|Shares Out. (in M):||23||P/E||0||0|
|Market Cap (in $M):||1,666||P/FCF||0||0|
|Net Debt (in $M):||400||EBIT||0||0|
|Borrow Cost:||General Collateral|
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UVV has a market cap of $1.7B and is the leading global leaf tobacco supplier operating in 30 countries on five continents to procure, finance, process, pack, store and ship leaf tobacco to the global cigarette manufacturers. In aggregate, 60+% of their revenues come from 5 customers: Philip Morris, British Tobacco, Imperial Brands, Japan Tobacco and China Tobacco. These 5 companies account 80% of the total tobacco manufactured.
We believe the recent 45% run-up in the last 2 months has been driven not by fundamental reasons but because the company has decided to mandatorily convert its outstanding 6.75% convertible perpetual preferred stock that has caused a significant amount of hedges to unwind during the mandatory 10 day VWAP period to determine the conversion price.
We will quickly review why we don’t think the fundamentals are driving the stock price and then discuss the details of the preferred conversion.
The company can best be summed up by the investor relations chart below. For the past 16 years, operating income has been ~$200M. It fluctuates depending on the tightness of tobacco supply / demand as well as the speculative inventory position that UVV has taken in various regions. But net/net, this is a fairly stable business.
Over time, UVV is challenged by declining tobacco usage. Industry data shows that cigarette consumption fell at a 0.1% CAGR. However, this includes a 2.2% growth CAGR in China, which is largely internally sourced. Excluding China, consumption fell by a 0.8% CAGR over that time period. Importantly, UVV sales are primarily flue-cured and burley tobaccos which are primarily used in American-blend cigarettes and smoked in the US and Western Europe. Those two regions are showing the worse secular trends in smoking with industry data showing that American-blend cigarettes declined at a 2.2% CAGR over the last 10 years. While Tobacco companies have managed these declines by pushing through price increases (it is an addictive product after all), tobacco sourcing brokers such as UVV do not have the same pricing power. While tobacco companies want tobacco brokers to remain in business, they know exactly how much money the brokers are making at any given point in time.
Given the relative stability of earnings, UVV has historically traded on a dividend yield. That dividend yield over the last 10 years has range from 3.5% to 5%. However, in the last 2 months, with UVV trading up 45%, its current dividend yield is at a historical low.
Even more perplexing than the 45% move in a boring tobacco stock is the fact that its direct competitor, Alliance One, a $160M small cap stock has not budged since December 8th despite UVV running up an additional 27%.
We have spent a significant amount of time analyzing why the stock has run and we attribute the move from December 2nd to December 8th in both UVV and AOI, along with tobacco stocks in general, to the election.
The second potential reason the stock would run-up is that British Tobacco agreed to acquire the remaining 58% of Reynolds America on 1/17/2017. Both MO and PM have rallied post this announcement. AOI has not budged. However, our work indicates that this transaction is net neutral for UVV at best, and at worst UVV will at some point in the future begin to lose business. This is because while British Tobacco uses UVV to source its tobacco in the US, Reynolds America has its own internal tobacco sourcing operation. Given the trend for British Tobacco to source its own tobacco in its core regions (i.e. Brazil), our research suggests that over time British Tobacco will likely use Reynolds internal sourcing arm in the US.
When we spoke to the company, they did not even indicate the BATS/RAI merger as a reason for the stock increase. The three reasons they gave were 1) small cap stocks have outperformed since the election 2) Tobacco stocks in general have run up post-election and 3) the potential for some unwinding of hedges used by preferred stockholders.
UVV issued 6.75% convertible perpetual preferred stock in 2006 that is convertible into 22.4306 shares of commons stock. In order to force conversion, the stock had to trade above 135% of its conversion price for 20 days in any 30 consecutive day period. This occurred for the first time on 1/6/2017 and the company issued an 8-K announcing the mandatory conversion on the very next day.
The Conversion price will be determined by the VWAP over a 10 trading day period starting on 1/17/2017 and ending on 1/30/2017. The shares will be settled in cash. There are ~2.4M shares underlying the preferred stock, or ~10% of total shares outstanding. Of these 2.4M shares underlying the preferred, we believe they were hedged with ~1.7M shares based on the SI prior to the announcement of the mandatory conversion. This means that after the company announced conversion, ~7% of the total shares outstanding were shorted that needed to be covered. On average, the company trades 180k shares / day. So this equates to almost 10 days’ worth of volume, which happens to be the testing period.
