Alliance One Is Still Risky, But New Business Lines Bring Upside Potential
- Shares of AOI are up more than double since the company announced plans to expand into new and more profitable business lines.
- The stock still trades at a low valuation though, and it isn't expensive compared to its own historical levels or in relation to Universal Corp.
- Integration risk and high debt levels are weighing on valuation, and the concerns are understandable.
- On the flip side, successful integration should result in shares trading at much higher multiples than they have historically.
Shares of Alliance One International (AOI) are up more than double since the company announced plans to expand into new business lines back in February. Still, the stock trades at low valuation multiples and isn’t particularly expensive compared to where it’s traded historically and in relation to direct competitor Universal Corp (UVV). Successful integration of AOI’s new businesses should see the company close its historical margin gap to UVV, and, in more optimistic scenarios, transition to much higher levels of profitability. But it’s clear the market has its doubts about management’s ability to integrate three new businesses while keeping the core operation running smoothly, and the company’s high leverage ratios add to the uncertainty. A discount is probably warranted in light of these risks, but AOI should trade at a higher multiple if management executes.
Alliance is one of only two publicly held leaf tobacco merchants (the other being Universal Corp), each with similar market caps and global market shares. The company purchases, processes, packs, stores, and ships tobacco to manufacturers of cigarettes and other consumer tobacco products around the world.
AOI operates an extensive international network of processing facilities and holds a leading position in most tobacco regions in the world. The company purchases tobacco in more than 30 countries, with approximately 25% of purchases coming from North America and 75% from other regions, predominately China, Brazil, Turkey, and Africa. The United States is AOI’s largest market but accounted for just 15% of revenues last year, followed by China, Belgium, Germany, Russia, and Indonesia.
Alliance is a major beneficiary of multinational cigarette companies expanding overseas, which has increased the demand for the services of leaf tobacco merchants who can source and process tobacco on a global basis. Yet the level of competition AOI faces has increased as a result of many of these companies integrating vertically, either through the acquisition of existing merchants or contracting directly with suppliers. Today most of the major tobacco companies are at least partially integrated and compete with AOI for the purchase of leaf tobacco products in several markets.
Business Trends and the “One Tomorrow Plan”
Sales volumes have stagnated over the past few years as customers slashed inventory levels in the aftermath of a global supply glut, but unit margins are trending up thanks to lower prices paid to suppliers (and a stronger dollar). Last year’s results were negatively impacted by El Nino, but global growing conditions have improved and volumes and yields are up in most regions for the first 9 months of FY18. But despite the tighter control over cost, Alliance’s average gross profit margin over the last five years is about 250 bps lower than it was between 2008 and 2013.
As is the case for any commodity producer, changes in pricing and cost are responsible for most of the y/y fluctuation in sales and profits. AOI has been able to keep the margin variance within a fairly narrow range, but there’s not much the company can do to materially improve its margin profile.
That is unless it starts selling new products that carry higher margins, which is precisely what the company intends to do with its “One Tomorrow Plan”. AOI is expanding into e-liquids, industrial hemp, and cannabis markets. These product lines generally require a greater degree of processing, so there’s more of an opportunity to add value that AOI should be able to exploit. Gross margins in the 30-40% range are fairly standard for e-cig markers, and marijuana producers had an average gross margin of 19% over the past five quarters, compared to just 13% for AOI.
The other advantage of these businesses is that they are growing faster. Tobacco use is in secular decline in most developed regions, and it will probably start to decline before too long in emerging markets as well. Many consumers who still use tobacco have switched to vaporized e-liquids, which are perceived as safer and cheaper compared to traditional cigarettes, and the cannabis market will continue to expand as more states legalize marijuana and the stigmas associated with pot use go away.
Alliance’s goal is to generate a “significantly higher portion of profit” from its new business lines by 2020, and while it’s impossible to predict the sales mix in a few years’ time with any degree of certainty, any reasonable shift in product mix should translate to somewhere between 200-1,000 bps of gross margin expansion. But even after the recent bounce, AOI still trades in line with its long-term averages and in relation to Universal.
Source: Madison Investment Research
The market seems to be aware that AOI is on the verge of becoming a more profitable company, and yet it doesn’t fully trust management to execute. Integrating three new business lines without tarnishing the legacy operation will be no easy task, but the risk to investors is reduced at this valuation.
High financial leverage is undoubtedly the other factor weighing on valuation. With a current D/E of 4.6 and an average D/E of 2.9 over the past ten years, AOI’s leverage levels more closely resemble those of a bank than your typical commodity producer. Commodity price volatility and financial leverage is a dangerous combination, and the interest payments on this debt swallow up most if not all of the income that AOI generates from operations.
But AOI should, at the bare minimum, close the margin gap (historically about 200 bps) to Universal within the next few years, and could potentially reach much higher levels of profitability if all goes according to plan. Management has made paying down debt a priority (interest expense decreased 5.4% in the latest quarter primarily due to lower average debt borrowings), and AOI should be able to deleverage more rapidly as production shifts to more cash-accretive business lines.
AOI is a high risk/high reward play on the burgeoning e-cig, hemp, and cannabis markets. The company’s performance is largely determined by external factors such as weather and currency swings, and high debt ratios are a big concern. Management’s “One Tomorrow Plan” is ambitious, but it’s what’s required if AOI wants to become a sustainably larger, and more profitable company. Management has a big task on its hands, but successful execution should result in AOI trading at a much higher multiple than it has historically.
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