Description

AOI VIC    

Description

AOI is one of two global suppliers of dried, processed tobacco to multinational cigarette companies who use the tobacco to make cigarettes and other tobacco products. AOI has an approximate 40% share of the 3rd party tobacco processing market, and a ~20% share of the overall market when factoring in direct purchasing by cigarette manufacturers. AOI (i) sources tobacco leaves from hundreds of farmers (cottage industry) across five continents, (ii) dries, processes and blends the leaves to meet customer requirements, and (iii) ships the finished product to customers around the world. This is a large scale logistics operation that is not easily replicated.

We show the Company’s capital structure below.  The Company has 9.875% 2nd lien bonds due 2021 that are currently trading in the 81 context and yielding 15%.  Leading into the summer, these bonds were trading in the high 80s.  We believe that as the company repurchases bonds, a greater than 30% total return on these bonds over 1 year is quite possible, while at the same time providing substantial downside protection.

Current Situation

In early November 2015, AOI announced an investigation into its Kenyan subsidiary and said that it would delay filing its FY Q2 report.  We show the Company’s statement below from that press release:

The delay is related to discrepancies in accounts receivable and inventory at its Kenyan subsidiary, Alliance One Tobacco (Kenya) Limited, discovered in the course of downsizing and terminating certain operations as part of AOI's previously announced restructuring and cost-saving initiative. Following the planned restructuring, the Company will no longer source Kenyan leaf tobacco, but will continue to process Ugandan-sourced leaf tobacco in a third party Kenyan facility.

Presently available information suggests that the discrepancies may stretch back to 2008 or earlier and could reach approximately $40 million in aggregate.  Because AOI has been unable thus far to determine the timing and amount of these discrepancies, no conclusion has been reached regarding materiality.  It is, however, possible that the discrepancies may prove to be material.  The discrepancies consist primarily of inventory variances that are not yet accounted for, including differences in deferred crop costs, finished goods inventory, green inventory, agricultural supplies, and packing materials. Independent counsel and forensic accountants have been engaged to help determine the nature and timing of the acts that caused the discrepancies and identify the parties responsible. AOI has no evidence indicating similar issues elsewhere within its organization and believes the problems are unique and limited to the Kenyan operation. 

On a side note, we point out that the Company handled this situation quite well in that they put out a press release on Saturday and had an investor call before the market opened to explain the situation and in the context of the whole business.  Nevertheless, the stock and bonds have sold off during the past few weeks.  

We highlight a few key questions that we have asked management:

1. Um, what exactly happened?  

During the growing season, several costs related to growing are capitalized and allocated to various crop inventory accounts.  We believe that this was done improperly in Kenya, eventually leading to an overstatement in inventory and an understatement of COGS (as the inventory was understated).  Ultimately, there may be an overstatement of inventory of up to $40mm in aggregate.  

2. Does this impact guidance going forward?  What about management’s stated interest in repurchasing bonds?

This has no impact on performance figures going forward and no impact on repurchasing bonds as this was to be driven by cashflow generation.  

3. Is this a widespread issue?

No.  The Company has engaged multiple parties to investigate and verify that this is limited to just Kenya.  So far, this appears to be the case.  There was a certain individual who acted as the controller in Kenya.  The errors were discovered after he left his position.  To reiterate, this was not a controls issue stemming out of corporate HQ in North Carolina.  This was a subsidiary level issue, discovered as the sub scale operation was being wound down completely.

4. So should we think of the business as ultimately having $40mm less cash?

Management has pushed back a bit on this assertion, particularly given that the investigation is ongoing.  From our perspective, we think that assuming $40mm of less value is appropriate.

Other than the unfortunate events in November, there have been no negative issues with AOI of late, and arguably only strong positives during the quarter.  Philip Morris (a top customer), came out with strong results in October for both its traditional products as well as for its new smokeless IQOS product (in spite of currency headwinds).  AOI supplies the tobacco for this new product, which actually uses more tobacco per unit than traditional “sticks”.  We show general cigarette consumption trends below:

Source: AOI September 2015 Investor Presentation

We show a slide from a recent investor presentation, which illustrates the recent financial performance of the enterprise.

