Image:Ustlogo.jpg

NOTE: On September 8, 2008, Altria Group announced that it was acquiring UST for $69.50 a share.


UST (NYSE: UST) makes smokeless tobacco and wine. UST focuses on premium smokeless tobacco, and commands over 90% of market share in that segment.[1] The company has struggled to maintain both market share and profit margins in the face of new competition. In particular, cheaper, discount brands have forced UST to choose between discounting its own products, thereby reducing profit margins, and keeping prices stable while losing market share.

In addition to competition from discounters, UST is also facing increasing competition from big, established names in the industry. As increased tobacco taxes and health concerns have weakened cigarette sales over the past 20 years[2], companies are seeking to diversify into the smokeless tobacco market. Tobacco giant Philip Morris has launched a moist smokeless tobacco under its Marlboro brand[3]. In addition, both Philip Morris and Reynolds American are marketing a spit-free, smokeless tobacco product called snus in test markets under their respective Marlboro and Camel brands.

In recent years, UST has increased wine sales as a percentage of total revenue (thereby further diversifying its revenue streams), but as a lower-margin product in an even more competitive industry, this shift towards wine seems a mixed blessing for the company.

Company Overview

UST manufactures and markets smokeless tobacco products under its premium and discount brand names, which are sold to retailers nationwide. In the 1970s, the company entered the wine business: in addition to making wine at its vineyards in the Northwestern United States, UST also imports wine from Italian winemakers. These wines are sold at state-licensed distributors throughout the United States.

Business and Financial Metrics

UST Revenue and Net Income (in millions of USD), 2005-2007.
UST Revenue and Net Income (in millions of USD), 2005-2007.[1]

Over the past three years, UST's revenue has shown modest growth given the strong growth in it's wine business and increased sales of its premium smokeless tobacco. Although UST has faced stiff competition from discount tobacco companies, it has been able to spur sales growth through increased promotional spending via "buy one, get one free" sales on its premium tobacco products. Operating income declined slightly over the same three year period, due to both the increase in promotional spending and UST's greater dependency on the low-margin wine business. However, operating income in 2006 was particularly low in part as a result of a one-time $22 million restructuring charge related to a cost-cutting project for the company.[4]

UST net can volume (in millions)[1] 2005 2006 2007
Premium541.0541.4556.9
Price-Value84.491.3102.1
Total625.4632.7659.0

Business Segments

UST Net Sales by Segment, 2005-2007
UST Net Sales by Segment, 2005-2007[5]

Smokeless Tobacco (79.3% of sales[1]): Accounting for $1.5 billion of UST's $2 billion of revenue in 2007, smokeless tobacco is the core of UST's business. The company controls over 90% of the premium market [1], where it sells Copenhagen and Skoal, two of the most well-known brands in the industry. The company also has a presence in the mid and lower-priced markets: it sells tobacco under the mid-priced Red Seal label as well as the discount brand Husky. Although smokeless tobacco accounts for the vast majority of UST's revenue, growth in that segment has stagnated in recent years, as consumers appear less willing to spend on the company's premium brands and are moving to the brands of its competitors. UST has initiated promotional offers to attract smokers and encourage brand loyalty within its customer base. But while such spending has helped increase UST's revenue, it has also contributed to the company's reduced profit margins.

Wine (18.1% of sales[1]): UST manufactures and markets wine under its brands, while include Chateau Ste. Michelle, Columbia Crest, Conn Creek, and Villa Mt. Eden. It also imports wine brands from Italy, including Tignanello, Solaia, Tormaresca, and Villa Antinori. While wine accounts for less than a fifth of UST's sales[1], it is the company's strongest growth generator. Between 2005 and 2007, the net sales for UST's wine business grew 43%, while its tobacco business was essentially flat over that same period.[5]. But while the wine business has been a strong growth engine for UTS, it comes with much lower margins. In 2007, UST's smokeless tobacco segment had an operating margin over twice its wine operating margin, 46.3% and 16.9% respectively[1]. As a result, over the past decade, UST's operating margins have consistently trended down over the past decade, from 51.8% in 1998 to 43.8% in 2007[1].

Trends and Forces

The Growth of the Discount Tobacco Industry Can Erode UST’s Market Share

UST has long positioned itself as a purveyor of premium smokeless tobacco products, which come with higher price tags and higher profit margins. However, growth in the industry has shifted away from premium brands and towards discounters: in 2007, total moist smokeless tobacco can volumes grew 7%, while UST’s premium Skoal and Copenhagen-brand can volumes grew by only 3.1%. The total discount segment showed double-digit growth over the same period. [6]

Weakness in the U.S. economy further exacerbates the downward pressure on premium brands. In particular, as many tobacco purchases are made at gas station convenience stores, consumers are reminded of their reduced discretionary income where they are likely to purchase their tobacco, encouraging them to either forego making a purchase or trading down to a cheaper brand.

Sucessful Anti-Tobacco Litigation Can Reduce UST's Earnings and Reputation

Given the evidence that the use of many tobacco products on the market leads to an increased risk of diseases and cancers, the tobacco industry has found itself mired in lawsuits over the past few decades. UST is no exception, having entered into the Smokeless Tobacco Master Settlement Agreement[7] with 45 state attorneys general in 1998. This agreement limits UST’s ability to advertise, and may require the company to pay upwards of $100 million for programs to decrease tobacco use among youth in the United States.[8]

However, it is important to draw a distinction between the cigarette and smokeless tobacco industries. The latter industry has a much lower litigation risk, as the link between moist smokeless tobacco and cancer is not a well-documented as it has been with cigarette smoke[9]. As UST has no involvement in the cigarette business, its litigation risk is substantially mitigated[10].

