Fitch Ratings has affirmed Universal Corporation’s (Universal) Issuer Default Rating (IDR) at ‘BBB-‘. The ratings apply to approximately $419 million of total debt (granting 100% equity credit for Universal’s convertible perpetual preferred shares) presently outstanding. The Rating Outlook is Stable.
A complete list of ratings is provided at the end of this release.
KEY RATING DRIVERS
— Universal, like other agricultural suppliers, is subject to vagaries of the marketplace with the company contending with uncertainties pertaining to weather conditions, crop yields and quality, supply conditions in the industry, and changes to government tobacco policies. Unexpectedly high tobacco prices in Brazil pressured margins during fiscal 2014 contributing to EBITDA margin compression of 280 basis points to 8.5%. An anticipated oversupply situation and a more stable pricing environment will lower raw material costs in the current fiscal year and boost margins closer to a historical average, in Fitch’s estimation.
— Unadjusted debt leverage (total debt to EBITDA) fluctuates with short-term borrowing needed to fund vacillating working capital requirements, specifically tobacco inventories. Universal reduced the debt level by almost $80 million keeping gross leverage for the year ending March 31, 2014 at 1.9 times (x) as earnings were depressed by higher tobacco leaf costs, unfavorable foreign currency effects, and a tough comparison to fiscal 2013 that benefited from higher sales of carryover and uncommitted inventories. Fitch sees Universal’s gross leverage generally falling below 2.0x and funds from operations (FFO) adjusted leverage below 3.0x.
— Universal’s external sources of liquidity act as strength while internal cash flow generation fluctuates due to inherent unpredictability of tobacco pricing that creates volatility in working capital usage. At the end of fiscal 2014, the company had full capacity under its $450 million revolving bank agreements and $342 million of unused uncommitted lines of credit, which Fitch considers a weaker form of support. Access to sufficient liquidity in order to address variable working capital needs is a key credit consideration.
— Universal’s product offering is diversified across key varieties of tobacco – flue-cured, burley, oriental and dark air-cured – as well as geographically. In addition, the company entered new marketplaces over the past year via establishing a partnership in liquid nicotine and a creating a new subsidiary focused on food ingredients. While not meaningfully contributing to overall profitability over the rating horizon, the new businesses provide an entryway into adjacent markets with promising growth potential.
Future developments individually or collectively, that may lead to negative rating action include:
Fitch is comfortable with Universal operating with gross debt leverage around 2.0x at the current rating. However, rating pressure will arise if EBITDA compression and/or a stubbornly higher debt load lead to sustained unadjusted leverage exceeding 2.5x. A prolonged meaningful decrease in profitability may stem from an unexpected fall in demand arising from a loss of key customers, cigarette manufacturer vertical integration, or an unexpected significant secular decline. Lack of FFO coverage of capital spending and dividends, such that meaningful incremental debt funding becomes necessary would also pressure the rating.
Future developments individually or collectively, that may lead to positive rating action include:
Fitch sees no positive rating action over the intermediate term; however, Fitch will favorably view a commitment to operate with total debt leverage below 1.5x, coupled with consistent cash flow generation for multiple years such that FFO margin stays around 10%. In addition, materially increased diversification of the portfolio with the ability to maintain EBITDA margins at 12% is a credit positive.
Leading Global Position In Tobacco Leaf Industry
Universal has the leading position in tobacco leaf procurement, and some modest diversification of its business portfolio. The company is diversified among the varieties of tobacco leaf offered as well as across key tobacco growing geographies. Globally, Universal competes with many smaller suppliers that can offer lower-priced goods due to lower overhead from a lesser commitment to agronomy services, which are a competitive strength for Universal and its main rival, Alliance One International, Inc.
The two tobacco suppliers control approximately 60% of the global supply for tobacco leaf and essentially overlap in major tobacco marketplaces. Universal estimates that it handles 35%-45% of annual production in Africa, 15%-25% of Brazil, and 25%-35% of flue-cured and burley tobacco output in North America. The shared market concentration has brought additional supply/demand stability as the market peaks and valleys of tobacco leaf supply have lessened over time.
Variable Tobacco Leaf Pricing Influences Profitability
Universal, like other tobacco leaf suppliers, is subject to high business risk stemming from agronomic pricing affected by uncertainties including weather conditions, crop yields and quality, supply conditions in the industry, and changes to government tobacco policies. In fiscal 2014, earnings fell $58 million year-over-year from higher tobacco leaf costs, unfavorable foreign currency effects, and a tough comparison to fiscal 2013 that benefited from higher sales of carryover and uncommitted inventories. While Fitch had already anticipated a rough year, operating income of $178 million and EBITDA of $217 million were well below nominal levels of approximately $200 million and $240 million, respectively.
