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UST

UST

In late 1998, UST Corp.’s board of directors was debating a plan for the company to borrow up to $2bn in order
to accelerate its stock repurchase program. This would represent a revolution for the moist smokeless tobacco
products leader known for its very conservative debt policy. All implications had to be weighted carefully.

In 1998, the US smokeless tobacco sector had $2bn in sales, evenly split between chewing and moist smokeless
tobacco. Several factors made moist smokeless tobacco the fastest-growing segment in the tobacco sector, with
volume rising at 3.7% per year vs. a 2% drop for cigarettes: Compared to cigarettes, moist smokeless tobacco
was cheaper, less unhealthy and immune to smoking bans. Growth forecasts were of 1-3% per year. Demand
was changing too: users remained 98% male, but now expanded beyond the traditional blue collar and rural
users with 30% of users being college educated.

With a 77% share of the moist smokeless tobacco market, UST was driving the market’s expansion, mostly via
product innovations (e.g. new forms and flavors). Its pricing policy was aggressive with twice annual increases in
prices over the past 25 years. Over 1988-98, its sales, earnings and cash flow had risen each year (1997 excluded)
at compound annual growth rates (CAGR) of 9%, 11% and 12%.

UST’s relatively modest activities outside its core business generated much lower returns. In 1998, smokeless
tobacco contributed 88% of the company’s sales and 97% of its profit. Wine and other businesses (cigars,
international marketing of smokeless tobacco, etc.) contributed 10% and 2% of sales, and 3% and 0% of profit.

UST was among the most profitable firms in the US. In 1997 and 1998, it easily topped Forbes’ rankings for ROE,
ROA and profit margin. Over 1988-98, average EBITDA, EBIT and net margins reached enviable levels: 53%, 50%
and 31%. ROE and ROA averaged 89% and 48%. Meanwhile, UST returned capital to shareholders: $2.2bn in
dividends and $2bn in share buybacks.

UST was far more profitable than other tobacco firms. Its profit margins, ROA and ROE dwarfed those of its peers.
Further, UST achieved these high returns with substantially lower financial leverage than its peers.

Profitability was driven by UST’s market share, premium products, strong brands, pricing flexibility, the moist
smokeless tobacco market’s growth, as well as by entry being limited due to advertising restrictions.

Nonetheless, legal and legislative issues and especially new entrants were causing investor unrest.

Smokeless tobacco companies were much less exposed to health-related lawsuits than cigarettes companies.
Indeed, cancer research on smokeless tobacco was inconclusive, and, obviously, second-hand smoke litigation
was a nonissue. Yet UST suspended its stock buybacks in 1997 due to legislative and legal risk.

On the legal and legislative fronts, 1998 was good to the industry: congress failed to pass tobacco legislation;
courts partly declassified second-hand tobacco smoke as a carcinogen and invalidated regulation of tobacco by
the Food and Drugs Administration (FDA); and cigarette firms won several class-action lawsuits. Further, cigarette
firms agreed to a $206bn settlement and to ban ads targeted at youths. Separately, UST agreed to pay $200m to
settle potential Medicaid disputes and to enforce restrictions on advertising targeted at youths.

Yet, lawmakers were likely to push for new laws to fight youth tobacco use, further restrict marketing, and
empower the FDA to regulate nicotine as a drug. Litigation was expected to continue. UST also faced a dispute
with Conwood which alleged it had violated antitrust and advertising laws and behaved anti-competitively.

On the competitive front, in recent years, rival “price-value” brands had been gaining some market share with
low-priced products. Several analysts were complaining that UST’s market share and strong brands had allowed
it to overlook and then neglect this threat. UST was notably criticized for slowing down innovation, new product
introductions and product line extensions. In fact, two executives had resigned over conflicts on strategy.

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UST launched its new Red Seal brand to combat price-value brands while preserving its premium brands’ pricing
power and profitability. It also introduced Copenhagen Long Cut, a new product to compete with Conwood’s full-
priced Kodiak brand, which was making inroads with young and new users, and Rooster, a new premium product.
UST also renewed its focus on marketing which, given advertising restrictions, focused on free samples, mail-in
rebates and promotional sales.

Yet analysts felt that UST’s reaction was sluggish. The price-value rivals had already gained a 9% market share.
Overall, UST’s market share had somewhat stabilized but analysts remained anxious about the threat of price-
value rivals and a softening smokeless tobacco market. Unlike cigarette firms, UST could not counter domestic
decline with international expansion. There was also concern that UST might use funds to over-invest in poorly-
performing non-core operations. Finally, public and political feelings towards the industry remained negative.

