Good Case Study About Primary Business Risks
During 1990’s UST was one of the leading producer of moist smokeless tobacco with 77% market coverage. Its product consist of chewing and snuff tobacco. UST is a profitable company focused on innovation and new product development. With the policy of rising the price of its products steadily and increasing demand for its smokeless products, its profits are increasing and shareholders are getting good deal of return. However, the company is criticized for not being able to introduce the new products quickly and losing its market share. So, UST introduced new products for its lower segment customers without reducing the price of its regular products. UST also improved its attention on the marketing movements, hurling promotions and growing couponing.
One of the important challenge for tobacco industry is the health related lawsuits. Even though the lawsuits are for cigarette companies, UST is also facing issues with health related lawsuits. The most profitable tobacco company of US was facing unannounced restrictions in debt collection, as people were unsure about the future of Tobacco Company’s future due to raising voice for healthy practices. Despite the fact that S&P had rated the bonds of tobacco companies to be of investable grade, the company was facing problem in raising debt. In this turmoil situation, the board of UST at the end of 1998 decided to borrow $1 billion debt to accelerate the stock repurchase program.
Legislation issues: The tobacco industry is highly prone to the changing laws. UST had seven pending lawsuits related with health issues by the end of 1998. In reality, the outcomes of the lawsuits remained indeterminate. Additionally, the lawmakers continued with the efforts to establish new laws that will discourage the use of tobacco by the youths as well as empower the FDA to monitor and regulate the inhalation of nicotine as drug despite the major Medicaid state settlements. There is a high probability that the litigation will continue to affect the tobacco companies, as many individuals will file suits in courts of law. Therefore, UST is at risk because of the indefinite litigation and legislative environment that will affect the future of its cash flow.
Nonetheless, UST is faced with uncertainties due to the filed lawsuits that condemned the company for violating antitrust and advertising laws. The company was also alleged of promoting an anti-competitive conduct. In a scenario, that UST loses the suit; it will be more exposed to face a thorough competition from third parties.
It is also seen that the researches done recently has found out the hints that tobacco is not only the cancer-causing agent, but it is unlikely that future researches will support this fact. This type of researches makes people aware about the fact. So, in future the sales of tobacco can be affected seriously.
Threats to Profitability arising from competition and other non-core businesses
Next kind of threat or business risk that the company is facing is the erosion of its high profit margins. Even though the company was one among the most profitable companies in US, it has been facing the threats to profitability due to different reasons as:
Majority share in moist smokeless market of tobacco: From 1991, UST has been experiencing the slow erosion of its market share. Its last 7-years CAGR has experienced a negative growth both in premium segment as well as in total market segment (Exhibit 2).
Flexibility in pricing: With the entry of competitors in the market, the profitability of the premium segment is decreasing as shown by Exhibit 2 of the case. The company is in the risk of losing its profitability from premium segment over its cigarette manufacturers competitors.
Unrelenting progression of moist smokeless tobacco: UST is the manufacturer of smokeless tobacco. In recent years, the growth of this moist smokeless tobacco segment has experienced the lagging or slow growth of 1.2%. UST has failed to implement policies that compete with the price-value brands. To make the matters worse, the CEO and President resigned without solving the problem in market erosion. The restrictions in advertisement and the erosion in the market share could force the company to cut its price to increase sales. This act of cutting price will decrease the profits of the company.
In addition to this, the other business segments of UST are not performing as per par. So, the bond holders should analyze the risk arising from the company’s decision to use some of the proceedings of the loan in these underperforming segments Lastly, in the future, the company may be limited to expand its market abroad because of the cultural shift from tobacco.
Leveraged Recapitalization and Debt Policy
UST aims at increasing the value of the firm by taking advantage of the huge tax shield because of leverage. Hitherto, the company was afraid of the default risk, and this enabled it to adopt a conservative capital structure strategy. At the moment, UST is advancing its aggressive level because of the minimal bankruptcy of the company.
Apparently, the managers are also forms part of the shareholders. For this reason, recapitalization has helped UST lessen the total share outstandingly, therefore increasing the relative percentage of other shareholders. The insiders are more influential, and they determine the policies implemented by the company. In the near future, UST will be required to lower the price of its products because of the competition. Such a move will not satisfy the short term investors because they will gain a little from the decision. It remains uncertain if whether the management team will manage to convince all stakeholders through purchasing the outstanding stocks via debt.
UST is considering a leveraged recapitalization since the step will help the company to stabilize and enhance its capital structure. The action is also beneficial because it boost UST stock price through the issuing of bonds, and the purchase of stock as done by the company. There is a tendency of companies to undertake recapitalization if their aim is to avoid becoming hostile takeover targets. To avoid this, they prefer taking huge amount of debts and dispensing substantial dividends to shareholders. Such actions jeopardize the stock, but the dividends are high enough to appeal to the shareholders.
