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Executives

Joel Thomas – EVP, CFO

J. Pieter Sikkel – President and CEO

Analysts

Karru Martinson – Deutsche Bank

Hal Holden – Barclays

Ann Gurkin – Davenport & Co.

Bryan Hunt – Wells Fargo Securities

Alliance One International, Inc. (AOI) F3Q 2014 Earnings Conference Call February 4, 2013 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to today's fiscal year 2014 third quarter results conference call hosted by Alliance One International. [Operator Instructions]

I would now like to introduce your host for today's conference call, Joel Thomas, CFO. Mr. Thomas, you may begin your conference.

Joel Thomas

Thank you. To all our stakeholders, we would like to thank you for joining us on our call today. With me this afternoon is Peter Siekel, our President and Chief Executive Officer.

First, we need to cover a few legal disclosures. Our discussions this afternoon will contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based on current expectations of future events. Such statements include, but are not limited to, statements about future financial and operating results, plans, objectives, expectations and intentions, and other statements that are not historical facts. Such statements are based on the current beliefs and expectations of Alliance One's management and are subject to significant risks and uncertainties. If underlying assumptions prove inaccurate, or known or unknown risks or uncertainties materialize, actual results may differ materially from those currently anticipated, expected or projected.

Factors that could cause Alliance One's results to differ materially from those expressed or implied by the forward-looking statements can be found in Alliance One's most recent annual report on Form 10-K and other filings with the Securities and Exchange Commission.

Any replay, rebroadcast, transcript or other reproduction of this conference call other than the replay as provided by Alliance One has not been authorized and is strictly prohibited. Investors should be aware that any unauthorized reproduction of this conference call may not be an accurate reflection of its contents.

Now, our results for the quarter. Total sales and other operating revenues decreased 6.4% to $654.6 million primarily due to a 6.7% decrease in tobacco sales revenues to $621.1 million while tobacco cost of sales decreased 7.5% to $550.9 million. The decrease in tobacco sales revenues and tobacco costs were primarily due to 7.1 million less kilos sold this year as a result of shipments from Brazil, Zimbabwe and China that occurred in the third quarter last year and were experienced in earlier quarters this year or have been delayed. Due to a large increase in South American byproducts sold this year, average sales prices and costs per kilo decreased when compared to the prior year. Processing revenue and cost of services remained consistent with last year. As a result, gross profit increased 0.9% to $83.8 million and gross profit as a percentage of sales improved from 11.9% to 12.8%.

Selling, general and administrative expenses decreased 10% to $30.2 million primarily from reductions in incentive compensation, amortization related to internally developed software and professional fees. Restructuring and asset impairment charges this quarter were the result of equipment charges in Africa and further employee termination costs related to our agreement for a joint processing venture in a foreign location. After the impact of SG&A and restructuring costs, operating income increased 1.6% to $50.1 million when compared with the prior year.

Our interest costs were consistent with the prior year as lower average borrowings were offset by higher average rates while our effective tax rate was 42.7% this year compared to 9.3% last year. The variance in the effective tax rate between this year and last year is primarily related to losses for which no tax benefit has been recorded and the effect of exchange gains and losses.

For the third quarter ended December 31, 2013, net income was $13.3 million or $0.15 per basic share, compared to net income of $21.3 million or $0.24 per basic share last year. Additionally, for the nine months ended December 31, 2013, net loss was $69.6 million or $0.79 per basic share, compared to net income of $8.9 million or $0.10 per basic share for the prior-year period. Included in net loss for the nine months ended December 31, 2013 was expense related to unrecovered farmer advances in Africa, restructuring and asset impairment, and debt retirement. After adjusting for tax, these expenses negatively impacted earnings per basic share $0.80.

Fiscal year 2014 is on track to experience improved volume and revenue versus last year with continued focus on core operating income, driven by solid full-service volume and strong demand for processing services. This is despite pricing for our customers that has not captured the full impact of increases in prices paid to farmers in certain markets.

