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October, 2007

U.S. Tobacco Cooperative

Universal Corporation Moves Forward, Leaf by Leaf

By Joseph Finora

The leaf institution positions for future growth.

In this day of consolidations, mergers, and acquisitions aimed at forming international tobacco conglomerates that span continents and time zones, Universal Corporation has long been one of the world’s leading independent leaf tobacco merchants and processors. Founded in 1918 and headquartered in Richmond, Virginia, the low-profile Universal (www.universalcorp.com) conducts business in over 35 countries and most recently, at the close of its last fiscal year on March 31, 2007, had revenues of some $2 bn.

While impressive enough, what’s more striking is that through two world wars, a worldwide depression, natural disasters, and a seemingly constantly evolving tobacco industry, Universal has remained true to its roots, which focus on the selecting, buying, shipping, processing, packing, storing, and financing of leaf tobacco throughout the world. It does not manufacture cigarettes or other consumer tobacco products and most of its revenues come from sales of processed tobacco and related service fees. While it may not be very well known outside tobacco-industry circles, within that world it’s generally a widely admired company.

“Universal has been and still is a great pure tobacco play,” says Mark Hall of Market Street Advisors, LLC in Smithfield, North Carolina, a one-time hub of Universal’s tobacco-processing activity. “The company has operated in Altria’s shadow forever. While it’s always been a dependable leaf pipeline and a very well run, efficient, innovative company, it’s also an agricultural commodity. As tobacco goes, so goes Universal.”

Proof of Universal’s efficiency can be found in its numbers. Revenue for the 2007 fiscal year was $2,007,272,000 up 13% from $1,781,312,000 for the prior fiscal year. Operating income from its continuing operations rose to $164 mn compared to $59 mn in 2006. Results were significantly improved over last year’s largely due to reduced restructuring and impairment costs, as well as improvements in its flue-cured and burley operations—its main businesses. Universal also makes a worldwide market in dark tobacco used for cigars, pipes, and smokeless products. Its dark tobacco operations are mainly located in the United States, the Dominican Republic, Indonesia, and Brazil.

“We are very pleased with our recovery in fiscal year 2007. While it will take time to restore our profitability to prior levels, we have made substantial progress,” Universal’s outgoing Chairman and Chief Executive Officer Allen B. King said in a statement. “Our customers have supported us with margin improvement during this difficult recovery year. We have significantly reduced our debt levels and strengthened our balance sheet, reflecting in part our significant asset sale earlier in the year. We are beginning to see the results of our efforts reflected in reported earnings and better cash flow.”

In the course of its long history Universal became involved in non-tobacco businesses, but recently has been selling them off to better concentrate on its original business line—processing and marketing tobacco leaf. Until late 2006, Universal also had an interest in the lumber and building products business in the Netherlands and Belgium, where its subsidiaries distributed and sold lumber and related construction products predominantly to customers in the construction industry. Its non-tobacco agribusiness included the selection, buying, shipping, processing, storing, financing, distribution, importing, and exporting of numerous products including tea, rubber, sunflower seeds, and canned meats. Universal sold its Dutch non-tobacco business in September 2006 for $547 mn. It recently completed most of a plan to sell its remaining non-tobacco agri-products businesses. Those businesses include trading companies in Richmond, Virginia, and Seattle, Washington, that mostly handle nuts and dried fruits; and a California nut-processing company. These businesses reported combined revenues of about $325 mn and a combined operating loss of approximately $6 mn in the year that ended on March 31, 2006. Its UK line Barrow, Lane & Ballard Ltd., a trading company founded in 1864 in London that markets nuts, dates, and apricots, was sold earlier this year. As part of its divestiture plan, it should have the remainder of its other non-tobacco related lines sold off by the end of its 2008 fiscal year. In addition to generating cash, these sales allow Universal to focus its financial and management resources on its core tobacco business. Proceeds from such non-essential unit sales have been largely used to repay debt. Other sales proceeds may be used to resume repurchasing shares of its own stock.

Similarly, income from continuing operations in 2006 included $24 mn in restructuring and impairment costs related to the closure of its Danville, Virginia, factory. Each of these actions, plus others, helped bolster Universal’s bottom line but analysts question how it will sustain such a cash flow without any substantial non-core assets to sell in the year ahead although absent significant working capital requirements, cash flow appears to be relatively stable.

“Universal’s tobacco strategy involves developing strategic alliances to sustain volume growth and drive long-term profitability,” notes Standard & Poor’s (S&P) tobacco-industry analyst Raymond Mathis.”

Finding New Markets
Universal has been able to benefit from the elimination of trade barriers, especially in East Asian markets. Likewise, the opening of previously closed markets in Central and Eastern Europe have proved beneficial for Universal. As demand for better quality, Western-style cigarettes grows in previously closed markets, Universal should benefit as sales rise from its traditional customer base of worldwide cigarette manufacturers. Herein lies one of the company’s key risks. The narrowly focused Universal, like so many other businesses, has its fate tied to that of its larger customers. Consider that in its 2007 fiscal year, Altria Group provided over 30% of Universal’s revenue. During this time flue-cured and burley tobacco operations provided 86% of company revenue and 82% of operating income. In fiscal year 2006 prior to the sale of non-tobacco businesses, tobacco products furnished 51% of revenue and 78% of profits as lumber and building products supplied 25% of revenue and 20% of profits and agri-products were 24% and 2% respectively. While these businesses did contribute to the bottom line, they were not as profitable as the leaf operations.

