Esade MSc Fin Corporate Finance Assignment UST Group 4C v002 PDF

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Debt Policy at UST Inc....

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CORPORATE FINANCE Vincente Bermejo 2019

Harvard Business Case: Debt Policy at UST Inc. Word count: 2498 overall

ESADE M.Sc. in Finance Section C – Group 4C Canals, Ignacio Cremer, Christian Parodi, Tommaso Rechberg, Katharina Wu, Huan-Yi (Johnny)

Corporate Finance 2019 | M.Sc. in Finance | Section C – Group 4C The most prominent producer of smokeless tobacco, UST Inc., is preparing to reform its capital structure by means of a stock repurchase worth USD 1,000M financed by long-term debt, reversing the company’s longstanding conservative debt policy and high dividend pay-out which once made it a wall street darling. However, the past years have shown increasing uncertainty in the industry and the business environment calling UST’s management to act even though the change might interfere with the company’s reputation. In this report, we examine several aspects of the planned change in UST’s capital structure; we assess its business and financial risk, develop an initial long-term credit rating based on the company’s historical performance, forecasts and market-driven factors such as bond yields. Lastly, we calculate the impact of the change in capital structure on UST’s enterprise and equity value. Q1) Business Risk: UST is a remarkably profitable company on its own and compared to its peers and companies from other industries. Its incredible performance stems from several factors: dominant market share, barriers to enter the industry, premium products, high profitability margins (gross, EBITDA, EBIT) and continued growth. Despite these advantages, UST still has some business risk. To begin with, UST is going to have an increased legal risk in the future. Indeed, it has lower litigation levels relative to other tobacco companies. However, more restrictive laws are expected to be introduced, especially concerning advertisement. Regulatory bodies are determined to empower the US Food and Drug Administration (FDA) to recognize nicotine as a drug in UST’s main market. For this reason, UST faces significant compliance risk. Furthermore, restrictions will have a negative influence on sales growth due to constraints in addressing young customers and the awareness of health consciousness in the society in general. In addition, UST has some strategic risk. Low-cost competition is entering the market and hence eroding UST’s market share. From 1991 to 1998, the premium market share declined from 99% to 89.2% (-1.5% CAGR) and price value of the low-cost market share increased from 1% to 10.8% (40.5% CAGR). Since UST’s strategy and products mainly target the premium market, the shrinking total market causes growth to slow down. Additionally, UST lost almost 10% market share in the past 10 years. In the price-value segment, UST failed to obtain considerable market share and let its main competitors, Conwood and Swedish Match, grow over the past years. Moreover, unlike cigarette companies who combat against declining domestic consumption trends, UST has no immediate opportunity or action for international expansion. Thus, the reliance on its main brands and domestic market combined with the ignorance towards the price-value market threat are factors eroding UST’s market position; the potential to grow in the next few years is declining. Finally, UST also expanded to another unprofitable product, which is wine. From Exhibit 4 in the case, we observe that wine only has 14.9% operating profit margin while this product accounts for 45.6% of CAPEX. Hence in order to decrease strategic risk, UST should concentrate on the more profitable investment projects and product lines, potentially around smokeless tobacco.

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Corporate Finance 2019 | M.Sc. in Finance | Section C – Group 4C Financial Risk: UST’s financial risk is far less than its business risk. UST’s ability to raise capital stems from its bond rating. To assess its credit risk, we compared some critical financial ratios to its competitors and industry. Exhibit 6 in the case compares UST’s ratio performance between 1996-1998 to its peers and industry medians. All of UST’s ratios are better than the median of the industry and it yields ratios well above S&P AAA-thresholds with the current capital structure. Capital Structure: Looking at the current capital structure, we see that although total debt on book value of capitalization has increased from 8.0% in 1993 to 47.1% in 1996 and down again to 17.6% in 1998, the ratio of total debt to market value of equity is low. It went from 0.7% in 1993, up to 4.1% in 1996 and down again to 1.5% in 1998. The longterm debt over free operating cash flow ratio is an average of 26.1% in the past 5 years, which is stable and stays at fair levels. Therefore, we could put forward the hypothesis that a higher leverage ratio would be more suitable to benefit from the tax shield without having a cost of financial distress. In addition, comparing industry peers, UST has 63% less debt in its capital structure than the next lowest company in the industry, Philip Morris, almost 80% less than the highest industry peer, North Atlantic Trading, and 73% less than the industry median. Therefore, UST’s capital structure relies greatly on equity capital and differs notably from all competitors in the industry. Benefit of Debt: First, through issuing new debt to repurchase stock, UST can take advantage of a tax shield effect which it does not currently use. Following the formula: V(L)=V(U)+TcD, issuing more debt will create more firm value (see also Q3) in this report) In addition, the leverage effect also increases ROE for shareholders. Second, UST can concentrate on shareholders. Buying back stocks from uncommitted shareholders may help the company to prevent a strategic disagreement in the long term. Additionally, the management can reduce the government's implicit tax stake in the company through the tax shield at the benefit of its shareholders. Third, since UST is in a comfortable financial situation and can expect a high bond rating, this implies that the company can receive raise debt at attractive low levels while equity financing and return expectations are always more expensive than debt financing. Hence UST can reduce the total amount of dividends paid out and lower the weighted average cost of capital because the tax shield effect is implicitly financing a part of the interest payments [CITATION Bre11 \p 469 \l 2057 ]. Lastly, being able to pass strict credit checks and get a loan is a signal well perceived by the market, therefore increasing investors’ confidence. Q2) The corporate management is planning a USD 1,000M senior debt-financed stock repurchase program implemented immediately without any tranches on January 1st, 1999. In order to raise the long-term debt intended for the refinancing measure, UST needs a credit rating by one of the renowned rating agencies such as Standard & Poor’s (S&P). Currently, the company only has a credit rating for its commercial paper which has historically stayed at A-1 (S&P). As we have established before, UST is almost entirely equity financed, its long-term debt

