3. Financial position
Financial position plays an important role in the decision of bondholders which would have a significant impact on the cost of the recapitalization. UST has historically maintained an A-1 credit rating for its commercial paper due to its high returns and strong cash flow. If UST issued long-term debt, it would increased its leverage and risk. S&P and other rating agencies will review UST’s overall corporate profile, pro-forma capital structure and investment intentions to determine the appropriate senior debt rating. Other indicators such as cash flow generation, payment obligations and key financial ratios would be in consideration too. However, S&P views the near-term outlook of the tobacco industry to be stable and the longer-term view to be less clear.
4. Potential underperform
Despite the new issued products in 1997, analyst still felt that UST was too slow in responding to the threat of value competitors. UST had been criticized recently for a reduction in innovation and tardiness of new product introductions and product line extensions. An alleged dispute over the company’s course of action reportedly led to the resignation of two key executives. Besides, historically lackluster performance of non-core operations creates some concern that management might use funds to over-invest in under-performing business. As the exhibit 4 shows the investments in wine and cigars operations have traditionally provided returns far below those of the core operation.
5. Negative political sentiment
Due to the passive affects on smokers’ health and other factors, public and political sentiment remains negative regarding the tobacco industry. The US tobacco industry is characterized by declining volumes, legal challenges, marketing restrictions, taxes, discounting and consolidation, and so the long-term view is not so clear. There is a trace that the growth of smokeless tobacco segment is decelerating recently, but still, the company has stable growth, high profits and most likely will not present a problem for the bondholder.
Attributes of UST Inc
1. Conservative debt policy and high payout
The leading producer of moist smokeless tobacco products is widely known for its conservative debt policy and high dividend payout. The company has paid uninterrupted cash dividends since 1912. As exhibit 3 shows that the company maintained its payout ratio at 50%-64% for decade which was increasing year by year. The company suspended its stock repurchase program since 1996.
2. Product advantages and stable growth
Smokeless tobacco products has been the fastest growing segment of the tobacco industry with volume increasing over 17 years compared the decline in the cigarette volume over the same period.
1) The increased prevalence of smoking bans has led consumers to switch to smokeless tobacco to circumvent the restrictions.
2) The moist smokeless tobacco is less of a health risk than cigarettes.
3) Smokeless tobacco is less expensive to use than cigarettes based upon an average per-week usage measurement.
4) Consumer have been shifting over time to moist smokeless tobacco from loose leaf chewing tobacco.
5) The consumer base expands over years. Consumer group is no longer confined to the stereotypical blue collar or rural users as approximately 30% of users have attended some college.
The overall moist smokeless tobacco market is expected to continue grow at an annual rate of 1-3%. The near-term outlook of tobacco industry considered to be stable.
3. Strong brand value
UST is the dominant producer of moist smokeless tobacco, or moist snuff, controlling approximately 77% of the market. Exhibit 2 shows UST occupy the 77.2% of the total market share. Table B displays the 1998 market share of the top moist smokeless tobacco brands. The No.1 brand and most of the top brands belong to UST Inc. As Exhibit 2 shows, before 1998, UST’s total market share focused on premium market share. The price value market share broke through zero until 1998.
4. High return and strong cash flow
UST has been aggressive with its price increases, instituting almost annual, often twice annual, price increases over the past twenty five years. Steadily increasing prices provided a solid boost to earnings and the company’s stock price.
Currently UST maintained enviable margins with average profit and it has historically been one of the most profitable companies, not only in tobacco sector, but also in corporate America. The strong profitability made the company’s financial ratio exceed far away from the opponents in the same industry.
2. Question Two and Answer
Why is UST Inc. considering a leveraged recapitalization after such a long history of conservative debt policy?
1. Tax shield
UST can increase the firm value by enjoying the huge tax shield provided by more leverage. A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. Because interest on debt is a tax-deductible expense, taking on debt creates a tax-deductible expense. Taking on debt creates a tax shield which a efficient way to save cash slows.
Since the company have strong profitability and optimistic prospective, the chance of bankrupt is significant low. The low default risk and cost of bankruptcy enable the company to increase its financial leverage and choose a more aggressive capital structure strategy.
2. Boost the stock price and high dividend
Recapitalization is often undertaken with the aim of making the company’s capital structure more stable and sometimes to boost the company’s stock price. It is also a signal to shareholders that it still commits to provide generous dividend returns.
3. Upgrade shareholder’s own weights
The recapitalization helps to decrease the total shares outstanding, thus increase the relative percentage of the remaining shareholders. Consequently, the insider will have more weights on the voting of the major policies of the company. On the other hand, the increased owning percentage could prevent the company to become hostile takeover targets. Usually companies will take measures by issuing bonds and buyback outstanding stock shares to higher to its financial leverage.
3. Question Three and Answer
Should UST Inc. undertake the $1 billion recapitalization? Calculate the marginal(or incremental) effect on UST’s value, assuming that the entire recapitalization is implemented immediately(January 1, 1999).
Formula:
Value of Levered Firm = Value of Unlevered Firm + PV of Tax Benefits – PV of Bankruptcy Costs
If PV of Tax Benefits – PV of Bankruptcy Costs >0, Value of Levered Firm will increase.
I:
PV of Tax Benefits = Value of Tax Benefits / Discount rate
= T* Interest Rate of Debt * New Debt / Interest Rate of Debt
= T* Debt = 38% * 1000million= 380million
II:
PV of Bankruptcy Costs = Probability of default *Bankruptcy costs
= 0.28% * 30%of firm value
= 0.28%*30%*(Equity + Debt )
= 0.28%*30%*(6470.8 + 1100)
= 6.359million
III:
PV of Tax Benefits – PV of Bankruptcy Costs = 380 - 6.359 = 373.6 million >0
Because Value of Levered Firm increases, the $1 billion should be recapitalized.
Notes:
Assume the Bond rating of the UST is AA credit rating. So the Probability of Default rate is 0.28%.
(a) Assume a 38% tax rate.
(b) Prepare a pro-forma income statement to analyze whether UST will be able to make interest payments.
Figure 1
From the table above, EBIT minus Interest is far above Zero, which confirm that UST is able to make interest payments.
(We also calculate the EBIT Interest coverage, which are all from 9.2 to 12.9. So the AA credit rate assumption is properly.)
(c) For the basic analysis, assume that $1 billion in new debt is constant and perpetual. Should UST alter the new debt via a different level or a change in the amount of debt through time?
Figure 2
When the value of New Debt to repurchase stock is 1000 (Figure 2), Earning Per share is 2.767. The EBIT Interest coverage is 11.89, which is from 9.2 to 12.9.
Figure3
When the value of New Debt to repurchase stock is 910 (Figure 3), Earning Per share is 2.75. The EBIT Interest coverage is 12.96.
Figure 4
When the value of New Debt to repurchase stock is 1320 (Figure 4), Earning Per share is 2.79. The EBIT Interest coverage is 9.21.
All in all, when we increase the debt to 1320 million, the Earning Per Share also increases to 2.79. Meanwhile, the EBIT Interest coverage still satisfies the AA credit assumption.
4. Question Four and Answer
UST Inc. has paid uninterrupted dividends since 1912. Will the recapitalization hamper future dividend payments?
Figure 5
As far as the dividends pay-outs are concerned I believe that they should continue their tradition. Recapitalization will not hamper dividend payments in the near future. Since they have very strong position and net income, they can pay the dividends as they always did, this would increase their value as a company and keep the shareholders satisfied. The Figure 5 shows that shareholders will get more dividend after the recapitalization.
