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FIN 5204 Managing Corporate Capital Investment and Capital Structure Fall 2007 Debt Polic at !

S" Inc#

$# %&at are t&e primar business ris's associated (it& !S" Inc#) %&at are t&e attributes o* !S" Inc#) +valuate *rom t&e vie(point o* t&e bond&older# Over the years, UST has been a dominant producer in the tobacco industry, specifically the moist tobacco industry. Even though the past strategy with UST has entailed raising the prices of its products on a regular basis, the company still shows signs of positive growth. Additionally, there have been recent issues with smokeless tobacco products, such as lawsuits. owever, there remains a constant consumer demand for UST products. !hen evaluating the business risk of a company, one of the primary drivers of its business risk stems from the price elasticity of its products. Thus, these are a few reasons that illustrate that the smokeless tobacco industry "UST#s most dominant E$%T contributor& has a relatively steep demand curve and should be considered as having an inelastic consumer demand. Also, it is important to note that UST has products outside of its core operations in the wine and premium cigar market. Also, UST has introduced products in the price value market as consumer demand has increased. Brand name and market position - superior Cash flow generating capacity' superior Cyclicality of revenues ' superior Product diversification ' poor Geographic diversification ' good Asset tangibility ' good Litigation Risk poor Obviously, the two most troubling business risks associated with UST are its litigation and product diversification risks. The smokeless tobacco industry will always face potential lawsuits because of the ongoing health concerns. Also, even though UST has diversified into other markets "wine and cigars&, these products are very minimally attributing to UST#s E$%T. (evertheless, UST products have a steady demand for their products, they produce positive cash flows year'to' year, and the company has a dominant market position and brand

name with regard to their core business. )or these reasons, it is determined that UST has a relatively low business risk.

2# Discuss !S",s past *inancial per*ormance# Is t&e past per*ormance e-pected to continue in t&e *uture) UST ear C/01 Net Sales -, +2I" //, +PS /0, 5. ear /verage ear /verage 0ross Pro*it Margin 11.0, Net Margin 0/.0, 13+ 3-./, Dividend Pa out +1.3, The historical financial data indicates that that compound annual growth per year has been declining in the past five year compared with the past ten years in (et Sales, E$%T, and E*S. Obviously, this is a sign of UST slowing down its financial performance due to factors such as an increase in competitors, less consumer demand, etc... (evertheless, it is comforting that within the past five years, the operating data is generally not moving backwards and is still growing "at a much slower rate&. !hen analy4ing the +'year and /5'year averages, the data indicates that UST financials are still steady and increasing. E6hibit 2 suggests that the market share of UST has been slowly decreasing over the past 1'years. 7ue to the fact that there has been increased competition in the premium smokeless tobacco market, UST is losing market share with products in its core operations. )urthermore, the price value products ./.., /22.3, 02.1, 1-.1, $0. -, ., +, istorical )inancial *erformance 5. ear C/01 $0.

in the industry are showing a dramatic increase in market share, yet UST only shows a 5.., market share in /--3 "late mover&. )or these reasons, UST needs to focus their efforts on attracting the growing demand with the price value smokeless tobacco products in order to strengthen their long'term financial performance. Thus, because of the increased competition in the smokeless tobacco industry, UST has to constantly look for innovative ways in order for them to be a driving force in the smokeless tobacco industry.

