1

Business

• Business/Strategy
• Operating performance

2
Business/Strategy

• UST:
– Moist smokeless tobacco
– Leading producer (near-monopolist): 77% market share

• Industry:
– Slow growing
– Brands
– Advertising ban  Favors incumbents, i.e. UST
– Value vs. premium segments

3
 Operating performance

• Stellar in absolute terms and relative to “peers”:

– Very high and stable margins, ROE, ROA, etc.
– Ever-increasing earnings

• Concern:
– Management unrest: conflicts over strategy, resignations,…
– Declining sales growth and market share
 Analysts are doubtful about (lack of) strategy

UST Philip Morris N.A.T. RJR Nabisco DiMon Std Com. Universal Median Mean
EBITDA margin 55.2% 20.8% 39.0% 17.5% 9.2% 5.7% 7.7% 13.4% 16.7%
EBIT margin 52.9% 18.6% 31.3% 12.0% 7.2% 4.4% 6.5% 9.6% 13.3%
Net margin 32.9% 10.3% 1.1% 3.5% 2.4% 1.8% 3.0% 2.7% 3.7%
Return on Equity (ROE) 99.9% 47.4% -6.5% 9.2% 12.3% 18.0% 23.8% 15.2% 17.4%
Return on Assets (ROA) 51.2% 12.8% 0.4% 2.5% 2.9% 3.2% 6.3% 3.0% 4.7%

4
 Current Capital Structure

• Description
• Explanation

5
 Leverage/Liquidity

UST Philip Morris N.A.T. RJR Nabisco DiMon Std Com. Universal Median Mean
Liabilities/Assets 48.7% 73.0% 105.9% 73.0% 76.5% 82.2% 73.4% 73.4% 80.7%
Debt/Assets 10.9% 24.5% 82.9% 36.2% 60.1% 56.0% 41.3% 41.3% 50.2%
Net debt/Assets 7.3% 17.7% 81.8% 35.2% 59.0% 51.9% 37.4% 37.4% 47.2%
Liabilities/Firm value 6.4% 25.2% NM 68.7% 73.3% 77.7% 53.4% 61.0% 59.7%
Debt/Firm value 1.4% 8.4% NM 34.1% 57.5% 52.9% 30.1% 32.1% 36.6%
Net debt/Firm value 1.0% 6.1% NM 33.1% 56.5% 49.1% 27.3% 30.2% 34.4%
Debt/EBITDA 0.1x 0.9x 5.9x 2.9x 5.4x 5.5x 2.6x 290.6% 387.3%
Coverage ratio NM 15.5x 1.2x 2.8x 1.9x 1.7x 4.4x 233.7% 457.3%

• NB: Firm value = Liabilities + Market Equity

• Leverage:
– Essentially none
– Much lower than peers

6
Sources and uses of funds

• Main source (1994-98):

– Net Income: $1.8b

• Main uses (1994-98):

– Dividends: $1.1b
– Repurchases: $710m

• NB: Equity overall is a source (≈ $100m over 1994-98) but here decomposing it
into inflows (net income) and outflows (dividends + repurchases) is useful

• All the rest is small in comparison

7
Why so little debt?

• Annual asset growth over 1993-98

g = (913.3/706.2)1/5 – 1 = 5.3%

• Ignoring regular share repurchases, 1998 sustainable growth

g* = (1 – d) × ROE = (1 – 64%) × 99.9% = 36%

• UST is growing much slower than its sustainable growth rate (g << g*)
 Its leverage will decrease… unless it does something about it:
1. repurchase equity
2. and/or increase dividends

8
• Why is UST’s actual growth so low?
– The industry is growing slowly
– UST’s market share is very high  Cannot grow fast by gaining market share

• Why is UST’s sustainable growth rate so high?

– Because it is extremely profitable
– Dupont decomposition
Leverage
ROA   
Net income Sales Assets
g*  1 - d  ROE  (1 - d)   
Sales Assets Equity

Very high Very high

margins asset turnover
≈ 33% ≈ 1.56x

9
Bottom line

• UST’s natural trend is to have low/decreasing leverage because its high

profitability allows its modest growth to be financed internally

• In fact, UST has a regular share repurchase program. If we take it into account as
part of the payout ratio:
g* ≈ 0%

• UST never had to lever up… but it still decided to counter cash accumulation:
– It pays dividends and repurchases shares
 Leverage increases very slowly

• Question: Should UST choose to lever up much more/faster?

– If so, how much?
– If not, will it be forced to?

