Don't Avoid This Leading Tobacco Leaf Supplier Because of Slower Growth
Given a choice between a market leader in a slow growth industry with limited competition and a run-of-the-mill company in a high-growth and intensely-competitive industry, I will always go with the former.
Universal is one of the top two suppliers of tobacco leaf globally, with Alliance One International the only other significant global player. Universal delivered a respectable ROE of 13% for the trailing-12 months, which is an indication of decent profitability in the face of limited competition.
High barriers to entry
Universal has been profitable in every single year for the past decade. The high barrier to entry in the tobacco industry are a key factor in Universal's consistent profitability for a number of reasons.
First, it is difficult to replicate the global supply network that Universal has built up over decades. It will be a challenge for any new entrant to manage the relationships and logistics requirements associated with playing the intermediary role between a large number of tobacco farmers and the tobacco-product manufacturers.
Second, the leaf-tobacco supply business is capital intensive, with significant capital required to be invested in tobacco processing plants. This favors Universal, which is large enough to derive economies of scale via the spreading of fixed costs over a larger revenue base.
Last but not least, the negative perception of the tobacco industry with respect to growth prospects and ethical concerns is also a significant factor in deterring potential entrants.
Concerns over direct sourcing are nothing new
A common reason for a bearish view on Universal is that an increasing number of tobacco-products manufacturers are sourcing tobacco leaf directly from the farmers. In its most recent fiscal 2013 10-K, Universal reiterated that it has not witnessed any increase in direct sourcing by its customers of late and does not expect any increase in direct sourcing in the near future either.
Given the capital-intensive nature and lower profitability of the tobacco-leaf supply business vis-à-vis tobacco-product manufacturing, it does not make economic sense for the tobacco-product manufacturers to engage in full vertical integration and source all of their tobacco leaf needs directly.
Reduced financial risk with de-leveraging efforts
Universal has significantly strengthened its balance sheet over the years through debt reduction and free cash flow generation. As at end of the first quarter of fiscal 2014, its gearing was approximately 0.2, comparing favorably with gross debt-to-equity ratios of 0.4 and 1.0 in fiscal 2012 and 2004, respectively. The significant reduction in financial leverage helped to partially offset some of the risks associated with the high operating leverage inherent in the tobacco-leaf supply business.
Financial review and future outlook
Universal's top line has remained flattish over the past five years, with revenue registering a negative CAGR of 0.9% from 2009 to 2013. Going forward, based on the upper end of forecasts by Philip Morris International in November 2012, global cigarette industry volume is expected to grow by a 2012-2015 CAGR of 1.1%.
Slower growth does not necessarily mean cigarette smokers will disappear altogether. It is more likely that this group of smokers will switch from traditional cigarettes to electronic cigarettes.
Universal has also started investing for the future. It announced in August that it has formed a joint venture with Avoca, a premier botanical extraction company, to produce liquid nicotine for the electronic-cigarette industry. The market for electronic-cigarette sales is expected to cross the $1 billion mark this year, and a study by Bloomberg Industries estimates that electronic-cigarette sales will exceed that of traditional cigarettes by 2047.
Universal's peers includePhilip Morris International and Lorillard , which trade at a premium to Universal with forward P/E ratios of 14 and 13, respectively.
Lorillard is the third-largest tobacco company in the U.S., with its flagship premium cigarette brand Newport the best-selling menthol brand in the country. It reported impressive cigarette volume data for the second quarter of fiscal 2013, with its domestic wholesale shipments flat compared with the second quarter of 2012.
In contrast, adjusted total cigarette industry domestic wholesale shipments fell by 4% year-over-year. However, I am negative on Lorillard given the potential regulatory risks related to menthol cigarettes. The Food and Drug Administration (FDA) sought public input on menthol cigarettes in July, which is a clear indication of future regulatory actions. Despite diversifying into non-menthol cigarettes, it will take time for the non-menthol category to be a significant contributor to Lorillard's top line.
Philip Morris is more diversified than Lorillard in terms of geography. With its products sold in more than 180 markets globally, Philip Morris is less affected by any negative regulatory actions or increased taxation in any single country.
Nevertheless, its financial results for the first half of fiscal 2013 were less than satisfactory, with diluted earnings per share up by 4.6%, excluding currency effects. This suggests that meeting the full-year forecast of a 10%-12% increase in diluted earnings per share will be challenging. The tough economic environment, which encouraged consumers to turn to illicit tobacco products in certain markets, was a key factor for the disappointing EPS growth. My biggest concern with Philip Morris is its weak balance sheet with negative shareholders' equity.
Despite concerns over direct sourcing and slower industry growth, I like Universal for its strong competitive position protected by high barriers to entry and its improved balance sheet. In addition, Universal is attractively valued at 9 times forward P/E, making it a buy in my books.
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notoriety of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.
The article Don't Avoid This Leading Tobacco Leaf Supplier Because of Slower Growth originally appeared on Fool.com.Mark Lin has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.