Harvard Business School

9-200-069
Rev. May 3, 2001

Debt Policy at UST Inc.
In December 1998, UST Inc.’s board of directors approved a plan to borrow up to $1 billion over five years to accelerate its stock buyback program.1 For UST Inc., the leading producer of moist smokeless tobacco products and a company widely known for its conservative debt policy and high dividend payout (uninterrupted cash dividends since 1912), this announcement generated considerable attention on Wall Street. Investors eagerly awaited the subsequent actions of Vincent
Gierer, Jr., UST’s Chairman and CEO.
In 1997, UST had suspended its stock repurchase program, approved in 1996, because of legislative and legal issues confronting the tobacco industry.2 In November 1998, the company signed the Smokeless Tobacco Master Settlement Agreement resolving its potential state Medicaid liability and reinstated its repurchase program.3 Management believed that this agreement represented significant progress with respect to the legal and legislative matters confronting the company, permitting UST to proceed with its business strategy and potential recapitalization.

The Smokeless Tobacco Market
The U.S. smokeless tobacco industry generated $2 billion of retail revenue in 1998 with approximately 5 million consumers of moist smokeless tobacco and 7 million consumers of chewing tobacco including loose leaf, twist, plug and dry.
Moist smokeless tobacco consumption approximated 50% of the total. See Table A on page 2 for a description of smokeless tobacco products. While decelerating recently, the USDA reported moist smokeless tobacco has been the fastest growing segment of the tobacco industry with volume increasing at a 3.7% annual growth rate over the past 17 years compared with a 2% annual decline in cigarette volume over the same period.
A.C. Nielson reported that moist snuff volume grew 2.9% in 1997 and 1.2% in 1998.4
A number of factors contributed to the continued growth of the moist smokeless tobacco segment. The increased prevalence of smoking bans has led consumers to switch to smokeless

1 UST Inc. Press Release, “UST Increases First Quarter 1999 Dividend; Accelerates Stock Repurchase with $1

Billion to Be Borrowed Over 5 Years,” December 10, 1998.
2 “UST Stock Buybacks: Initiatives Planned for 1999,” Dow Jones News Service, December 10, 1998.
3 Merrill Lynch & Co., “UST Inc.,” December 4, 1998.
4

Data in this paragraph from Credit Suisse First Boston, “UST, Inc.: Still Chewing on the Story – Stay Tuned,”
August 27, 1999.

Professor Mark Mitchell prepared this case from published sources with the assistance of Janet T. Mitchell as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.
Copyright © 2000 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.
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Debt Policy at UST Inc.

tobacco to circumvent smoking restrictions. Consumers perceive that moist smokeless tobacco is less of a health risk than cigarettes. Smokeless tobacco is less expensive to use than cigarettes based upon an average per-week usage measurement. Additionally, consumers have been shifting over time to moist smokeless tobacco from loose leaf chewing tobacco. While the consumer base remains primarily male (approximately 98%), smokeless tobacco use is no longer confined to the stereotypical blue collar or rural users as approximately 30% of users have attended some college. The overall moist smokeless tobacco market is expected to continue to grow at an annual rate of 1-3%, with a large portion of the growth expected in the price-value segment.5
Table A

Smokeless Tobacco Products

Category

Definition

Use

Brand/(Manufacturer)

Snuff
Dry

Powdered dry tobacco

Snorted through nose

(Conwood), (Swisher), (UST) & (B&W)

Moist

Fine, long or powdered cut moist tobacco

Placed between lower lip and gum

Copenhagen (UST), Skoal (UST), Kodiak
(Conwood), Silver Creek (Swisher) &
Timber Wolf (Pinkerton)

Loose Leaf

Moist tobacco which is cut into small strips

Placed between cheek and gum

Red Man (Pinkerton), Levi Garrett
(Conwood) & Beech Nut (National)

Plug

Moist or dry tobacco compressed into a chunk

Placed between cheek and gum

Day’s Work (Pinkerton), Red Man
(Pinkerton), & Levi Garrett (Conwood)

Twist/Roll

Tobacco fashioned into a roll

Placed between cheek and gum

(Conwood)

Chewing
Tobacco

Source:

Credit Suisse First Boston, “UST, Inc.: Still Chewing on the Story – Stay Tuned,” August 27, 1999

Competitive Position
UST is the dominant producer of moist smokeless tobacco, or moist snuff, controlling approximately 77% of the market.6 Exhibit 1 provides a description of UST’s products and Exhibit 2 displays market share in the moist smokeless tobacco market from 1991 to 1998. Table B on page 3 displays the 1998 market share of the top moist smokeless tobacco brands. UST was a driving force in the overall expansion of the moist smokeless tobacco market over the years, primarily through product innovations such as new forms and flavors. Historically, UST has been aggressive with its price increases, instituting almost annual, often twice annual, price increases over the past twentyfive years. Steadily increasing prices provided a solid boost to earnings and the company’s stock price. Meanwhile, as UST expanded the category and continued to raise prices, smaller players eroded UST’s market share primarily by cutting price.
Given UST’s relatively significant share erosion in recent years, the investment community called upon management to take actions to compete more effectively against the value brands and stem the erosion of market share. Despite its history of expanding the overall smokeless tobacco industry through new product introductions and innovations, UST had been criticized recently for a reduction in innovation and tardiness of new product introductions and product line extensions.