4# 5a6 Compare !S",s *inancial per*ormance and capital structure to ot&er tobacco *irms#

+-&ibit "N.4 Summar Companies

Financial In*ormation *or !S" and ot&er "obacco

USTs margins were far superior to all of its competitors8 its growth 9>9 (abisco UST ?ommercialStandard (orth Atlantic =edian "e6UST& 23 2.1 22. + 0./ .+. 1 :3. 5 :./ *hillip =orris Universal /:. 0 0.5 2+. . ..+ +-. : 0-. 2 :.: 7imon /2. + 2.1

@ross *rofit =argin ",& (et =argin ",& 9OE ",& 9OA ",& 7ebt<$ook ?ap ",& 7ebt<=arket ?ap ",& E$%T7A<%nterest coverage"6& ?orporate ?redit rating

35./ 02./50. : +0.3 /1.. /.+ /5+. .

$$$ $$ $$' A' (= ' A margin was 2.-6 the industry median and its net margin was/26 the median. USTs 9OE was an astonishing /50.:, and its 9OA is e;ually impressive at +0.3, compared to a 0./, median. %ts debt<book capitali4ation and debt<market capitali4ation is 0.16 and 026 lower than the median respectively. %ts interest coverage of /5+.. 6s is 2+ 6s more than the industry median. 5b6 %& is %all Street concerned about !S"s *uture prospects leading to a 7neutral rating8 on t&e compan ) !all Street felt that the company#s management was content with its dominant market share and was being too la6 and slow in responding to smaller competitors particularly in the value segment of the market. Analysts were also concerned about the softening smokeless tobacco

:/. 1 /5. 0 :-. 0 /0. 2 :1. + /5. / /2. 1 A

.+. : /./ (= 5.: -5. 5 (A /.. $A

:..2 /2. 0 0.+ 2.: 3.: 2.:

-.1 /.3 22. + 0.: 12. 0 15. : +.:

+:.: 1/. +2./ .3. 0 0.1 0.0

market where unlike cigarette companies lack the option of fighting declining domestic consumption with international growth8 UST had no immediate opportunity for e6panding internationally. )inally, the public and political sentiment was negative regarding the tobacco industry.

4# %& is !S" considering a leveraged recapitali9ation a*ter suc& a long &istor o* conservative debt polic ) UST is considering a leveraged recapitali4ation as a mean to enhance the firm#s value. )irst, UST will benefit from the interest ta6 shield "roughly the increase in debt multiplied by the corporate ta6 rate&, in addition8 this value plus the initial enterprise value will be distributed across a small number of outstanding shares significantly increasing the value of each share. =oreover, servicing this debt should not add any e6tra risk of financial distress due to the highly cash generative nature of USTs business plus the predictability of their future cash flows with a high level of confidence. Second, this debt will help discipline managers from investing in proBects that earn returns below the firms cost of capital where UST have historically performed poorly. USTs investment in non'core operations of its wine business and cigars business generated operating profit margins of /:.-, and +.-, respectively compared to its tobacco operating profit margin of +1.-,. $y adding interest payment obligations into the framework e6cess cash will be better utili4ed instead of being invested into underperforming operations and proBects.

+.& Should UST undertake the C/ billion recapitali4ationD (a) *repare a pro'forma "/---& income statements to evaluate UST#s ability to make interest payments.
E6hibit T(':E %ncome Statement *roBections *ro' forma /--- "%& /:-:.0. 1-2.5/ 5 1-5.+2 055.:5 :-5./2 5 ' ' ' *ro' forma /--"%%& /:-:.0. 1-2.5/ 15.+ 12/.+/ 21:./1 ::1.0: /555 5.515+ //.2 A

Actual /--3 Sales E$%T %nterest E6pense *re'ta6 earnings Ta6es (et %ncome (et debt %nterest 9ate %nterest ?overage 7ebt 9ating /:20.2 1+0.0 '2.2 1++.+ 231.. :.1.5 ' ' '

*ro'forma /--- "%%%& /:-:.0. 1-2.5/ 13.2 1/0.3/ 21/.2+ ::2.+. /555 5.5132 /5./0 $$$

*ro'forma /--- "%F& +, Annual /:-:.0. @rowth 1-2.5/ +0, of sales 31 15+.5/ 2.1.-5 03, ta6 rate :01.// /555 5.531 E$%T<%nterest -./5 E6pense $$

