Description

Disclaimer: This note reflects my view as of today and may change. We may have a position in the security referred to in this note.

Universal Corporation is a structurally challenged business with questions around terminal value, which is now on the wrong side of the capital cycle, with leverage, so its equity is more vulnerable than usual.

It was last written up on VIC by yarak775 in 2017 (as a short). Please see for a more detailed business description. Since then, its market cap is down 20% versus a very strong market, but the enterprise value has risen by about a quarter as Universal has taken on significant debt.

Universal is the number one producer of tobacco leaf, focused mainly on flue-cured and burley tobacco used to make American-blend cigarettes. ~90% of segment profits come from tobacco leaf production with the balance from ingredients.

Background—Narrow Moat, Commodity Industry, with Declining End Demand

Often wrongly described as a duopoly with Alliance One (the number two), the flue-cured and burley tobacco leaf markets are open with low barriers to entry and easy switching by customers. Universal and Alliance One together make up about one third of global leaf supply, with the balance met by the tobacco manufacturers themselves and smaller local players (e.g. Premium Tobacco Group). Tobacco manufacturers own or control operations outright (e.g. Japan Tobacco owns the Tribac Leaf assets in Africa and the Kannenberg assets in Brazil) and these resell into the global market. Even worse, customers are all regional monopolies (Universal’s six largest customers make up ~60% of revenues). This is seen in the limited pricing power and “harvesting ability” that the leaf producers have (compared to the cigarette manufacturers). Earnings power is entirely subject to the generosity and will of its customers.

Flue-cured and burley tobacco is used to make American-blend cigarettes which are smoked mainly in developed markets (compared to, for example, “kretek” and “oriental” varieties which are smoked in emerging markets)—so end demand is more geared to the negative trends of Europe and the US.

Thesis:

• Capital cycle and terminal value pressures: The structural backdrop has led to returns on capital and total shareholder returns below cost of equity (and well below the market). That said, the largest customers have continued to allow Universal to make a profit to stay in business and earnings have been steady. So why short now?

1) Capital cycle: As a commodity industry where competitors are subject to the institutional imperative to “keep dancing while the music is playing,” tobacco leaf is vulnerable to supply booms. In the last two years, unfavourable weather in Brazil, Malawi, and Zimbabwe, combined with post-COVID logistics overhangs, led to supply-shortages of tobacco leaf, and elevated Tobacco segment profits. Strategic overbuying led to burley and flue-cured pricing rising by ~40% on 2019. This is seen in Universal’s inventory position and DSIs as of calendar Q1 which reached peak historical levels (see chart below). Note this understates DSIs by about 10% versus 2019 given that Ingredients are now about 10% of revenues (faster turning inventory).

Source: Capital IQ

After two challenged crop cycles, the industry is still short on supply but has responded as expected: bountiful plans for planting in the next cycle. While previous cycles of oversupply (2014-2015, 2019-2020) have been worked through without too much fallout, this capital cycle may be worse because crop shortages were more extreme, and end-market decline rates continue to accelerate:

2) Accelerating terminal value pressures: Developed market volumes are declining by 3%-8% depending on the market. Unlike cigarette manufacturers that have brand power, captivity, and pricing power, tobacco leaf manufacturing behaves more like a commodity industry when faced with declining end demand. While the cigarette manufacturers have allowed the producers to make some profit (albeit below their cost of equity), this headwind that comes from supply-demand imbalances gets stronger with time. This is seen in progressively lower returns on capital and peak margins with each cycle.

• Classic signals of pressured core business:
  • Leverage is high (greater than 4x mid-cycle EBITDA) partly because of elevated inventory, but also because of acquisitions in fiscal years 2020–2022 of natural ingredient businesses to try and diversify away from tobacco. These were Universal’s first acquisitions since 2005. Universal has no scale or competitive advantage in the sector, and unsurprisingly the ROI has been poor (just above breakeven segment profits after ~$340mn of acquisitions). The $310mn revenue segment remains a distraction.
  • George Freeman, CEO and architect of the above acquisitions (age 61), is stepping down on the 1^st October 2024 after 16 years as CEO. Note management has minimal skin in the game with consistent insider selling over the last three years.

Valuation and Downside:

Universal has typically traded at 1.1x TBV despite sub-cost of equity returns (and this is where it sits today). Possibly because of the perceived stability of the business and dividend. Net debt should drop by $400mn–$500mn as working capital unwinds, but the fallout from a bad capital cycle may lead to inventory write-downs and weaker profits. A bad capital cycle combined with growing questions around terminal value, along with leverage, mean we could see this on 0.7x a tangible book value that may be 15% lower. So, a return of 40%-45% net of dividends (assuming a dividend cut) over two years. Intrinsic value could be much lower (consider, for example, Dean Foods, Alliance One).

Risks:

The biggest risk is that Universal is acquired by a customer to secure supply if the market remains tight (especially given that Alliance One is struggling with its debt load). But buyers are likely to be price sensitive given the commodity nature of the assets. Moreover, with declining volumes, the sector is less likely to give rise to “strategic” assets.

Catalyst

Poor earnings in the next eighteen months coming out of the other side of the capital cycle, and continued declines in end volumes.