Assess the Business and Financial Risks of Ust. What Do You Think About Ust’s Capital Structure? What Are the Benefits of Debt in Ust’s Case?

Q1. Assess the business and financial risks of UST. What do you think about UST’s capital structure? What are the benefits of debt in UST’s case?

UST Inc. is a US based company which operates in the moist smokeless tobacco products sector. Despite its decreasing share of the market, it is clearly the leader in its sector, which is divided between the premium market and price value market. The sector is one of the fastest growing among the overall tobacco industry, with an annual growth rate of 3.7% over the past 17 years and 1-3% forecasted in the near future. UST is mainly present in the premium market where it controls 76.6% of the market share due to its long presence in it, which allowed UST to build a strong brand name and quality, which justify the continuous price increases in its products. However, in the last years the threat from new competitors and some issue linked to the health consequences of tobacco have undermined the leading position of UST.

From the point of view of the business risk, it is possible to identify three main areas of concern. The first one is the evolution of the pricing of the overall market, which is going against the historical policy followed by UST. Indeed, while UST has always increased the prices of its products once or twice per year, the new smaller entrants saw the opportunity of eroding its market share by introducing competing products at cheaper prices. Since UST managers seek to maintain the brand image of premium quality producers they have decided not to decrease prices and to introduce a new brand which would not modify the reputation of their already existing products. This has had mixed results, on the one hand it has decreased sales growth rate from an average of roughly 10% in the years from 1988 to 1996 to just 2.2% and 1.5% in 1997 and 1998, respectively. On the other hand, most of the margins (Gross margin, EBITDA and EBIT margin) are increasing.

Extremely connected to the first one, the second source of business risk is the lack of innovation in the products proposed by UST. While all other competitors are struggling to increase their market share, analysts are concerned that the management of UST is growing arrogant about their dominant position and becoming tardy in proposing competitive products which could appeal to the growing number of customers. Indeed, it is important to highlight that while the overall market size is growing, UST is losing market share at a much faster pace, which could be the explanation in the lower sales growth rate. While trying to diversify their investment in the winery and cigar industry (nearly 50% of capex in 1997), UST has not done many efforts in penetrating the value price market, which is the one which is expected to grow the most as opposed to the premium market which is expected to shrink over time.

The third and final source of business risk lies in the lawsuits which are typical