Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member UST Inc. (UST) reported significantly better than expected financial results. Sales of $491 million were slightly ahead of the consensus estimate but earnings per share of $0.87 ($0.90 excluding charges) were nicely ahead of the $0.85 consensus.

The smokeless tobacco segment continued to show improvement, particularly with regard to their new premium brands, but the real story was in the wine business:

In the second quarter 2007, net sales for Ste. Michelle Wine Estates increased 28.3 percent to $79.5 million. Strong growth was driven by the incremental benefit from the distribution of Antinori products and the acquisition of Erath in the back half of last year, combined with continued product innovation, increased distribution and favorable acclaim on the company’s core brands. Total premium case sales advanced 19.5 percent to 1.2 million cases. Net sales growth combined with good cost control as a result of Project Momentum led to a 19.7 percent increase in operating profit to $11.2 million.

I’ve had the Ste. Michelle, and can recommend it. The stock also continues to grow on me, particularly given their guidance:

As a result of the strength in second quarter 2007 results, the company is increasing its 2007 diluted earnings per share guidance. On a GAAP basis, diluted earnings per share is targeted at $3.21, with a range of $3.16 to $3.27 and reflects an additional $.03 in charges in the second half of 2007, comprised of Project Momentum related restructuring charges and lease charges in connection with the sale of the company’s headquarters. On an adjusted non-GAAP basis, the diluted earnings per share target has been raised $.03 to $3.35, with a range of $3.30 to $3.41.

The consensus was anticipating such a move, as the existing estimate was for $3.36. The stock is not exactly priced cheaply on the basis of current earnings, but turnaround stories seldom are.

Today Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member UST Corp. (UST) announced that it has settled a legal case:

The first quarter 2007 Form 10-Q filed today with the Securities and Exchange Commission, which is available on the Company’s website at http://www.ustinc.com, includes a $93.6 million pretax charge for the California settlement and includes financial statements which supersede the GAAP financial results included in the Company’s earnings release. The after tax impact of the charge was $60 million, or $.37 per diluted share. As reflected in the attached table reconciling GAAP to non-GAAP financial measures, first quarter adjusted diluted earnings per share were not impacted.The inclusion of the charge also had no impact on the Company’s outlook for the year. Accordingly, full year 2007 adjusted non-GAAP diluted earnings per share remains targeted at $3.32 with a range of $3.27 to $3.40. The adjusted non-GAAP target excludes the gain on the sale of the Company’s headquarters, restructuring charges related to Project Momentum and antitrust litigation charges, details of which can be found in the first quarter 10-Q.

When the earnings were initially reported, the company had indicated this was in the works but was unable to put a precise number on the charge. At the time, they described it as an “opportunity” and we said:

The two “opportunities” are a restructuring charge for layoffs the company expects will reduce future expenses and a possible charge related to resolution of antitrust lawsuits currently in mediation. And even though the company raised its own outlook, the new target still falls below the $3.35 level the consensus was already expecting.

When we reviewed the 10K we called it a “solid company that is not especially cheap.” That type of valuation typically requires exceeding expectations to drive the stock price.

Analysts are still expecting $3.35 in adjusted non-GAAP pro-forma earnings per share excluding the bad things that happen to companies from time to time. As far as the earnings under Generally Accepted Accounting Principles, it now looks like that translates into somewhere south of $2.95 - with the remaining shortfall to be determined when the company figures out the scale of the restructuring charge.

Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member UST Corp. (UST) reported earnings:

For the first quarter ended March 31, 2007, net sales increased 3.1 percent to $447 million, operating income increased 38.2 percent to $271.4 million, net earnings increased 44.2 percent to $167.1 million and GAAP diluted earnings per share increased 45.1 percent to $1.03 versus the prior year period.

Beyond operations, several factors affected first quarter 2007 results. As previously announced, the Company realized a gain from the sale of its corporate headquarters. This gain was partially offset by restructuring charges related to the implementation of Project Momentum and the resolution of the Wisconsin indirect purchaser antitrust case which the Company settled late last week during court ordered mediation. The Company felt it was in the best interest of shareholders to resolve this matter, which ultimately benefits its adult consumers by providing coupons for future product purchases.

Combined, these three items generated a net gain of $.28 per diluted share. As indicated on the attached table reconciling GAAP to non-GAAP financial measures, first quarter 2007 adjusted non-GAAP diluted earnings per share was $.75, up 4.2 percent versus the year-ago period.

