UST: Review of UST’s 10K - Company Looks Solid But Not Cheap
Large Cap Watch List (Track at Marketocracy) member UST (UST) is a leading provider of smokeless tobacco products, which it markets under the Copenhagen, Skoal and other brand names. It also produces Washington State wines. We reviewed the company’s recently issued 10K report, and summarize our key findings below.
First, at risk of stating the obvious, the businesses UST are involved in entail a fair amount of legal, social and regulatory risk. Investors must be comfortable that the price they are paying provides adequate compensation for these risks. Over the last five years this has been the case, as tobacco companies gained 140% compared with just a 35% cumulative gain on the S&P 500. However, there is no assurance that can continue, particularly since sales and earnings have been essentially flat for the last three years. A restructuring initiative that the company believes will result in $100 million of cost savings appears largely incorporated into analyst estimates.
Inventory management looks poor at first, as the Days On Hand ratio logs in a hefty 522 days. However, both tobacco products and wines require significant aging before they can be sold. The “finished goods” DOH is a more reasonable 111 days. In this context, the inventory levels do not pose as significant a concern. However, it is worth noting that over the last three years the company has significantly under-reserved for inventory obsolescence and bad debts (see chart). Had the company’s reserves for these contingencies equalled the actual costs incurred, diluted earnings per share from continuing operations would have been a penny lower in 2006 and three cents lower in 2004.
Free cash flow generation has been steady in the $500 - $550 million range, resulting in an enterprise value/FCF multiple of 19-20x, which can be justified if the current initiatives result in a mid-single digit earnings growth rate going forward. Off-balance sheet liabilities are fairly modest, and include approximately $100 million in future lease payments as well as purchase commitments for both grapes and tobacco. In addition, the intrinsic (minimum) value of outstanding stock option grants is $123 million.
Pension plans and other post-retirement benefits are under-funded by nearly $240 million, and due to the recent adoption of SFAS 158 the full liability is now recognized on the balance sheet. This increased reported liabilities by approximately $115 million compared with 2005, but the economic liability was essentially unchanged. The plans are using an expected return assumption of 7.5%, and are allocated 70% to equity and 30% to fixed income. Assuming a 5% return on fixed income given the flat yield curve generates an implied expected return on stock investments of 8.5%, which appears a reasonable assumption under the circumstances.
All in all, the 10K suggests a reasonably solid company that is not especially cheap.
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[…] The two “opportunities” are a restructuring charge for layoffs the company expects will reduce future expenses and a possible charge related to resolution of antitrust lawsuits currently in mediation. And even though the company raised its own outlook, the new target still falls below the $3.35 level the consensus was already expecting. When we reviewed the 10K we called it a “solid company that is not especially cheap.” That type of valuation typically requires exceeding expectations to drive the stock price. […]