Universal Corp (UVV 0.08%) is something of a misunderstood company. For this reason, investors tend to look toward Reynolds American (RAI) or Lorillard (LO.DL) as their play on the tobacco sector. That's why in this piece I'm going to try and explain what Universal does and how the company is a great fit for any income-seeking investor.
Universal knows what it's doing
Founded back in 1918, Universal has become a world leader in the supply of tobacco leaves to major industry players. And it's taken a while to get here; Universal has built up a network of farmers, distributors, and customers, all of which rely on the company's logistical supply network to get the tobacco to factories in time.
For this international network, Universal employees 25,000 farmers. It is responsible for around 40% of Africa's tobacco production, 30% of North America's production, and 25% of Brazil's production. Think of Universal as a middle man and an essential service for farmers; Universal buys their crops, process the tobacco, and then sells it on to big tobacco companies.
Furthermore, Universal's customers are no small players; the company's biggest customers are Philip Morris and China Tobacco, the two dominant forces in the global tobacco market. These two behemoths account for 58% of the global market.
Actually, this is really important, as China Tobacco is a state-owned company. Therefore, Universal is the only way private investors can get any real access to the domestic Chinese tobacco market -- the fastest-growing tobacco market in the world. Indeed, between 2012 and 2015, it is expected that the volume of cigarettes sold within China will have increased by 1.5% to 2.5%, and Universal is set to benefit from this.
It's not all good news
Unfortunately, as Universal is involved in growing tobacco, its business is somewhat seasonal due to the nature of crop timings, drought, yields, etc. As a result, income and revenue are somewhat unpredictable and revenue has not really grown over the past five years. The company's profit margin before interest and taxes has also varied from 10.3% to 7.4%.
Nonetheless, Universal is an extremely well-managed company, and a robust free cash flow more than makes up for lackluster income expansion. Free cash flow has been in the region of $189 million to $269 million per year for the last five years. In addition, net debt to equity is low at only 32% compared to the tobacco sector average of 100% to 200%.
Moreover, the company has increased its dividend payout every year for the past 43, making Universal one of the market's dividend aristocrats. The company's management authorized aggressive stock repurchases in the period 2008 to 2010, when the market was extremely depressed; this shows that management is using investor cash wisely and is not throwing it away repurchasing expensive shares.
If you can't beat them, join them
However, one of the most disruptive technologies to emerge during the past decade is the electronic cigarette, which poses a huge threat to Universal's business model.
As the saying goes, though, if you can't beat them, join them. That's exactly what Universal has done. Universal's subsidiary, Virginia Tobacco, has joined with Avoca, one of the world's premier botanical extraction companies, to form AmeriNic. AmeriNic's goal is to produce liquid nicotine for the electronic-cigarette industry. The company is focusing on producing high quality, United States Pharmacopeia- grade liquid nicotine using fully traceable and compliant tobaccos.
This partnership is a really exciting endeavor for Universal. Expansion into electronic cigarettes opens up a huge new market for Universal, allowing the company to benefit from the global drive by all major tobacco companies to bring electronic-cigarette offerings to market. With every tobacco company trying to get in on the act of electronic-cigarette production, Universal should be able to easily acquire customers.
This should drag Universal into the 21st century, bringing it into line with domestic peers such as Lorillard and Reynolds American, both of which already have electronic-cigarette products on the market.
The competition
Lorillard's electronic offering comes in the form of blu eCigs, which held a 47% share of the domestic market throughout 2013. Sales of blu totaled $230 million during 2013. Sadly, Lorillard reported a net profit of zero for e-cigs for full-year 2013 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 did not count toward Lorillard's total net income of nearly $1.2 billion for 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 electronic cigarette Vuse, which has limited distribution.
Foolish summary
So all in all, Universal is an integral part of the global tobacco supply network, offering exposure to the still-expanding Chinese cigarette market. Additionally, Universal has been paying and increasing its dividend for 43 consecutive years, a record that is tough to beat. Management has also undertaken well-timed buybacks. Overall, Universal's dominant market position and cash returns are something investors should be interested in.
