Description

Universal Corporation (UVV) is one of the two major tobacco leaf distributors in the world. UVV controls around 55-60% of the industry, Alliance One (AOI) controls 30% and a couple of smaller peers comprise the balance.  The global leaf market is characterized by low single-digit organic demand growth with the highest growth coming from China (3-5% annually since 2000). The supply/demand has been relatively stable since 2000 because customers began providing leaf dealers with future purchase requirements to avoid supply imbalances. While tobacco smoking in developed countries is declining, consumption is increasing in developing countries. China is the world's major cigarette consumer. About 100 countries produce tobacco. The major producers are China, India, Brazil, the U.S., Turkey, Zimbabwe and Malawi, which together produce over 80% percent of the world's tobacco.  Five years from now, the industry should look very similar to the way it looks today.

UVV purchases tobacco leaf and processes it for delivery to cigarette manufacturers such as Phillip Morris and RJR. The business has been around since the mid-19th century. UVV itself was incorporated in 1918. Tobacco leaf distributors serve as the intermediary between farmer and manufacturer and the industry has high barriers to entry. Leaf processors must have a strong presence in major tobacco processing areas, efficient processing factories and multiple customers (this point discourages vertical integration by manufacturers). UVV buys cured leaf tobacco directly from farmers through direct contacts or on the auction market. Cured tobacco deteriorates rapidly with heat and humidity, requiring processing near growing areas. UVV processes the leaf (removes stem, packs stem and leaf separately for shipment). UVV handles all types of leaf tobacco but flue-cured and burley leaf represent the majority. Customers typically hold tobacco 1-2 years to protect blends against crop failure for proper aging. UVV processes 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. UVV negotiates contracts every season and passes through leaf price increases but sometimes there is a lag. Contracts are usually cost plus. The Sept and Dec quarters are typically UVV’s most profitable quarters.

UVV has the largest market share, highest returns on capital, and best management in its industry.  Since 2000, while sales growth has been relatively low, operating margins have approximated 8-10% in all but 2 years (when there was temporary oversupply). If one applies normalized margins of 8.0%-10.0% to run-rate sales, EPS approximates $4.30 - $5.80.  The dividend is $2.04 which implies a yield of 5.0% while you wait. 

UVV has never been subject to any tobacco litigation. I suppose that regulatory rules could change or trade barriers could emerge but given UVV’s diverse business mix and long operating history, I don’t view this risk as material.

Why is Universal mispriced?

Tobacco leaf markets are currently oversupplied and these periods of oversupply typically take 12-18 months to work through. 

Is there a catalyst?

Philip Morris International recently announced that it will begin sourcing its tobacco externally again after several years of attempting vertical integration.  This may be the sign of a broader industry movement back towards the leaf manufacturers. 

Catalyst

Universal Corporation is the #1 market share player in the tobacco leaf processing industry, which is a duopoly that is characterized by low growth but generally stable margins.  The stock sold off earlier this year due to temporary supply/demand imbalances.  Beginning around 2008, several of the cigarette OEMs began to vertically integrate, which raised concern about the leaf processors' long-term business models.  Over the past few months, several OEMs have indicated a reveral of this stance which should bring some business back to UVV and the #2 player, and bolster sales over the short term.  An additional catalyst is also a gradual working off of excess tobacco leaf supply, which generally takes about 12 months.