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Tuesday, October 10, 2006

Analyzing Tobacco Industry Trends, Risks & How To Profit From It (MO, REY, UST, UVV & AOI)

By Yaser Anwar, CSC of Stock Market Beat

Litigation risks that have haunted the tobacco industry seem to be lifting alongside downard pressures on tobacco multiples due to the resolution of legal trials and reviews.

However, risks always remain from the litigation side & the decreasing cigarette consumption by 2-4% a year in the US. On the positive side of falling consumption the market has witnessed price increases. Being an ex-smoker I can vouch for the price of Marlboro cigarettes climbing over the past 3-4 years.

Majority of the growth seems to be coming from emerging markets such as China, India & rest of the Asian countries where tobacco companies have been active in acquisitions. Most of the growth in Altria & Reynolds has dried up, although Altria can still climb higher when it breaks up the company. Altria & Reynolds are good defensive stocks which have great dividend yields & are consistent but one cannot look to them for growth.

I'd like to highlight three stocks; two of which I like & the last one I'm not sure about.

1) UST Inc (UST): UST is a highly profitable company with operating & gross margins that are close to 50% & 78% respectively. A reason UST has much higher profit margins than the average tobacco maker because of its focus on smokeless tobacco.The majority of profits come from its Skoal, Copenhagen and Red Seal brands.

UST's objective in the Smokeless Tobacco segment is to continue to grow the smokeless tobacco category by building awareness and social acceptability of smokeless tobacco products among adult smokers.

Management also plans to be competitive in every moist smokeless tobacco category segment. UST its future growth and profitability is in attracting growing numbers of adult consumers, primarily smokers, as approximately every 1% of adult smokers who convert to moist smokeless tobacco represents a 10% increase in the segment's adult consumer base.

UST has some cigar marketing operations, and about 20% of sales are derived from wine marketing. I expect the majority of growth to come from the price value segment, as double digit volume gains will likely outweigh pricing pressure in this category and volume pressure in the premium category.

What I like about UST is that the company lowered its debt by 26% in 2005 & with its share repurchase agreements UST is on track to provide shareholder value.
2) Univl Corp (UVV): UVV is not a cigarette maker but handles tobacco for various cigarette makers. An upside of this is UVV cannot be slapped with legal liability. I expect UVV's tobacco revenues increasing 6% on a recovery in certain European countries and continued strength in tobacco shipments from South America and Africa.

UVV has decided to dispose of 540 million$ worth of non-core assets. The proceeds will likely be used for the retirement of debt and some share buybacks, both of which will be beneficial to the share price in the long term. In the meanwhile, shareholders are rewarded with a 4%+ dividend yield.

The health of major cigarette manufacturers is crucial to the future of Universal Corp.'s primary subsidiary, Universal Leaf Tobacco, the world's largest independent leaf tobacco merchant.

Other than tobacco, UVV is also the holding company for subsidiaries engaged in the lumber and buildings products and agriproducts businesses. UVV aims to become the market leader in these non tobacco businesses by developing their respective niche markets.

Tobacco products contributed 51% of revenues and 85% of operating profits in 05. Lumber and building products accounted for 26% of revenues and 12% of profits, agriproducts for 23% and 4%, respectively. UVV operates in many international markets. In 05 US revenues accounted for 21% of the total, and the Netherlands for 24%.

3) Alliance One Int. (AOI): AOI has lost half its value since the merger with Dimon and Standard Commercial in 2005 due to poor operational performance & integration. Adding insult to injury, AOI has witnessed political problems in some foreign countries as a result of the falling prices of low-quality tobacco.

IMO, AOI is the worst among the tobacco cohort. Other than its managerial malpractices, it doesn't even pay a dividend. Historical precedent suggests that when low margin, high volume wholesale businesses have seen trouble, market forces have led their shares fall hard.
Despite market expectations of a 2-4% decline in consumption for the next few years, I believe industry operating profits will rise due to cost saving efforts and merger synergies that would offset larger investment in focus brands.

Disclosure: I don't own any of the aforementioned stocks

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