A Tiny Tobacco Company Earning Big Profits

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Historically, defensive and high yield cigarette companies, such as Altria (NYSE: MO), Philip Morris International (NYSE: PM), Lorillard, and Reynolds American are currently looking slightly overbought as their yields and valuations reach five year highs. Indeed, despite the sell-off in the rest of the high yield sector, these companies have continued to outperform. That said, there is one company that is yet to catch up; tobacco grower and distributor Universal (NYSE: UVV).

As a grower and distributor of tobacco to the major tobacco companies, Universal operates within the same industry but it appears as if investors and the market have almost no trust in the company.

For example, Universal trades at a TTM P/E ratio of 13 and a price-to-sales ratio of 0.5 compared to larger peers, Altria and Philip Morris, which trade at TTM P/E ratios of 17.1 and 17.2, respectively, and price-to-sales ratios 3 and 1.9, respectively. Additionally, Lorillard and Reynolds American trade at TTM P/E ratios of 19 and 14.9, respectively. So, on average, Universal trades at a 31% discount to its tobacco sector peers on a TTM P/E basis and an 80% discount on a price-to-sales basis.

But why is Universal a better investment?

As I have written above, Universal grows and distributes tobacco, which is then sold to tobacco giants like Philip Morris to manufacture cigarettes. This is Universal's biggest strength, you see, while the company does not actually manufacture cigarettes, it would appear that growing tobacco is actually a more defensive industry.

Indeed, it is well known and documented that cigarette consumption around the world is in gradual decline, as consumers realize the negative health consequences. However, the consumption of tobacco, through both smoking and chewing, is actually on the rise and Universal is in the right place to benefit.

According to the Centres for Disease Control and Prevention, global cigarette consumption has been in steady decline, at the rate of between 1% and 5% a year for the last ten years. On the other hand, the CDC notes that the consumption of pipe tobacco and large cigars has risen 482% and 233%, respectively, during the same period and the use of non-cigarette smoked tobacco has risen 123%.

Universal has a strong balance sheet

Universal is fiscally prudent and the company has a much stronger balance sheet than that of its tobacco peers. In particular, peers Philip Morris, Altria, Reynolds, and Lorillard are repurchasing stock financed with debt, currently a sensible idea considering the low interest rates available in the market. However, over the longer term, this could come back to haunt the companies when interest rates start to rise and they need to refinance at higher rates.

In comparison, Universal has been buying back stock with cash on hand, not using debt unless necessary. Indeed, at the end of Q1 this year, the company's net debt position stood at around $130 million, which when broken down, equated to $370 million cash and $500 million debt -- a debt to shareholder equity level of 10%. Furthermore, Universal's current and quick ratios stood at 2.8 and 1.5, respectively, while current assets covered all liabilities both current and long-term 1.7 times.

On the other hand, all of Universal's peers, especially Philip Morris and Altria, are in a much worse financial position. On average, the four major tobacco companies have an average quick ratio of 0.9, and Altria's debt is equal to more than three times shareholder equity. Unfortunately, due to large amounts of borrowing, Philip Morris has negative shareholder equity so a gearing ratio is impossible to calculate.

Cash is king and value prevails

Universal has many benefits over its peers, but one of the more important factors is the company's asset value per share, which currently stands at $44.80, with 35% of this, or $15.78 per share in cash. Currently, trading around $60.70 per share, Universal is trading at a P/B ration of 1.4 -- below the majority of its peers and approaching value territory.

Foolish summary

All in all, Universal presents a compelling investment opportunity in a defensive sector, which for the most part, looks slightly expensive at present. Additionally, the company is still experiencing strong demand for its tobacco, has a strong balance sheet, and trades at a significant discount to its peers in the sector. Moreover, the company is also buying back stock and should continue to return cash and provide capital growth in the future.

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Fool contributor Rupert Hargreaves owns shares of Altria Group. The Motley Fool owns shares of Philip Morris International. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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