Source: AOI September 2015 Investor Presentation

AOI Opportunity and Valuation

AOI has leverage that bounces around with seasonality. Using periods at the end of the last selling season, leverage was approximately 5.25x.  Purchasing, processing and selling activities have several associated peaks where cash on hand and outstanding indebtedness are generally significantly greater in FY Q1 and Q2.  The company enters its cash generative period in the next few months.  This is where one of the major catalysts should occur: we anticipate the company will begin to buy back these Notes in the open market. The company has been active in purchasing notes in the past and has been explicit in their desires to do so again. While it would have been nice for the company to purchase these Notes during this latest sell off, the company will say (as will nearly every CEO/CFO we respect), they can’t run their business on a month to month basis to purely satisfy the needs of the short term desires of capital markets. The current season is among the weakest for the company during the year on a cash flow basis.  However, there is a silver lining: the further the Notes fall due to short term liquidity needs of investors, the easier it will be for the company to de-lever.

In the next few months we expect to see the company out in the market providing support to these Notes and cleaning up weak hands. We anticipate the company will purchase at least $30mm of Notes during its fiscal year and potentially as high as $50mm.  After that, when the earnings are released and the buyback is confirmed, it is possible that the rating agencies could become more positive on the credit leading to a substantial price increase and a total return potential of ~40% assuming the Notes trade to a 9% yield over the next 12 months (roughly 32 points from a price appreciation to 103 and 9.875% coupon). The market right now is just not a fan of “CCC” credits, and any move towards getting back towards “B” should lead to significant incremental buy interest from the long only community.

Moreover, we think resolution to the Kenyan situation will relieve additional overhang on the bonds, as lenders / investors will likely see this as a one-off situation and not representative of some endemic problem in the organization.

Downside Protection

We believe the Notes are fully covered, and show an estimated analysis and sensitivity below based on an EBITDA of $175mm.  We would need to see valuation multiples at <6.5x for our value to be impaired (and before factoring in balance sheet assets).  We note that Universal Corp, AOI’s key competitor, trades at +8x EBITDA.  

We take additional comfort in the asset coverage to the 9.875% notes.  We show a table below which incorporates our estimate for cash, working capital and PP&E through FYE 2016 (March 2016) to illustrate the assets underlying the senior secured notes.  We have taken a discount to the face values of these items, including a 25% discount to our inventory value and a 50% discount to AOI’s PP&E/other assets.  We also strip out $50mm of inventory value from our projections, which is more aggressive than the $40mm maximum amount that management has indicated.  With tobacco gross margins in the 12% range, a 25% reduction in inventory would nearly triple gross margins for a purchaser of that inventory stock. Years ago the industry ended up “short” tobacco and AOI as well as its much higher multiple competitor UVV, ended up scrambling for leaf, we believe they may have over $100mm of excess inventory that they can monetize over time (simply by purchasing less going forward) which will allow the company to generate FCF for the next several quarters in excess of simple FCF.

Further, customers want AOI to survive, the merchant tobacco leaf industry is dominated by UVV and AOI, the large tobacco players have little desire to see AOI fail and we believe are a final backstop if necessary. Either way, a very solid simple capital structure provides for substantial downside support in either a reorg or an even rarer safety net: a liquidation.

By our estimate, we believe we believe the 9.875% notes are +90% covered today employing the haircuts noted in the table below.  Coverage improves through March 2016 to over 100% as the inventory is sold down and seasonal debt is repaid.  Employing no discount to the noted balance sheet items, the notes are +1.6x covered over the selected time period.

This analysis is by no means meant to indicate that we anticipate a liquidation, but rather is meant to show that we anticipate significant value underpinning the notes in a far more draconian scenario as liquidations generally produce horrific results for creditors.

Catalysts

There are four catalysts that give us comfort in AOI, which we ultimately think will be paid out at par (this ignores a restructuring which also leads to par):

1. The Kenyan issue is resolved with no major issues in the coming weeks.

2. The Company is implementing a cost cutting restructuring plan that should yield $30-$35mm of cost savings. At a multiple of 7.5x that is worth an incremental +$225mm of implied value beneath our bonds

3. A previous customer that vertically integrated is switching back to buying from AOI and the other main supplier of tobacco leaves.  The exact volume mix is not yet known, but this should be incrementally positive for the company.

4. The company begins the bond repurchase program supporting the bonds and people see the value creation through the following quarterlies..as models are adjusted, interest expense drops allowing more LFCF, allowing for more bond repurchases and further delevering and so on.

Catalyst

see end of write up above