As you can see below, volume picked up immediately once the testing period began.
We believe UVV’s stock has been caught in a “perfect (upwards) storm” for the last 6 weeks. General momentum in tobacco stocks post-election pushed the stock up over the 135% conversion price (roughly 60.) This begat a reflexive situation – the company has made it known for some time that they would like to cover this fairly expensive piece of paper – so savvy convert arb players likely began covering their short positions prior to the actual announcement. The near simultaneous commencement of the 10 day testing period and the official announcement of the BATS/RAI merger added fuel to the fire. Our best estimate is that not only has there been “forced” covering over the last 10 trading days, but technical, momentum, and retail investors have further exacerbated the move higher.
We think that once this short covering is exhausted, there is no fundamental reason for the recent stock gains to hold without the incremental buyer propping up the stock. As short covering abates and the stock loses momentum, we anticipate non-fundamental investors will sell to crystalize their gains (or avoid eventual losses.) UVV should trade back to yielding ~3.5-4%, which would equate to a stock price of $54-$61.75. This would be 15-25% below current prices and the stock should re-rate fairly quickly.
The pushback might be that since they are settling the shares in cash, this equates to ~10% share buyback. They are also retiring paper that is expensive, given historical dividend yield has been 3.5%-5% whereas this paper yields 6.75%. We make two observations on this.
First, f we are right that there is no fundamental reason for the share price appreciation, UVV is overpaying by ~$15 / share for the conversion on 2.4M shares. This equates to $36M worth of overpayment on these shares. If they are repurchasing shares at above intrinsic value, then share repurchases add no value.
Second, you could argue that they are retiring expensive paper with cash that is yielding pretty much nothing. This statement is true. They are saving $7.5M in preferred dividend payments by not having this expensive paper outstanding. However, the company could convert this paper at any point after March 2018. So in reality, they are only saving 13 months by retiring this based on the stock price. So UVV is overpaying to retire this paper by $36M to save $7.5M in dividend payments.
A few other items
First, the company announced the CFO was taking temporary medical leave starting on January 12, 2017. We don’t know exactly what to make of this but thought it was worth pointing out. It is particularly odd given it was the day before the 10 day conversion price determination began.
Second, Philip Morris shifted from internally sourcing tobacco and using UVV to process and ship the tobacco to having UVV both source and process the tobacco. UVV makes a little more money if they do both given the buying and sourcing the tobacco is capital intensive and will earn a return on this. However, given how large and important Philip Morris is to UVV, we don’t think the economics are game changing for UVV. However, when UVV buys the tobacco vs. just processes the tobacco there is a revenue recognition delay. UVV numbers were helped in Q4 2016 and 1H 2017 numbers were helped by this change but the benefit is no running through the numbers both sequentially and YoY. Per their 10-Q:
Our results for the six months ended September 30, 2016, were in line with our expectations and reflected modestly higher total sales volumes and lower selling, general, and administrative costs. The previously announced changes in our leaf supply arrangements in both the United States and Mexico positively impacted our results in the first half of our fiscal year.
After consecutive years of leaf tobacco supply and demand imbalance, global demand remains soft and may contribute to delays in some customer purchase and shipment timing decisions. Consequently, our shipments are still expected to be weighted to the second half of the year, and we anticipate that total lamina sales volumes in fiscal year 2017 will be lower than those of last year. Reduced crop purchases in Brazil in the current fiscal year, as well as challenging market conditions in Tanzania, will negatively impact our sales volumes for this fiscal year. We expect the most significant drop in volumes to occur in the fourth quarter of our current fiscal year as Brazil shipped heavily in the fourth fiscal quarter of 2016, and we do not expect to attain a similar level of shipments there this fiscal year.
At the same time, the lower current crop levels have reduced our working capital needs this year, decreasing our seasonal borrowing requirements and increasing our cash reserves. Our uncommitted inventories have been well-managed and remained within our target range at 14% for the end of the second fiscal quarter. As a result, we have continued to maintain our very strong balance sheet and are pleased to reward our shareholders with an annual dividend increase for the 46th consecutive year, as announced earlier today.
UVV is set to announce Q3 earnings on February 7th 2017. Based on their forward looking guidance provided last quarter, it appears Q4 numbers will be challenged.
End of 10 day VWAP period to determine conversion price (this was today.)
Non-fundamantal investors selling once momentum comes to a halt.
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