UST Inc.: One Of The Most Profitable Companies
Corporate Finance Xudong Huang
Homework Assignment No.1 Xi Huang Oct 23, 2012 Vasudha Nukala Ji Qi
Executive Summary
UST Inc. has historically been one of the most profitable companies. Profitability stems from its commanding market share, strong name brand recognition, historical pricing flexibility, and growing smokeless tobacco demand. However, UST faces business risks including eroding market share, tobacco lawsuits, and reduction in innovation. UST Inc. is considering a leveraged recapitalization to help in shielding the tax, increasing the share price and eliminating idle cash and debt …show more content…
capacity to give the company more opportunities to expand its market share. After considering the effect of leveraged recapitalization on free cash flow, financial flexibility and dividend policy, it is suggested that UTC should undertake the $1 billion recapitalization.
Business and Risks:
UST has historically been one of the most profitable companies, with a gross profit margin of 80% compared to a median of 28% for tobacco companies shown in Exhibit 5.
UST observed its operating profit of 96.8% from tobacco and 3% from wine in 1998. With the fast growing of smokeless tobacco segment and less exposure to health related lawsuits, UST’s 77% market share of smokeless tobacco market generates large profit for the company. Other attributes including premium product, strong name brand recognition, historical pricing flexibility, and limited market access by new competitors.
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 1.5% 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.
Despite the attributes, UST suffers from a significant share erosion in recent years because of its tardiness in new product introduction and slow in global expansion, and competitors’ price cutting and. In November of 1998, UST signed the Smokeless Tobacco Master Settlement Agreement, which provided that UST pay $100 to $200 million, or $.015 to $.02 per can, over 10 years and agree to advertising and promotion restrictions.
Reasons for Recapitalization:
UST is considering recapitalization after years of conservative debt policy. The recapitalization of the company increases the leverage of the company and helps in shielding the tax, increases the share price and thus increasing the value of the firm, thus increasing the shareholder value of the company, eliminating idle cash and debt capacity to give the company more opportunities to expand its market share. It also potentially evades the possibility of a hostile takeover from the large companies in the industry by adding debt. The recapitalization also helps in employing debt’s disciplinary effect to improve performance and make necessary interest payments to increase the shareholder value.
Effects of Levered Recapitalization:
From our pro-forma income statement (see Appendix), 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 its 5-year average of 5%, 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 the effect of leveraging the company with $1 billion debt. Assuming the entire recapitalization is implemented immediately, the share price will increase to $43.67, making a profit of $8.8 per share for investors who hold their shares, and EPS will increase from $2.52 to $2.78. 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.
Regarding the level of the debt, it can be seen that, if using market equity value, the debt to capital ratio of UST is 16.1%, much smaller than the A-rating ratio, which is 39.2%. It thus implies that, given the stable cash flow of UST, in the future the firm could steadily increase its debt ratio to fully extract the benefit of leverage.
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 $2.2 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 reinvest in equipment, R&D and products. For the company to be able to generate 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:
It is suggested that the company undertake the $1 billion recapitalization since it increases shareholder value without driving the likelihood of financial distress. It also helps to avoid potential hostile takeover by eliminating debt capacity. However for the company to stay profitable, it should consider reducing its dividend payout ratio and investing the money in new projects to be able to answer the concerns of bondholders and investors.
Homework Assignment No.1 Xi Huang Oct 23, 2012 Vasudha Nukala Ji Qi
Executive Summary
UST Inc. has historically been one of the most profitable companies. Profitability stems from its commanding market share, strong name brand recognition, historical pricing flexibility, and growing smokeless tobacco demand. However, UST faces business risks including eroding market share, tobacco lawsuits, and reduction in innovation. UST Inc. is considering a leveraged recapitalization to help in shielding the tax, increasing the share price and eliminating idle cash and debt …show more content…
capacity to give the company more opportunities to expand its market share. After considering the effect of leveraged recapitalization on free cash flow, financial flexibility and dividend policy, it is suggested that UTC should undertake the $1 billion recapitalization.
Business and Risks:
UST has historically been one of the most profitable companies, with a gross profit margin of 80% compared to a median of 28% for tobacco companies shown in Exhibit 5.
UST observed its operating profit of 96.8% from tobacco and 3% from wine in 1998. With the fast growing of smokeless tobacco segment and less exposure to health related lawsuits, UST’s 77% market share of smokeless tobacco market generates large profit for the company. Other attributes including premium product, strong name brand recognition, historical pricing flexibility, and limited market access by new competitors.
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 1.5% 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.
Despite the attributes, UST suffers from a significant share erosion in recent years because of its tardiness in new product introduction and slow in global expansion, and competitors’ price cutting and. In November of 1998, UST signed the Smokeless Tobacco Master Settlement Agreement, which provided that UST pay $100 to $200 million, or $.015 to $.02 per can, over 10 years and agree to advertising and promotion restrictions.
Reasons for Recapitalization:
UST is considering recapitalization after years of conservative debt policy. The recapitalization of the company increases the leverage of the company and helps in shielding the tax, increases the share price and thus increasing the value of the firm, thus increasing the shareholder value of the company, eliminating idle cash and debt capacity to give the company more opportunities to expand its market share. It also potentially evades the possibility of a hostile takeover from the large companies in the industry by adding debt. The recapitalization also helps in employing debt’s disciplinary effect to improve performance and make necessary interest payments to increase the shareholder value.
Effects of Levered Recapitalization:
From our pro-forma income statement (see Appendix), 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 its 5-year average of 5%, 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 the effect of leveraging the company with $1 billion debt. Assuming the entire recapitalization is implemented immediately, the share price will increase to $43.67, making a profit of $8.8 per share for investors who hold their shares, and EPS will increase from $2.52 to $2.78. 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.
Regarding the level of the debt, it can be seen that, if using market equity value, the debt to capital ratio of UST is 16.1%, much smaller than the A-rating ratio, which is 39.2%. It thus implies that, given the stable cash flow of UST, in the future the firm could steadily increase its debt ratio to fully extract the benefit of leverage.
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 $2.2 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 reinvest in equipment, R&D and products. For the company to be able to generate 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:
It is suggested that the company undertake the $1 billion recapitalization since it increases shareholder value without driving the likelihood of financial distress. It also helps to avoid potential hostile takeover by eliminating debt capacity. However for the company to stay profitable, it should consider reducing its dividend payout ratio and investing the money in new projects to be able to answer the concerns of bondholders and investors.