UVV - Universal Corporation: Stable Business But Growth Is Stagnating

2023-11-28 11:16:43 ET

Summary

• Universal Corporation is a seasoned player in the tobacco industry with a strong position in the global market.
• The company has diversified its operations to include the Ingredients segment, aiming to create additional revenue streams.
• Universal Corporation has demonstrated strong financial performance, with a focus on shareholder returns through dividends and share price gains.

Introduction

Continuing my ongoing series on the tobacco industry, in this article, I turn the spotlight onto Universal Corporation ( UVV ), a seasoned player with roots dating back to the breakup of American Tobacco in 1911. As one of the oldest tobacco companies in the United States, Universal has witnessed and adapted to the industry's evolution, solidifying its pivotal role in the global market.

Throughout its century-long history, Universal has demonstrated resilience. Its largest customer is Altria (Philip Morris USA), which is a testament to its enduring legacy and significant influence in the tobacco supply chain.

Its solid position within the stable tobacco industry has allowed Universal to drive substantial shareholder returns through dividends and share price gains, helping to deliver a decent total return profile.

In today's article, I'll briefly summarize its corporate history and then delve into its latest quarterly results, and offer my insights into its current standing within the tobacco industry.

Brief Company Overview

Universal Corporation operates as a supplier to the tobacco industry, focusing not on the branding of tobacco products but simply on the supply chain by dealing with the procurement, processing, packing, and global sale of tobacco.

Further setting the company apart, and beyond traditional tobacco leaf "roots", it has expanded its operations to include the Ingredients segment. As part of its Ingredients segment Universal produces and sells specialty chemicals and ingredients catering to the flavor, fragrance, food, beverage, and cosmetic industries. This strategic diversification aims to create additional revenue streams beyond conventional tobacco leaf processing.

The company has indicated that it will continue to opportunistically acquire further companies in the plant-based ingredient space as it continues to develop this aspect of the business. However, they note that they will continue to prioritize maintenance of their investment grade credit rating and return excess cash flow to shareholders.

For example, Universal Corporation expanded its portfolio through multiple acquisitions, including FruitSmart, Inc. in 2020, Silva International, Inc. in 2020, and Universal Ingredients - Shank's Extracts, LLC in 2021.

Financial Performance

Looking at the company's latest results, its Q2 2024 earnings call unveiled a strong performance for the year thus far. Operating income expanded by 30% and 46% for the six months and quarter ended September 30, 2023, showcasing the company's financial strength in the face of a challenging macro environment.

Gross profit margins, particularly in the Ingredients segment, were pivotal in this positive trend. Notably, the Tobacco Operations segment demonstrated strong demand for leaf tobacco, while the Ingredients Operations segment showed some improvement too. The result is that its gross profit margin now sits at 18.39% a strong rebound from earlier (though still a ways off from where margins were a year ago).

During the call, management emphasized demand stabilization in its Ingredients Operations segment that occurred in Q2 2024. Management attributed lower results in the first six months due to customers working through excess inventory levels, this may signal a positive trajectory going forward.

SG&A

Selling, general, and administrative expenses increased by $10.5 million for the first half of the fiscal year 2024. Historically, SG&A expenses at the company have closely tracked its overall revenue growth, both are up 6-8% over the past decade.

Debt Management and Financial Discipline

2023 has been a year that's marked by higher interest expenses for companies worldwide, Universal has been no exception to this phenomenon. Total interest expense is now up $16.1M on a quarterly basis, this is nearly triple compared to 2022. I believe this is something investors should certainly keep their eye on, especially in light of continued acquisitions.

Nevertheless, the company managed to decrease net debt levels by about $70 million on September 30, 2023, compared to the same period in 2022, demonstrating a commitment to prudent financial management in the face of volatile rates.

Tobacco Market Dynamics

In navigating the tobacco market, Universal Corporation was resilient amidst a double-digit drop in the domestic cigarette industry volume. The Q&A session underscored the company's global perspective, with the U.S. market representing a small fraction of the overall tobacco landscape.

The company highlighted strong demand for its diverse tobacco product portfolio despite industry challenges. The emphasis on undersupply in various categories and participation in new-generation products indicated a forward-looking strategy, positioning Universal Corporation as a supplier across evolving market segments.

ROIC

Returns on invested capital are a crucial metric for investors, reflecting a company's efficiency in generating profits from its capital investments. A higher ROIC suggests effective utilization of resources, while a declining trend can signal challenges. In the case of Universal Corporation, the company has witnessed a concerning downturn in ROIC since 2010. Starting around 10%, the current figure has dwindled to approximately 5%.

This decline may indicate a diminishing pool of internal growth opportunities within its core tobacco business. The strategic acquisitions in the ingredients space may respond to this trend, highlighting Universal's pursuit of new avenues for durable returns. Investors keen on the company's future performance should closely monitor how/if these acquisitions contribute to revitalizing its returns on invested capital.

Risks

While Universal Corporation's Tobacco Operations segment has historically been the cornerstone of its business, the company faces the inevitable headwind of a slow decline as overall smoker rates decrease.

This shift in consumer behavior prompted a strategic move towards diversification, with a notable focus on the Ingredients segment. However, the journey toward a robust stand-alone Ingredients business is not without challenges. Operational intricacies and the evolving landscape of consumer preferences present new hurdles that the company must navigate.

Furthermore, the Ingredients business contends with heightened competition, as the tobacco industry's stigma is not attached to these products, making success more challenging. As Universal seeks to balance its traditional strength in tobacco with the growth potential in Ingredients, the outcome remains uncertain, requiring careful observation of how the company addresses these challenges in the coming years.

In my view, the greatest risk investors face with Universal is that they may continue to deploy capital into its ingredient business to preserve the company's long-term future at the expense of proper capital allocation. In the end, dividends may be a better use of capital.

Valuation

Valuation is a pivotal aspect of investment decisions, yet successful investing demands a measured approach. While I emphasize the importance of valuation, employing strategies like dollar-cost averaging can help investors navigate short-term fluctuations. Currently, Universal Corporation is trading at a price-to-earnings ratio of 11.5x. Comparatively, this valuation is higher than peers like Vector Group Ltd. ( VGR ) (10.5x) and Altria Group, Inc. ( MO ) (8.5x), as explored in my previous article. Despite recent surges in the stock price, it's noteworthy that Universal remains below its 2017 highs of over $70 per share. While it may be on the higher end of price-to-earnings ratios, as far as tobacco goes, potential short-term momentum may continue into play if market sentiment remains strong.

For those interested in learning more about Vector Group and why I am bullish on that name in particular I would suggest you read the article I put out on that business just this month.

Conclusion

In the end, my stance on Universal Corporation is neutral. The looming longer-term threats in the tobacco industry, coupled with the unproven nature of the Ingredients strategy, give me pause. Its recently elevated stock price poses a challenge for initiating a position though long-term investors might find potential in the company's resilience and innovative growth strategy intriguing.

I rate Universal Corporation a "Hold"

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