Still Avoiding Universal Corp
- The shares are much cheaper on a PE basis now than they were when I last looked at this stock. They're not cheap enough in my view.
- The dividend is barely covered, and the capital structure has deteriorated significantly.
- While I normally like to write put options at this point, the premia on offer for reasonable strike prices don't justify the effort or risk.
It's been about 13 months since I signaled that I was turning neutral on Universal Corp. (NYSE:UVV) in an article with the exceedingly original title "Switching to Neutral On Universal Corp.", and in that time the shares have risen about 4% against a gain of over 7% for the S&P 500. The total return for the stock came in at 11%, though, thanks to the dividend. In this article, I want to revisit the company again to see if it makes sense to buy back in. I'll make that determination by looking at the financial history, paying particular attention to the sustainability of the dividend. I'll also look at the stock as a thing distinct from the underlying firm. Finally, I did well on my two previous options trades here, and I want to use those as yet further evidence to drive home the risk-reducing, yield-enhancing potential of these instruments. If anyone tells me that I'm just using this lesson as an excuse to brag, I'd tell them that they're being cynical and accurate.
In case you're the sort of person who doesn't have time to read headlines, and can't be bothered wasting time on bullet points, but will leap to the 183rd word in an article and start reading attentively at that point, then this "thesis statement" paragraph is for you. It's in this paragraph where I reiterate what someone could have gleaned from the title and from the bullet points but chose not to. The financial history here is either "good" or "bad" depending on your frame of reference. If you compare the latest results to the period just before the pandemic, things look pretty good. If you compare the most recent period to 2014, things look rather bad. This is a business that seems to be in long-term decline. Add to that the fact that the dividend isn't well covered in my view. This suggests to me that the shares need to be quite cheap for us to consider buying. While they're much cheaper than they were last year, they're not cheap enough for me given the above. Additionally, while I normally like to write deep out of the money puts in circumstances like this, the premia on offer doesn't justify the effort and risk in my view. I'm forced to simply wait for shares to drop to a more reasonable price before buying back in.
A review of the long-term financial history here indicates that this is a company that seems to be in long-term decline. For example, revenue was about 22.4% lower in the year just before the pandemic relative to calendar year 2014. Investors should consider this to be a "cash cow" business.
Turning to the more recent history, if the latest financial results are any indication, it seems that the demand for tobacco and tobacco-related products has returned to pre-pandemic levels. Specifically, over the most recent three quarter period, revenue climbed 6.6%, and net income was up an eye-popping 26.5% relative to the same period a year earlier. More interestingly, things look quite good relative to the nine months immediately preceding the pandemic, with revenue up about 14%, and net income up about 8% compared to the time before we were gripped with fears of toilet paper shortages.
It's not all ice cream and animated bluebirds at Universal Corp., though. The capital structure has deteriorated markedly from the period just before the pandemic, with long-term debt up by ~$150 million, or 40%. At the same time, cash increased by about $34.5 million. Different enterprises have levels of sensitivity to rising interest rates, but I'd suggest that even if it's not immediately problematic, rising debt raises the level of risk. Investors need to be compensated for that in my view. All of this puts me in the mood to review the sustainability of the dividend, so I'm about to review the sustainability of the dividend.
I think dividend sustainability is important for two reasons. First, a dividend is supportive of price, meaning that the stock of a company that pays a regular, sustainable dividend has a price floor below which it won't go. The dividend is particularly important for a stock that sports such an illustrious dividend history as Universal. Second, investors like predictability, and there's nothing bad about a predictable injection of dividend cash into your account.
Now, I'm as much of a fan of accrual accounting as any semi-sane person can be, but when it comes to dividends, I remove my "accrual hat" and put on my "cash flow hat" as I compare the size and timing of future cash obligations with the size and timing of current and likely future sources of cash. Let's start by looking at the obligations, shall we? I've plucked the following table of contractual obligations from page 39 of the latest 10-K for your enjoyment and edification. Please note that this table is now over nine months old, so the "2022" column is no longer relevant, as it ended this past March. The company doesn't break down the 2023-2024 periods, so I'm going to make a simplifying assumption and say that they're on the hook to spend about $204 million in each of the next two years, and $165 million in each of the two years after that.
Against these obligations, the company currently has about $99.3 million in cash. Additionally, over the past three years, they've generated an average of about $132 million from cash from operations. At the same time, they've spent an average of $119 million funding the business via CFI activities. This CFI figure was juiced by business purchases, though. If we strip out the $241.9 million spent on such activities, we get a more "typical" CFI figure of ~$38.8 million.