10
 Target Capital Structure

• Pros of Debt
• Cons of Debt: Risks × Distress Costs

11
Debt pros

• Taxes:
– How much would UST benefit from the tax shield of debt?
– UST pays taxes of $250m-$300m per year
 Could use the tax shield of debt

• Discipline:
– How much would UST’s investment policy be disciplined by debt?
– UST generates more cash than it needs for its operations
– General concerns: Bad investments, complacency, low reactivity, etc.
– Debt might be a way to avoid this by “pumping cash out of the firm”
+ Sluggish reaction to rivals: debt might have given a sense of urgency
+ Some (but few) odd M&A: debt might have avoided those
 Some limited benefits for UST

12
Debt cons: sources of risk

How risky is UST’s business?

• Cyclicality? • Technology risk? No.

– Earnings up for 36 years
– Small ticket items • Asset tangibility?
– Non-durable – Few tangible assets (very low
B/M ratio)
• Competition risk?
– 77% market share • Litigation?
– Entry difficult – On the rise
– Brand recognition – Health concern in US

• Taxes? Input prices? • Diversification?

– Inelastic demand – 1 product + 1 location
 Pass to consumers

13
Debt cons: distress costs

• Investment:
– Would UST need to cut critical and inflexible investments?
– Not much CAPX, R&D, M&A + Can likely be postponed w/o major disruption

• Assets:
– Would UST have to sell illiquid assets at a big discount or raise funds against
hard-to-value assets?
– UST has intangible assets…
– … but these are its brands and they are relatively easy to value and sell

• Competition:
– Would UST’s rivals become more aggressive?
– There is not much competition + Entry is difficult
– This is b/c entry requires developing brands but there is an advertising ban

14
• Costumers:
– Would UST’s customers stop buying its products?
– No: these are non-durable, small ticket items + costumers are “addicted”

• Suppliers/Employees/Others:
– Would they care if UST were in distress?
– No, at least not more than for the average business

• Management:
– Would they fail to cope with distress situation?
– Possibly:
+ They are untested: UST has been doing well for decades
+ They are already unsettled

15
Target capital structure: Checklist
Makes debt more attractive
than for average business?
GENERIC FACTORS No! OK Yes! ?
PRO1. Taxes: Do ITS make debt attractive? Pay $300m in taxes per year X
PRO2. Discipline: Is over-investment a risk?Sluggish to react to entry
X
+ Odd M&A (but small)
CON1. Main Business Risks: Demand? Rivalry? Very safe.Main risks: litigation,
Techno? Regulation? Political? Etc. demand + single
country/product
CON2. Cost of Financial Distress: Business
disruption if struggling for funds
Investment: Large, inflexible needs No more than average X
Assets: Hard-to-value/redeploy, intangible Brands (main asset): easy to
value + in high demand if sell X
(b/c entry difficult)
Rivals: Can they hurt you if you're down? No rivals to speak of X
Customers: Durable good, warranties, etc. Non-durable, small ticket item X
Suppliers: Do they care if you're distressed? Not sure X
Employees: Human capital-intensive? No X
Management: Will they fold? Some management unrest X

 UST should have high leverage

16
 Leveraged Recapitalization

• Mechanics
• Value impact
• Transaction
• Effect on interest rate and dividends

17
Recapitalization: Mechanics

1. Issue debt
2. Use the proceeds to repurchase shares (or pay a special dividend)
 Change in capital structure (no change in assets)

E=?

18
$1bn recapitalization: value impact

• Before the recapitalization is announced:

– Market equity Epre-recap = $6,470m
– Debt Dpre-recap = $100m
– Firm value Vpre-recap = $6,570m

• After the recapitalization is implemented:

– Tax shield created PVTS ≈ t × New D = 38% × 1,000 = $380m
– Firm value Vpost-recap = 6,570 + 380 = $6,950m
– Debt Dpost-recap = 100 + 1,000 = $1,100m
– Market equity Epost-recap = 6,950 – 100 – 1,000 = $5,850m

• Market equity drops but shareholders are better off as overall they get:
Eat announcement = Payout + Epost-recap = 1,000 + 5,850 = $6,850m

19
$1bn recapitalization: transaction

• Repurchase how many shares (n) and at what price (p)?

