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

ERODING MARKET SHARE

From 86.2% in 1991 to 77.2% in 1998 Inroads by competitors in price-value segment Slow response to competition Lesser new product introductions and innovations

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.

BUSINESS ATTRIBUTES OF UST INC.

Strong brand name recognition Market leader Premium products Economies of scale Management issues Lack of initiative and foresight

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

BONDHOLDERS PERSPECTIVE

BONDHOLDERS 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, esp. long-term bondholders will view this as less favourable

BONDHOLDERS 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

BONDHOLDERS 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

BONDHOLDERS 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

BONDHOLDERS 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, esp. the short-term bondholders will like this aspect as it implies very little risk of default

RATIONALE FOR LEVERAGED RECAPITALIZATION

BEFORE RECAPITALIZATION
Long history of conservative debt policy
Long-term debt to capitalization ratio of 17.6% as of end of 1998, as compared to industry average of 55.9%

Highly cash generative business

UST Inc. ROA ROE 53.8% 103.4% Industry 4.8% 23.7%

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

Fear of negative effects on stock prices Investors 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

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

1INCREASING STOCK PRICES

Through Stock Repurchase
Suggest confidence
Accelerate stock repurchase with additional leverage Intensity of stock buyback might reflect insiders information and confidence, suggesting that USTs 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 Tax Shield
Incremental tax shield:
Amount of incremental borrowing x corporate tax rate Eg. $ 1 billion x 0.38 = $ 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

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. of outstanding shares

Further increase in stock price

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. might not be taking advantage of increased profits that financial leverage may bring

3 DISCIPLINE MANAGEMENT
Align the managers interests with USTs 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, it is imperative to note that UST Inc. has a strong financial position in the industry, which forms the underlying basis that why UST could even consider leveraged recapitalization.

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

PRO-FORMA
Assumptions
Annual growth = 1.20% EBIT/Sales = 53.28% 10 year corporate bond yields

PRO-FORMA INCOME STATEMENT

LUMP SUM V.S. OVER TIME

LUMP SUM V.S. OVER TIME

Cons of Lump Sum over Smaller issues:
Higher risk of increased financial distress and thus, bankruptcy costs. However, financial ratios are very healthy thus credit ratings will not be affected default rate (and thus bankruptcy costs) will not be affected as much

Source: Debt Policy at UST Inc. (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 11.2 12.7 41.8

UST Inc.

101.5 105.6 296.5

Return on capital (%)

Operating income/sales (%) Total debt/capital (including ST debt) (%)

38.4
26 49.3

140.6
55.7 28.2

Pros of Lump sum over Smaller issues

Higher Tax shield Larger increase in firms market value
(in millions, 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. 185.5 6470.24 0 6470.24 0 34.88 Status-Quo S1 Billion Recap (Lump Sum) 380 10 6839.95 1000 36.873 27.12 158.38 5839.95 0.17

PV of tax shields from each period

S1 Billion Recap (Over time) 339 10 6798.87 1000 36.652 27.28 158.22 5798.87 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

EFFECT ON DIVIDEND PAYMENTS

Actual Debt = $1 billion Net Income 1998 1999 Lump sum debt 437.8 1999 No debt

467.9

475.8

Shares EPS
Dividend Payout Dividends per share

185.5 2.52
299.5

158.38 2.76
280.2

185.5 2.56
304.5

1.61

1.77

1.64

EFFECT ON DIVIDEND PAYMENTS

Actual Debt = $1 billion Net Income 1998 1999 Lump sum debt 437.8 1999 No debt

467.9

475.8

Shares EPS
Dividend Payout Dividends per share

185.5 2.52
299.5

158.38 2.76
280.2

185.5 2.56
304.5

1.61

1.77

1.64

EFFECT ON DIVIDEND PAYMENTS

Actual Debt = $1 billion Net Income 1998 1999 Lump sum debt 437.8 1999 No debt

467.9

475.8

Shares EPS
Dividend Payout Dividends per share

185.5 2.52
299.5

158.38 2.76
280.2

185.5 2.56
304.5

1.61

1.77

1.64

EFFECT ON DIVIDEND PAYMENTS

Uncertainty in the long run

Unforeseen circumstances affecting USTs 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