“Although we have seen improvements this year from steps we took last year, we continue our efforts to improve our worldwide operations and to eliminate unproductive operations and assets,” said King. “We have made the decision to end our direct involvement in various flue-cured growing projects in Africa and are taking the necessary steps to right-size the operations. Looking ahead, we expect new challenges. We have reduced our Brazilian flue-cured production and the quality of the crop is better, but smaller burley crops in Africa along with higher costs in most of the major producing areas of the world will present challenges for next year.”

Other industry-wide risks are growing as well, such as smoking bans, which currently are impacting the developed world at a rapid pace. An overall greater concern for health matters by both governments and individuals, as well as rising excise taxes, are combining to create less than favorable sales climates in more and more environments. One of the early results of this phenomenon is that it is forcing tobacco companies to become more efficient at generating steady revenue as these forces work to lower overall consumption in traditionally strong markets such as Western Europe and North America. While US tobacco consumption continues to decline at an annual rate of 1-2%, Universal must count on the fact that its customers continue to find favorable conditions in other parts of the world.

Looking forward, S&P’s Mathis is calling for a “sharp revenue falloff” in fiscal year 2008 for Universal, but anticipates later tobacco revenue climbing by some 6% as key markets, particularly in Europe, improve. He also sees some “execution risks” as Universal aims to increase efficiencies at overseas facilities. A weak dollar has had the effect of raising costs overseas but having paid off substantial debt will have the result of less interest expense for Universal. However, if European consumer markets fail to deliver sales as anticipated, Universal’s bottom line can suffer. Similarly, should an oversupply of tobacco leaf hit the markets, should it suffer a year of poor crop quality or political risk in a key geographic country or region, sales may also tumble. Universal, however, has a long history of navigating foreign markets and the risks that come with them. In 1924, capitalizing on growing world demand for tobacco, it organized its foreign subsidiary Universal Leaf Tobacco Company of China. It entered Canada in 1925 as a potential new source of flue-cured leaf tobacco. The move soon turned into a new revenue source. In the late 1940s it expanded into Southern Europe and Africa and during the same period began modernizing its processing facilities in the United States to meet growing global demand for tobacco and started acquiring smaller companies that fit into its long-term growth strategy.

King, looking back on steps taken during the past two years, remains optimistic on the company’s future. “Fiscal year 2008 should not see the same level of impairment and restructuring costs that we have recognized over the last two years,” he said. “We believe that we have been taking the necessary actions to improve our performance for the long term.” For the year ended March 31, 2007, flue-cured and burley operations earned $172 mn, up $73 mn from last year. Results of the North America segment improved by $15.2 mn, and the primary factors causing that improvement were increased export and processing volumes, cost savings related to last year’s closure of the Danville, Virginia, facility, one-time sales of tobacco purchased from cooperatives and better pricing. It also enjoyed a benefit of $8.5 mn in revenue as a result of a South American tax case. Overall, the South America region saw a 9% revenue increase due primarily to higher sales prices. Operating improvements were also noted in African and European operations.

At the end of the day however, Universal is a gigantic agricultural company with nearly all of its fortune tied to one crop. While its widely diverse contracts should help to cushion it from most agricultural catastrophes, depending on one crop will always be risky business. Consider that Universal cut its forecast for global production of burley tobacco by nearly 6% after reassessing crop estimates for Malawi and Mozambique. Malawi’s “crop estimate was reduced by 25 mn kgs as a result of a recent crop survey,” Universal reported while also forecasting a world burley tobacco crop of 657 mn kgs (1.45 bn lbs) in a report filed in late June. That compares with a 698 mn-kg forecast made the prior month as Canadian production is also estimated to fall short.

Universal utilizes a seven-item Supply Chain Integrity Program (SCIP) to assure quality in its products and integrity and responsibility in its practices and work force. Items covered include good agricultural practices to support a sustainable environment, sound manufacturing practices to meet or exceed customer requirements, environmental performance to reduce environmental impact, health and safety, product integrity and traceability to assure product quality throughout its supply chain, and social responsibility programs and industry involvement to monitor such issues as child labor in international agriculture and employee protection.

Changing of the Guard
Allen B. King, 60, Chairman and Chief Executive Officer (CEO) of Universal Corporation, announced his plans to retire as CEO on March 31, 2008. Universal’s board Board of Ddirectors elected George C. Freeman, III, 44, currently President, to succeed King as CEO as of April 1, 2008.

Freeman has been with Universal since 1997 after a career at Hunton & Williams, an international law firm. Earlier, he had been a law clerk for the Hon. Lewis F. Powell, Jr., Associate Justice, United States Supreme Court after graduating near the top of his class from Yale Law School in 1989. Freeman was elected general counsel in November 2005 and President in 2006. King joined Universal in 1969 and was its President for over 10 years and became CEO and Chairman of its Board of Directors in 2003.

“I’ve spent nearly 40 years with Universal and its many talented and dedicated employees, and it has been an honor to lead the Company during the last five years,” said King in a statement. “I am very pleased that George will succeed me as Chief Executive Officer. He has a broad knowledge of all aspects of the company. He and his team are the right group to lead Universal in the future.”

King, after a long career, is leaving Universal after restoring the company to profitability. He’s engineered an internal re-examination of Universal, making the recommendations to sell off non-core assets and focus on what it does best – internationally market tobacco leaf. The company, which occupies a key place in the large-scale tobacco leaf supply chain, is entirely focused on one task with many dimensions to it.


Tobacco International - October, 2007

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