Growth Rate 1% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%
Free Cash Flow 428.6 413.1 419.4 425.9 432.4 439. 445.8 452.6
0
Debt 100.0 1100. 1100. 1100. 1100. 1100 1100. 1100.
0 0 0 0 0 0
Interest 5.6 61.6 61.6 61.6 61.6 61.6 61.6
Interest tax shield 1.96 21.56 21.56 21.56 21.5 21.56 21.56
6
Cash Available For 428.6 409.5 379.4 385.8 392.4 399. 405.7 412.6
Dividends 0
Dividends 301.1 305.7 310.4 315.2 320.0 324. 329.9 335.0
9

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Debt Policy at UST Inc. 9

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