UST’s management and board of directors were debating the pros and cons of a leveraged recapitalization,
whereby UST would borrow a large amount of funds to be used entirely to repurchase UST shares. This would
leave UST’s assets unchanged (as all of the cash raised would be paid out) but increase its leverage ratio.

One issue was the new debt’s interest rate. It would largely depend on the rating the debt would obtain from
credit rating agencies, based on a review of UST’s business, strategy, and financial policy. Tobacco firms tended
to get good ratings thanks to their high cash generation. Yet while the short-run outlook seemed stable, the
longer-run was less clear due to legal challenges, declining volumes, marketing restrictions and taxes.

Currently, UST’s debt of $100m was rated AAA and carried a 5.85% interest rate. UST’s management estimated
that borrowing an extra $1bn would lower the rating to AA and increased the interest rate to 6.90%. Similarly,
borrowing an extra $2bn would lower the rating to BBB and increased the interest rate to 9.1%.

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EXHIBIT 1: UST FINANCIAL DATA EXHIBIT 2: TOBACCO COMPANIES 1998


1994 1995 1996 1997 1998 Philip Morris N.A.T. RJR Nabisco DiMon Std Com. Universal
Income Statement
Net sales 1,204.0 1,305.8 1,371.7 1,401.7 1,423.2 74,391.0 93.1 20,563.0 2,171.8 1,492.8 4,287.2
Sales growth 9.7% 8.5% 5.0% 2.2% 1.5% 3.2% 10.2% -0.5% 2.2% 10.2% 4.2%
EBITDA 668.9 736.9 779.2 749.8 785.0 15,501.0 36.3 3,602.0 200.2 85.8 329.5
Depreciation and amortization 28.2 29.1 28.3 30.5 31.7 1,690.0 7.2 1,135.0 43.5 20.5 51.1
EBIT 640.7 707.8 750.9 719.3 753.3 13,811.0 29.1 2,467.0 156.7 65.3 278.4
Interest expense 0.1 3.2 6.4 7.5 -2.2 890.0 24.9 880.0 83.8 37.8 64.0
Earnings before tax (EBT) 640.6 704.6 744.5 711.8 755.5 12,921.0 4.2 1,455.0 72.9 37.1 231.3
Taxes 253.1 274.8 280.5 267.9 287.6 5,248.6 3.2 737.0 20.9 10.2 100.9
Net income 387.5 429.8 464.0 443.9 467.9 7,672.4 1.0 718.0 52.0 26.9 130.4
Balance Sheet
Cash and Cash Equivalents 50.7 69.4 54.5 6.9 33.2 4,081.0 2.8 300.0 18.7 34.1 79.8
Other assets 690.5 714.6 752.1 819.5 880.1 55,839.0 257.2 28,592.0 1,778.8 805.4 1,976.9
Total assets 741.2 784.0 806.6 826.4 913.3 59,920.0 260.0 28,892.0 1,797.5 839.5 2,056.7
Debt 125.0 200.0 250.0 110.0 100.0 14,662.0 215.6 10,467.0 1,079.5 469.9 849.6
Other (non-debt) liabilities 254.5 291.2 275.4 279.6 345.0 29,061.0 59.8 10,616.0 296.1 220.0 659.2
(Book) equity 361.7 292.8 281.2 436.8 468.3 16,197.0 -15.4 7,809.0 421.9 149.6 547.9
Total liabilities and equity 741.2 784.0 806.6 826.4 913.3 59,920.0 260.0 28,892.0 1,797.5 839.5 2,056.7
Stock Price Data
Year-end stock price 27.88 33.38 32.38 36.94 34.88 53.50 NA 29.69 11.25 15.94 37.38
Price/Earnings Ratio 14.5 15.1 13.1 15.3 13.8 16.9 NA 13.4 9.6 7.3 10.1
Market equity 5,631.8 6,489.1 6,068.0 6,793.3 6,470.2 129,951.5 NA 9,616.6 500.6 197.7 1,315.8
Earnings and Payout
Shares outstanding 202.0 194.4 187.4 183.9 185.5 2,429.0 528.2 323.9 44.5 12.4 35.2
Earnings per Share (EPS) 1.92 2.21 2.48 2.41 2.52 3.16 0.00 2.22 1.17 2.17 3.70
Dividend per Share (DPS) 1.12 1.30 1.48 1.62 1.62 1.68 0.00 2.05 0.66 0.00 1.11
Dividends 226.2 252.7 277.4 297.9 300.5 4080.72 0 663.995 29.37 0 39.072
Dividend payout ratio 58% 59% 60% 67% 64% 53% 0% 92% 56% 0% 30%
Share repurchases 298.8 274.8 237.8 45.7 151.6

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