Description

 Trading at 4-5x trailing and forward cash earnings, Alliance One is a solid (albeit boring) business looking to get back on the radar of Wall Street (currently just one sell-side equity analyst and one credit analyst publish on it).  In addition to earnings improving from organic revenue growth and the build-out of lower cost capacity in Brazil, run-rate EPS is poised to grow by 20+% over the next 12-15 months as the interest rate on its seasonal credit lines comes down by 500+bps from peak levels and FCF is used to deleverage (the company is very committed to paying down debt). 

 Fiscal year ends March 31 (FY2010 ended March 31, 2010)  

As illustrated above, FY2010 included unusually high GAAP interest expense as explained below.  Preliminarily, I believe FY2011 EBIT is likely to be similar to FY2010 at this stage but tighter tobacco markets / better pricing and relatively flat SG&A may lead to some upside.  If I'm dead wrong and EBIT declines, the lower interest expense is likely to ensure that cash earnings remain above the $1/share level i.e., stock will be at around 5x earnings in my downside EBIT case.

The company is a tobacco leaf processor and merchant.  This is a relatively working capital intensive business and recently consolidated market in which two companies together control 80%+ of the global market.  The 5.5% converts due 2014 (trading at ~$123) are an even better risk-reward in my opinion, as they enable exposure to share price appreciation (i.e., 10x earnings represents intrinsic value of $200+ on the converts including respective dilution) while offering excellent downside protection as they mature two years prior to the rest of the company's unsecured debt.

Brief company description

AOI finances, purchases, processes, stores and sells tobacco leaf.  Although it buys leaf from 45 countries and sells to customers in more than 90 countries, most of the leaf is purchased in South America (primarily Brazil) and Africa (Malawi, Zimbabwe, etc) and sold into North America, Europe and Asia.  The company has 15 tobacco production facilities in 10 countries.  Approximately 40% of sales (primarily from Brazil) involve the company providing short-term financing (for seeds and fertilizer) and agronomic services to the hundreds of thousands of farmers it buys from.

From the 10-k- "tobacco purchased by the company is processed through a complex mechanized threshing and separating operation and dried to precise moisture levels in accordance with customer specifications (processing of leaf tobacco facilitates shipping and prevents spoilage)."  Cigarette manufacturers make up ~85% of the demand for tobacco.

Tobacco generally comprises a few % of the cost of making a cigarette (the major costs are marketing, distribution and litigation-related expense) but obtaining the right blend of leaf is critical i.e., not all leaf is alike.  The major leaf types are called flue-cured, burley and oriental.  A traditional American blend cigarette e.g., Marlboro, uses all three whereas non-US cigarettes are predominantly flue-cured.  Certain types of leaf can only be sourced from certain markets and so not all flue-cured tobacco, for example, is interchangeable.

Brief industry / market overview

AOI was formed by the mid-2005 merger of Dimon and Standard, the second and third largest leaf tobacco merchants respectively (over $150mm of cost savings have been achieved) and now represents ~40% of the leaf merchant market, with Universal (ticker: UVV) a little larger and representing ~45%.  Integration of Dimon and Standard and behavior of AOI and UVV as effective 'duopolists' took a few years but these companies are beginning to reap the benefits of this with more rational pricing and apparently stable ~15-16% gross margins at AOI (vs 20% at UVV) although smaller players can occasionally have an impact on the market.

A portion of AOI's sales are pure cost-plus arrangements (I believe it is over 25% from discussions with UVV) and the bulk are effectively made as purchase commitments from large, repeat customers where price is not established at the time AOI buys the unprocessed tobacco but the price it receives typically reflects a mark-up as adjusted for currency as well.  As an illustration of the stability of its business / the market, UVV's EBITDA margin over the past 10 years has averaged 11% with an outlier low of 9.4% and outlier high of 13.3%.

Amidst, bans on smoking indoors in public places and tax increases on cigarettes (primarily in the Western world and Japan), the global cigarette market has grown 1.5-2.0%/year in the past several years and been flat to up 0.5% excluding China during this period (some pretty charts on this in the materials referred to below- couldn't paste them into VIC).