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Corporate Finance 2019 | M.Sc. in Finance | Section C – Group 4C consists exclusively of USD 100M commercial paper in 1998. Naturally, the credit rating under the new capital structure will impact the interest costs for UST over the next years. In assessing the credit rating, we follow the S&P rating approach as outlined in Exhibits 7 and 8 of the case [CITATION Har01 \p 13-14 \l 2057 ], and mainly focus on the EBITDA as well as the EBIT Interest Rate Coverage Ratios in accordance with the case questions. The methodology behind any credit rating is a multi-step process aimed to examine all important aspects of a company and factors affecting its ability to service debt interest and principal repayments. Both, historical developments, as well as future perspectives for several years, must be considered to ensure that long-term debt can be served by the company. For S&P, in a first step, the business risk profile and the financial risk profile are assessed – similar to what we do in Q1) – to determine an Anchor Raking which is then modified towards to a stand-alone credit profile and finally an issuer credit rating [CITATION Sta13 \p 5 \l 2057 ]. Through the analysis we performed, we determine UST’s long-term S&P credit rating to be an AA investment-grade rating in 1999 after the financial restructuring and a long-term debt interest rate of 5.81%; this is based on the strong values for both EBITDA and EBIT interest rate coverage ratios. Over the years, the rating improves towards a AAA rating in 2003. To determine the rating, we have assessed a selection of key financial ratios used for debt ratings over a period reaching 5 years back to 1993; consecutively, we have forecasted UST’s financial statements 5 years into the future to 2003 to monitor the effects of the stock repurchase program and the new capital structure. Error: Reference source not found depicts the results of our analysis. In the following, we lay out the approach that we followed to determine the rating and key assumptions which we followed in the forecast of the financial statements.

Exhibit 1: Based on UST’s historical financial information, SEC filings, own analysis

From the moment of recapitalisation in January 1999, interest rate coverage ratios are the main financial ratio for rating decisions. These ratios naturally rely on actual gross interest expenses 1 incurred before subtracting any potential interest income. However, interest rates can only be determined with a credit rating in place making the rating decision circular. Additionally, many economic factors have changed notably since 1998 which cannot be ignored and that make a direct comparison between today's situation of the economy, capital markets and interest rate non-trivial. To overcome this, we determined all historical financial ratios over the last 5 years back to 1993 to conclude a pre-debt implicit rating and interest rate. Through heuristics, we used the rate to compute theoretical interest expenses post-debt in 1999 as an average; after recalculating the financial ratios, we revalued 1 Total interest expenses can be retrieved from the 10K SEC filings [CITATION UST99 \p 27 \l 2057 ]

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Corporate Finance 2019 | M.Sc. in Finance | Section C – Group 4C the rating and repeated the process until the rating stayed constant (see Exhibit 2). With the post-debt interest rate at hand, we completed the forecast under the following main assumptions: (i) sales grow at 3% as a proxy of GDP growth, this is lower than the past 5 years CAGR (5%); (ii) Gross, EBITDA and EBIT Margins over sales stay constant at the average of the past 5 years; (iii) future interest income is neglectable; (iv) the tax rate is the average effective tax rate of the past 5 years; (v) there are no non-recurring items or gains; (vi) share dilution does not take place and the dividend pay-out ratio is equal to the past 5 year’s average (61.6%); (vii) Assets only change due to depreciation, changes in working capital and capex; (viii) no principal is repaid on long-term debt in the forecast; (ix) Net income not paid out as dividend flows into retained earnings in the shareholders’ equity; working capital and capex are the average percentage value over sales over the past 5 years 2; (x) the interest on commercial paper is 5.9% [CITATION UST99 \p 20 \l 2057 ].