South American new crop marketing is beginning now, and along with other markets, is following the delayed purchasing trend versus the prior year due to moving into slight global oversupply. These conditions place less pressure on purchasing activities that reflect the largest portion of our costs.

Our balance sheet is well-positioned to meet current global supply conditions with $770.4 million of inventory at December 31, 2013, $137.7 million less than the prior year, while uncommitted inventory is in our stated range with expectations to further decreased levels by fiscal yearend. Working capital improvements, driven primarily by decreasing inventory levels, helped reduce net debt by $115 million, for over -- to over $1,018 million at quarter-end compared to last year.

As of December 31, 2013, available credit lines and cash were $940.8 million, comprised of $303.7 million in cash and $637.1 million of credit lines. In line with our emphasis on reducing long-term debt, we're planning to use up to $55 million of cash to retire our remaining outstanding convertible notes through a tender process during the fourth quarter.

In closing, consistent with our global plan, we will continue rolling out our integrated production system to further enhance our dedicated worldwide supplier base that uniquely positions us to meet customer requirements with increasing demand for higher quality. Our success in these areas combined with our attention to our customers' evolving requirements and our ability to address their longer-term needs cost-effectively should improve our results and enhance long-term shareholder value.

Operator, at this time we'd like to open the call up to questions. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]

And we'll first go to Karru Martinson from Deutsche Bank.

Karru Martinson – Deutsche Bank

Good afternoon. Just to start with, in terms of the Chinese New Year impact, I mean what was it on the quarter and should we get that back in the fourth quarter?

Joel Thomas

Karru, we've not put a specific number out there, but Chinese New Year occurred about a little inside of two weeks earlier this year. And so when you think about the shipping timing from various parts of the world, it had some level of impact.

J. Pieter Sikkel

We -- all of those products that were held up by that had now moved out. But essentially after the 10th of December we couldn't ship to these because of the timing of Chinese New Year and really there being no officials on duty to accept those products in these countries.

Karru Martinson – Deutsche Bank

Okay. And when you guys improved volume and revenue, I mean I think we started the year with kind of with a third leg there, you know, improved profitability as well, certainly hearing the shift here, but continued focus. I mean what's your level of confidence on the improved profitability?

Joel Thomas

Yeah, Karru, there are obviously a lot of moving pieces as we look at the back half of the year with the volumes that we expect to see. And so we're working through that back half of the year with very sizable shipping schedules to meet. And we're keeping our eye very closely on profitability and all the components that can enhance it.

Karru Martinson – Deutsche Bank

Okay. And when you guys talk about less pressure on purchasing activity, I mean does it seem then that you'll be able to capture a greater share of the cost here in the fourth quarter and moving in to fiscal 2015 or am I reading that or hearing that incorrectly?

J. Pieter Sikkel

I think the key here is 70% to 80% of our cost is in green leaf tobacco purchasing, with moving into a slightly oversupply situation. I think one of the issues we've talked about all through the year is with unexpected price increases to farmers or really that occurred throughout the crops in 2013, we see less pressure on those -- on that purchasing as we move into 2014. That obviously reduces our cost and at least of leaves. We remain extremely competitive in terms of our conversion costs. And with that, we see a strong potential to improve our margins as we move into fiscal 2014.

Karru Martinson – Deutsche Bank

Okay. And just on the cash balance, I mean you've done a great job on working capital. If I look at the cash balance, I think we're holding more cash on the balance sheet than I think we have in many, many years. We have that one $55 million [ph] payment made. But what's the use of cash here and why so much on the balance sheet right now?

Joel Thomas

Yeah, Karru, like we've talked about in the past, the timing by which payments come in sometimes precludes us from being able to utilize that cash, so you get into that last day or two right before the quarter-end, and if the cash comes in, you may not be able to apply it to reduce various lines around the world. And what you don't want to have happen is to have that cash get caught in that in-between place related to being transferred to reduced lines. So that's really the driver there.

Karru Martinson – Deutsche Bank

Okay. So that will be a reduction in lines going forward?

Joel Thomas

Yeah.

Karru Martinson – Deutsche Bank

Thank you very much guys.

