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DEBT POLICY AT

UST INC.
Group 2C
Ang Wee Kiat Kwek Louis Lai Yuting Mavis Tay Yang Kangjie

INTRODUCTION TO UST INC.

BACKGROUND OF UST INC.

Moist smokeless tobacco industry
 Fastest growing segment of the tobacco industry

77% market share
Premium Positioning
 Steady price increases  Product introductions and innovations

STOCK REPURCHASE PROGRAM

1997 Suspension

Dec, 1998 Approval of $1bil loan plan

1996 Approval

Nov, 1998 Reinstated

BUSINESS RISKS OF UST INC.

LEGAL CHALLENGES 7 pending health related lawsuits Smokeless Tobacco Master Settlement Agreement Antitrust lawsuit Possibility of new laws and regulations .

2% in 1998 Inroads by competitors in price-value segment Slow response to competition Lesser new product introductions and innovations .2% in 1991 to 77.ERODING MARKET SHARE From 86.

NEGATIVE SENTIMENTS Causes cancer Regarded as a social menace Restrictions on public advertising  Difficult to increase sales  High barriers to entry .

LIMITED OPPORTUNITIES Saturated domestic tobacco market  Growth 1-3% annually. mostly in price-value segment No immediate opportunity for international expansion Poor performance in non-core operations .

.ATTRIBUTES OF UST INC.

      Strong brand name recognition Market leader Premium products Economies of scale Management issues Lack of initiative and foresight .BUSINESS ATTRIBUTES OF UST INC.

FINANCIAL ATTRIBUTES OF UST INC.       Most profitable company in 1997 and 1998 Market leader Strong financials Generous return of capital to investors A-1 credit rating for commercial paper Poor performance of non-core operations .

BONDHOLDER’S PERSPECTIVE .

long-term bondholders will view this as less favourable . esp.BONDHOLDER’S PERSPECTIVE Potential liabilities from lawsuits  Pending health-related and anti-trust lawsuits  Higher likelihood of facing more health-related lawsuits in the future as more research is done This represents a likely increase in the liabilities of UST in the future  Bondholders.

BONDHOLDER’S PERSPECTIVE Weakness in management team  Resignation of 2 top executives  Not profitable in its non-core operations This could affect the long-term survival of the firm  Long-term bondholders will view this as a risk for long term bonds .

BONDHOLDER’S PERSPECTIVE Negative public and political sentiments  Increased regulations and restrictions  High possibility of more of such regulations in future  Possibility of extreme regulations such as banning UST from selling tobacco products or nicotine being regulated as a drug This could also affect the long-term survival of the firm  Long-term bondholders will also view this as an increased risk of holding long-term bonds .

BONDHOLDER’S PERSPECTIVE Strong brand name recognition Ability to reap economics of scale Highly profitable in the short-term future  Bondholders will have increased confidence of UST to make its interest payments in the short-term .

esp.BONDHOLDER’S PERSPECTIVE Healthy financials  Most profitable company in 1997 & 1998  Financial ratios that measure solvency and liquidity are way above industry average.  Very low debt-equity ratio Implies a very high ability to meet its obligations in the short-term  Bondholders. the short-term bondholders will like this aspect as it implies very little risk of default .

RATIONALE FOR LEVERAGED RECAPITALIZATION .

as compared to industry average of 55.6% as of end of 1998.7% .4% Industry 4.BEFORE RECAPITALIZATION Long history of conservative debt policy  Long-term debt to capitalization ratio of 17.8% 103. ROA ROE 53.9% Highly cash generative business UST Inc.8% 23.

What could have prompted the management to change its debt policy and consider leveraged recapitalization? .

Fear of negative effects on stock prices Investor’s loss of confidence in UST Inc.  Competitive position affected by growth of value players in moist tobacco industry  Eroding market share  Management issues  Legal and marketing restrictions might slow down future growth .

WHY LEVERAGED RECAPITALIZATION 1 Increase stock prices and firm value pre-emptively to signal confidence  Through stock repurchase  Through tax shield 2 3 Increase debt-to-equity ratio Discipline management .

suggesting that UST’s stocks are under-valued  Reflects an increasing EPS  Hint to investors that stocks were being under-valued  Drives up stock prices .1INCREASING STOCK PRICES Through Stock Repurchase  Suggest confidence  Accelerate stock repurchase with additional leverage  Intensity of stock buyback might reflect insiders’ information and confidence.

38 = $ 380 million  Value of firm:  Initial enterprise value + increased tax shield  Increase in firm value spreads across number of outstanding shares and increases stock price  Possibly higher corporate tax rates  Higher tax shield . $ 1 billion x 0.1INCREASING STOCK PRICES Through Tax Shield  Incremental tax shield:  Amount of incremental borrowing x corporate tax rate  Eg.

of outstanding shares Further increase in stock price .1INCREASING STOCK PRICES Combined effect  Stock repurchase will amplify the increase in stock price that results from tax shield  Increase in firm value will spread over decreased no.

might not be taking advantage of increased profits that financial leverage may bring .2INCREASING DEBT-TO-EQUITY RATIO Target an appropriate mix of debt and equity  History of conservative debt policy  Stable long-term incomes  Low debt-to-equity ratio indicates that UST Inc.

