Through The Smoke

Universal Corporation (UVV) is a US based merchant and processor of tobacco leaf. It makes money from buying / selling tobacco, and also from processing fees. Despite its $1 billion small cap size, UVV is one of the world's leading independent tobacco merchants and operates a global business with operations from Brazil to Zimbabwe. While UVV does not make cigarettes, its primary customers are cigarette manufacturers.

As a commodity, the tobacco that UVV buys is subject to cyclical price swings. And at the same time, cigarette manufacturing is dominated by a handful of major players like Phillip Morris and Reynolds. You would think that puts a company like UVV in between a rock and a hard place (volatile input costs and little pricing power). In fact, UVV's management team has already indicated that it expects margin pressures in 2011. In addition, the long-term outlook is clearly not spectacular as regulation has gotten increasingly critical of "big tobacco" over time. All these reasons may have contributed to why UVV has basically gone no where over the last year. Meanwhile the S&P 500 has climbed 10%. Currently trading around $43, I think UVV looks like an attractive long-term opportunity - here's why.

1. While tobacco markets may be volatile, UVV's management has done a good job anticipating changes and has been proactive about managing costs and inventory as needed. As a result, UVV has posted positive earnings and strong cash flow every year over the past decade. With a seasoned management team in place running an operation that has been around since 1918, there's no reason to assume the company will not continue executing.

2. UVV is in good financial condition. Low levels of debt, plenty of cash, and available credit facilities add up to high levels of liquidity, solvency, and financial strength.

^{_{Source: Standard & Poor's, Thomson Reuters, MSN Money}}

3. UVV looks undervalued, UVV is trading at a discount to its fundamentals relative to peers. My estimate for fair value based on normalized P/E, current P/B, and discounted cash flow is $50 - $55.

Source: Standard & Poor's, Thomson Reuters, MSN Money

4. Longer term, UVV's customers will surly face continued regulatory challenges. However, the short term outlook seems benign for now. Currently, I see no major regulatory obstacles over the next twelve months. And let's face it, given the sticky nature of "big-tobacco's" products, demand is probably not going to fall off a cliff anytime soon.

5. Throw in a 4%+ current dividend yield that's only about 30% of earnings with a history of steady payouts, and I think we have a pretty good story here.

Critics will point to recent disappointing revenue numbers and cautious company guidance. While those concerns are valid, I think they have already been discounted into the current price. And more importantly, I think they are also temporary. As long as the company has the financial strength and managerial competence to weather passing storms (which it appears to), its stock price should end up trading at a valuation that better reflects its fundamentals.

I realize tobacco stocks may not be for everyone, and I'm not endorsing anyone's product. I'm just sharing my objective evaluation of a business based on the numbers. The bottom line, I think UVV is currently a good buy at $43 or better.

_{* Disclosures: Victor Lai, Bellwether Capital Management LLC, and/or its clients currently own UVV common stock. This does not constitute investment advice, investors should perform their own due diligence and/or consult with their professional advisors before taking investment action.}