Case: Debt Policy at UST Inc.

| Protagonist: Vincent Gierer

Introduction:
The case deals with a smokeless tobacco company with the protagonist, Vincent Gierer along
with the management trying to migrate to a new debt policy for the company. The board has
already approved of a plan to buy back stock up to $1 billion over a period of five years.
However this was suspended because of the legislative and legal issues coming up in the
tobacco industry in 1997. However, since its resolving these issues with the signing of the
Smokeless Tobacco Master Settlement Agreement and dispelling its liability the company has
moved again on its repurchase programme.
Overview of the Smokeless Tobacco Industry:
The smokeless tobacco generated a revenue of $2 Billion in 1998 with consumers in both
moist smokeless tobacco and chewing tobacco. Within the tobacco industry this was the
fastest growing segment with 3.7% annual growth rate as compared to the 2% decline in
cigarettes over the past 17 years.
With the increased prevalence of the smoking bans the consumer are expected to move to the
moist tobacco and smokeless alternatives. Also there is a general trend of consumers moving
from loose tobacco to moist tobacco as well.
USTs Position:
UST has maintained its position with product innovations such as new forms and flavours.
However analyst were of the views that UST was slow in responding to the newly upcoming
value segment where it turned its nose away against smaller players which ended up gaining
9% of the market share.
As alternative movement, UST also renewed its focus on marketing and promotion with steps
like couponing, sales force expansion, retailer and wholesaler incentive provisions, outlet
expansions and unique product commemorations.
Legal Position:
UST and the smokeless industry has faced little litigation exposure however, with the recent
efforts towards reducing the exposure of teenagers and youth to tobacco the long-term
outlook is uncertain.With the signing of the smokeless tobacco master settlement agreement
the exposure was fixed at $100 to $200 million over 10 years amounting to $0.015 to $0.02
per can with restrictions on advertising and promotion. It being the only company to sign the
agreement, the competitors could still use the promotions to eat market share. However, they
would be exposed to the uncertain litigation outcomes in future.
Financial Position:
Historically, UST has been a strong company for investors with a five year return on capital
of 92.1%. Its profitability came from the command over the moist smokeless tobacco market
share, premium products and a strong brand name in the market with a historic pricing
flexibility.
In comparison to the industry UST has an unusually low debt to book capitalization ratio of
17.6% as opposed to 66%.
Our Findings and Position:
If we take on Debt for an assumed value of 1.89 Billion dollars then also per the calculations,
we would retain an investment criteria of BBB which is minimum acceptable and has the
minimum WACC value which optimises the overall capital structure. Debt level 30%. (Refer
Excel embedded in the appendix) We take the debt level at increments of percentage of the
total capital value as part of the invested value raised through the firms capital structure.
Based on our findings at various levels of debt we notice that at levels of debt ranging from
0% to 40% at 10% increments. The current debt level to book capitalization ratio for UST
INC. is 17.6%
If we assume an ideal debt value of 30% of the capital structure of the firm, we find that still
our debt levels would be much lower than the overall industry median of 66%. This would
give us a leverage and an overall investment value of 1.89 billion dollars out of which we
need only 1 Billion dollars.
Based on our calculations, we find that based on the concept of optimal capital structure we
find that the minimum cost of WACC is found at the debt level 30%. This would also serve
the benefit of maximizing the NPV of future projects and ensure better debt ratings for
investment purposes. At this level of debt, we find that we still ensure to achieve a BBB
rating which is the minimum rating necessary to be classified as a safe investment. However,
one concern in this scenario is that due to the additional debt which gives us the added benefit
of an income tax shield but also reduces our debt rating and would have to provide sufficient
returns to our investors.
The recommended debt level is high but is feasible for the company as the industry trends
show an outlook of continued strong cash flows which given the financial cash flows of UST
can be utilised to finance the periodic debt repayments and would help them undertake the
stock buyback program successfully.
Also, on a strategy point of view UST can let go of its Wine and other business segments
which takes nearly 12% of capital but contributes to only 3% of the operating profit. Also
~45% of the capital expenditure is form the wine segment which is very high for a very
poorly performing segment. And keep close an eye on the Rooster product line for its
profitability and market viability which must perform to become a potential cash cow in the
future.