Description

The stock price of AOI is up almost 80% off the bottom earlier this year and is still trading at a significant discount to intrinsic value and it's nearest competitor.  The company has $650mm of net debt and an equity cap of $550 for TEV of $1,200mm.  The company is currently doing about $175mm of EBITDA, CAPEX is about $25mm and CFFO-CAPEX is about $65mm; so the company is trading at 8.0x EBITDA-CAPEX and has a 12% CASH YIELD to the EQUITY.  Importantly, the company is improving its return on invested capital (by reducing the capital employed in the business through asset sales), reducing its cost of capital (by paying down expensive debt), and has the opportunity to improve its cash flow over the intermediate term.

Background:

Alliance One International (AOI) was created on 5/13/05 when Dimon acquired Standard.  These companies were the #2 and #3 players in the tobacco leaf processing business.  Today, AOI has a duopoly with Universal (UVV) in tobacco leaf processing; there are a few regional players, but AOI and UVV basically split the business 50/50.  Tobacco leaf processing is a simple business: the tobacco processors buy tobacco from growers (all over the world), process the tobacco according to their major customer’s specifications and deliver the tobacco to the major tobacco companies for use in cigarettes (and other tobacco products).  

The timing of the acquisition (and attempt to tap the capital markets) in 2005 was awful.  Brazil, one of the major producing areas, had a terrible crop and at the same time decided to increase taxes on the intrastate transport of tobacco (which was eventually overturned), and the Brazilian real appreciated in value, which increased their costs of production.  Basically, everything that could have gone wrong did and the pricing of AOI's bonds reflected that in the marketplace.   (Note: we own the bonds too and like the 11% senior notes and 12.75% senior sub notes, which are trading modestly over par with attractive yield(s) to maturity.)

Improving ROIC and Lowering Cost of Capital:

Since the merger, the company has been selling assets, reducing working capital, and using the proceeds to reduce debt.  In fact, over the past two years the company has reduced net debt by $400mm.  Although generating cash from working capital has largely run it's course, AOI has additional opportunities to reduce it's hard assets; the company probably has at least another $50mm of non-earning asset to sell and has announced a few of them in recent days.  As far as the debt is concerned, the company has recently got an amendment to it's bank deal and it's A/R facility to repurchase it's 11% senior notes, which is a nice arbitrage given that its $300mm revolver is undrawn with a rate of LIBOR + 275 and the A/R facility has over $50mm, which was recently increased and the rate reduced to lower than that of the revolver.

Operating Expense Cost Improvement Potential:

AOI continues to work at reducing its operating expenses; EBITDA margins are 8.5% at AOI versus almost 12% for UVV.  Clearly, in the recent past, the company has fallen short of goals to improve cash-flow approaching UVV, which has weighed on the stock at the end of last year and the beginning of this year.  We continue to believe that the company can partially bridge the gap to UVV's EBITDA, which LTM is approximately $255mm.  If AOI bridge the gap even halfway to UVV's EBITDA, it would add another $40mm to EBITDA (and reduce the EBDIT-CAPEX number to only 6.3x excluding cash generation).  Importantly, industry tobacco leaf supply is very tight and leaf prices have increased materially for the current crop (as noted by Phillip Morris Int'l in its spin off presentation to investors), which is a nice tailwind and should benefit the leaf processors.

Valuation:

At $64, UVV is trading at a TEV of $2.4 billion or 10.6x EBITDA-CAPEX and a 6.0% cash yield to the equity.  Clearly, UVV is currently (and historically has been) a better run company, but we believe that paying $1.2 billion for AOI versus $2.4 billion for UVV is unwarranted given the oligopoly structure of the industry and improvements that the company is making.

Catalyst