Switching To Neutral On Universal Corp.

Summary

• As I demonstrated in my previous missive on this name, I think the dividend is reasonably well-covered. Investors shouldn't expect much growth though.
• The problem is the valuation. I think the market has gotten ahead of itself, and this makes no sense in light of the recent financial performance in my view.
• For those interested in making some kind of return here, I've done well with short puts and I offer yet another such trade below.

After buying small positions in Universal Corp. (NYSE:UVV) on two occasions, I’m basically at a breakeven on the investment, and I thought I’d take another look to decide whether I should finally deploy the capital I had put aside and acquire a full position in this name. I’ll try to make that determination by looking at the financial history and by looking at the stock as a thing distinct from the underlying business. Finally, I want to update investors on my short put strategy with this trade.

I know that you’re a busy crowd, dear readers, and for that reason, I’ll leap right to the point. I’ll write this “summary paragraph” for the individuals who missed the title of this article, and the three bullet points just below the title and landed on this, the second paragraph in the piece. I think Universal is a decent business, and I think the dividend is barely sustainable. I don’t expect much dividend growth going forward, though.

The problem in my view is that the shares are much more expensive now than they were when I last looked in on this name, and that’s bad because history demonstrates that the price you pay really matters. For that reason, I would recommend eschewing the shares at current prices. That said, I’d be very happy to buy these shares at $40, and so I’ll be selling some put options with a $40 strike price.

Financial Snapshot

In my previous missive on this name, I made what I think is a compelling argument to suggest that the dividend is covered, but only just. I made this argument by looking at the size and timing of contractual obligations, and compared those to the company’s resources. I don’t want to go over that well-worn ground again, and I welcome those masochists who want to read two of my articles in a single sitting to check out my earlier work on this question.

In my previous piece, I also noted that revenue has been in long-term decline, and long-term debt has grown dramatically. That said, I think the “revenue is in terminal decline” thesis is simplistic and is at odds with the facts. For example, revenue in 2019 was the highest it had been for several years. This suggests to me that “sales are in a straight line decline because tobacco is unpopular” is a very naive perspective. In addition, while long-term debt has certainly ballooned over the past several years, net interest expense is actually lower now than it was in 2014. The company has quite obviously benefited from lower interest rates. That’s where the (somewhat) good news ends, I’m afraid.

The first nine months of the year were mixed in my estimation. In spite of the fact that revenue was ~$88 million higher in the first nine months of 2020 relative to the same period a year ago, net income was about $4.4 million lower. This was driven primarily by the fact that COGS and SGA were $73.5 million and $8.33 million higher. Many of the companies I’ve reviewed over the past several years have been negatively affected by Covid, obviously. The vast majority of these have managed to reduce their cost structure as a result. Not so Universal, suggesting a risk that is unique to this enterprise. In spite of this, the dividend is 1.3% greater in the most recent period.

The company remains profitable but in some ways that’s beyond the point. The company is a dividend superstar, and the dividend has grown at a CAGR of ~6.3% over the past seven years alone. Although this is quite an impressive feat, this level of growth is in the past in my view, and investors shouldn’t assume this level of growth going forward, though. The payout ratio has been creeping higher for years, and is currently sitting above 115%. I don’t think there’s imminent risk of a dividend cut, but growth needs to slow. This suggests to me that I’d be happy to finally top up my position at the right price.

Source: Company filings

The Stock

I’ve written it, whispered it, shouted it so often that even I am growing tired of experiencing the phrase, so I can only imagine what you’re going through, dear readers. The fact is that a good company can be a terrible investment at the wrong price, and a challenged company can be a great investment at the right price. I’ll drive this point home by using Universal as an example. Although consistent dividend growth has buoyed the stock somewhat, it hasn’t fully insulated investors against loss here.

For example, had an investor bought in February 2017, they’d be sitting on a loss of ~34%. This loss happened in spite of a 42% increase in the dividend since then. Had the investor waited three years to buy, they’d be up 6%. This tells me that the market is willing to sell off the stock in a dividend superstar company, and it tells me that the price paid for an investment is clearly of critical importance. We reduce our risk and enhance our returns when we insist on buying cheap.