Fitch sees margins rebounding in fiscal 2015 to historical levels as prices should moderate from an oversupply of tobacco leaf in the marketplace, mainly from the U.S. and Europe manufacturers adjusting inventory purchasing to match a decline in cigarette sales in the regions. Fitch believes that pricing will offset stable to declining volume during the year. As such, Fitch expects overall flue-cured and burley leaf margins (including North America) to expand in fiscal 2015 as Universal realizes the benefits of more rational raw material pricing. In addition, the Brazilian leaf market may prove to be more stable this fiscal year, which should contribute to overall EBITDA margin improvement to more than 9%.
Working Capital Needs Fluctuate
Higher priced tobacco leaf also drives increased leverage from increased short-term borrowings, while pressuring cash flows. As such, free cash flow (FCF) can jump from positive to negative almost annually. FCF was negative $81.2 million in fiscal 2014, compared to $172.5 million in fiscal 2013, as greater tobacco inventories increased working capital usage at year-end. Working capital swung to a cash use of $164 million in fiscal 2014 from a source of $12 million in fiscal 2013.
The higher tobacco inventories at the end of the past fiscal year should benefit cash flow upon sale throughout fiscal 2015. Nonetheless, Fitch expects Universal to generate negative FCF in fiscal 2015 for a second consecutive year primarily driven by increased capital spending to $80 million for continued expansion in Africa and construction of a new manufacturing plant for Carolina Innovative Food Ingredients.
Commitment To Investment Grade Demonstrated With Debt Reduction
Universal reduced total debt by nearly $80 million to maintain consistent leverage while earnings were depressed in fiscal 2014. Universal kept gross leverage (total debt to EBITDA) and FFO adjusted leverage for the year ending March 31, 2014 at 1.9 times (x) and 2.8x, respectively, which were below Fitch’s expectations. The debt level of $419 million includes 100% equity granted to $213 million in convertible preferred stock per Fitch’s hybrid security criteria. Fitch sees a relatively steady debt load coupled with higher earnings yielding gross leverage under 2.0x in fiscal 2015. Additionally, FFO adjusted leverage will fall around 3.0x in most years.
Universal’s upcoming long-term debt maturities are manageable given the company’s current sources of liquidity and access to the capital markets. The company’s sole maturity over the next three years is $100 million in 6.25% unsecured medium-term notes maturing in December 2014. Fitch anticipates Universal to refinance the long-term debt maturities.
Tobacco Industry Concentration Drives Customer Dependence
A constant threat to leaf tobacco suppliers’ operational performance is the possibility that the typically concentrated customer base expands vertical integration efforts, essentially bypassing the suppliers’ expertise by negotiating directly with growers. Universal’s top five customers – Philip Morris International, Imperial Tobacco, British American Tobacco, China Tobacco International, and Japan Tobacco – represented more than 60% of revenues over the last four years.
Universal counters the concern through its long-standing relationships with the multitude of tobacco leaf producers. The company maintains and enhances its ties with farmers through experienced local management teams that include more than 800 agronomists and technicians who serve as crop advisors, assisting and training tobacco farmers on all aspects of compliant leaf production. Manufacturers, on the other hand, generally prefer to negotiate with tobacco suppliers rather than dealing with large numbers of farmers in the growing regions around the world.
Solid External Liquidity Backstops Internal Cash Flow Volatility
Universal’s external sources of liquidity are strength while internal cash flow generation fluctuates due to inherent unpredictability of tobacco leaf pricing. The company had full capacity under its $450 million revolving bank agreement maturing in November 2016 and $342 million of unused uncommitted lines of credit at the end of fiscal 2014.
Fitch recognizes the additional liquidity support from uncommitted lines of credit fully backstopped by available capacity under the revolving credit facility; however, Fitch does consider the uncommitted lines to be a weaker form of support. Modest liquidity support also comes from the company’s committed inventory levels that typically represent 80% of total inventory. Access to sufficient liquidity in order to address variable working capital needs is a key credit consideration.
Fitch anticipates no meaningful changes to dividend policy or share repurchase activity over the ratings horizon. Universal has modestly increased dividends for decades and repurchased minimal amounts of common shares over the past years. Last year, the company paid dividends of $46.7 million (not including the $15 million convertible perpetual preferred stock dividend) and had net share repurchases of $13.7 million. Future dividend increases and share buy backs that are not supported by sustained operating income increases or are outside of historical norms, would be concerning.
Fitch affirms Universal’s rating with a Stable Outlook as follows:
–Issuer Default Rating (IDR) at ‘BBB-‘;
–Senior unsecured credit facility at ‘BBB-‘;
–Senior unsecured notes at ‘BBB-‘;
–Convertible perpetual preferred stock at ‘BB’.
Applicable Criteria and Related Research:
–‘Corporate Rating Methodology’ (Aug. 5, 2013);
–‘Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis’ (Dec. 23, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology – Including Short-Term Ratings and Parent and Subsidiary Linkage
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis