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I was reading Khrom Capital's Q4 investor letter over at My Investing Notebook and was quite impressed with the stock ideas discussed in detail. The author discusses Universal Corporation (NYSE:UVV), a stock I've looked into before as well as its main competitor, Alliance One (NYSE:AOI). Outside of the in-house operations of major cigarette companies, Universal and Alliance One control most of the market for tobacco leaf purchasing and processing. The major cigarette companies buy from them as well. It's pretty much a no-growth business, but it's fairly consistent, generally profitable, and extremely hard to imagine any new competitors. The recent headline scare (1-2 years) discussing how cigarette companies are bringing in more leaf procurement in-house has worried investors and the stocks don't really have high valuations.

Khrom presents a contrarian view in that the leaf merchants play too integral of a part to ever be cut from the supply chain of cigarette manufacturers. I agree. The business has been around for at least 100 years. A couple points not touched on in the letter include that the company (Universal) has increased its dividend every year since 1988 - an indication of a shareholder friendly management and an implicit recognition of the minimal reinvestment needs of the business. I'm also of the opinion that it helps free up working capital on the cigarette manufacturers' balance sheets to optimize them for repurchases and share buybacks. It might not be a huge amount, but just from looking at their balance sheets they are well run operations. While they don't sell an admirable product, they are for the most part well run and shareholder oriented.

The author casually mentions Alliance One, Universal's main competitor. A while back I looked into the stock because I saw that Seth Klarman's Baupost Group had a stake in it. The author notes that the new CEO at Alliance One specializes in turnarounds and restructurings and that the stock is at an attractive level. I agree that the stock is beaten down a lot. The company has been restructuring for years since a merger in 2005 of the second and third largest tobacco leaf merchants which created Alliance One. While this is going to result in a lot of frustrated sellers and create an opportunistic buying environment, it is important to make sure there is something worth buying.

I wouldn't chalk up Alliance One's problems completely to its $760m in debt - not included $240m in notes payable to banks. Debt is part of the operating model because the company needs funds to finance its acquisition of tobacco. The alternative to long term debt would be a revolver with a floating rate. As if just under 2x LT debt to equity were not a prudent capital structure, exposing oneself to the uncertainty of fluctuating interest payments would probably be too much to bear. By comparison, Universal's LT debt/equity ratio is 1:4, which is why it is consistently profitable and is able to raise its dividend and buyback stock (they bought back $100m in stock back in 2008-2009 when the price was lower). Universal's success shows that the business itself is fundamentally sound, but must be conducted with prudent leverage (I apologize if you find the term "prudent leverage" to be offensive).

Thought exercise: If Alliance One didn't have to pay $80m in interest and used all cash to finance its working capital, equity would rise from $415m to $1,175m. The company is not really earning much money right now, so I will use Fiscal 2010 and 2009 as an example when the company earned $120m (excluding debt retirement expense) and $130m, respectively. If they didn't have 80m in interest payments (interest expense was actually higher in these years, but this is just a theoretical exercise), they would have earned $172m and $182m (decrease expenses by $80m, taxed at 35%) on equity of $1,175m. That's a ROE of 15% on the business. That's not bad. Even adjusting for goodwill and restructuring charges, earnings from 2006-2008 were nowhere near that good. The problem is that a business that earns a 15% ROE at its peak is not very attractive, and over the cycle of tobacco leaf prices (whole bunch of other agricultural dynamics that would complicate matters) the company probably isn't doing anything much more exciting than 10-year treasuries. You do have the additional risk of them not being able to move excess inventory or any other numerous operational risks. So clearly a debt free tobacco leaf merchant makes very little economic sense. I apologize if this doesn't make sense, I tried to outline my thoughts step by step. I think the ultimate conclusion is correct. There needs to be some leverage in the capital structure for it to make sense.

Back to reality. As stated in the recent earnings release, Alliance One is seeing downward pressure in tobacco leaf prices which is hurting profits. Another worrisome point is that their the so far in fiscal 2011 are mostly from asset sales which are non recurring. Their cash flow otherwise would not be enough to service the debt if my calculations are correct (less $37m in other income, but adding back in D&A, non cash debt amortization, and restructuring charges). There is cash from operations at ~$33m compared to interest payments of $79m in the past nine months. This is a very crude calculation and I might have missed something, but clearly there are some difficulties to overcome. They have been paying down debt as best as they can, which is encouraging.

Alliance One is a speculation for the aforementioned reasons, and in my case it falls under the "too hard" category. The business is incredibly lumpy. Tobacco leaf is not purchased on a consistent quarterly basis, so cash flows are always going to be erratic. The harvest periods in different regions that Alliance One sources from reach their peaks at different times. For a smart person - i.e. not me - wrapping their head around the cash conversion cycle (the quarterly statements don't really reflect what's going on with the company in a way to calculate the CCC in a way that is truthful or beneficial) of the company might allow them to get comfortable with the risks. The company may very well be currently converting a lot of its tobacco inventory to cash which can be used to service and pay off debt. The situation is definitely worth continuing to pay attention to.

One last note is that a big chunk of the balance sheets of both companies consists of tobacco leaves. On the whole, I think impairment of the stated values are unlikely. This is interesting because in a runoff situation, it could easily be converted into cash. A good chunk of the leaves are slated for delivery to specific parties, so there wouldn't be a huge flood of inventory onto the market. Tobacco isn't exactly a widely traded commodity though, so I don't know how such a scenario would really play out. It is however something to think about.

Source: Alliance One and Universal: A Publicly-Traded Tobacco Leaf Duopoly