To:UST Board of Directors
From:UST Financial analysis team
Date:18 January 2011
Subject:Future debt policy at UST and recapitalization option
1. Analysis of UST business current and future environment
UST operates in the smokeless Tobacco industry, a market with 2 B$ of revenues, which grew at a CAGR of 3.7% over the past 17 years, but more recently experienced a decrease in growth rate, dropping to 2.9% in 1997 and 1.2% in 1998. In this market, UST has a very dominant yet decreasing market position, with an actual market share of 77.2% in 1998 falling from 86.2% in 1991. Since the market has been growing faster than the firm’s decline in market share, net sales of UST have been growing from 898.4 M$ in 1991 to 1,423.2 M$ in 1998, a CAGR of 6.8%. Consumers of smokeless tobacco are largely male (98%) with an increasing share of college-educated workers (30%).
It would seem that UST is very successful at its operations given that it is the most profitable firm in the USA in terms of return on equity (“RoE”), return on assets (“RoA”) and gross profit margin (“GM”). Actual (1998) RoE is at 103.4%, RoA at 53.8%, GM at 80.1%, EBITDA at 55.2% and net margin at 32.9%, all those five metrics are up from 1993 respectively at 71.0%; 41.6%; 77.5%; 53.9% and 31.7%. Those five KPIs reflect the strong financial performance of UST by reflecting that both each dollars of assets and equity provide significant return while operational margin (GM), EBITDA and net margin show the ability to keep a very high portion of every dollar of sales. This also comes from the low elasticity of tobacco product which allows UST to increase price, while cost are constant, and lose less revenues from forgotten consumers than the gain from the increase in price. Also, those five KPIs are way above all competitors, both in Tobacco Product Manufacturers and in Tobacco Leaf Merchants. Moreover, two other operational KPIs would be market share in the Premium market and the Price value market. Indeed, these two metrics represent the strengths of the presence of UST in the smokeless tobacco market. As the Price Value is the growing market, this metric would be important for future growth while the Premium market is the traditional cash cow of UST so at least a stable market share would be a good KPI. The last KPI should be the actual amount in litigation, that would give an idea of the legal risk that UST is bearing and how this compare to their annual operational free cash flow.
Looking at the future, we know that the smokeless Tobacco industry will grow at a slower pace. The market is divided in two branches; one which is the Price Value market, actually at 10.8% of the market, up from 1.0% in 1991 and the other is the Premium market which represents the rest of the market, so it fell from 99.0% in 1991 to 89.2% in 1998. Since UST is not dominant in the Price Value market, if no move is done to improve our position in this segment of the market, overall market share is likely to decline. However, due to those price increase, the dependence toward tobacco product by our consumers and the very low elasticity of our consumers, a sustainable growth rate in term of sales revenues is likely be positive, probably at a rate between 1 to 3% per annum, which reflect the 2 past years, rather than the 3.7% average of the past 17 years.
Finally it should be noted, that UST has some non-tobacco related businesses most notably in the wine and cigars industry which provide some diversification. However, these businesses appear to be significantly less profitable while requiring increased capital expenditure over the last few years.
2. Analysis of UST financial policy and capital structure
The sustainable growth rate for UST is , where is the sustainable growth rate and the dividend payout ratio. We can construct a table from 1991 to 1998 to see the evolution of sustainable growth rate compared to actual growth...