Description

Quick! Name the company that has operating margins north of 50%, controls 70% of an entire market, and counts Warren Buffett as an investor. If you guessed UST, you were right.

Overview:

UST (UST $35) manufactures and sells smokeless tobacco products (Copenhagen, Skoal, Red Seal and Rooster), wines and craft beers (wines sold nationally through the Chateau Ste. Michelle, Columbia Crest, and Villa Mt. Eden wineries), and premium cigars (Don Tomas, Astral and Habano Primero). For the year 2000, the smokeless tobacco segment had net sales of $1.3 billion, and accounted for 87 percent of consolidated sales. Wine segment net sales totaled $174 million, while all other sales were $29 million.

Why UST is attractive:

I find UST attractive for several reasons. The first reason is simply because of the product. While Wall Street undervalues “redneck" stocks because fund managers and analysts lack proximity to “redneck” activities, Joe public does not. Smokeless tobacco has all of the attractive qualities of cigarettes (addictive, strong pricing power, high barriers to entry etc.) less the litigation risk. The second reason I like UST is valuation. In this environment of uncertain earnings growth, UST’s meaningful and predictable cash flow are valuable. Furthermore, UST just increased its dividend to $1.95 annually resulting in a 5.5% yield at the current price.

UST Financial Snapshot

Share Price: $35.00
Shares Outstanding 164.5mm

Valuation Ratios:
P/E (2001E) 11.9x
P/E (2002E) 11.4x
TEV/EBITDA (2001E) 6.4x
TEV/EBITDA (2002E) 6.1x

2000 Profitability Ratios:
ROE 187%
ROA 33%
ROIC 66%

Besides trading at 6.4 times Enterprise Value to EBITDA and being highly profitable (however you want to measure it), UST’s balance sheet looks good. As of 9/30/01, UST had cash of $900 million, comprising of $629 in restricted deposits and $271 in unrestricted cash. Total debt was $867 million resulting in a net cash position of $33 million. Shareholders equity was $453 million.


DCF Analysis:

I have run a discounted cash flow analysis on UST, which shows the intrinsic value for UST based on varying assumptions. Because a stocks true worth is only as good as the analyst’s assumptions and because these assumptions are never consensus (nor truly predicable), a valuation range is necessary (as Warren Buffett once said, “ it is better to be approximately right than precisely wrong”).

For my base case, I have assumed 3% revenue growth going forward (this is for margin of safety – management just reiterated that its goal of net income growth of 10% through 05) and 50% operating margins. Both assumptions start in 2003. The weighted average cost of capital is 6.7%. The model runs until 2050 and carries no terminal value assumption (the PV of UST’s FCF after 2050 is negligible).

UST INTRINSIC VALUE:

Operating Margin REVENUE GROWTH
0% 3% 5%
40.0% $30.89 $39.77 $48.84

45.0% $34.10 $44.22 $54.58

50.0% $37.31 $48.66 $60.31

55.0% $40.53 $53.11 $66.05

60.0% $43.74 $57.55 $71.78

Under the base case scenario (3% revenue growth and 50% operating margin), UST is currently worth $48.66. Of course, if you believe UST is only going to achieve no revenue growth and 45% operating margins going forward, then UST is only worth $34 dollars to you and does not represent a compelling buying opportunity.



Risks:

I stated earlier how UST faces relatively less litigation risk than the cigarette companies. The numbers bear this out. Approximately 2,400 smoking and health cases have been filed since 1954. Approximately 50 of those cases have been tried to a verdict, with approximately 10 adverse jury verdicts. As for smokeless tobacco products, approximately 35 cases have been filed since 1954. Only one case has been tried to a verdict, resulting in a unanimous jury decision in favor of UST.
However, there is one recent lawsuit that warrants mention.
In March 29, 2000, a jury in Paducah, Kentucky, rendered a verdict UST, awarding $350 million in damages, subject to trebling, to Conwood Tobacco Company, L.P. for its claims under federal antitrust laws. The court upheld the verdict in August and rendered a judgment for $1.05 billion. While, UST is appealing the verdict and analyst are optimistic that the company will prevail, there could be downside pressure on the stock if the Conwood verdict is not overturned. UST cannot repurchase stock or increase its dividend in excess of 5% per year until the claim is resolved.

Catalyst

Catalysts:

· Resolution of the Conwood case
· Share repurchases
· Continued shift by investors to “defensive” stocks
· Valuation