5 Ibid.
6 Ibid.

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Inroads by smaller competitors, primarily in the value segment, led to missed earnings and lowered
Wall Street expectations. A Wall Street Journal article in 1997 noted “The company’s management, pleased with their dominant market share and keenly aware of the company’s strong heritage, turned their noses at the smaller upstarts.”7 In fact, an alleged dispute over the company’s course of action reportedly led to the resignation of two key executives. In February 1997, John J. Bucchignano, CFO, and Robert D. Rothenburg, President of the tobacco unit, resigned due to “philosophical differences about the strategic direction of the company.”8
Table B

Smokeless Tobacco Brands (1998 Dollar Share)

Copenhagen Fine Cut (UST)
Skoal Fine Cut Wintergreen (UST)
Kodiak Wintergreen (Conwood)
Skoal Long Cut Wintergreen (UST)
Copenhagen Long Cut (UST)
Skoal Long Cut Straight (UST)
Skoal Long Cut Mint (UST)
Skoal Long Cut Cherry (UST)
Skoal Bandits Wintergreen (UST)
Skoal Long Cut Classic (UST)
Skoal Long Cut Spearmint (UST)
Skoal Fine Cut Straight (UST)

Source:

29.9%
11.8%
9.5%
9.4%
7.2%
5.9%
4.4%
2.9%
2.2%
2.0%
1.8%
1.3%

1998 A.C. Nielson data

In 1997, rather than cut prices to counter the growth of value players, UST introduced its Red
Seal brand tobacco to compete with the price-value brands and preserve pricing power and profitability of its premium brands.9 Despite this new product, analysts felt that UST was too slow in responding to the threat of value competitors. At the time of its introduction, the value segment had already gained 9% market share, requiring Red Seal to compete against already successful value brands. Another 1997 product introduction, Copenhagen Long Cut was introduced to combat
Conwood’s full-priced Kodiak brand. Conwood, through its promotion of “long-cut” brands, which are easier to use than fine cut products, had made strong inroads with young and new consumers.
UST originally stood by its traditional Copenhagen Fine Cut, only succumbing to the pressure to introduce a competitive product after continuing market share losses. Rooster, introduced in 1998, was a new premium product packaged in a larger can, 1.5 ounce compared to the traditional 1.2 ounce, to provide more tobacco for the consumers’ money.10
In addition to product introductions, UST renewed its focus on marketing and promotion.
Due to restrictions on public advertising, UST focused its marketing expenditures on free samples, mail-in rebates, and promotional sales. In 1997 and 1998, the company implemented a number of marketing initiatives and promotions. For example, UST offered 4-for-3 pricing on selected products, increased couponing, expanded its sales force, provided retailer and wholesaler incentive programs,

7 See Suein L. Hwang, “UST Stock Falls 12% as Firm Says Profit Won’t Meet Expectations,” Wall Street Journal,

March 3, 1997.
8 See Cathleen Egan, “UST Resignations Likely Turned on Battle vs. Private Labels,” Dow Jones News Service,
February 24, 1997.
9 David Adelman, “UST(UST): No Surprises in 1Q Results; Retaining Underperform Rating,” Morgan Stanley
Dean Witter U.S. Investment Research, April 30, 1998.
10 Credit Suisse First Boston, “UST, Inc.: Still Chewing on the Story – Stay Tuned,” August 27, 1999.
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expanded outlets and/or markets for new products, executed selected per can discounts, used special commemorative lids and repositioned certain Skoal products.11