Exhibit 2: One step of the heuristic determination of the long-term interest rate for 1999 based on the previously determined rate of 5.91% which yielded the resulting rate of 5.81%

The resulting financial ratios in the forecast show a slightly more mixed rating for UST due to the notable change in its capital structure. While we provide all ratios, we focus on the interest rate coverages from 1999 onwards which both increase. Being profitability measures, the increase indicates that the company’s profitability is growing relative to its interest expenses meaning that UST will continue to be able to serve its debt without problems. The company reaches higher benchmarks for both ratios later lifting the S&P rating to AAA in 2003. Comparing the financial ratios here to its industry peers (Exhibit 6 on the case), UST clearly leads against all of its competitors. Q3) UST’s proposition is to accelerate its share repurchase program is through USD 1,000M long-term debt which implies changes in the firm’s capital structure as well as firm and equity value. The changes in the capital structure will come from both, increasing long-term debt and a decreasing of shareholders’ equity on the balance sheet by the amount of the equity market value repurchased on the open market by accounting it under the treasury stock account (negative entry on balance sheet). Revaluing the company’s firm value must take the tax shield into account which will have a significant impact. Following the formula: V(L)=V(U)+TcD, we need to determine the value of the unlevered firm and add the present value of the tax shield to derive the new value of the levered firm; from there we can conclude the equity value through an adjustment for net debt and, hence, calculate the share price after the full repurchase. In an all-cash financed (retained earnings) stock repurchase, the share price would not change in the process because there is no tax shield effect. To calculate the value of the tax shield we determine the effective tax 3 rate paid by 2 Determining Working Capital through regression only yielded a 2% R-Squared value and was therefore a bad proxy 3 The marginal effective tax rate should be used for larger corporations [CITATION Bre11 \p 469 \l 2057 ]

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Corporate Finance 2019 | M.Sc. in Finance | Section C – Group 4C UST at 38.07%; we assume the tax rate is going to remain constant. With this rate, we can calculate the tax shield before and after the USD 1,000M debt injection as well as the impact on firm and equity values as depicted in Exhibit 3.

Exhibit 4: Impact of stock repurchase on market capitalisation (Equity value) and Price per Share (PPS)

Exhibit 3: Tax shield calculation and determination of firm and equity values

Exhibit 5: Formula to calculate the firm value with a tax shield

With USD 1,000M debt, the tax shield increases by USD 380.68M; this change is necessary to calculate UST’s value with the formula mentioned before and depicted in Exhibit 5. Equity value is equivalent to the value of the unlevered firm before changes of the capital structure. For net debt, we assume the USD 100M commercial paper and 25% of the cash & cash equivalents on the balance sheet as excess cash that is not needed for operations. To determine the new equity value (market capitalization), we need to compute the value of the levered firm and deduct the net debt adjustment. After introducing the debt, the firm value increases by the change in tax shield. V(U) = USD 6,562.5M and adding the tax shield we obtain the new firm value of USD 6,943.2M. With the net debt adjustment, we derive the equity value before and after are USD 6,470.8M and USD 5,851.5M, respectively. For the number of shares outstanding and the price per share, we first have to determine the number of shares outstanding after the repurchase program. The pre-purchase number of shares was 185.5M shares; buying back shares worth USD 1,000M at the market price of USD 34.88 per share reduces the shares outstanding by approximately 28.67M shares. With the new equity value and the new number of shares outstanding, we can determine the new price per share at USD 37.31, a 7% increase. In addition to the increase in share price from the tax shield effect, earnings per share, and dividends per share develop positively for shareholders, even with lower payout ratios in the forecast (Exhibit 6); this is due to the decrease in shares outstanding.

Exhibit 6: Development of Earnings per share, dividends and payout ratio

References Brealey, Myers, & Allen. (2011). Principals of Corporate Finance - Global Edition. Harvard Business School. (2001). Harvard Business Cases: Debt Policy at UST Inc. S&P Rating Services. (2013). Ratings Direct - Criteria, Corporates, General: Corporate Methodology. Retrieved from https://www.spratings.com/scenario-builder-portlet/pdfs/CorporateMethodology.pdf UST Inc. (1999). 10K Filings 1998.

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Corporate Finance 2019 | M.Sc. in Finance | Section C – Group 4C

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