Operator

We'll now go to Hal Holden from Barclays.

Hal Holden – Barclays

Hi.

Joel Thomas

Hi, Hal.

Hal Holden – Barclays

Yeah. Thanks for taking my call, Joel. I just had three quick ones.

Can you just talk us through what essential translation effect could happen, could be in your numbers going forward, and how it will impact margins, specifically for Brazilian reais?

Joel Thomas

Yeah. A lot of the various developing countries, their currencies have been under pressure as the U.S. dollar has been strengthening. And so we're seeing that in a number of places around the world including Brazil. And so from a dollar perspective, each day that goes by that the Brazilian currency weakens against the dollar, it's helpful on the cost side. And so we'll just have to wait and see how it plays out. It's still early days related to buying activities in Brazil and other countries for that matter as we look out to the next fiscal year.

Hal Holden – Barclays

Second question for Brazil is, I understand it's been very dry there, at least we're hearing that from some of the sugar producers, and I was wondering if that had any impact, if that -- on your expected yields.

J. Pieter Sikkel

I think we got three main growing areas in Brazil, or three states, that we grow tobacco: Santa Catarina, Rio Grande and Parana. We've got excellent growing conditions in two of those, and average growing conditions in the other one. So we're seeing an average to good crop coming on the tobacco side, and no real issues there. There may be a little bit of volume drop-off, but that's not such a bad thing in this situation.

Hal Holden – Barclays

Okay. And then last question, from a big-picture standpoint, if you could talk a little bit about recent change, government actions to kind of reduce indoor smoking, you know, if that changes your overall outlook for long-term demand in that market.

J. Pieter Sikkel

I think we could expect that eventually regulations in China will not only be approved but also implemented, and that's what's going on. And tobacco or cigarettes along with alcohol and various other products have been affected by the government crackdown, particularly on wasteful spending, I think as well. But at the end of the day, we've seen up until the end of October Chinese cigarette consumption continue to increase, I think it grew year over year by 1%. That's a little bit lower than in the past.

And for us, our opportunity with China, the brands that are growing, they still lead the major brands, they contain a considerable portion of imported tobacco. And we see the opportunity too that offshore tobaccos will continue to increase their share of Chinese cigarette production. So the place of growth is not just in the cigarette consumption, it's in the actual share of the cigarette production within the country.

Hal Holden – Barclays

Great. Thank you very much guys.

Operator

We'll now go to Ann Gurkin from Davenport.

Ann Gurkin – Davenport & Co.

Good evening.

Joel Thomas

How are you?

Hi, Ann.

Ann Gurkin – Davenport & Co.

Hi. I'm going to start going back to the SG&A expenses which came in lower in the quarter. I understand the reasons. I was just curious how to think about that SG&A line for Q4 and also for fiscal 2014.

Joel Thomas

Yeah. You know, Ann, kind of going back to the efficiency and cost improvements that were begun back in December of 2010, we're still seeing the impact and benefit from those, as well as some of the other items that we laid out. So it's a very consistent sort of methodical approach to the cost as it relates to overheads. And as we look out to next year, we probably are in a -- we're currently experiencing a run rate that is similar to what we should see next year.

Ann Gurkin – Davenport & Co.

Quarterly run rate, is that what you're saying?

Joel Thomas

Well, the quarter results this quarter don't necessarily define the run rate. If we kind of look at the last 12 months, the last four quarters, we're probably looking at a run rate that is fairly consistent with what it will be next year.

Ann Gurkin – Davenport & Co.

Okay.

J. Pieter Sikkel

But I mean, I think we're very pleased with our control of those costs and we expect to continue to handle those and monitor those and achieve those very strongly going forward.

Joel Thomas

Still looking for opportunities.

Ann Gurkin – Davenport & Co.

Okay, great. Great. You called out the movement for a slight oversupply of leaves. Within that statement, is there any change in customer orders? Are those softer than expected as we now head into the end of the year? Is that a change in the outlook? The oversupply comment seems to be relatively consistent with what we heard back last quarter, I was just curious if there's a change in there from customers.

