Editor's Note: Buck Hartzell (TMFBuck) manages The Motley Fool's Money Advisor. He also possesses a keen investing mind. He recently produced some research on an intriguing Rule Maker company in a highly profitable (but controversial) market.
What would you pay for a company with these attributes?
- Controls an astounding 75% share of the lucrative -- but slow growing -- smokeless tobacco market.
- Customers are brand loyal and make frequent, repeat purchases. As a matter of fact, it sells over 1.7 million cans of its product each day.
- Generates approximately $500 million in free cash flow (defined as operating cash flow (less tax benefits for stock options) minus capital expenditures) each year.
- For the first six months of 2002, it generated $292 million in free cash flow, or $52 million more than net earnings of $240 million.
- Paid dividends without interruption since 1912, and has increased dividends 36 out of the last 37 years.
- Currently offers a dividend yield of 6% and sports a P/E just over 10.
What kind of cash-generating machine fetches less than 10 times earnings when the average member of the S&P 500 garners a multiple of 25? UST (NYSE: UST), the producer of market-dominating brands such as Skoal, Copenhagen, Rooster, and Red Seal does, yet many investors are loath to invest in a company that makes much of its money in tobacco, even though it is a legal product. In addition to its smokeless tobacco products, UST makes wine and cigars, though the bulk of its sales (87%) and almost all its profits come from its core tobacco business. Let's take a deeper look at this underappreciated stock.
What UST is not
This isn't a fancy growth rocket (4% annualized revenue growth over the last five years). This is not an exciting company that people like to talk about at parties. Perhaps most importantly, this is not a cigarette company.
What UST is
It's a highly profitable company with an excellent track record for earnings and cash flow generation that is priced at a steep discount relative to its industry peers and the overall market. It has well-known brands, market share domination (75%+ of smokeless tobacco sales), excellent gross margins (79%), and a consumer repeat-purchase model that rivals any other non-monopoly company. Of course, the source of this discount is obvious. It is a tobacco company, and out of principle many investors will not invest in it. It also has significant legal overhang. UST lost a $1.05 billion anti-trust verdict in 2000, though it has appealed to the Supreme Court.
Just as important as the anti-trust case is the possibility of ongoing tobacco product liability litigation, including a class action suit that was filed against UST and some of its competitors. I'm not going to ignore those issues, and neither should you. They are clearly risks and the inability by anyone to put a number on the level of liability UST potentially faces is one of the big reasons that its stock trades so far below companies with similar economics.
My guess is that their potential tobacco liabilities are real but nowhere near those of cigarette companies. In addition, the anti-trust settlement has been known for a long time and factored into the stock. While the downside risk in this settlement is quantifiable, I actually believe there's upside if the settlement is reversed or the damages reduced. Either way, they've got the cash flow to cover it.
The bigger picture
Industry experts estimate that there are about 5 million people who use smokeless tobacco in the United States, as opposed to the estimated 40 million to 50 million Americans who smoke. With the crackdown on public smoking, some people will be looking for alternative sources of nicotine. This is a potential windfall for those who can meet their needs, and UST is trying hard to do just that. It recently launched a spitless (yes, spitless) product called Revel to appeal to people who want a source of nicotine but do not consider themselves "dippers." Time will tell whether this or other UST smokeless products become a suitable alternative for smokers.
This company is attractive for its ability to generate cash efficiently over long periods of time. Tobacco is a profitable business, with low recurring capital costs and high gross -- and for well-run companies, net -- margins. Here's a breakdown of the company's numbers for the first half of this year:
First 6 months of 2002 (ended June 30)
Revenues: $807 million
Gross Margins: 79%
Net Profit Margin: 29.4%
Cash to total debt: 0.75
Free Cash Flow: $292 million
Market Cap: $4,500 million (10/11/02)
Price to Free Cash Flow: 7.5
A few things to consider
According to industry statistics, in the U.S. smokeless tobacco is the only tobacco segment that is actually growing. Pipe, cigar, and cigarette usage have been in decline since the mid-1990s, though cigar smoking did have a revival through the latter part of the decade. UST controls 75% of the total smokeless tobacco market, and owns the two top brands: Skoal and Copenhagen. Just as Philip Morris (NYSE: MO) considers itself a brands company, UST spends millions of dollars promoting and defending the position of these two powerhouses. This is a nicotine product, so let's face it, there is plenty of repeat business, and consumers are notoriously brand-loyal in this market.
One more thing: UST currently has a dividend yield of 7.40%. Generally speaking, yields this high are the realm of REITs, or operating businesses that are facing some trouble. UST's dividend yield is a sign of a company that generates enormous amounts of cash but does not necessarily see opportunities to re-invest much of it, so it returns this cash to shareholders.
All told, UST looks like a solid stock that already has the bad news priced into it. When I think of UST, two things come to mind: cash flow and capital preservation. I've been hard-pressed to find a market leading company with similar cash flows, excellent margins, and premium brands priced near the levels UST exhibits today.