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At first glance, Universal Corporation (UVV) looks like a great stock that has just been tossed under the bus recently. After all, its dividend yield is higher than 5% and its PE is less than 10.

That’s why people say looks can be deceiving. The bulls tout it to be a great opportunity with a sound dividend, but we feel differently after finding some issues in the financial statements. We are rating this dividend booby trap a Pass for three different reasons that relate to its operational efficiency, liquidity levels, & cash flow from operations.

1. Operational efficiency could be an explosive hot potato

When reviewing operational efficiency, the first thing we looked at were items relative to revenue. For example quarterly revenue growth (yoy) looks quite strong, but receivables turnover illustrated that something was off. UVV actually has a low receivables turnover, which isn’t a good thing. Essentially the firm is tying up a good amount of its working capital in AR (Accounts Receivable). Credit-sales look great on the income statement, but it also means the firm isn’t receiving cash at the time of sale.

Next we reviewed inventory items and we saw the same issue. Inventory turnover was very low, which means that a good portion of working capital is being tied up in inventory. What’s worse is the fact that Days Inventory was high. This means that not only is a good amount of working capital being tied up in inventory, but also that it’s not moving off the shelf quickly. In a business where the customer is literally addicted to the product, we wouldn’t expect to find inventory sitting for 146.5 days (Days Inventory-TTM) and/or see this number consecutively increasing over the last three years. Unless UVV is going to start paying out its dividends in the form of tobacco leaves, it needs to improve operational efficiency quick.

2. Liquidity is a real concern

If we were to measure UVV’s ability to repay upcoming obligations by only using the current ratio, then it looks great at 3.08 for the latest quarter. Unfortunately, over half of its current assets consist of inventory; given how long it’s sitting on the shelf, we decided to dig deeper on the subject of liquidity.

The quick ratio came out at 0.95. Normally this isn’t the end of the world, but since the Sales Outstanding number has continued to increase for three years, we were more concerned than normal.

Currently cash and cash equivalents only make up 5.5% of Current Assets. That puts the cash ratio at 0.148 and far below 1. Here is where we start up the liquidity-warning siren. This is because the firm’s Sales Outstanding number (time it takes a customer to pay it back in days) has continued to increase over time as well. The longer it takes a firm to get paid by its customers, the longer it takes the firm to pay its own bills -- let alone dividends. From our view, this isn’t helping the confidence of any dividend investors.

3. Dividend paying ability up in smoke

The coup de grace comes with the dividend coverage ratio. This ratio is Operating Cash Flow (CFO/ Dividend Payment). UVV’s dividend coverage ratio came out less than zero for the nine months ended Dec. 31, 2010. Generally dividend investors become concerned if this number falls below one. In addition, the reason this number came out to be negative is due to the fact that CFO was negative (nine months ended).

The accounting concept here is that if cash being received from CFO is less than the dividends being paid, then the firm isn’t generating enough cash to sustain it. It's guaranteed the firm will pay its bills before it pays out a dividend to shareholders.

Conclusion

The firm currently has a short interest of 15.2% because short sellers obviously smell something funny. The funny smell most likely has to do with them picking up on some of the same things we did when deciding to give it a Pass rating. We do like dividend-paying stocks such as Altria (MO) but currently UVV doesn’t make the cut in our opinion.

Source: 3 Reasons to Avoid Universal Corp.