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DEBT POLICY AT UST Inc. B.B.Chakrabarti IIMC

THE ISSUE UST planning a major change in capital structure via a debt-financed stock repurchase program Dec 98 UST Board approved a plan to borrow $1 billion over 5 years

UST - BACKGROUND       

175 year old company Dominant producer of moist smokeless tobacco Uninterrupted cash dividends since 1912 One of the most profitable American companies 5-year ROCE of 92.1% Increasing EPS and Share price P/E ratio = 13.8

SMOKELESS TOBACCO MARKET (1998)  $2 bn in retail revenue  5 mn consumers of moist smokeless

tobacco  7 mn consumers of chewing tobacco  Moist smokeless tobacco fastest growing segment at 3.7% annual growth over past 17 years against 2% annual decline in cigarettes

UST and COMPETITION UST Ph. Morris Median-ex UST GPM 80.1 41.7 28.0 NPM 32.9 10.3 2.7 ROE 103.4 49.3 22.5 ROA 53.8 13.2 3.1 Debt/ Mkt Eq. 1.5 10.1 49.8 EBITDA Int. Cov. 105.6 12.7 4.1 Debt Rating A

LITIGATION and LEGISLATIVE ENVIRONMENT  Litigation and legislation are everyday

occurrences  7 pending health related lawsuits (98)  UST to pay $100 - $200 mn over 10 years as part of Smokeless Tobacco Master Settlement Agreement to settle Medicaid disputes (Nov 98)  Lawmakers to continue to push new laws against tobacco use

UST – FINANCIAL RESULTS Net Sales EBIT EPS GPM NPM ROE Div Payout

5-Yr CAGR 5% 6% 9% 79.7% 32.7% 122.8% 61.6%

10-Yr CAGR 9% 11% 13% 77.3% 31.3% 89.1% 51.4%

WALL STREET OUTLOOK In late 98, analysts maintain neutral rating on UST. Reasons - Continued threat of price-value competitors - Softening smokeless tobacco market - No international expansion - Lackluster performance of non-core operations - Public and political sentiment against tobacco

UST – ATTRIBUTES and RISKS VIEWPOINT OF BONDHOLDER Brand Name and Market Position - Dominant Producer with 77% market share - Largely insulated from competition due to advertising restrictions

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Cash Flow Generation - Cash cow Expected to continue generating strong cash flows for a long time

UST – ATTRIBUTES and RISKS VIEWPOINT OF BONDHOLDER Cyclicality - Small $ purchases - Relatively inelastic demand - UST able to raise prices in excess of inflation Geographical Diversification - Minimal sales outside of US

UST – ATTRIBUTES and RISKS VIEWPOINT OF BONDHOLDER Product Diversification - Very high single product risk (smokeless tobacco) Asset Tangibility - Few tangible assets Litigation - Moderate - Low relative to cigarette manufacturers

KEY FINANCIAL RATIOS FOR DEBT RATINGS AAA EBIT Interest Coverage 12.9

AA 9.2

Return on Capital

25.1 15.4

30.6

Long-term Debt/Capital 21.4 40.8

29.3

BBB 4.1

S & P Industrial Senior Debt Ratings Distribution - 1999 AAA AA A BBB BB B CCC D

1% 4% 13% 20% 24% 32% 4% 2%

UST – INCOME STATEMENT PROJECTION Sales EBIT Interest PBT Taxes Net Income Net debt Int. Rate Int. Cover Debt rating

Actual 98 1423.2 753.3 -2.2 755.5 287.6 467.9 0.0

Pro-forma 99 1494.2 5% growth 791.9 53% of sales 0.0 791.9 300.9 38% 491.0 0.0

UST – INCOME STATEMENT PROJECTION Sales EBIT Interest PBT Taxes Net Income Net debt Int. Rate Int. Cover Debt rating

Pro-for. 99 1494.2 791.9 64.7 727.2 276.3 450.9 1000.0 6.47% 12.2 AAA

Pro-for. 99 1494.2 791.9 67.6 724.3 275.2 449.1 1000.0 6.76% 11.7 AA

Pro-for. 99 1494.2 791.9 78.2 713.7 271.2 442.5 1000.0 7.82% 10.1 BBB

UST - VALUATION PV Tax Shields Value of UST Net Debt Stock Price Shares Repurchased Shares Market Equity Debt/Market Equity

Status Quo $1 bn Recap 380 6,469 6,849 0 1,000 34.875 36.924 27.08 185.5 158.4 6469 5849 0.00 0.17

IMPACT OF RECAPITALIZATION ON DIVIDENDS Net Income Shares EPS Div Payout Div per Share

Actual 98 467.9 185.5 2.52 301.1 1.62

Pro-for. 99 491.0 185.5 2.65 314.2 1.69

Pro-for. 99 442.5 158.4 2.79 283.2 1.79

Net debt 0.0 1000.0 Int. Rate 7.82% Debt rating BBB Assumed: UST continues to pay 64% of earnings as dividends

UST – REPURCHASE PROGRAM OVERVIEW -

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1999 - Raised $240 mn in 10-yr debt (rated A+) Repurchased 16.1 mn Shares for $466 mn at avg. price of $28.94 - Dividend - $1.76 per share 2000 - Raised $300 mn in 5-yr debt (rated A+) - Repurchased 4.7 mn Shares for $97 mn Repurchase program suspended due to $1.05 bn award against UST for violation of antitrust laws