By Jason Born, CFA
Buying any business that is already or may be commoditized in the future is always dicey. But it is precisely that fundamental risk that creates opportunities in companies that sell undifferentiated products. Investors consistently over- or under-react to news about the product (be it tobacco, corn, or whatever), which enhances price volatility, thereby increasing the chances that the company may be bought at a bargain.
Today's case in point is Universal Corporation (UVV) one of the world's largest leaf tobacco merchants. To set the stage here, picture buyers from UVV contracting with farmers all over the globe for them to sell their tobacco leaves to UVV. Universal then processes, packages, and supplies the larger, more famous name-brand cigarette companies. In recent years Philip Morris (PM) and Imperial Tobacco (OTCQX:ITYBY) each made up over 10% of UVV revenues.
There are some who have, in the past, tried to compare Universal to its own customers such as PM or ITYBY because they are, after all, in the tobacco business. This is likely always going to achieve the same result. It will always tell you that UVV is undervalued compared to the name-brand peers. Of course it is cheaper when looking at all the typical measures such as PE, PB, PCF, PS if you look at those same metrics for Philip Morris International. Philip Morris has spent billions of dollars over decades building raving fans of its tobacco brands. Most people have never heard of UVV. It is in the commodity business of leaf procurement compared to the biggies with their loyalty or affinity brands.
Now, of late UVV has had some additional competition from its own customers as they have begun to send out their own buyers to tobacco farmers, in an age-old effort to "cut out the middleman." We fully acknowledge this is a possible threat as the efforts may be successful in further pinching UVV's tight margins. We'll just be very conservative, demanding a large margin-of-safety to outweigh such dangers.
We won't compare UVV to PM. UVV has been around since 1918, so let's just simplify things and compare it to itself over time. For our analysis, we will make another conservative, simplifying assumption that going forward the world tobacco market will shrink at about 0.5% per year. We think this is exceedingly reasonable in that UVV has demonstrated a negative annual growth rate of negative 0.2% for the past ten years.
Before we ever even bother looking at the income statement, we dive into the balance sheet. This is rare indeed in our world where quarterly EPS seems to be the holy grail of numbers. But our staid approach fits our staid personalities and likely best serves our staid clients. The balance sheet for UVV is quite solid. Its long term debt makes up only 25% of its total capital. We are kitchen-sink types of guys and gals, so we add in a few of UVV's other liabilities that are long term in nature to come up with a LTD/Total Capital ratio of just over 28% -- not bad at all for a recession-resistant business. The majority of the debt comes due several years into the future (though some is due in 2013) so we should not have to worry about troubled refinancing turning into a liquidity event. Working capital per share is astounding at $56. Get this, if we take each and every liability the company owes, both long and short, and take it away from the current assets to get a "Net, Net Working Capital" per share we get a positive $27. So, despite claims in a posting on this website from 2011, ironically made near the stock price bottom for the company (3 Reasons to Avoid Universal Corp.), UVV has ample liquidity and a very good balance sheet. The dividend is safe, but history shows that cuts and rebuilding in their dividend amount have occurred from time to time.
Operating income for the latest fiscal year covers interest expense by about 8 times, certainly healthy. The number of shares outstanding has been relatively steady for the past decade, so its use of cash to buy back bits of shares to offset any issuance seems a reasonable way to prevent dilution.
The most recent fiscal year revenue was $2.45 billion. Remember we will use a negative 0.5% annual growth rate for their sales. This completely ignores any growth via acquisitions that may occur. We will use a net margin of 4.5% going forward, which is safely in the historical range and even a little conservative. Any efficiency UVV can wring out of the business in the future is not included in this projection. These simplifying assumptions make the math quite straightforward and we do not fear that they escape reality. Over the long run we completely expect these conservative assumptions to be proven correct.
Naming the discount rate is a nasty business, filled with pitfalls and peril. Set too high, meaning too conservative, and the investor stays in cash an awfully long time. If it is set too low, the investor quickly learns the importance of a margin-of-safety - the hard way. Though nearly completely arbitrary and misleading in its presented precision, we calculated a required rate of return for the equity of 9.3% using beta (we'll not bother showing you the inputs as you can make up whatever you want to force the outcome). To sniff test this result, we looked at the company's capital structure. UVV has 6.75% convertible preferred stock outstanding. They also have some borrowings at 7.1%.
We think 9% as the actual cost of equity should suffice and voila, with all the inputs, the equity is intrinsically worth $50.
A final, short-hand double check that our estimate of $50 for the price is accurate involves looking at book value. We treated the outstanding preferred stock on the balance sheet as debt and calculated a book value per share of $42. Since the global financial meltdown occurred, the stock has traded at an average multiple of 1.2 times book, which is lower than the previous five years. If we take the conservative, historical price-to-book of 1.2 times the very conservative book value of $42 we get a value of, $50 for the stock.
We think the stock provides excellent value at its current price. Should the stock grow beyond its intrinsic value we would not hesitate to reduce exposure since it is a company producing a commodity with no real differentiation.