J. Pieter Sikkel

I mean I think we're starting to get indications in for the next crop, and as we move forward. And oversupply is a mix of the crop size and the customer demand. So really what we've got to start seeing now is where the actual crop size is thought out versus that demand. At the moment I would say we're probably about 5% above demand which is not a bad figure for us to be at. And it doesn't take much. As you've seen, our industry, the cycle that used to be kind of seven years of moving to under to oversupply and back down again now. It really changes through a much shorter cycle and those things can turn around pretty quickly. But in general, I'm probably happy with the situation as it stands.

Ann Gurkin – Davenport & Co.

Okay. Will you look for average selling prices for fiscal 2014 to be uplifting [ph] or is that still a possibility?

J. Pieter Sikkel

That's really very much dependent on the mix of the products and the mix of the countries that comes out. Obviously we're experiencing local cost potential reductions in local currencies and then how that translates through into actual prices. That's going to vary from market to market. Some will go up, some will go down, and the balance of that by the end of the year is hard to tell. But I don't see significant increases in prices in many markets around the year [ph].

Ann Gurkin – Davenport & Co.

Okay. At your Investor Day, Pieter, you all had, if I heard correctly, still targeted operating margins in the range of 13% to 15% long term. Is that still doable or do you think, due to the shortened cycles and maybe pulled out [ph] a lot of costs, I don't know, is that number still doable?

Joel Thomas

I think that the reference that you just made to margins, while we don't provide any specific guidance, right, we have talked about our gross margins historically being either in the range of call it 12% to as high as 17%. And so right now based on where we are, we're working and working our way back up to that 13% level.

Ann Gurkin – Davenport & Co.

Okay. Great.

J. Pieter Sikkel

I think the answer is yes.

Ann Gurkin – Davenport & Co.

I think so too. That's great.

And then can you just tell me what the tax rate for the year, Joel, and reading the Q it seems like a huge number, but is it something else?

Joel Thomas

Yeah. Ann, again what we've talked to is our cash taxes are paid, and if you look on our cash flow statement, cash taxes through the first nine months are just over $13.9 million. And there will probably be another couple of million, to maybe $4 million, that could occur between now and the end of the year. But yeah, the cash rate is heavily influenced by a lot of other factors that bleed through. And so you're right, that tax rate for the full year is hard to work with.

Ann Gurkin – Davenport & Co.

Okay, that's great. That's all I have. Thanks, Joel.

J. Pieter Sikkel

Thank you.

Operator

Our next question comes from Bryan Hunt from Wells Fargo Securities.

Bryan Hunt – Wells Fargo Securities

Thank you and good afternoon.

Joel Thomas

Good afternoon.

J. Pieter Sikkel

Hi, Bryan. Good afternoon.

Bryan Hunt – Wells Fargo Securities

First question, you mentioned on your press release the cigarette volume challenges at some of your customers. Do you believe those are one-off challenges or are those challenges of long-term trends in declining consumption?

J. Pieter Sikkel

I mean I think we've all seen what's been happening over the last year. But I was interested in looking through our latest customer figures and it'll be -- a few others have still got to report. But probably the decline is slowing at this point in time. As we're seeing various customers' results coming out, and I think the trend seems to be -- the trend at the time seems to be on the decline, if you see what I mean there.

But obviously the actual declines for this year I think were somewhat unexpected by a lot of our customers. And when that happens, they might end up with duration increases. They've got to make some adjustments for that as we look forward. And then it depends on the period of time that they take to make that, whether they make that adjustment or they're a single-crop cycle or a multiple-crop cycle, that would make the difference in the orders.

But with the focus on sustainability and security of supply and future supply of tobacco, I think all our customers will take a very responsible approach to that, because it doesn't take a lot to encourage farmers to switch to other crops. And we got to maintain a certain level of crop sizing around the globe. And I have high hopes that our blue-chip customer base in particular will take a very responsible attitude to [indiscernible].

Bryan Hunt – Wells Fargo Securities

When I look at the improvement margins that we've seen, how sustainable is the product mix today, or do you expect a Tier 1 large customer continuing to up-tier their mix of product, do you expect a continuing mix spend [ph] over time?

