compiled presentation 1

8/2/2019 Compiled Presentation 1

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Group 2CAng Wee KiatKwek Louis

Lai Yuting

Mavis Tay

Yang Kangjie

DEBT POLICY AT

UST INC.


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INTRODUCTION TO

UST INC.


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Moist smokeless tobacco industryFastest growing segment of the tobacco industry

77%market share

Premium PositioningSteady price increases

Product introductions and innovations

BACKGROUND OF UST INC.


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STOCK REPURCHASE PROGRAM

1996Approval

1997Suspension

Nov, 1998Reinstated

Dec, 1998Approval of

$1bil loan plan


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BUSINESS RISKS OF

UST INC.


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7 pending health related lawsuits

Smokeless Tobacco Master Settlement Agreement

Antitrust lawsuit

Possibility of new laws and regulations

LEGAL CHALLENGES


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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

ERODING MARKET SHARE


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Causes cancer

Regarded as a social menace

Restrictions on public advertising

Difficult to increase salesHigh barriers to entry

NEGATIVE SENTIMENTS


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Saturated domestic tobacco market

Growth 1-3% annually, mostly in price-value segment

No immediate opportunity for internationalexpansion

Poor performance in non-core operations

LIMITED OPPORTUNITIES


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ATTRIBUTES OF UST

INC.


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Strong brand name recognition

Market leader

Premium products Economies of scale

Management issues

Lack of initiative and foresight

BUSINESS ATTRIBUTES OF UST INC.


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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

FINANCIAL ATTRIBUTES OF UST INC.


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BONDHOLDERS

PERSPECTIVE


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Potential liabilities from lawsuitsPending 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 futureBondholders, esp. long-term bondholders will view thisas less favourable

BONDHOLDERS PERSPECTIVE


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Weakness in management teamResignation of 2 top executives

Not profitable in its non-core operations

This could affect the long-term survival of thefirm

Long-term bondholders will view this as a risk for longterm bonds



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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 USTfrom selling tobacco products or nicotine beingregulated as a drug

This could also affect the long-term survival ofthe firmLong-term bondholders will also view this as anincreased risk of holding long-term bonds



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Strong brand name recognition

Ability to reap economics of scale

Highly profitable in the short-term futureBondholders will have increased confidence of UST to

make its interest payments in the short-term



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Healthy financialsMost 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 obligationsin the short-term

Bondholders, esp. the short-term bondholders will likethis aspect as it implies very little risk of default



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RATIONALE FOR

LEVERAGEDRECAPITALIZATION


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Long history of conservative debt policyLong-term debt to capitalization ratio of 17.6% as ofend of 1998, as compared to industry average of 55.9%

Highly cash generative business

BEFORE RECAPITALIZATION

UST Inc. Industry

ROA 53.8% 4.8%

ROE 103.4% 23.7%


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What could have prompted the management tochange its debt policy and consider leveraged

recapitalization?


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Fear of negative effects on stock prices

Investors loss of confidence in UST Inc.

Competitive position affected by growth of valueplayers in moist tobacco industry

Eroding market share

Management issues

Legal and marketing restrictions might slow downfuture growth


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Increase stock prices and firm valuepre-emptively to signal confidence

Through stock repurchase

Through tax shield

Increase debt-to-equity ratio

Discipline management

WHY LEVERAGEDRECAPITALIZATION

1

23


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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

INCREASING STOCK PRICES1


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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 ofoutstanding shares and increases stock price

Possibly higher corporate tax rates Higher tax shield



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Combined effect

Stock repurchase will amplify the increase in stock

price that results from tax shield

Increase in firm value will spread over decreasedno.of outstanding shares

Further increase in stock price



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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 thatfinancial leverage may bring

INCREASING DEBT-TO-EQUITY RATIO2


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Align the managers interests with USTs goals

Better investing decisions

Incremental debt introduces additional interestobligations

Decreases amount of capital managers access to invest

in new projects

Improves decision-making such that under-performingprojects are avoided

DISCIPLINE MANAGEMENT3


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Last but not least, it is imperative to note thatUST Inc. has a strong financial position in theindustry, which forms the underlying basis thatwhy UST could even consider leveraged

recapitalization.