More important, the overall trend regarding global tobacco usage growth appears poised to continue in the next several years as cigarette consumption in developing nations (as wealth per capita increases) continues to outpace declines in developed economies (a couple research firms, like Euromonitor, publish detailed projections on this).  AOI's sales to China are likely to continue growing, especially as virtually all of China's purchases of tobacco from the merchant leaf market are premium / more expensive grades (which aren't grown domestically due to climate and other reasons) as I understand it.

One way to get a free overview and updates on the market is to check out the Operations tab on Universal's website (www.universalcorp.com/Include/Menu-Operations.asp)- every piece of research on the subject is vulnerable to a bias of sorts but the Supply & Demand reports are good overviews.  PMI's website/presentations is another way to stay abreast of the global market.  SWM, a cigarette paper company, also makes global estimates of the cigarette market in its presentations.

During recent quarters, solid execution has enabled UVV and AOI to put up good results- despite a soft December quarter (as discussed beneath), AOI's EBIT is up 10% year over year during the first nine months of the current fiscal year.  Various factors contributed to a strong trend in AOI's earnings over the past few years ranging from the completion of an operational restructuring (including dropping/selling less profitable product lines and volumes) to cost control (SG&A is flattish despite sales growth and a new ERP system currently being implemented) and general industry discipline.  It is too early to say whether volumes will grow during FY2011, but the consumer-particularly in emerging markets-having more discretionary income is a meaningful positive.

The company manages its foreign currency exposure with a range of swaps, etc to try to protect its cost structure- the company didn't always have this philosophy and was slightly harmed by the weakening US$ a few years ago.  Mark-to-market accounting of hedges can make quarterly earnings a little noisy but effectively the company is not trying to bet on the US$ weakening or strengthening at this stage.

Sell-side coverage

Only one sell-side equity analyst (Davenport) and one credit analyst (Wells) publish research on the stock to my knowledge.  Although the Davenport price target is $10, the Davenport earnings estimates and valuation appear conservative in that  

• a) management has expressed that they are very comfortable with FY2010 sell-side revenues and EBIT expectations (and too early to comment on FY2011 but AOI likes to keep the bar low).
• b) Davenport uses a diluted share count of 111mm shares (instead of 89mm currently) to reflect dilution from the convert even though (i) the convert is out-of-the-money currently (and interest is counted in the earnings) and (ii) the covered call overlay on the convert prevents any actual dilution to the company below $7.33 (over 40% up from the current stock price).
• c) they use GAAP taxes vs cash taxes and do not provide any value for the NOLs, look at run-rate interest expense, etc.

As an anecdotal indication of how 'underfollowed' these companies are by Wall Street, UVV (a $2bn EV company) canceled its investor day last year due to a lack of interest.

Attractive Free Cash Flow Dynamics

GAAP earnings do not tell the whole story with AOI because

• a) due to a bevy of US and foreign NOLs and various tax structures (e.g., inter-company loans / management fees, etc) and operations in jurisdictions with low tax rates, the company's cash taxes have been $8-15mm/year and are expected to be below $20mm for at least the next few years. While the company is understandably unwilling to make public pronouncements regarding its medium or long-term tax rate, it acknowledges it is unlikely to grow substantially even beyond the next few years absent tremendous pre-tax earnings growth, thus creating a significant, long period of heavy free cash flow to stakeholders. For FY2010, mgmt recently changed its GAAP tax rate guidance to ~4% in the 10-q (due to a complicated change in tax reserves and a reversal in Brazil) so GAAP earnings will more closely approximate cash earnings.
• b) maintenance capex is around $15-20mm (which is roughly what they've been running at recently) vs D&A of ~$31mm. Capex in the next couple years will be close to $40mm as the company is building a new $55mm facility in Brazil (with 70,000 tons of processing capacity) that they believe will have a ~3 year pre-tax payback return, provide tax credits/benefits and begin processing the FY2011 crop.
• c) due to a major refinancing in June/July 2009, the company had various fees, expenses and periods of 'double exposure' in this fiscal year where proceeds from newly issued debt couldn't be used immediately to repay refinanced debt. As broken out in the P&L, in FY2010 the company incurred $40.4mm of debt retirement expenses (paying a premium to retire bonds of $22.9mm, "non-cash accelerated recognition of $16.9mm of debt issuance costs and original issue discounts related to the existing debt", etc). Interest expense also includes some debt amortization costs which is non-cash (but will probably recur in FY2011). These collectively weigh on earnings meaningfully.

