Fitch Affirms Universal Corp.'s IDR at 'BBB-'; Outlook Stable
KEY RATING DRIVERS
Oversupplied Market Conditions are Easing: Universal has navigated two consecutive years of oversupplied market conditions that pressured leaf pricing, depressing revenues in fiscal 2015 and 2016. While global production levels have largely moved into balance with demand, Universal's fiscal 2017 earnings will be depressed due to poor crop size and quality in Brazil.
Gross Leverage has Consistently Remained within Expectations: Unpredictable factors in any given year, such as tobacco leaf diseases and weather, can influence the yield and the quality of tobacco leaf, creating variability in leaf pricing. In addition, annual production levels and end user demand (typically declining) vary and determine supply conditions of key tobacco leaf (flue-cured and burley) across the globe. As a result, EBITDA can fluctuate on an annual basis. Universal has nevertheless consistently maintained gross leverage (total debt/EBITDA) around 2.0x and Fitch expects this trend to continue.
Customer Outsourcing Provides Opportunity: Vertical integration of operations at tobacco product manufacturers has been an ongoing threat to leaf processors; however, the risk may be easing, as indicated by Universal's largest customer, Philip Morris International, which has increased its outsourcing of direct purchasing of tobacco leaf to global suppliers over the past few years. This activity is a reversal of prior efforts by manufacturers to control more of the supply chain, and may prove to be an opportunity with Universal's other large cigarette makers.
Sufficient Liquidity Backstops Volatility: Universal's cash flows can be variable, moving in conjunction with working capital requirements mainly driven by fluctuating inventory costs influenced by tobacco leaf pricing and customer purchasing patterns. As such, access to sufficient external liquidity in order to address variable working capital needs is a key credit consideration.
Tobacco Use Remains in Long-Term Secular Decline: Global consumption of cigarettes continues to trend steadily lower, and is projected to decline at a modest pace for the foreseeable future. Over time, this will lead to lower demand for Universal's tobacco leaf sourcing and processing business.
Fitch's key assumptions within the agency's rating case for Universal include:
--Stagnant 2017 revenues as oversupply of tobacco leaf begins to ease but poor crop output in Brazil pressures volumes. Revenues pick up in 2018 and 2019 as supply stabilizes and volumes normalize;
--Lingering headwinds from oversupply combined with Brazil pressures earnings before more balanced supply environment and return to normal crop yield in Brazil lead to improvement in 2018 and 2019;
--Capital intensity remains elevated at more than 2% in 2017, given investments into its new food ingredients plant, then eases closer to historical levels of 1.6% annually in 2018 and thereafter;
--Overall debt load is fairly stable, including consistent short-term financing of between $50 - $60 million and no term loan amortization
--Leverage increases to 2.2x in 2017 due to earnings decline, and trends lower over the remainder of the forecast period;
--Free cash flow vacillates on working capital swings but remains at least modestly positive through the forecast period.
Fitch sees Universal operating with gross debt leverage around 2.0x within the current rating. Trending of the metric has been negative over the past years as EBITDA has compressed from various marketplace pressures; however, Fitch will grow more concerned when unadjusted leverage exceeds 2.5x on a sustained basis, likely due to negative EBITDA growth trends and/or a stubbornly higher debt load.
While not anticipated over the ratings horizon, a significant and durable decrease in profitability may arise from an unexpected fall in demand arising from a loss of major customers, heavy competitive inroads in key tobacco markets, 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.
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.
2017 EARNINGS PRESSURED BUT TOBACCO LEAF OVERSUPPLY EASING
Universal has navigated two years of oversupplied market conditions, which has pressured revenues and depressed earnings in fiscal 2015 and 2016. The oversupply followed a spike in tobacco leaf production in 2014 after prices jumped from short supplies in the prior year. The resulting decline in tobacco leaf pricing was exacerbated by lower than expected end-user demand during the period. The resulting headwind to revenues stressed Universal's EBITDA, which fell by 6% in 2015 to $204 million. In fiscal 2016, EBITDA rebounded to $223 million, due to higher volumes, cost efficiencies, and improved gross margins.
Global oversupply conditions are projected to improve in fiscal 2017. Production estimates for crops to be sold in Universal's fiscal year 2017 have continued to decline on reduced plantings and the impact of El Nino weather patterns on certain crops, particularly in Brazil. Universal estimates that (excluding China) production key tobacco crops, flue-cured and burley, will fall by 12% and 5%, respectively in fiscal 2017.
