Debt Policy at Ust Inc.
Essay by lily • November 26, 2012 • Essay • 1,225 Words (5 Pages) • 1,692 Views
Executive Summary
As the leading manufacturer in the moist smokeless tobacco industry, UST Inc. has long been recognized by its ability to generate high profit using low financial leverage. With a dominant market share of 77%, the company maintains a pricing power that allows it to institute annual price increases without losing costumers. However, UST's market share was eroded significantly in recent years by price-value competitors who enter the market with lower prices. Although UST responded to these threat by introducing new products, market share still decreased by 1.6% over past 7 years. In addition, UST is also exposed to an unfavorable legislative environment, in which the company is under advertising and product promotion restrictions. The increasing business risks force management of UST to consider a recapitalization plan in which UST borrows up to $1 billion to repurchase its stocks. The marginal effect of the recapitalization will be a $380 million increase in firm value, which is the present value of interest tax shield. Besides the recapitalization benefit, management also needs to notice the costs of recapitalization, which include higher bankruptcy costs and a potential of lower credit rating. UST has a high and constant dividend payout history since 1912. The recapitalization will expose more risks to shareholders since revenues will be used to pay interest before pay dividends. Thus, the recapitalization may hamper future dividend payments.
Background
Having long been the leading company in the moist smokeless tobacco industry, UST Inc. was famous for its product innovation, dominate market share, and pricing adjusting power. However, as the competition of the moist smokeless tobacco industry became more intense and the legislative environment became more unfavorable, UST is facing several business risks:
1. Lose of market share. Relying on its superior products and innovation ability, UST used to control most of the moist smokeless tobacco market and was able to increase the price of its products year by year without losing its customers. The historical pricing flexibility gave UST a robust earning performance and bumped up its stock prices. However, as the speed of product innovation became slower, UST is facing the threat of price-value competitors, who enter the market by charging a lower price. Although later UTS responded to the threat by introducing new products, the company's market share still dropped from 86.2% in 1991 to 77.2% in 1998.
2. Increase exposure to legislative environment. Moist smokeless tobacco manufactures used to face fewer lawsuits than cigarette manufactures due to less scientific evidence liking smokeless tobacco to cancer. However, the legislative environment has become more unfavorable to smokeless tobacco manufactures since the industry has agreed on a ban on advertising in order to settle state Medicaid lawsuit. Also, UST was the only main manufacturer that signed an agreement on promotion restrictions that aim to reduce youth exposure.
Recapitalization
UST has been widely known for its conservative debt policy, which allows the company to generate high returns with very low financial leverage. However, as business risks such as market share erosion and unfavorable legislation exposure increase, UST has an incentive to change its capital structure in order to benefit from interest tax shield and maximize the firm value. Recapitalization will also benefit shareholders in a way of higher company stock price since the proceeds from debt will be used to repurchase outstanding stocks. Also, although UST has a very high gross profit margin and return on assets on its core business compared to other smokeless tobacco manufactures, the poor performance of its non-core operations such as market wine and premium cigars give UST a low to zero profit contribution. UST's management needs to diversify its product
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