The case “Debt Policy at UST Inc. ” deals with the progressively lowering growth and the company’s board decision to borrow up to $1 billion over five years to accelerate its stock buyback program. The case talks about how the company has seen its commanding market power decline over the years due to price challenge from smaller companies and has been experiencing slow growth rates due to lack of innovation in recent years. The investors had concerns regarding the future of the company and hence, the board has decided to take up recapitalization of capital structure.
UST Inc. is the dominant producer of moist smokeless tobacco, or moist snuff, controlling approximately 77% of the market. UST Inc. primarily has the moist smokeless products as its premium products. It also has a secondary product- wine generating revenues for the company. When faced with stiff competition from smaller brands that had lesser prices for their products, UST Inc. did not cut down their prices; however they introduced new higher valued products to battle the competition.
Also, UST- the only major smokeless tobacco manufacturer signed to an agreement of paying $100 to $200 million over 10 years and to restrictions on advertising primarily aimed at youth exposure. The company’s eroding market power along with its lowering earnings made the company decide on taking up $1 billion as debt to repurchase its stock. The effects of recapitalization of capital structure are: * A higher leveraged company * Rise in share price of the company and thus increasing the shareholder value * Avoiding the possibility of a hostile takeover Provide management with higher percentage of share ownership and control
The recapitalization of the company will make UST a higher leveraged company, raise its share price, provide the management with more ownership and avoid a hostile takeover by other major players in the tobacco industry. However, the credit analysts and bond holders might have concerns regarding the company’s recapitalization plan. The possible risks from the viewpoint of bond holders are: Is the cash flow sufficient to meet the necessary interest payments? * How is the company going to use the $1 billion debt? * Is the company going to invest the $1 billion in new projects? * How would the company’s growth be affected due to this $1 billion? * The litigation agreement signed on by UST: How will this affect the revenues of the company? Financial Performance: As mentioned in the case study, UST has historically been one of the most profitable companies in the corporate America.
UST’s profitability is due to its attributes of commanding share of moist smokeless tobacco market, premium product and strong brand name, historical pricing flexibility, continued growth of moist smokeless tobacco market due to the restrictions on tobacco users and high barriers of entry into the moist smokeless tobacco market. The net sales, gross profit, EBITDA and EBIT have been progressively increasing for the company from 1988 to 1998. However, the sales growth increased from 7. 2% in 1988 to 18. 8% in 1991, later the sales growth declined to 1. % in 1998. Net Income has also seen a decline from 23. 9% in 1988 to 5. 4% in 1998. However, the company has been seeing steady growth of free operating cash flow. It can be concluded that the company is not in any position of financial distress. However, the company’s decision of taking on $1 billion as debt to leverage the company can be an issue for the investors.
UST observed its operating profit of 96. 8% from tobacco and 3% from wine in 1998. (Questions: is the past performance expected to continue in the future? UST’s financial performance can be considered better than most of its counterparts in the industry. Its net income of $467. 9 million is greater than North Atlantic, DiMon Inc. , Standard Commercial and Universal Corp who have net incomes of $1 million, $52 million, $26. 9 million and $130. 4 million respectively. UST’s characteristics of good amounts of cash flow and high dividend payout ratios make it a highly attractive company for shareholders. Prior to the decision of taking on $1 billion as debt, UST had a total debt /total asset ratio as 0. 1.
It competitors had the total debt/total asset ratio ranging over 0. 2 to 0. 83. Compared to the other tobacco firms in the industry, UST had a very conservative debt policy. Its total debt/total asset ratio of 0. 1 suggests that it can be considered as an all equity firm. Debt Recapitalization: The company should borrow the $1 billion as it helps in shielding the tax, increases the share price and thus increasing the value of the firm. It also potentially evades the possibility of a hostile takeover from the large companies in the industry by adding debt, eliminating idle cash and debt capacity.
The recapitalization also helps in employing debt’s disciplinary effect to improve performance and make necessary interest payments to increase the shareholder value. From our valuation, considering that the debt decreases the credit rating of the company to A from AAA and assuming that the company is expected to grow at 1%, it can be seen that UST would be able to make the necessary payments. The company is able to save $380 million on tax shield as n effect of leveraging the company with $1 billion debt.
From the analysis, it can be observed that bringing on leverage, does not hamper the cash flows of the company. Hence, the company can be considered to be healthy and is in no condition of financial distress. However, the case of the company being acquired can be considered. Valuation Model: (——) Dividend Policy: UST has historically been giving out high dividend payout. It has always seen a dividend payout ratio over 50%. However with this recapitalization plan, it can be observed that the interest expense increases from $2. million in 1998 to $63. 40 million in 1999. Its net income has seen a decline falling from $467. 9 million to $417. 41 million. If we consider that the dividend payout ratio remains the same, the company will not be able to payout the debt sooner. For the company to be able to experience free cash flow and for the company to grow, it is suggested that the dividend payout ratio should be reduced and the money to be invested in new projects to increase the value of the company and thus be able to pay off the debt soon. Conclusion:
The recapitalization of the company increases the leverage of the company and thus increasing the shareholder value of the company. It increases the share price of the company. The company should take the $1 billion debt to avoid a hostile takeover due to reduction in sales and market power. However for the company to stay profitable, it should consider investing the money in new projects to be able to answer the concerns of bondholders and investors. It should reduce its dividend payout ratio to be able to pay back its debt along with its interest payments.