While global production levels have largely moved into balance with demand, Universal's fiscal 2017 earnings will be depressed due to the impact of the afore-mentioned weather patterns on crop size and quality in Brazil, where a significant portion of Universal's contracts to purchase tobacco are located. As a result, Universal's Brazilian crop purchase levels and sales volumes, as well as third-party processing volumes, will drop in fiscal year 2017. While the company expects Brazilian crop levels and its volumes there to recover in fiscal year 2018, Fitch notes that the inherent unpredictability of future weather patterns reduces visibility.
LEVERAGE CONSISTENTLY WITHIN EXPECTATIONS
Despite occasional earnings volatility, Universal has consistently maintained gross leverage around 2.0x. Fitch expects this trend to continue. Gross leverage (total debt to EBITDA) improved to 2.0x in fiscal 2016 (ending March 31, 2016) from 2.1x in the prior year, as EBITDA rose by roughly $20 million. Cost efficiencies and modestly higher sales volumes more than offset pricing pressure stemming from a second consecutive year of worldwide oversupply conditions.
Fitch anticipates that leverage could rise modestly in fiscal 2017, reflecting moderate EBITDA declines and stable debt levels, before improving in 2018 on incremental earnings growth. This assumes that crop yields revert to historical norms in fiscal 2018, and that global supply/demand ratio remains near equilibrium. Fitch is comfortable with Universal operating with leverage around 2.0x for the current rating, but would grow concerned if leverage were to approach 2.5x.
VERTICAL INTEGRATION REVERSING
Vertical integration of operations at tobacco product manufacturers has been an ongoing risk to leaf processors that also serve these same end-users further along the value chain. In recent years, Universal has increased its services package to its largest customer, Philip Morris International (PMI), to include direct purchasing from farmers as PMI shifts its supply chain to increased outsourcing of inventory buying in the U. S. and Mexico. This activity is a reversal of prior efforts by manufacturers to control more of the supply chain, and may prove to be an opportunity with Universal's other large customers. Future growth may also stem from a trend by product manufacturers to simplify tobacco supply bases as well as to choose processors/suppliers capable of providing compliant and sustainable tobacco leaf in light of risk from social issues in tobacco leaf farming, including child labor and deforestation concerns. Universal's margins may enhance as the company receives more reward for greater risk linked to possessing inventories earlier in the supply chain.
FLUCTUATING CASH FLOWS
Universal's cash flows can be variable, similar to tobacco and other agricultural commodity processors, moving in conjunction with working capital requirements mainly driven by inventories that fluctuate in cost due to tobacco leaf pricing as well as in amount given timing of customer purchasing. On the flipside of the headwind created by oversupply conditions on operations, cash flow generation benefits from lower priced inventories. After providing strong positive cash flows in fiscal year 2015, cash flows from operations were lower, but still positive, in fiscal year 2016, in part due to carryover shipments delayed into fiscal year 2017 and a change in business with PMI in the United States. Universal's relationship with PMI shifted from a pure processing model to the current arrangement where Universal procures, processes and then sells tobacco to PMI.
Given vagaries of tobacco leaf pricing, free cash flow can jump from positive to negative nearly annually, although Universal's FCF was positive for the past two fiscal years. In fiscal 2017, Universal expects that lower crop production and purchase levels, along with similar customer shipment timing will produce a modestly positive working capital cash flow, while Brazilian crop recovery anticipated for fiscal 2018 will create a modest working capital utilization. Fitch currently projects at least modest free cash flow throughout the forecast period, while recognizing that FCF could turn negative in a given year, depending on inventory levels in response to market conditions. Fitch would be concerned by consecutive annual free cash flow deficits, should the situation arise.
Universal maintains ample sources of liquidity that provide support as internal cash flow generation fluctuates due to inherent unpredictability of tobacco leaf pricing. At the end of fiscal 2016 Universal's sources of liquidity included full capacity under its $430 million revolving bank agreement (includes a $25 million sub-limit for letters of credit) plus $319.4 million cash and cash equivalents, which vary seasonally. Additional liquidity comes from uncommitted lines of credit that support working capital requirements internationally, of which $306.0 million were unused at the end of fiscal 2015. Fitch does consider the uncommitted lines to be a weaker form of support.
FULL LIST OF RATING ACTIONS
Fitch affirms the following:
--Long-Term IDR at 'BBB-';
--Senior unsecured credit facility at 'BBB-';
--Convertible perpetual preferred stock at 'BB'.
The Rating Outlook is Stable.