!hen e6amining UST#s ability to make interest payments, it is important to focus on the interest coverage ratio under each of the different pro'forma scenarios. The interest coverage ratio illustrates the ability of the company "in this case, UST& to make interest payments on the outstanding debt. As the interest coverage ratio approaches /, the ability of the company to make these interest

payments becomes problematic. )rom a bondholder#s perspective, the bondholder wants to be sure that the company is always able to make the interest payments. )or UST, in this case, as the debt rating of UST decreases from a bond rating of A "Scenario %%& to a debt rating of $$ "Scenario %%&, the interest coverage ratio is decreasing. owever, from the bondholder#s perspective, the decrease does not warrant a cause for alarm Bust yet. The -./5 coverage ratio is still a ;uality measure, and shows that UST is able to meet the demand for the interest payments as of the current proBection.

"b& ?alculate the valuation impact of the recapitali4ation plan by estimating the value of the interest ta6 shields, assuming a corporate ta6 rate of 03,. !hat other factors, beyond the corporate interest ta6 shields, should UST consider in assessing the valuation impact of the planD
E6hibit T('+E Faluation =odel Status Guo *F Ta6 Shields "t7& Falue of UST "S I Fu& (et 7ebt Stock *rice Shares 9epurchased Shares =arket E;uity 7ebt<=arket E;uity 5.55 .,:.-.5 5 5.55 0:.33 n<a /3+.+5 .,:.-.5 5 5.55 C/ $illion 9ecap *lan 035.55 .,3:-.55 /,555.55 0..-2 21.53 /+3.:2 .,3:-.55 5./+ /555<.3: 03,HC/5 55 C035 A .:..3:-</3+ .+

There are other factors, beyond the corporate ta6 shield, that UST should consider when assessing the impact of the C/ billion dollar recapitali4ation plan. Some of these factors include the signal that UST

will be sending to investors with this recapitali4ation plan. The effect that the recapitali4ation will have on the value of the firm8 due to the change of the capital structure. Since the firm will be adding debt, and incurring ta6 savings, this will have a positive effect on the stock price "Jes, it is true that the number of shares will also be decreasing, leading to a higher E.*.S&. Another factor that should be considered is the fact that this recapitali4ation will have a negative effect on the firm#s li;uidity. Since the debt<e;uity value of the firm will be increasing, the leverage of the firm is increasing, and conse;uently the riskiness of the shares of common stock will also be increasing. %t is important for UST to consider these factors as the firm implements and follows through with the recapitali4ation.

6.) UST %nc. has paid uninterrupted dividends since /-/2. Assess the impact of the plan on UST#s C dividend and dividend per share, assuming it continues to payout .:, of its earnings as dividends.
E6hibit T('.E %mpact of 9ecapitali4ation on 7ividends *ro'forma /--- (o debt :-/ /3+.+ 2..+ 0/:.2 /..*ro'forma /--- 9d I 1.32 ::2.+. /+3.:2 2#7: (%<Shares 2;4#24 (%H..: $#7: E*SH..:

7ebt I C/ $illion (et %ncome Shares Earnings per Share 7ividend *ayout 7ividends per Share

Actual /--3 :.1./3+.+ 2.+2 05/./ /..2

!hen assessing the impact of the plan on the C dividend and the dividend per share, it is clear that the recapitali4ation plan reduces the total dividend payout from C0/:.2 to C230.2:8 however, the dividend per share value increases from C/..- to C/.1-. This is caused in part by the reduced number of shares outstanding as a result of the

recapitali4ation. These assumption are based on the fact that UST continues its# policy of paying out .:, of earnings as dividends. %t is important for UST to continue to uphold this tradition of this dividend payout ratio in order to keep the stockholder#s happy, and to not signal any negative ideas to the stockholders and to !all Street.

FIN 5204 Managing Corporate Capital Investment and Capital Structure Fall 2007 Debt Polic at !S" Inc#

0uillaume <a**itte.Smit& <eonard %ebb =&alid /l.Sarabi