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EFFECTS OF

RECAPITALIZATION


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Credit Rating

PV Tax Shield

PV Bankruptcy Costs

MARGINAL EFFECT


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Credit Rating

PV Tax Shield

PV Bankruptcy Costs

MARGINAL EFFECT


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Depends on bondholders concerns regarding USTBlah

Blah

Blah

Most probably get a credit rating of A

CREDIT RATING


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Credit Rating

PV Tax Shield

PV Bankruptcy Costs

MARGINAL EFFECT


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$1 billion debt

38% Tax Rate

PV Tax Shield = 38% * $1 billion

= $380 million

PV TAX SHIELD


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Credit Rating

PV Tax Shield

PV Bankruptcy Costs

MARGINAL EFFECT


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Probability of default * Cost of bankruptcy

PV BANKRUPTCY COSTS


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PV Tax Shield PV Bankruptcy Costs

Decision: Should undertake recapitalization

MARGINAL EFFECT


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AssumptionsAnnual growth = 1.20%

EBIT/Sales = 53.28%

10 year corporate bond yields

PRO-FORMA


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PRO-FORMA INCOME STATEMENT


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LUMP SUM V.S.

OVER TIME


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Cons of Lump Sum over Smaller issues:Higher risk of increased financial distress and thus,bankruptcy costs.

However, financial ratios are very healthy thus creditratings will not be affected

default rate (and thus bankruptcy costs) will not be

affected as much

LUMP SUM V.S. OVER TIME


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Three years (1996-1998) Philip Morris UST Inc.Corporate Credit Rating AOutlook Stable

EBIT interest coverage (x) 11.2 101.5EBITDA interest coverage

(x) 12.7 105.6Free operating cash flow/debt (%) 41.8 296.5Return on capital (%) 38.4 140.6Operating income/sales (%) 26 55.7Total debt/capital (including ST debt) (%) 49.3 28.2

Source: Debt Policy at UST Inc. (Case) Exhibit 6


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Pros of Lump sum over Smaller issues

Higher Tax shield

Larger increase in firms market value

(in millions, except stock)price)

Status-Quo S1 BillionRecap

(Lump Sum)

S1 BillionRecap

(Over time)

PV Tax Shields 380 339

PV of Bankruptcy cost 10 10

Market Value of UST 6470.24 6839.95 6798.87

Increase in Net Debt 0 1000 1000

Stock Price 34.88 36.873 36.652

Shares Repurchased 27.12 27.28

Shares 185.5 158.38 158.22

Market Equity 6470.24 5839.95 5798.87

Debt/Market Cap. 0 0.17 0.17

PV of tax shields

from each period


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Objective : To maximise the value per

share of the shareholder

Decision : To issue in one lump sum

LUMP SUM V.S. OVER TIME


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EFFECT OFRECAPITALIZATION

ON DIVIDENDS


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EFFECT ON DIVIDEND PAYMENTS

Actual 1999 1999

Debt = $1billion

1998Lump sum

debtNo debt

Net Income 467.9 437.8 475.8

Shares 185.5 158.38 185.5

EPS 2.52 2.76 2.56

DividendPayout

299.5 280.2 304.5

Dividendsper share

1.61 1.77 1.64


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Actual 1999 1999

Debt = $1billion

1998Lump sum

debtNo debt

Net Income 467.9 437.8 475.8

Shares 185.5 158.38 185.5

EPS 2.52 2.76 2.56

DividendPayout

299.5 280.2 304.5

Dividendsper share

1.61 1.77 1.64


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Actual 1999 1999

Debt = $1billion

1998Lump sum

debtNo debt

Net Income 467.9 437.8 475.8

Shares 185.5 158.38 185.5

EPS 2.52 2.76 2.56

DividendPayout

299.5 280.2 304.5

Dividendsper share

1.61 1.77 1.64


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Uncertainty in the long run

Unforeseen circumstances affecting USTsability to pay off debt

Decrease in credit ratings

Higher Cost of debt



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Decrease in income

Decrease in dividend payout

Decrease in retained earnings for investmentin R&D



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CONCLUSION


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Needs to overcome:Legal challenges

Limited opportunities for growth (internationalexpansion)

Strong financial position

Tax Shield

CONCLUSION

Recapitalization in

one lump sum offer

compiled presentation 1

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