Litigation and Legislative Environment
Litigation and legislation are everyday occurrences in the tobacco industry. Smokeless tobacco manufacturers have historically faced less exposure to health related lawsuits than cigarette manufacturers. For example, UST had seven pending health related lawsuits (excluding the state
Medicaid cases) at the end of 1998, compared to cases numbering in the hundreds filed against cigarette companies.12 The lower exposure to health-related lawsuits is largely due to the fact that scientific evidence linking smokeless tobacco to cancer is less conclusive than studies researching cigarettes tie to cancer, and snuff producers face no potential “second hand” smoke litigation.
In 1998, the tobacco industry experienced a number of developments in the legal and political arena, most of which were viewed positively by the industry. In June, Congressional efforts to pass broad-based tobacco legislation unfavorable to the industry collapsed. In July, a U.S. District court judge issued a ruling to “vacate” major portions of a 1993 EPA report classifying environmental tobacco smoke as a known human carcinogen.13 In August, a federal appeals court ruled that “the
FDA lacks jurisdiction to regulate tobacco products, and all of the FDA’s regulations of tobacco products are invalid”. Additionally, cigarette manufacturers won dismissal of several class-action lawsuits filed on behalf of smokers and labor union health care funds. 14
Furthermore, in a landmark event for the tobacco industry, the industry agreed in November to settle state Medicaid lawsuits with a $206 billion settlement and a ban on advertising and promotions that appeal to youths. The settlement was negotiated among the four major cigarette manufacturers and eight states, but received unanimous approval of all 46 Attorneys General for states attempting to recover Medicaid costs for treating victims of tobacco related ailments.
Separately, in November, UST negotiated and signed the Smokeless Tobacco Master Settlement
Agreement to settle its Medicaid disputes. The agreement provided that UST pay $100 to $200 million, or $.015 to $.02 per can, over 10 years and agree to advertising and promotion restrictions, primarily aimed at reducing youth exposure. UST was the only major smokeless tobacco manufacturer to sign this agreement. Despite the major Medicaid state settlements, lawmakers are expected to continue to push for new laws to combat youth tobacco use, further restrict advertising, and empower the FDA to regulate nicotine as a drug. Other litigation against tobacco companies is expected to continue, especially suits filed by individuals. In addition to health related litigation,
UST also faced a pending dispute at the end of 1998 whereby Conwood Co. alleged that UST had violated antitrust and advertising laws and participated in anti-competitive conduct.

Financial Results
UST has historically been one of the most profitable companies, not only in the tobacco sector, but also in corporate America. In 1997 and 1998, UST received accolades from Forbes which named UST the top company in terms of profitability. UST’s five-year return on capital of 92.1% was

11 Ibid.
12 In 1986, UST prevailed with a unanimous jury verdict in the only moist smokeless tobacco liability lawsuit to

make it through the trial process.
13 See “Judge Rejects EPA Secondhand Smoke Report,” Association of Trial Lawyers of America, 1998.
14 See Alissa J. Rubin, “Judges Rule against FDA on Tobacco. U.S. to Appeal Decision that Bars Regulation,” Los

Angeles Times, August 15, 1998.
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nearly 20% higher than the 2 ranked firm.15 In a profitability study performed in 1998, John
Dorfman of Dreman Value Management found UST the most profitable company as measured by return on equity, return on assets and gross profit margin. Of 1,825 U.S. companies with a market value in excess of $500 million, only 15 companies passed a stringent test that included a minimum
40% return on equity, minimum 20% return on assets and a gross profit margin of 20% or more. UST beat corporate icons such as Coca-Cola and Microsoft to attain the title of most profitable company.16
UST’s profitability stems from several factors including its commanding share of the moist smokeless tobacco market, premium product and strong name brand recognition, historical pricing flexibility, continued growth of moist smokeless tobacco and limited market access by new competitors due to tobacco advertising restrictions. nd Exhibit 3 presents summary financial information for the 11-year period from 1988 to 1998.
Other than decreases in earnings and cash flow in 1997, UST posted continuous increases in sales, earnings and cash flow over the entire period. Sales, earnings and cash flow have grown at 10-year compound annual growth rates of 9%, 11% and 12%, respectively. Concurrently, UST maintained enviable margins with average gross profit, EBITDA, EBIT and net margins of 77%, 53%, 50% and
31%, respectively. Annual return on equity averaged 89% and return on assets averaged 48%. Over this same period, UST provided a generous return of capital to investors, paying $2.2 billion in dividends and repurchasing $2.0 billion in stock.
While the vast majority of UST’s operations revolve around the production of smokeless tobacco products, the company also produces and markets wine and premium cigars. Historically,
UST has dallied modestly in operations outside of its core moist smokeless tobacco operations.17
Such investments in non-core operations have traditionally provided returns far below those of the moist smokeless tobacco business. In 1998, smokeless tobacco contributed approximately 88% of revenues and 97% of operating profit. Wine and other businesses (cigars and international marketing of moist smokeless tobacco) contributed 10% and 2% of revenues, respectively, and 3% and 0% of operating profit, respectively. Exhibit 4 provides segment information for UST’s operations from
1996 to 1998.

