The primary issue in this case is related to pending litigation of the company and increasing competition in the tobacco industry that is likely to erode the market share of the company.
Why is UST Inc. considering a leveraged recapitalization after such a long history of conservative debt policy?
UST is considering a leverage capitalization in order to benefit from the tax shield associated with the debt financing. The increase in value along with existing enterprise value will be distributed amongst lower number of shareholders. Moreover, considering the past performance of UST, the company has a high cash generative capacity of the company’s business.
Evaluate the business risks of UST from the viewpoint of a credit analyst or potential bondholder. Rate the overall business risk of UST.
In terms of analysis from the viewpoint of credit analyst, the pending litigation cases of the company will be a major source of concern. Important to note, UST have several pending healthcare related lawsuits and if the outcome of the law suits is against the company, this will be detrimental for the company as well as the investors. On the other hand, even the bondholders of the company will be concerned with pending lawsuits, but since these are secured creditors, they will largely be concerned with repayment risk of the company. However, considering the inelastic demand for the company’s products and launcg of products in price value market, bondholders will most likely face minimal risk.
Is the past performance expected to continue in the future?
No, referring to the give exhibits in the case study, we believe that UST may not be able to deliver past performance in the future. For instance, exhibit 2 reveals that market share of UST is on decreasing trend. During 1991-1998, the market share of the company has decreased from 86.2% to 772% on account of increasing competition . Secondly, exhibit 3 also reveals that compounded annual growth of the company has been decreasing during the past five years with impact of pending law suits and increasing competition clearly visible on the financial performance of the company.
How are UST’s financial performance and capital structure different from other tobacco companies?
UST have an outstanding performance compared to other tobacco companies. The gross margin of the company is 2.9 times than the industry median while the net margin was 12 times the industry median. The ROE of the company at 103.4% and ROA at 53.8% was astonishing. Moreover, the interest coverage ratio of the company at 105.6 was also significantly higher than the industry median of 25, thus confirming strong solvency of the company relative to industry peers.
Should UST borrow the $1 billion?
Assumptions:
Sales growth at 5%
EBIT at 53% of sales figue
We prepared the pro-forma income statement under three different interest scenarios and found that even under worst case scenario of high interest, the interest coverage ratio of the company is 9.81, which is acceptable. Therefore, the company should borrow $1 billion. In addition to the interest shield, the company should also consider the issue of pending litigations against it.
Assess the impact of the recapitalization plan on dividend payout. UST Inc. has paid uninterrupted dividends since 1912. Will the recapitalization hamper future dividend payment?
Recapitalization plan will result in increase in EPS of the company because of interest shield, however, we expect that dividend payment will be negatively affected in the future as the company will look to reinvest the increased EPS in growth opportunities rather than increasing dividend payout.
References
"UST Case Study." Case Study. n.d.