Joel Thomas

Well, Bryan, we have a very robust customer mix with a number of large customers. And so you then have to layer on what's moved during a particular quarter, and there are quarters where we will have lower margins based on product mix and there will be quarters when we will have higher margins as a result of product mix.

And again I think consistent with what we've been talking about, there's been focus on improvement in margin dollars, and over time margin percentage we're working on improving as well. And so I think it's a very consistent thing.

Bryan Hunt – Wells Fargo Securities

All right, great. And then when I look at your working capital improvement, pretty substantial during the period, with the delay in purchase, do you expect working capital to pop right back up to where it was historically, or should it have some significant impact in inventory because [indiscernible] cost? Can you just talk about what your outlook would be for inventory going forward?

J. Pieter Sikkel

I mean I think we've been very focused on this and we continue to be very focused on this. And certainly our hope as we progress through this year is that we continue to see improvements in that, that's our target. And as we move through future crops, obviously when we're looking at operating cycle and all the other metrics and parts of it, it's a core focus of our company to be absolutely keyed in on that balance sheet, working capital use, and operating cycle. And that will continue. I feel very positive in that area.

Bryan Hunt – Wells Fargo Securities

Yeah. Pieter and Joel -- I mean, Pieter, you just said continued improvement -- continued improvement from where you were today at 770 [ph], the inventory, or continuing improvement on a year-over-year basis? How should --

Joel Thomas

Yeah. Bryan, remember we have the Southern Hemisphere buying that occurs that causes the mid portion of the fiscal year to see increases in inventory levels, and from a volume and dollar perspective. So that will stay consistent. The question becomes, can we see working capital improvements year over year? And that's one of the things that we're working real hard on.

Bryan Hunt – Wells Fargo Securities

Great. And then my last question, last quarter you all had some issues in your processing facilities. I was wondering, have those losses improved or kind of where do you stand on improving those operations?

J. Pieter Sikkel

I think in the value-added products, we've seen a bit of stabilization in the business this quarter. And hopefully that will continue and we'll get back to growth in that area.

Bryan Hunt – Wells Fargo Securities

Very good. I appreciate your time.

Operator

And we'll now go to Karru Martinson from Deutsche Bank.

Karru Martinson – Deutsche Bank

Now just as a follow-up, in terms of the vertical sourcing, we've certainly heard some guys reversing that. I was kind of wondering what you're seeing on that trend and as the market moves into a slight oversupply, will that have any impact on those trends?

Joel Thomas

When you look at what's happened with the partial vertical integration strategies that a couple of our customers started four, five years ago, as we move into the slight oversupply situation that we're seeing now, it really just sort of helps to take pressure, as we mentioned before, off of buying. And it's good for everybody in the marketplace. And when you think about sustainability and what we're trying to do with the farmer today, we think that we're well-positioned and that really again helps to take pressure off of the purchasing, that again should not impact vertical integration one way or the other.

Karru Martinson – Deutsche Bank

Okay. And when you talked about trying to do more with the farmer on the ground, as you look at the charges that you had in the first quarter, the $11 million, how do you feel about your credit standards as we head into kind of fiscal 2015?

Joel Thomas

We've worked really hard in the market where we have that challenge in the first quarter, to beef up our processes, our team on the ground there, and to step forward from those challenges. And we think we're well-positioned moving forward. And we're excited about the future there and believe we got the right team.

Karru Martinson – Deutsche Bank

Thank you very much guys.

Operator

And there are no further questions in the queue, so I will turn the conference back over to Mr. Thomas for any additional or closing remarks.

Joel Thomas

Great. Thank you for joining us on our call this afternoon. The call will remain available for playback for any interested persons through 8:00 p.m. on February the 9th.

Our financial results on Form 10-K as well as other information can be accessed on our website, www.aointl.com. As usual I'm available by phone should anyone have further questions.

Again thank you for participating in our conference call this afternoon.

Operator

This concludes today's presentation. Thank you for your participation.

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