The Tobacco Industry
UST’s 1998 financial performance relative to other tobacco companies is shown in Exhibit 5.
Review of the operating statistics indicates UST compares very favorably to the other tobacco firms.
UST’s gross profit margin of 80% compares to a median of 28% for the group. Average return on assets of 54% and return on equity of 103% for UST compare to medians of 3.1% and 22.5% for the group. Furthermore, UST achieves these high returns with low financial leverage. UST’s total debt to book capitalization is 17.6% compared to the group median of nearly 66%.
Standard & Poor’s (“S&P”) rates the debt of three of the six other tobacco companies as investment grade and two companies are rated BB, the highest level of speculative grade credit ratings. See Exhibit 6 for tobacco companies’ S&P ratings and financial ratios. The favorable ratings are due primarily to the highly cash generative nature of the tobacco industry. S&P views the nearterm outlook of the tobacco industry to be stable and the longer-term view to be less clear. Despite

15 Forbes’ annual ranking of companies.
16 See John Dorfman, “Smokeless Tobacco Maker UST Tops Profitability Test,” Rocky Mountain News, August 16,

1998.
17 For example, UST purchased two Michigan television stations in 1980 (sold in 1985), acquired Heritage
Health, a chain of alcohol and substance abuse centers, in 1986 (sold in 1988), bought 76% of the stock in Camera
Platforms, a firm that leases camera cars to the movie industry, in 1990 (sold in 1995), and formed Cabin Fever
Entertainment in 1988 to produce video and television programming (sold in 1998).
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strong cash flows, the U.S. tobacco industry is characterized by legal challenges, declining volumes, marketing restrictions, taxes, discounting and consolidation.18
UST has historically maintained an A-1 credit rating for its commercial paper. As UST increases its debt level, it will likely issue long-term debt, thereby increasing the average maturity of debt outstanding. S&P and the other rating agencies will review UST’s overall corporate profile, proforma capital structure and investment intentions to determine the appropriate senior debt rating for the company. S&P will consider, among other things, UST’s cash flow generation and payment obligations, financial policies, market position and brand name recognition, geographic and product diversification, pricing power, industry dynamics, profitability margins and returns, capitalization ratios and coverage ratios. The rating determination could have a significant impact on the cost of the recapitalization. See Exhibit 7 and Exhibit 8 for an overview of S&P’s ratings criteria and key financial ratios.

Outlook
Once a Wall Street darling, research analysts in late 1998 have mixed views of UST’s future, with a number of analyst’s maintaining “Neutral” ratings on the company. While UST has somewhat stabilized its market share, analysts remain concerned about the continued threat of price-value competitors and a softening smokeless tobacco market. Unlike cigarette companies who combat declining domestic consumption trends with offshore growth, UST has no immediate opportunity for international expansion. Historically lackluster performance of non-core operations creates some concern that management might use funds to over-invest in under-performing businesses.
Additionally, public and political sentiment remains negative regarding the tobacco industry.
Despite the less than glowing outlook, the board of directors decided to borrow up to $1 billion to accelerate the company’s stock repurchase program. Looking forward to 1999, Vincent
Gierer and the UST management team face the task of implementing the major change in debt policy.

18 See “Divergent Credit Trends for the Global Tobacco Industry,” Standard & Poor’s (September 22, 1999).

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Exhibit 1

UST Inc. Product Information

Brands

Category

Introduction

% 1998
Sales

Copenhagen

Full Price

1822

48%

Skoal Fine Cut

Full Price

1935

Skoal Long Cut

Full Price

Skoal Bandits

Full Price

Red Seal

Price Value

Rooster

Full Price

Source:

-7-

1998 Average
Retail Cost per Can

Description

Competition

$3.13

Top selling brand in the industry. Straight-flavored.
Copenhagen has a "made-date" on bottom of its container so consumers recognize that it is fresh.
Both fine and long cut varieties. Long cut variety introduced in the first quarter of 1997.

Timberwolf (Swedish Match) and Redwood (Swisher)

18%

$2.98

Second largest selling brand in the industry.
Wintergreen and straight-flavored.

Kodiak (Conwood)

1984

29%

$3.11

Available in six varieties: wintergreen, straight, mint, cherry, classic and spearmint.

Kodiak (Conwood), Timberwolf
(Swedish Match) and Silver
Creek (Helme)

National introduction in 1983

3%

$3.10

Skoal packed in "tea bags" that are individual portion packs that make it easy to use and dispose.

Renegades (Swedish Match)

Third Qtr 1997

1%

$1.29

Available in wintergreen and straight-flavors.
Introduced in a 1.2 oz package.

Timberwolf (Swedish Match),
Cougar, Redwood (Swisher) and Silver Creek (Helme)

Test Marketed in
Fourth Qtr 1997;
National
introduction in 1998