Analysts were expecting the company to earn $0.75 per share on $448 million in sales. The stock was down on the news, which probably makes sense. The company also raised its earnings outlook, but warned of charges that would have an unknown impact on the numbers:

The Company will be returning the net cash generated by the sale of its corporate headquarters to shareholders by increasing the 2007 share repurchase plan from $200 million to $300 million, with the increased purchases taking place in the second half of the year.

As a result of the strength in first quarter 2007 results and the utilization of incremental cash generated from the headquarters sale, the Company is increasing its 2007 adjusted non-GAAP diluted earnings per share target to $3.32, with a range of $3.27 to $3.40. Adjusted non-GAAP diluted earnings per share in the second and third quarter is anticipated to increase over the prior year in the range of 1 to 3 percent, with the balance of the increase coming in the fourth quarter due to the presence of an extra billing day in the Smokeless Tobacco segment.

The Company is focused on adjusted non-GAAP measures because there are two additional opportunities under consideration to strengthen future operations which might require charges that management does not associate with underlying results.

The two “opportunities” are a restructuring charge for layoffs the company expects will reduce future expenses and a possible charge related to resolution of antitrust lawsuits currently in mediation. And even though the company raised its own outlook, the new target still falls below the $3.35 level the consensus was already expecting.
When we reviewed the 10K we called it a “solid company that is not especially cheap.” That type of valuation typically requires exceeding expectations to drive the stock price.

We have noted several times over the last week that the departure of a Chief Financial Officer tends to raise alarm bells. And while Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member UST Corp.’s (UST) CFO departure in March was billed at the time as a retirement after 26 years of service with the company, an SEC filing that just happened to occur on the Good Friday market holiday appears to suggest otherwise:

On April 6, 2007, upon the recommendation of its Compensation Committee, the Company entered into an agreement with Mr. D’Alessandro to set forth the mutual agreement of the Company and Mr. D’Alessandro as to the rights and obligations of the parties in connection with his retirement from the Company, all as contemplated by the agreement entered into by the Company and Mr. D’Alessandro on June 23, 2006 (the “Employment Agreement”). The new agreement is referred to herein as the “Non-Competition and Release Agreement.”

Under the “Non-Competition and Release Agreement,” D’Alessandro will collect nearly $100,000 per month for the next 24 months, a pro-rata portion of the annual bonus he would have received, and continue to receive health care coverage. In addition, he “will also become a participant in the Company’s Officers’ Supplemental Retirement Plan (the “SOP”). His separation from service, therefore, constitutes retirement under the terms of the SOP and for purposes of all outstanding equity awards.”

Note the wording: by letting him participate in the plan his departure therefore constitutes retirement. And it sounded so nice when the press release came out last month.
Still, we wouldn’t mind being in D’Alessandro’s shoes. Although the benefits come with strings attached they don’t appear to be particularly binding.  “Mr. D’Alessandro has agreed not to compete with the Company for a period of two years from the date of separation by engaging or participating in any business or industry which is then in direct or indirect competition with any businesses in which the Company participates wherever located in the world.”

As we noted when we reviewed the 10K, “UST is a leading provider of smokeless tobacco products, which it markets under the Copenhagen, Skoal and other brand names. It also produces Washington State wines.” Barring both direct and indirect competitors, by our reckoning, limits D’Alessandro to offering his talents to only about 7,000 publicly traded companies in the U.S.

The other restriction we thought was interesting was the agreement to “release the Company and its affiliates from all liabilities and claims that he may have against them arising prior to March 31, 2007.” We have no idea whether that is a standard clause in a “non-competition and release agreement” or whether it related to something specific. However, it was fun to speculate that he might have been a claimant in one of the tobacco class-action suits or something equally ironic.

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Large Cap Watch List (Track at Marketocracy).

Though less than the Small Cap Watch List and Mid Cap Watch List (Track at Marketocracy), there was still relatively high turnover in this list. 14 of the original 33 names made the cut for the new list (which was trimmed to just 26 names.) Part of the reason for the turnover was to reduce overlap between the lists. One third of the Mid Cap Watch List (Track at Marketocracy) names appear on each of the Small Cap and Large Cap Watch List (Track at Marketocracy)s, but there is no longer any overlap between small and large.
So without further ado, the names on the chopping block from the previous list are:

3M (MMM); Continental (CTTAY.PK); Mitsui (MITSY); Anheuser-Busch (BUD); ConocoPhillips (COP); Helix Energy (HELX); IndyMac Bancorp (NDE - Annual Report); Barr Pharmaceutical (BRL - Annual Report); Quest Diagnostics (DGX); Public Storage (PSA); ITT Educational Services (ESI); Equifax (EFX); Rent-a-Center (RCII); Kroger (KR); Ricoh (RICOY); First Data Corp. (FDC); Expeditors International (EXPD); and Keyspan (KSE).

