While Others Struggle, This Tobacco Company Has Plenty to be Happy About

Universal has a strong balance sheet, and demand for its tobacco is high. Unfortunately, things aren't going as well for Lorillard and Reynolds American.

Jan 31, 2014 at 11:34AM

It is unusual to see a tobacco company that is struggling to keep up with demand. Indeed, one of the biggest threats facing the tobacco industry right now is falling sales, and this something that Lorillard (NYSE:LO) and Reynolds American (NYSE:RAI) are having to grapple with. However, demand for Universal's (NYSE:UVV) tobacco is actually greater than the company has the ability to supply.

Falling yields
Universal is a tobacco-leaf producer that, through its subsidiaries, grows and sells tobacco to the big-tobacco players in the industry. Unfortunately, Universal reported lower sales and revenue for the first half of this year, but these lower figures were a result of a decline in production. Crop sizes were affected within the U.S. by high levels of rainfall, and harvests from South America and Africa came in below estimates -- exacerbating global conditions of undersupply in the tobacco market.

That said, the company notes that crops for 2014 are expected to produce a better yield, and demand for tobacco remains strong -- so strong, in fact, that Universal's management noted within the fiscal second-quarter earnings report that uncommitted inventories remain at extremely low levels.

As I have already mentioned, it is unusual for a tobacco company to be noting such high demand for its products, considering the declining consumption of tobacco worldwide, which reinforces Universal's position as one of the best tobacco industry plays in the market.

Rising sales
Specifically, data from Reynolds shows that the market for pipe and roll-your-own tobacco, which is generally cheaper per equivalent cigarette, has exploded over the same period. For example, during 2006 the annual sales of pipe and roll-your-own tobacco rose from 20 million pounds to an estimated 41 million pounds for full-year 2013.

Universal is seeking to capitalize on this trend and recently embarked on a program to increase its production capacity within Mozambique. Similarly, other smaller-scale projects are currently in development in several other regions to enhance local processing and leaf services. All in all, the company plans to spend $50 million upgrading existing facilities.

Branching out
However, one thing that has been holding Universal back is its lack of diversification -- in particular, its lack of exposure to the e-cig market, the newest and fastest-growing segment of the tobacco market. But now Universal is on the warpath, and one of its subsidiaries has recently struck up a partnership with a premier botanical-extraction company to produce liquid nicotine for electronic cigarettes.

This partnership should drag Universal into the 21st century, bringing it into line with domestic peers such as Lorillard and Reynolds American, both which already have electronic-cigarette products on the market.

The competition
Lorillard's electronic offering comes in the form of blu eCigs, which at the end of the second quarter were available in 30,000 retail outlets and held a 49% share of the domestic market. Sales of blu totaled $177 million for the first nine months of last year. Sadly, Lorillard reported a net profit of zero for e-cigs during the fiscal third quarter due to a higher marketing spend, although for the first nine months of 2013 the company reported income of $9 million. As a result, income from blu only accounted for 0.6% of Lorillard's total net income of nearly $1.6 billion for the first nine months of the year.

Still, with tobacco sales declining, and when marketing costs fall, this could be a lucrative business segment for the company. At the end of the third quarter, Lorillard acquired SKYCIG, a British-based e-cig business .

Meanwhile, Reynolds American is also active in the not-tobacco nicotine sector. Reynolds' subsidiary, Niconovum USA, has entered its first lead market in the United States with Zonnic, a nicotine replacement therapy gum, while another subsidiary, R.J. Reynolds Vapor, has introduced an electronic cigarette, Vuse, which has limited distribution.

Universal is in a better position for falling sales
Universal is used to the irregularities of crops; therefore, the company keeps a relatively clean balance sheet, so there is no obligation to pay large amounts of interest on debt every quarter. In comparison, both Lorillard and Reynolds have been borrowing to buy back stock, to such an extent that Lorillard's shareholder equity is now negative $2 billion (liabilities exceed assets), and Reynolds' balance sheet is propped up with $8 billion of goodwill, without which, or on a tangible-asset basis, the company has negative shareholder equity.

On the other hand, Universal's debt-to-equity ratio is 0.4, and the company's current ratio is greater than 2 (both Reynolds and Lorillard have current ratios of less than 1).

Foolish summary
Universal is a good play in an industry that is otherwise considered to be declining. The company also has one of the best balance sheets in the tobacco sector, so there is plenty of room for additional investor returns.

On the other hand, the financial positions of Reynolds American and Lorillard are fine at the moment, but declining sales could pile on the pressure in future years. All in all, Universal just looks to be the better choice.

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Fool contributor Rupert Hargreaves owns shares of Universal. The Motley Fool has no position in any of the stocks mentioned. 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.

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