Universal Corporation procures, finances, processes, packs, stores and ships tobacco for sale to manufacturers of consumer tobacco products. While it might seem like a bad idea to invest in a declining industry, Universal still provides ample value to investors. More importantly, some of that value comes from a long dividend payment history. Let’s take a look at the business and see why it’s still in our Dream Team and could be in your Emperor portfolio.
What does Universal do?
Universal operates in over 30 countries spanning 5 continents with revenue totaling $2.2 billion for fiscal year ended March 31, 2019. Universal has 3 operating segments:
- Flue cured & burley tobacco (North America)
- Flue cured & burley tobacco (Other Regions)
- Other tobacco operations
Universal procures tobacco by contracting directly with farmers and farmer coops providing financing and agronomy support which the farmers really need. Universal then processes the tobacco leaf and sells the different parts of the plant to a variety of buyers who may be interested in only certain parts of the plant.
Universal’s long-standing customer relationships and understanding of their unique requirements for tobacco style, volume and quality, allow Universal to serve as a trusted partner for the large consumer tobacco companies.
But why don’t cigarette companies procure their tobacco directly from the farms?
The Tobacco Pipe…line
Cigarette companies only spend about 6 cents to make a pack of cigarettes. Lots of work is required to grow and source leaves directly and that work provides a much lower return on capital compared to selling the branded cigarettes to consumers. In addition, flavor and smoking characteristics of tobacco vary based on the type of tobacco and region where the tobacco is grown and the position of the leaf on the stalk of the plant.
Many different styles and grades of tobacco may be produced in a single tobacco crop. A manufacturer may only want and have use for certain leaves of a plant. The leaf tobacco supplier therefore plays a vital role in the industry by finding buyers for all the leaf grades and styles of tobacco produced in a farmer’s crop.
Universal also brings operational efficiencies to the industry, which in turn helps to reduce the costs. These efficiencies include economical utilization of processing capacity, an established and scalable global network of agronomists and technicians helping maintain a stable, productive and sustainable farmer base as well as agronomic and production improvements to optimize leaf yields and qualities.
The Winds are Changing
In the current market structure, a third of the tobacco is sourced directly by tobacco companies and 2/3 is sourced through intermediaries such as Universal. Universal and its largest competitor, Alliance One International, together source 1/3 of all tobacco plants used by tobacco consumer companies.
There has been an increase in the level of direct purchasing, processing & other supply chain services that Universal provides to its customers in recent years. There has also been a reduction in sourcing from lower volume tobacco growing origins by both global leaf suppliers and major manufacturers.
Additionally, the production of “compliant leaf” continues to grow in importance. For leaf to be compliant it must utilize good agricultural practices, which requires significant investment of resources and infrastructure and this favors Universal and Alliance One.
Where There’s Smoke There’s Fire
We have established that Universal performs a valuable function to the tobacco farming and processing supply chain. I believe that most of the decline in worldwide tobacco consumption should not affect Universal too much as they are likely to take market share away from smaller less efficient tobacco suppliers. It is reasonable to expect roughly flat to slightly declining earnings over the next 10 years. Our next concern is the quality of their earnings and the balance sheet. Two issues stand out which are:
- Universal sponsors defined benefit pension plans. I have estimated that Universal’s defined benefit assumptions underestimate net periodic benefit costs by around $6 million. Earnings are overstated and should be adjusted to take that into account.
- Is Universal adequately capitalized? (In other words, do they have too much debt?) Universal’s net debt is $71 million while my conservative estimate of its earning power is roughly $100 million. Therefore, it is well capitalized.
The Smoke Clears
Universal’s earning quality is very high with substantially all reported earnings representing free cash flow. In fact, free cash flow in the last few years has been significantly above reported earnings. Universal exhibits stable and predictable long-term earnings, high earning quality, a seasoned management team, and a leading position in the tobacco supply chain. On the downside, tobacco consumption will continue to decline for the foreseeable future until a normal level of consumption is reached which will have a slight negative effect on Universal over time.
Given these economic characteristics, current interest rates and what you can earn on utility companies, I believe that a 6% to 7% discount rate is an appropriate discount rate and given a conservative estimate of $100 million in earning power with minimal debt, the enterprise should be worth somewhere between $1.4 billion to $1.7 billion. Universal’s shares are on the cheap side of valuation with roughly a $1.4 billion enterprise value.
 1% or less
 Defined benefit pension plans (DBB) are pension plans where the employer pays the employee a fixed salary amount upon retirement based on the length of service and final year salary. These plans used to be the norm for a long time but have since been phased out or are in the process of being phased out in favor of a defined contribution pension plan. DBBs are being phased out because the employer incurs the risk of not setting aside enough money to cover the retiree’s promised payments or investment returns are inadequate to cover the retiree’s promised payment. DBB account is complex, hard to understand, and the assumptions used to calculate the DBB obligations could prove to be too optimistic or pessimistic. I will therefore skip over to how I got to the estimates I will be using below.
 Universal’s debt load is roughly $369 million while cash and cash equivalents total $298 million. $369 – $298 = $71 million
 Easily predictable long term cash flows should lead us to not expect a return much higher than that of utilities
 10-year government bonds near 2%
 Utilities yield roughly 5% while growing earnings inline with inflation of 1.5 – 2%.