The economic and environmental factors affecting USTs operations - Coursework Example

The Board of UST Inc UST Consultant UST Debt Policy 27 February Report 0 Introduction UST Inc is involved in the manufacture of tobacco products which continue to be one of the oldest and most profitable industries. This fact has been borne out not only in the ratios but the fact that the company has been identified as the most profitable company in the United States by one of the most trusted sources – Forbes. The financial results speak to this fact. However, as in any industry there is competition and what has been happening is that even though the market is growing by 3.7% per annum UST has not been able to grow with it. This is due to the fact that the company has not been responding appropriately to the threats posed by its competitors. However, there are some environmental factors that have been affecting the company and so UST needs to answer these and other questions including: What environmental factors affect the operations of UST’s business? What business risks does the company face, Can the company undertake the recapitalisation process effectively? Why is UST considering recapitalisation and what would be the incremental effect on the company’s value? What other factors beyond interest rate shields should UST consider in assessing the value of its recapitalisation plan? 2.0 Economic and other environmental factors affecting UST’s operations The environmental factors include political/legal, economic, and social issues. In addition to industry factors these affect every business and should therefore be given due consideration. In terms of the political/legal aspects the tobacco industry has been faced with tough regulations. These have had a negative impact on the cigarette industry but much less on the moist smokeless tobacco. However, and restrictions have had a negative impact on the prospects for future growth in the industry. While being saddled with a $100 to $200 million over the next 10 years in payment as settlement in keeping with an agreement arrived at with Medicaid the company also face restrictions on its advertising and promotional campaign which is aimed at reducing the exposure of the youth population to tobacco products. Additionally, UST has a few litigations pending which is the nature of this industry. However, the smokeless tobacco industry has a much lower exposure to health related law-suits. The Medicaid settlement signifies a reduction in net income which cannot be recouped at this time when UST’s market share is declining. In terms of the economic issues although consumption has been increasing UST’s market share has been declining. The growth that has been experienced appears to be going to the company’s competitors. UST has a track record of growth and innovation but this has not been the case in recent times. The company is used to the practice of annual price increases – sometimes even twice per year but the competition will definitely prevent the company from doing so for most of its brands. This trend of increasing prices has been somewhat abated by the introduction of price-value brands by the company’s competitors. Although UST is large in comparison to its competitors and has a major share of the market the company has not responded the way that investors and analysts would like and so they are doubtful as to whether UST has not been able to respond in a timely and appropriate manner in order to regain its market share. Additionally, the resignation of the company’s chief financial officer (CFO) and the Director of Tobacco in 1997 is a signal to investors that something is fundamentally wrong on terms of both the companies manufacturing operations and its financial management which are two key areas. These are key persons within the company and who obviously would have impacted the company’s financial results. Like most other companies that are engaged in the production of goods the aim is to have products at each stage of the product lifecycle and to have products that will appeal to different groups. This will enable the company to ensure some stability in its earnings. This can only happen if UST get back to its innovative ways by engaging in research and development in order to introduce new products and to extend the life of its current brands. In terms of the social issues tobacco has been proven to cause some of the world’s major health problems and even though this has not been proven for smokeless tobacco, it is still a product of tobacco and so there are still some major health concerns associated with its use. Consumers are now more aware that ever of the increasing health risk associated with using the product. The fact that a settlement has been arrived at with Medicaid has done a lot to keep the negative social issues associated with the product out of the limelight – for at least sometime. Thus the board has now decided to accelerate its sock repurchase programme. 3.0 Primary Business Risks Associated with UST’s Business Business risk is any circumstance of factor that may negatively impact a business. The primary business risks that UST faces have been noted above. However, in relation to the proposed recapitalisation shareholders will be the ones to bear the risk if the bank fails as secured debt holders have prior claims on the company’s assets. Additionally, there is the risk that the company may not be able to make principal and interest payments as they fall due. Therefore, the EBITDA interest coverage and the EBIT interest coverage will be of importance. Not being able to pay or to cover interest comfortably may indicate that UST’s past dividend policy of increasing dividend per share over the years could be negatively affected. This would definitely send a negative signal to investors and analyst and may increase the risk of investors offloading shares on the market and thus negatively impacting UST’s share price. The company’s funds flow to total debt and free operating cash flow to total debt are very critical to the evaluation of risk. They are of significant importance as these ratios will indicate UST’s ability to cover its total debt with its EBITDA and annual cash flow from operations respectively. These ratios will reveal if there are any severe liquidity problems. These ratios provide more information that the traditional balance sheet ratios – quick and current ratios. Return on capital employed (ROCE) will also be of extreme importance as it will indicate how efficient and effective UST’s management has been in generating returns from the capital employed in the business. The comparison of EBIT and the capital employed (long-term and short-term debt plus equity) provides a clear picture of the impact that gearing has on profitability. UST’s operating margin – operating profit to sales ratio will be off extreme importance as this will indicate how much the company earns on each dollar of sales before depreciation and amortisation, selling, general and administrative expenses. The higher the margin then the better it will be for the company. If after recapitalisation the margin declines then this will be a cause for concern. A healthy operating margin is required if UST is to be able to pay the interest on its debts. Long term debt to capitalisation indicates what proportion of the company’s capital structure is represented by long term debt while total debt to capitalisation indicates how much of the company’s capital structure is represented by debt. The long-term debt to capitalisation ratio provides an indication of the level of gearing and is an indication of the company’s exposure to financial risk. A ratio of over 50% indicates very high levels of gearing. High levels of gearing will make UST’s shares very sensitive to changes in interest rates. 