So, to sum up, they're spending about $204 million this year and next. They generate net cash (CFO-CFI) of about $90 million, and they've got about $99.3 million in the bank at the moment. Given all of this, I'm not sure the ~$75 million the firm spends on dividends annually is particularly well covered. I'd be willing to buy, but given the negative long-term growth, and thin dividend coverage, the shares would need to trade at a deep discount in my view.
Some of you who follow me for reasons known only to yourselves are aware that this is the point in the article when I turn into the human equivalent of a damp rag. It's here where I start writing about risk-adjusted returns, and how even the stock of a sustainable dividend machine can be a terrible investment at the wrong price. A company can make a great deal of money, but the investment can still be a terrible one if the shares are too richly priced. This is because all businesses are essentially just organisations that take a bunch of inputs, add value to those inputs, and then sell products or services (hopefully) for a profit. The stock, on the other hand, is a proxy whose changing prices reflect more about the mood of the crowd than anything to do with the business. In my view, stock price changes are much more about the expectations about a company's future. This is why I look at stocks as things apart from the underlying business.
Forgive me as I indulge my tendency to "drone on" about an idea. I feel a need to demonstrate the importance of looking at the stock as a thing distinct from the business by using Universal stock itself as an example. The company released its latest quarterly results on February 2nd. If you bought this stock that day, you're up about 5.8% since then. If you waited exactly one week, you're up 15.4%. Not enough changed at the firm over these seven days to justify a 9.5% variance in returns. The differences in return came down entirely to the price paid. The investors who bought virtually identical shares more cheaply did better than those who bought the shares at a higher price. This is why I try to avoid overpaying for stocks.
My regulars know that I measure the cheapness (or not) of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like sales, earnings, free cash flow, and the like. Ideally, I want to see a stock trading at a discount to both its own history and the overall market. In my previous missive, I fretted that the PE was trading at a whisper under 21. On that basis, the shares are much cheaper per the following:
At the same time that valuations have come down, the yield is reasonably high relative to the historical norm, per the following. The problem is that I think dividend growth is done, and there's a chance that it may actually need to be cut.
In addition to simple ratios, I want to try to understand what the market is currently "assuming" about the future of this company. If you read me regularly, you know that I rely on the work of Professor Stephen Penman and his book "Accounting for Value" for this. In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in a fairly standard finance formula. Applying this approach to Universal at the moment suggests the market is assuming that this company will grow at a rate of ~32% in perpetuity, which I consider to be exceedingly optimistic.
Taking all of the above into consideration, I have to continue to recommend avoiding these shares. I may continue to miss out on the dividends, but I'm of the view that clipping these dividends at the moment is akin to picking up nickels in front of a steam roller.
Options As An Alternative?
In each of my previous articles on this name, I suggested selling put options in lieu of buying shares, and these trades worked out well. Specifically, I sold the February 2021 puts with a strike of $35 for $1.80 each, and then sold the August 2021 puts with a strike of $40 for $0.80 each. These added about 5% to my total returns on the original investment, which highlights the power of short puts once again in my view. The strike on the most recent puts was about 28% out of the money, for instance, which set up what I characterise as a "win-win" trade. Since the shares remained above $40, I simply added the most recent premia to the pile already received. Had the shares fallen, I would have been obliged to buy, but would have done so at a dividend yield of ~7.8%.
While I normally like to try to repeat success when I can, I can't recommend it in this case, because the premia don't justify it. For instance, the November put with a strike of $40 is currently bid at 0. Additionally, I'm nervous about the sustainability of this dividend, and I would suggest that investors not be seduced by the big, shiny yield. There's more risk here, and the current dividend doesn't justify taking it on in my view.
I think the financial history here is either "good" or "bad" depending on your frame of reference. Looking over a longer time horizon, we see obvious decline. When we look at how the company performed relative to pre-pandemic levels, things don't look so bad. My fear is that the shares aren't objectively cheap, and I fear even more that the dividend growth the market has come to expect will soon be "crowded out." I don't think the future of dividend growth will resemble the past, and I think the future will be markedly worse than the past here. For that reason, I would recommend avoiding the name until the price falls to match value. I'll become excited about this stock if and when it falls to $40, but in the meantime, I'll avoid it. I would recommend others do the same.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.