A more important reason for the recapitalization, however, is the fact that operations and investment projects would benefit positively. The new capital sources would promote a more confident investment framework within the company. Managers would feel more comfortable in implementing quality operations and investing in greater projects with a backing of capital behind the investment plan. Finally, the recapitalization would insulate the company’s non-core operations. As at December 1998, UST subsidiary in wine and spirits and cigars yield marginal profits estimated at 14.9% and 5.9% which in comparison to the smokeless tobacco subsidiary’s 57.9% is significantly low. The recapitalization, therefore, would enable the company to drive its main operations while insulating itself against the uncertainty of its non-core operations.
Recapitalization and the Future Dividend Payment
The current rating for the company’s bond is AAA
The marginal corporate tax rate is 38%
The marginal personal tax rate is 21%.
The combined cost (direct & indirect) of bankruptcy is 30%
In addition to these, we will consider the following informations from exhibit 3 and exhibit 8.
The Equity’s market value of the company at the end of 1998 is $6470.8 million
The market value of the company’s debt at the end of 1998 is $100 million
EBIT of the company in 1998 is $753.3 million
The 10-years AAA bond yields the return of 5.60%
We have the formula to calculate the shield on tax obtained from financing the company’s capital structure with debt as:
Then, the expected cost of bankruptcy with the current capital structure is:
UST Value= VU+TS-E(BC)
Since, we are assuming that the company’s bond rating is AAA, so there is virtually no possibility of bankruptcy. So, in this case E(BC) = 0. Therefore:
We will also calculate the marginal effect seen in the value of the company after capitalization, which is the sum of the tax shield less the value of financial distress discounted to present value.
Or, VL = VU + Tax Shield – Expected Bankruptcy Cost
Or, VL = VU + tD - PV (Financial Distress)
Or, VL = VU + tD - (probability of bankruptcy * cost of bankruptcy)
Or, VL = VU + tD - (probability of bankruptcy * (g * VU))
Given that, the g is the constant ranging from 5% to 30%. For our calculation, we will take the extreme value of g to be 30%.
So, the marginal effect is:
VL = tD - (probability of bankruptcy * (g * VU))
= (0.38)*($1billion) - (0.0028)(0.30)($6.5billion)
= $0.375 billion
As shown below, even when the company recapitalizes its capital structure with the debt, the company’s interest coverage ratio will not be compromised much, and the company will have ability to maintain AAA credit rating. Due to this fact, the company will not have any impact on the bankruptcy i.e. the risk of bankruptcy or the cost of bankruptcy will not change with the recapitalization while it will increase the tax shield of the company by $215 million. So, without giving the second thought the company should recapitalize with the $1 billion debt.
We will also prepare the pro-forma statement for better visual by considering the conservative growth in sales by 1.5% every year from 1998 while COGS, profit margin and expenses are forecasted to be constant as the sales percentage. This forecast also shows that the company will have more free cash to make the payments for the interest on the debt.
However, the new capital structure will not be optimal one. The optimal capital structure is the one with the highest benefit or the capital structure that incurs lowest cost and adds maximum value is optimal capital structure.
Recapitalization and future dividend payments
If we assume that the company’s dividends have the same conservative growth rate as that of sales, then the recapitalization of the company will not hamper the dividend payout in future given that the all other forecasts are accurate. The company will have enough cash to pay dividends even after paying interest.
Issues and recommendations
The key issues identified include:
The passage of the antitrust law will lower the threshold of companies that aims at arriving in the tobacco market. One of the important provision made in the antitrust law is that the company will have to maintain lower threshold to enter the market. When the threshold are lowered, then it is very probable that the other companies can enter the market easily. So, the competition will be increased and profit might decrease. So, to face this situation, the company must invest its fund in developing new products that are preferred by the customers. Customer loyalty program is the must essential because this will enable company to retain the customers even during steep competition. New market development is also necessary.
The current situation of the company in the market is not good as it is losing its market share to small companies. In addition to this, the legal file suits regarding the issues on health as well as antitrust laws will affect the operation and performance of the company. These laws will increase the cost of bankruptcy of the company. The company must find its way out to tackle this problem. The company must show that it is equally responsible towards the health of the public.
As discussed earlier, the stockholders are also the managers of the company. There is not separation of management. This is violating the fundamental principle of management. There must be the separation of ownership because if the stockholders are the managers then they will only work for their benefit keeping the debt holders at risk. If the company borrows the debt to repurchase its stock, then the stockholders will have higher stake or power. The concentration of the ownership after stock repurchase will increase the agency cost. So, there must be separation of ownership.
In addition to this, the company’s capital structure is not optimal as shown above. The company must see to drive towards the optimal capital structure. The company is foregoing the benefits by not leveraging the firm. The company must increase its debt portion and derive higher tax shields and benefits. To conclude, even though the company will not face any problem in interest payment and dividend payment after recapitalization, the company must take cautious steps to prevent itself from failing after recapitalization.
Haevard Business School, and Mark Michell. Debt policy at UST Inc. Harvard Business School Publishing, 2000.