Excise Taxes on Wine and Tobacco Products Pose Continuing Threat to Profit Margins

Wine and tobacco products are subject to both state and federal excise taxes. The U.S. Federal Government taxes wines with 14% alcohol or less at $1.07 per gallon, which translates to a $0.21 tax per 750ml bottle[11]. Across the country, state excise taxes per gallon range from $0.11 in Louisiana to $2.50 in Alaska[12].

In the mid-1980s, the government initiated a tax on smokeless tobacco products, which has been increased five times (most recently in 2002). The tax ranges from $0.01 to $0.04 per one ounce tin or pouch. If either excise tax is increased, UST would have to pass the costs on to consumers, or absorb them at the cost of reduced profit margins. But although many state governments nationwide have taken a strong pro-tobacco tax position, these taxes often are levied against cigarettes, not smokeless tobacco products[13]. Therefore, UST is less likely to have its operations affected than its cigarette-making competitors, and may even benefit from smokers switching to smokeless tobacco to avoid high cigarette taxes.

Increased Commodities Prices Can Reduce UST's Profit Margins

UST's profit margins are very sensitive to fluctuations in wine grape and tobacco prices. Given increased global demand, prices for many commodities have soared in recent years[14]. Tobacco leaves and wine grapes are no exception: California wine grapes are at some of their highest prices in seven years[15], while the prices for processed leaf tobacco have more than doubled in the past two years [16]. However, UST has some insulation from price jumps as many of its wines are made with grapes from the company's own vineyards. But given that demand for premium smokeless tobacco is waning in favor of discount brands, if tobacco prices continue to rise, UST would certainly find it harder to keep consumers on their premium brands.

Competition

UST faces competition from U.S. tobacco and wine manufacturers, as well as smaller, privately held brands and businesses. While there aren't public companies that sell only discount tobacco, there are smaller companies that do focus on discount brands, including Stokers Chewing Tobacco and Low Bob's Discount Tobacco. In addition, UST competes against a variety of online retailers who sell directly to consumers, thereby reducing overhead costs and avoiding higher sales taxes. UST's public competitors include:

Reynolds American: Reynold's American is the United States' second largest tobacco company, manufacturing about one-third of the cigarettes sold domestically[17]. In addition to its cigarette business, Reynolds is the parent company for Conway, which sells various brands of smokeless tobacco. Conway's brands include Union Workman, Taylor's Pride, Peachey, and Morgans.

Lorillard: Lorillard is a manufacturer of five brands of tobacco products, including its flagship cigarette brand Newport, which accounted for 92% of the company's sales volume in 2007. Formerly a wholly-owned subsidiary of Loews Corporation, Lorillard became an independent publicly-traded company in June 2008.

Phillip Morris USA: A wholly-owned subsidiary of Altria Group, Phillip Morris USA is the United State's largest cigarette producer. Phillip Morris is selling smokeless tobacco products and a spit-free tobacco in test markets.

Constellation Brands: The largest wine company in the world[18], Constellation Brands also makes and markets beers and alcoholic spirits. The company's portfolio consists of over 250 brands, including Twin Fin wine and SVEDKA vodka. Constellation also has a joint venture with Mexico's Grupo Modelo, where it imports popular brands like Corona and Modelo Especial.


UST and Competitors, 2007[19] Revenues Operating Margin Net Income Gross Margin
UST $1,930[20]47.71%[20]$537.78[20]74.45%[20]
Altria Group$18,664[21][22] 35.99%[20] $3,131[23][22] 56.32%[20]
Reynolds American $8,920[20]27.07%[20]$1,520[20]44.96%[20]
Lorillard$3,300[20] 74.35%[20] $848[20]82.93%[20]
Constellation Brands $3,800[20]14.23%[20] -$538.96 [20]36.31%[20]




References

  1. 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 Data from UST's 2007 10-K (filed February 22, 2008)
  2. "As cigarette sales dip, new products raise concerns", USA Today (August 7, 2007)
  3. Marlboro Smokeless Tobacco Fact Sheet, Phillip Morris USA
  4. "UST Reports Stronger Than Anticipated Results For The Year 2006"
  5. 5.0 5.1 Data from UST's 2006 10-K (filed February 23, 2007) and 2007 10-K (filed February 22, 2008)
  6. http://www.thestreet.com/p/rmoney/investing/10411737.html
  7. Smokeless Tobacco Master Settlement Agreement, California Department of Justice
  8. UST statement on the Smokeless Tobacco Master Settlement Agreement
  9. Favorite Stock: UST, CNN Money (September 19, 2002)
  10. Prior to 1986, UST did manufacture cigarettes, but the company has since determined that its litigation risk for those products is essentially zero, as its market share was negligible.
  11. Federal Wine Tax Rates
  12. State Wine Excise Tax Rates (January 1, 2008)
  13. "Tobacco tax cuts into smokers' ranks", Daily Iowan (November 6, 2007)
  14. "Commodity prices show no letup", International Herald Tribune (June 12, 2008)
  15. 2008 "Wine grape prices highest in seven years", Western Farm Press (July 31, 2008)
  16. "Soaring commodity prices could boost local tobacco sector", Taipei Times (January 22, 2008)
  17. Reynolds American website
  18. Constellation Brands, "About Us"
  19. All numbers in millions of USD.
  20. 20.00 20.01 20.02 20.03 20.04 20.05 20.06 20.07 20.08 20.09 20.10 20.11 20.12 20.13 20.14 20.15 20.16 20.17 Yahoo! Finance
  21. Altria Pro Forma Statement of Earnings for FY ended December 31, 2007
  22. 22.0 22.1 This figure excludes revenue from Kraft Foods and Phillip Morris International, both of which have since been spun off from the company.
  23. Altria Pro Forma Statement of Earnings for FY ended December 31, 2007
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