• Pre-recap, 185.5m shares

• Stock price reaction to the recap announcement:

– Stock price pre-recap $34.88
– Stock price at announcement 6,850/185.5 = $36.93

• Shares post recap

– UST repurchases 1,000/36.93 = 27.1 million shares
– Remaining shares 185.5 – 27.1 = 158.4 million shares

• Stock price post recap 5,850/158.4 = $36.93

20
Recap Amount 0 1,000 2,000
Book equity pre-recap 468.3 468.3 468.3 Book value of equity before the recap is announced
Number of shares pre-recap 185.5 185.5 185.5 Number of shares outstanding
Stock price pre-recap 34.88 34.88 34.88 1998 year-end stock price
Market equity pre-recap 6,470 6,470 6,470 = Number of shares × Share price pre-recap
Debt pre-recap 100 100 100 Debt (book) value before the recap is announced
Firm value pre-recap 6,570 6,570 6,570 (Market equity + Debt) before the recap is announced
Tax rate 38% 38% 38% Corporate tax rate
New debt - 1,000 2,000 Amount borrowed in the recap
Value of tax shield created - 380 760 = Tax rate × New debt
Firm value post recap 6,570 6,950 7,330 = Firm value pre-recap + Value of tax shield created
Debt post-recap 100 1,100 2,100 = Debt pre-recap + New Debt
Leverage ratio post- 2% 16% 29% = Debt post-recap/Firm value post-recap
Market equity post-recap 6,470 5,850 5,230 = Firm value post-recap − Debt post-recap
Book equity post-recap 468.3 (531.7) (1,531.7) = Book equity pre-recap − Total repurchase
Total repurchase - 1,000 2,000 = Amount paid out in the repurchase
Market equity at announcement
6,470 6,850 7,230 = Market equity post-recap + Total repurchase
Stock price at announcement34.9 36.9 39.0 = (Market equity/Number of shares) at announcement
Number of shares - 27.1 51.3 = Total repurchase/Stock price at announcement
Number of shares 185.5 158.4 134.2 = # shares pre-recap − # shares repurchased
Stock price post- 34.9 36.9 39.0 = (Market equity/Number of shares) post-recap
Debt rating post-recap AAA AA BBB Inferred from corporate bonds statistics
Interest rate 5.85% 6.9% 9.1% Inferred from the yield of same-rating corporate bonds
EBIT 768.4 768.4 768.4 = (1+2%) ×EBIT 98 (=753.3)
Interest expense 6 76 191 = Interest rate × Debt post-recap
Earnings before tax 763 692 577 = EBIT − Interest expense
Tax 290 263 219 = Tax rate × EBT
Net Income 473 429 358 = EBT − Tax
Return on Equity (ROE) 101% NM NM = Net income/Book equity post-recap
Earnings per share (EPS) 2.55 2.71 2.67 = Net income/Number of shares post-recap
21
NB: Can book equity really be negative?

• UST’s recapitalization can result in a negative book value of equity.

• NB: That is one of several different accounting treatments of recapitalizations.

• Can book equity really be negative? Yes

• Does this mean the firm is in bankruptcy? ?No
• Is this possible even if the firm is doing well? Yes

22
Conclusion

23
UST: Takeaways

• Dynamics:
– Slow growth + High profitability
No need for outside funds
Leverage will decrease… unless UST does something (dividends + buybacks)

• Target capital structure (C/S):

– Debt pros are high: Large tax benefits (+ perhaps a bit of discipline)
– Debt cons are limited:
+ Small distress probability: Safe business, stable cash flows, etc.
+ Little costs if in distress: No major investments, liquid assets, no
competition, etc.

 UST’s business characteristics imply UST should increase its leverage

24
Other considerations…

• For UST:
– Repurchasing shares can adjust capital structure to a more suitable target
– But perhaps it can also serve other purposes

• Say UST’s management think the stock is underpriced

• If they want to correct the mispricing (to benefit all shareholders)

Increase dividends, pay a special dividend, major share buyback

• If they want to exploit mispricing for long-term shareholders (+ themselves?)

Major share buyback program

• NB: This is a very different perspective on financial policy:

– Not about the business
– More about “pricing”

25
What happened?

• Dec 1998: UST’s board approves $1bn recapitalization plan over 5 years

• May 1999:
– private placement of $240m in 10-year debt
– repurchased 16.1m shares for $466m

• Dec 1999: Dividend increased to $1.76

• March 2000: private placement of $300m in 5-year debt (S&P A+ rating)

– lower maturity due to investor concerns about litigation
– repurchase 4.7m shares for $97m

• May 2000: the plan is put on hold due to $1bn award in antitrust case

• Aug 2002: The plan resumed

26