Also, I believe that the company's run-rate earnings are just starting to benefit from an annualized pre-tax savings of ~$13mm or around $0.13 of EPS as the weighted average rate on its foreign seasonal credit lines returns to normal.  Effectively, the company's rate went from 4-5%/year in previous years to ~9% in 2009 and as of the March quarter is back to ~4% (the weighted average rate during the past 9 months was 6.2% per 10-q vs 8.6% in the 6 months ending September 30, indicating a major drop in the quarter, as inter-bank lending in those countries normalized and the company locked in better spreads). 

The company also possesses the ability to use its growing cash balance (or ~3% rate untapped $270mm US revolver) to fund working capital needs going forward, so reliance on its foreign lines will decrease. 

In addition, the company has said on earnings calls and investor meetings said it will continue to delever by buying back or calling its most expensive coupon bonds.  Considering the low tax rate at the company, taking out $80-100mm of 10% bonds (a distinct possibility for the next 12 months), ought to mean $0.08-$0.10 of run-rate EPS growth.

Between the deleveraging, the lower interest rate on the seasonal credit lines and getting some of the refinancing fees and non-cash junk out of interest expense, I believe run-rate cash earnings could be up over 20% by the end of  FY2011 (which just began).

Recent Results and Outlook

Channel checks confirm management's comments regarding a tight tobacco market (smaller crop in Malawi due to dry weather and a smaller crop in Brazil to an excessive rainy season which destroyed crops) which I believe will benefit selling prices over the next few quarters.  Another indicator of potential tightness is the amount of uncommitted inventories of tobacco held by leaf merchants- these continue to be at relatively low levels as shown below (and corroborated by AOI's own uncommitted inventories being close to the low end of its $50-150mm range).  

While it is subject to interpretation, it appears to me that PMI, ~25% of the leaf merchant market (a couple large players like BAT have some captive processing which makes PMI disproportionately larger in the traded market), was destocking its tobacco inventories during 2008 and 2009 (in an effort to reduce working capital) which is unlikely to recur to the same extent in 2010/2011.

Oftentimes, shipments will slip from one quarter to the next if there are port issues (delays on shipments don't create a fundamental risk as the inventory doesn't waste but obviously impacts quarterly earnings).  UVV and AOI experienced this dynamic in Malawi as discussed on both earnings calls, and in particular, it appears AOI's shipments of lamina (the higher margin part of the leaf as opposed to stem) were pushed from this quarter to the next.  This generates a tailwind for the March / June quarters' volumes and margins to the extent shipments aren't indefinitely pushed to future quarters.  

The Japan Tobacco Issue

Japan Tobacco (JT), the third largest tobacco company globally and a large customer of AOI (24% of revenue) and UVV announced acquisitions of a few smaller leaf processors in Brazil (Kannenberg), Malawi (Tribac) and US (Hail & Cotton) in the summer of 2009 for $230mm, with potential implications to the leaf merchant landscape starting in 2011 (i.e., will not affect the calendar 2010 tobacco crop significantly from what I can tell).

Given JT's 2007 purchase of Gallaher (a $15bn+ revenue cigarette producer) and that tobacco leaf prices have been rising amidst tighter global supply (particularly as the Chinese have increasingly begun to buy tobacco from AOI and UVV (best grades of tobacco can not be grown in China due primarily to climate, and land restrictions imposed by the government are constraining tobacco production overall), the decision appears to have been motivated by the desire to ensure steady supply of premium tobacco leaf.  In aggregate, JT acquired leaf processing capacity that covers ~25% of its needs and has not stated a desire to further vertically integrate, as corroborated by discussions with industry contacts and JT.