4.0 Impact of the capitalisation process on profits and interest cover The indications are that if the proposed loan is taken UST will be able to cover interest comfortably. Table 1 shows the projected pro-forma income statement for 1999 using the 5 year compound annual growth rate. UST's Pro-forma Income Statements for 1999 Assuming 5 Year CAGR 1999 Projections Interest Rates Scenario Description Growth rate (%) $m A (6.12%) BBB (6.84%) BB (8.72%) Net sales 5 1494.4 1494.4 1494.4 1494.4 Gross profit         EBITDA 6 832.1     EBIT 6 798.5 791.0 791.0 791.0 Interest expense/(Income) ($m)     61.2 68.4 87.2 Pre-tax earnings         Net income 6 496               EBIT/Sales     52.93% 52.93% 52.93% EBIT Interest Coverage (times)     12.9 11.6 9.1 Table The information indicates that if UST is given the lowest investment grade rating which carries an interest rate based on corporate bond yields of 6.12% the company will be able to cover its debts 12.9 times. This is equal to the EBIT interest coverage for the industry at the highest - AAA investment grade level. Therefore, if UST were to reduce its Funds flow to total debt, and free operating cash flow to debt and return on capital by up to 75% , the company could obtain this rating. This would place the company in a good position with investors and analyst. At the lowest investment grade rating (BBB) UST would have covered its interest at 11.6 times which is twice the industry rate of 4.1. At a credit rating of BB which borders speculative and investment grade rating UST’s EBIT interest coverage would be 9.1 which places it way above the industry average of 2.5. Despite all these positives the company’s increased debt will pose a problem. If we were to use the 1998 debt and capitalisation ratios as a benchmark the company’s total debts, capital and gearing ratio would as shown in the Table 2. UST's Gearing Ratios Description 1998 ($m) 1999 ($m) Proj Long term Debt 100 900 Total Debt 100 1100 Long-term Debt + Equity 568.3 1568.3 Total Debt + Equity 568.3 1568.3 Total debt/Capitalisaton 0.175963 0.701396417 Long-term Debt/capitalisation 0.175963 0.573869795 Table 2 The information in Table 2 indicates that UST’s Total Debt/Capitalisation and Long-term Debt /Capitalisation would only meet the CCC debt rating or at most the –BB rating. I would therefore recommend that UST borrow a smaller debt. The largest amount that the company could borrow to place the company into the investment grade category of A and BBB or the lowest speculative grade BB would be as per Table 3 below. Loan Recommendation Description A BBB BB Loan Amount ($m) 200 300 500 Long term Debt 200 300 500 Total Debt 300 400 600 Long-term Debt + Equity 668.3 768.3 968.3 Total Debt + Equity 768.3 868.3 1068.3 Total debt/Capitalisation 0.390472 0.460670275 0.56164 Long-term debt/Capitalisation 0.299267 0.390472472 0.516369 Table 3 Table 3 shows the loan amounts recommended if UST wants to be in the in A, BBB or BB credit rating categories. It would have three choices. It would be best if UST sticks to a $200mn loan and maintain a good rating so that it will be able to borrow at a low rate. The company can add an additional amount in the following year up to year 5. By doing so investors will be pleased and this should not affect UST’s shares negatively. As debt increases over the years the value of the company’s shares will increase with it. Borrowing more than $200mn at this time will increase the risk of debt holders and would place a lot of pressure on the company to pay its debts if its sales revenue or EBIT falls drastically. Additionally, this increase would result in an increase of over 100% in its total debt to capitalisation ratio over the previous year. This increase is considered more than reasonable at this time. However, if there is risk of a hostile takeover if UST waits for too long before recapitalisation then there might be good reasons to repurchase the shares right away without delay. However, shareholders might object to it and it could be a long drawn out process. Reasons for leveraged recapitalisation Recapitalisation which is actually replacing equity with debt will help prevent a hostile takeover which would be disadvantageous to the company at a time when its share prices are falling. It would therefore suit the company to buy back these shares instead of allowing a competitor who wants to takeover to do so. The best thing therefore is for the company to recapitalise if there is a strong possibility of this happening. However, the fact that the company is currently a public company, recapitalising means that it will no longer be public. This means the long term strategic focus of increasing shareholders wealth might be lost and the focus will be on short term gains in order to repay the loan. Additionally, the burden that this additional debt poses might place the company in a precarious position where it may face the risk of defaulting on the loan. This may be worst than a hostile takeover as the company could end up in bankruptcy resulting in loss of jobs and therefore financial problems for those persons who built the company over the years. Recapitalisation will also result in tax benefits for the company since interest charges are allowable for tax purposes. Based on the calculations in Table 1 a tax rate of 38% would result in tax savings of between $23.3mn and $33.1mn for UST if $1bn loan was borrowed. Therefore, more profits would be retained in the business and this will allow the company to take on additional projects if required. Additional factors to consider in assessing recapitalisation plan Other factors to consider in assessing a recapitalisation plan are as follows: The fact that company will no longer have to consider making dividend payments and will therefore have more money to expand its operations overseas if necessary. The company will no longer have to meet the stringent requirements for preparation of quarterly and annual financial statements when they are listed on the stock exchange. Shareholders have different objectives and so the recapitalisation will help resolve this issue. The management team will be preserved. This is not likely to happen in a hostile takeover The differences in how the company is seen will be reduced. Conclusion UST needs to evaluate its options carefully and consider the pros and cons associated with its proposed recapitalisation plan. It is clear that the board has agreed to carry it through but more thought needs to be given to the whole process before embarking on such a plan. It is therefore important that the board meets and take a look at some of the points raised in this report. References Mitchell, M. (2001). Debt Policy at UST Inc. MA: Harvard Business School Publishing Read More