The new list is:

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Mid Cap Watch List (Track at Marketocracy).

As with the Small Cap Watch List (Track at Marketocracy), we were surprised at the amount of turnover in our screens. Only 7 of the original 29 names made the cut for the new list (which comes in at only 24 names.) Part of the reason for the turnover was to reduce the overlap between the Small Cap and Mid Cap Watch List (Track at Marketocracy)s. Now there is only one-third overlapping names rather than two thirds. Furthermore, given the level of outperformance we saw in the first quarter (actually just two months) and the fact that much of those gains were achieved early, perhaps the turnover is warranted.

So without further ado, the names on the chopping block from the previous list are:

Silgan Holdings (SLGN - Annual Report); Middleby (MIDD); Olin (OLN); Vector Group (VGR); Sanderson Farms (SAFM); Tesoro (TSO); Downey Financial (DSL); Waddell & Reed (WDR); Gamco (GBL); Apria Healthcare (AHG); Quest Diagnostics (DGX); ITT Educational Services (ESI); Equifax (EFX); Delhaize Group (DEG); Papa John’s (PZZA); Rent-a-Center (RCII); Cato Corp (CTR); Dassault Systemes (DASTY); Ingram Micro (IM); Energy East (EAS); South Jersey Industries (SJI - Annual Report); and American States Water (AWR).

The new list is:

Large Cap Watch List (Track at Marketocracy) member UST (UST) is a leading provider of smokeless tobacco products, which it markets under the Copenhagen, Skoal and other brand names. It also produces Washington State wines. We reviewed the company’s recently issued 10K report, and summarize our key findings below.

First, at risk of stating the obvious, the businesses UST are involved in entail a fair amount of legal, social and regulatory risk. Investors must be comfortable that the price they are paying provides adequate compensation for these risks. Over the last five years this has been the case, as tobacco companies gained 140% compared with just a 35% cumulative gain on the S&P 500. However, there is no assurance that can continue, particularly since sales and earnings have been essentially flat for the last three years. A restructuring initiative that the company believes will result in $100 million of cost savings appears largely incorporated into analyst estimates.

Inventory management looks poor at first, as the Days On Hand ratio logs in a hefty 522 days. However, both tobacco products and wines require significant aging before they can be sold. The “finished goods” DOH is a more reasonable 111 days. In this context, the inventory levels do not pose as significant a concern. However, it is worth noting that over the last three years the company has significantly under-reserved for inventory obsolescence and bad debts (see chart). Had the company’s reserves for these contingencies equalled the actual costs incurred, diluted earnings per share from continuing operations would have been a penny lower in 2006 and three cents lower in 2004.

Free cash flow generation has been steady in the $500 - $550 million range, resulting in an enterprise value/FCF multiple of 19-20x, which can be justified if the current initiatives result in a mid-single digit earnings growth rate going forward. Off-balance sheet liabilities are fairly modest, and include approximately $100 million in future lease payments as well as purchase commitments for both grapes and tobacco. In addition, the intrinsic (minimum) value of outstanding stock option grants is $123 million.
Pension plans and other post-retirement benefits are under-funded by nearly $240 million, and due to the recent adoption of SFAS 158 the full liability is now recognized on the balance sheet. This increased reported liabilities by approximately $115 million compared with 2005, but the economic liability was essentially unchanged. The plans are using an expected return assumption of 7.5%, and are allocated 70% to equity and 30% to fixed income. Assuming a 5% return on fixed income given the flat yield curve generates an implied expected return on stock investments of 8.5%, which appears a reasonable assumption under the circumstances.

All in all, the 10K suggests a reasonably solid company that is not especially cheap.

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Large Cap Watch List (Track at Marketocracy) (to be measured against the S&P 500) follows.

Astute observers will notice less overlap between this watch list and the names in the Small Cap Watch List and Mid Cap Watch List. This was not for lack of overlap, as the smallest S&P 500 name has a market capitalization of $600 million, which would allow for complete overlap with the Mid Caps if we chose. Instead we selected an arbitrary low of $2 billion for large-cap names, which cuts off five names that are actually in the S&P 500.
In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.