3 DISCIPLINE MANAGEMENT Align the managers’ interests with UST’s goals Better investing decisions  Incremental debt introduces additional interest obligations  Decreases amount of capital managers access to invest in new projects  Improves decision-making such that under-performing projects are avoided .

.Last but not least. which forms the underlying basis that why UST could even consider leveraged recapitalization. has a strong financial position in the industry. it is imperative to note that UST Inc.

EFFECTS OF RECAPITALIZATION .

MARGINAL EFFECT Credit Rating PV Tax Shield PV Bankruptcy Costs .

MARGINAL EFFECT Credit Rating PV Tax Shield PV Bankruptcy Costs .

CREDIT RATING Depends on bondholders’ concerns regarding UST  Blah  Blah  Blah Most probably get a credit rating of A .

MARGINAL EFFECT Credit Rating PV Tax Shield PV Bankruptcy Costs .

PV TAX SHIELD $1 billion debt 38% Tax Rate PV Tax Shield = 38% * $1 billion = $380 million .

MARGINAL EFFECT Credit Rating PV Tax Shield PV Bankruptcy Costs .

PV BANKRUPTCY COSTS  Probability of default * Cost of bankruptcy .

MARGINAL EFFECT PV Tax Shield – PV Bankruptcy Costs Decision: Should undertake recapitalization .

28%  10 year corporate bond yields .PRO-FORMA Assumptions  Annual growth = 1.20%  EBIT/Sales = 53.

PRO-FORMA INCOME STATEMENT .

OVER TIME .LUMP SUM V.S.

financial ratios are very healthy thus credit ratings will not be affected  default rate (and thus bankruptcy costs) will not be affected as much . bankruptcy costs.S. OVER TIME Cons of Lump Sum over Smaller issues:  Higher risk of increased financial distress and thus.LUMP SUM V.  However.

2 12.6 55.7 41.Source: Debt Policy at UST Inc.5 105.6 296. (Case) Exhibit 6 Three years (1996-1998) Corporate Credit Rating Outlook EBIT interest coverage (x) EBITDA interest coverage (x) Free operating cash flow/debt (%) Philip Morris A Stable 11. 101.3 140.8 UST Inc.7 28.4 26 49.5 Return on capital (%) Operating income/sales (%) Total debt/capital (including ST debt) (%) 38.2 .

95 1000 36.87 1000 36.28 158.17 PV of tax shields from each period S1 Billion Recap (Over time) 339 10 6798.88 Status-Quo S1 Billion Recap (Lump Sum) 380 10 6839.38 5839.95 0.5 6470.873 27.Pros of Lump sum over Smaller issues  Higher Tax shield Larger increase in firm’s market value (in millions.12 158.652 27.24 0 34.22 5798.24 0 6470. except stock) price) PV Tax Shields PV of Bankruptcy cost Market Value of UST Increase in Net Debt Stock Price Shares Repurchased Shares Market Equity Debt/Market Cap. 185.87 0.17 .

LUMP SUM V.S. OVER TIME Objective : To maximise the value per share of the shareholder To issue in one lump sum Decision : .

EFFECT OF RECAPITALIZATION ON DIVIDENDS .

64 .EFFECT ON DIVIDEND PAYMENTS Actual Debt = $1 billion Net Income 1998 1999 Lump sum debt 437.9 475.56 304.52 299.5 158.5 2.8 1999 No debt 467.2 185.77 1.8 Shares EPS Dividend Payout Dividends per share 185.38 2.61 1.5 2.5 1.76 280.

9 475.61 1.77 1.52 299.5 2.5 158.5 2.8 Shares EPS Dividend Payout Dividends per share 185.5 1.64 .38 2.8 1999 No debt 467.EFFECT ON DIVIDEND PAYMENTS Actual Debt = $1 billion Net Income 1998 1999 Lump sum debt 437.56 304.2 185.76 280.

56 304.5 2.61 1.2 185.5 2.5 1.76 280.52 299.5 158.8 Shares EPS Dividend Payout Dividends per share 185.64 .77 1.38 2.9 475.8 1999 No debt 467.EFFECT ON DIVIDEND PAYMENTS Actual Debt = $1 billion Net Income 1998 1999 Lump sum debt 437.

EFFECT ON DIVIDEND PAYMENTS Uncertainty in the long run Unforeseen circumstances affecting UST’s ability to pay off debt  Decrease in credit ratings  Higher Cost of debt .

EFFECT ON DIVIDEND PAYMENTS Decrease in income  Decrease in dividend payout  Decrease in retained earnings for investment in R&D .

CONCLUSION .

CONCLUSION Needs to overcome:  Legal challenges  Limited opportunities for growth (international expansion) Strong financial position Tax Shield Recapitalization in one lump sum offer .