Most important, JT has not done anything to grow tobacco leaf supply i.e. add farmers; rather, it acquired trading and leaf processing capacity for ~25% of its typical requirements.  As the tobacco market is a zero sum game, AOI and UVV are starting to pick up displaced non-JT volume that Kannenberg, Tribac and Hail & Cotton have begun to lose, as those facilities become captive / dedicated for JT (and as companies don't typically prefer to buy raw materials from a competitor).

It is too early to say whether AOI or UVV will pick up more share than the other from these customers, but both appear to be acting rationally regarding the situation and the tobacco market from all indications.  Even if the common wisdom is wrong on the way this plays out, this is a gradual transition that affects ~25% of a 24% customer or ~5% of revenues i.e., a manageable issue over the next couple years.  Thus, whether JT's foray into captive leaf processing is successful or not, AOI expects to do a substantial amount of continued business with JT and similar to the dynamic between other large customers and the leaf merchants, the relationships involved are multi-decades and matter a great deal given AOI and UVV's market share in the leaf market and JT's share in the cigarette market.

Free Option on Food Safety Business

To management's credit, they have looked at whether they can add to earnings with complementary businesses given the processing facilities they own across the globe.  Over the past few years, the company has grown a division it owns called Delta Technology & Software (www.deltatechsoft.com) that it alludes to on conference calls but has been immaterial to earnings.  An IT business, Delta Technology leverages off the expertise the company possesses in handling and processing consumables and provides product compliance and food testing software and consulting.  Delta announced its first major trial with Food Lion (1,300 grocery stores) in early 2010.

While it is too early to ascribe any value to DeltaTech at this stage in my opinion, it is being trialed at several national supermarkets / grocery retailers currently so some value may emerge in 2010.

5.5% converts

The company's converts mature in July 2014, prior to the lion share of the company's debt- senior notes are due July 2016.  Net debt/EBITDA through the converts is under 4x, and over the next 12 months, the company's credit profile will likely improve as already discussed ad nauseam.  Although convertible at $5.028/share, the company entered into a hedging transaction (bought and sold warrants equal to the amount of shares underlying the convert) that effectively increases the conversion price to $7.332 from the company's / equity owners' perspective.

Overall / Valuation

The question becomes at this stage whether Alliance One will indefinitely trade at 4-5x cash earnings, particularly as leverage declines.  With cash earnings of $1.17 in FY2009 and over $1.00 in FY2010 (earnings decline is due to higher interest and taxes, not a lower EBIT), I believe earnings could be $1.25+ in FY2011 as some of the non-cash and non-recurring crap in interest expense clears up and conservatively assuming no EBIT improvement (the new Brazilian facility will mainly impact calendar 2011/FY2012).  We can debate if 7x, 9x or 11x earnings is appropriate, but for a business that organically grew EBIT during 2008 and 2009 (can't think of too many companies that did that) and operates in a duopoly environment with stable / recession-proof demand for its product, an earnings multiple of 4-5x appears wrong.  For reference, UVV trades at ~8x EBIT and at ~10.3x earnings.

A few years ago when the company appeared poised to do ~$200 of EBITDA and debt was higher, the stock traded north of $10 and since then the company's balance sheet has improved and there hasn't been meaningful dilution, and EBITDA is in the $240+ range.  The company is better positioned than before, capital structure-wise, yet trading unusually cheaply on a trailing and forward earnings basis. 

Management says that the focus of 2009 was on the debt, and they are more focused now on getting the share price up so will be more active with investor conferences, etc this year, but while waiting for the world to care about the low 20s% free cash flow yield, this oligopolist is likely to show earnings growth for several years as it pays down ~9% after-tax cost debt and humans continue a 5,000+ year tradition of smoking.   

Catalyst

Continued deleveraging of the balance sheet with heavy free cash flow yield ought to simultaneously force earnings higher and reduce risk perception

Management expects to participate in more equity conferences (was just at Goldman consumer conference in NY) and non-deal roadshows over next several months to get the story out (same as UVV)