This Tobacco Stock is Blowing Nothing But Smoke

By Tom Gibbs - May 7, 2012 | Tickers: AOI, ITYBY.PK, LO, PM, UVV | 0 Comments

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Tobacco stocks have historically showcased several key characteristics that have made them attractive additions to any portfolio.  The goods are created from a renewable resource, they cost pennies to make and sell for many multiples of their input costs, and garner an unmatched level of consumer loyalty.  As such, players within the industry have generally enjoyed ever-increasing top lines as the worldwide population has grown, and a meaningful level of free cash flow that has been used to please shareholders with programmed dividend hikes. 

Despite the recent headwinds that the industry has faced over the past several years – overabundance of leaf supplies, reduced consumer spending, ever-increasing cigarette regulation and taxes, heightened awareness in emerging nations of the products’ negative effects – it can generally be predicted that tobacco products, and the companies that produce them, are here to stay and will continue to generate billions of dollars in annual revenues for the far foreseeable future.  The same, however, cannot be said for all players within the worldwide tobacco industry, as multiple headwinds continue to pound the market’s middlemen.  Alliance One International (NYSE: AOI), a leaf merchant operating between crop farmers and the end product producers, continues to face hardship even as the general economic conditions underlying the tobacco industry slowly improve.

• Debt
• The operations of a leaf merchant are inherently capital-intensive, as larger players including Alliance One and close competitor Universal Corp. (NYSE: UVV) have significant investments in tobacco processing plants in many of the world’s largest tobacco producing nations.  Likewise, the corporation faces the additional working capital burden of making advancements to its less capitalized growing partners.  The supply of seeds, fertilizer, pesticides, and other products related to the growing of tobacco to these suppliers requires leaf merchants like Alliance One to be highly reliant on long term debt to ease the seasonal working capital fluctuations.  Over the past several years, however, the indebtedness has greatly crippled profitability – total long-term debt has increased 60% over the past twelve quarters, and interest coverage (operating income/interest expense) has decreased by more than 45% over the same time period.  The coverage of interest expense has been marginally over 1x over the past several quarters, and as the corporation continues to devote large amounts of capital spending in right-sizing operations and growing into new markets, the total debt burden has little chance of easing anytime over the mid-term. 

• Inventory Management
• Although tobacco inventories almost always have enough end-product demand to ensure that crops will not go unsold, this does not imply that inventories are not subject to markdowns due to changes in market spot prices or obsolescence (crops are not an imperishable commodity).  After topping $1 billion in the first quarter of this fiscal year, the growth of Alliance One’s inventories have been driven by factors that are largely out of the company’s control.  Large amounts of inventory have built up, for instance, due to shipping delays in Malawi and other African nations that stem from limited trucking availability.  Inventories in the most recent quarter were 30% greater than the comparable period in 2011, and the corporation makes it known in its financial filings that a meaningful portion of the inventory has not yet been committed to specific buyers.   A repeat of the $15.4 million inventory write-down in 2011 is not an unreasonable outcome in the coming quarters. 

• Vertical Integration
• Among the most troubling shifts in the worldwide tobacco industry is the ever-changing dynamics of the industry’s supply chain.  Unfortunately for players like Alliance One and Universal Corp., the middlemen leaf merchants tend to have significantly less supply chain control than larger end-product producers including Philip Morris (NYSE: PM), British American Tobacco, and Imperial Tobacco Group (NASDAQOTH: ITYBY.PK).   In order to better handle leaf supplies and costs, as well as to enhance their expertise in leaf procurement, for example, several of these larger players have recently made proactive moves to sidestep the leaf merchant services and directly procure leaf from local farmers in certain markets.  Although there is a very minimal risk that the leaf merchant role will become completely obsolete in the near future – end-product producers still purchase a large bulk of their total supply from middlemen like Alliance One and Universal Corp. – it is worrisome that these corporations’ services can be replaced to a certain extent.  Partially driven by the loss of some of these customers’ business, Alliance One’s revenues have been in free-fall mode after peaking at around $2.4 billion in the four quarters ending in June 2010.  Although larger end-product producers like Philip Morris and Japan Tobacco International seem to have completed their most recent rounds of further vertically integrated operations, there is no guarantee that they will not do so again in the future, taking an even bigger piece away from the middlemen – the incentive to do so has little chance of disappearing.

(in Thousands of Dollars)

Despite the 40+% run up in price since its 2011 low early last October, there are several worrisome headwinds and a lack of meaningful catalysts with known timeframes to make Alliance One an attractive pick in the tobacco industry.  Larger and more influential players within the space are undoubtedly going to be better picks over the mid-term -- Philip Morris and Lorrilard (NYSE: LO) sell for 13.7x and 15.2x next year's earnings and offer 4.7% and 3.5% dividend yields, respectively.  The significant amount of clout the larger end-product producers have within the industry also grants them a much more meaningful ability to control their own destiny as compared to middle players like Alliance One and Universal Corp. As a result, I'm not so sure that any investors should try to take a puff from this cigar butt. 

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