If you follow my stuff regularly, dear readers, you know that I determine whether something’s cheap or not in a few ways. First, I look at the ratio of price to some measure of economic value. In particular, I want to see a company trading for a discount relative to both the overall market and its own history. In my previous diatribe on this name, I went on a great deal about the fact that the shares were trading at a very reasonable valuation. They’re currently about 45% more expensive when I last looked in on them, per the following:

Data by YCharts

In addition to looking at the relationship between price and value, I want to try to understand the market’s “mood” about a given company. In order to do this, I turn to the work of Professor Stephen Penman and his book “Accounting for Value.” In this work, Penman walks investors through how they can isolate the “g” (growth) variable in a fairly standard finance formula. The more pessimistic the market is about a given company’s future, the better in my estimation.

In order to apply this approach in this case, I needed to estimate EPS for the next two years. I forecasted a range of forecasts around the current EPS, and came up with a range of implied growth rates for the firm as a result. Applying this approach to Universal suggests that the market is forecasting a long-term (i.e. perpetual) growth rate between ~20-40%, which is egregiously optimistic in my estimation. For these reasons, I can’t recommend buying more at current prices.

Options Update

In my previous rant about this company, I recommended investors sell the February 2021 puts with a strike of $35 for $1.80. These expired worthless, which enhances my overall return on this investment by ~3.5%. I like to try to repeat success when I can, so I’ll be entering another short put trade here, a few weeks after the latest puts expired worthless.

Although I’m not willing to buy shares at the current prices, I think they’re a good buy at $40, and will be selling that strike price. Specifically, the August 2021 puts with a strike of $40 are going for $.80-1.30 at the moment. I think selling these presents a win-win trade. If the investor sells, and the shares remain above $40 over the next several months, they simply pocket the premium as I just recently did. If the shares drop, they’ll be obliged to buy, but will do so at a net price about 27% below the current level. Thus, whatever the outcome, I consider this to be a win-win trade.

I hope that you’re very excited about the prospects of a “win-win” trade, dear readers. The more excited you are, the greater will be my pleasure in bursting the balloon of happiness surrounding the phrase “win-win trade.” I never suggested that I’m a nice person. Anyway, I’ll be popping that bubble by writing about the risks of selling put options. Short puts like every investment ever conceived comes with risk. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risks of share ownership should be obvious to readers on this forum.

I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.

Puts are distinct from stocks in that some put writers don't want to actually buy the stock - they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don't want to own the underlying security. I like my sleep far too much to play short puts in this way. I'm only willing to sell puts on companies I'm willing to buy at prices I'm willing to pay. For that reason, being exercised isn't the hardship for me that it might be for many other put writers. My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you'd be happy to own.

In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.

I'll conclude this rather long discussion of risks by indulging my tendency toward beating proverbial dead horses. I'll use the trade I'm currently recommending as an example. If an investor is exercised on the puts described above, they'll buy Universal at a net price ~27% below the current price. Holding all else constant, this would represent a dividend yield of ~7.75%, which is very attractive in my estimation. Buying at $39.20 is a much more attractive prospect than buying at the current market price, and for that reason, I consider the short put to be less risky than the stock by definition. It may be ironic to write that short puts are less risky than stocks in a section on "the risk of short puts", but it's the truth.

Conclusion

I think Universal is a reasonable business, but the shares are unreasonably priced at the moment. History has demonstrated that it’s possible to lose capital by buying this business at the wrong time, and I think now is very much the “wrong” time. That said, I think there is a way to generate further returns at the moment. It’s possible to sell the right to sell you this stock at a very reasonable price, and I consider that to be a “win-win” trade. If such exotic things are too spicy for you, dear reader, I would recommend avoiding the shares until price falls to match value. For my part, while I’m not going to add to my position, I’m certainly going to sell the puts described above.

Analyst’s Disclosure: I am/we are long UVV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I'll be selling 10 of the puts described in this article this week.