UNIVERSAL CORPORATION
The following discussion and analysis of financial condition and results of
operations is provided to enhance the understanding of, and should be read in
conjunction with, Part I, Item 1, "Business" and Item 8, "Financial Statements
and Supplementary Data." For information on risks and uncertainties related to
our business that may make past performance not indicative of future results, or
cause actual results to differ materially from any forward-looking statements,
see "General," and Part I, Item 1A, "Risk Factors."
OVERVIEW
Universal Corporation is a global business-to-business agri-products supplier to
consumer product manufacturers, operating in over 30 countries on five
continents, that sources and processes leaf tobacco and plant-based ingredients.
Tobacco has been our principal focus since our founding in 1918, and we are the
leading global leaf tobacco supplier. Through our plant-based ingredients
platform, we provide a variety of value-added manufacturing processes to produce
high-quality, specialty vegetable and fruit-based ingredients as well as
botanical extracts and flavorings to food and beverage end markets. We have been
finding innovative solutions to serve our customers and meet their agri-product
needs for more than 100 years. We derive most of our revenues from sales of
processed tobacco to manufacturers of tobacco products throughout the world and
from fees and commissions for specific services. We hold a strategic position in
the world leaf tobacco markets where we work closely with both our customers and
farmers to ensure that we deliver a compliant product that meets our customers'
needs while promoting a strong supplier base. We adapt to meet changes in
customer requirements as well as broader changes in the leaf tobacco markets,
while continuing to provide the stability of supply and high level of service
that distinguishes us in the marketplace. We believe that we have successfully
met the needs of both our customers and suppliers while adapting to changes in
leaf tobacco markets.
Recognizing that leaf tobacco is a mature industry, we have also been
positioning our company for the future by investing in and strengthening our
plant-based ingredients platform, while maintaining our position as the leading
global leaf tobacco supplier. In fiscal year 2022, we continued to make progress
towards building and enhancing our plant-based ingredients platform. On October
4, 2021 , we acquired Shank's, a specialty ingredient botanical extracts and
flavorings company with bottling and packaging capabilities. We have been
integrating and exploring opportunities for synergies between our acquired
businesses, FruitSmart acquired on January 1, 2020 , Silva acquired on October 1,
2020 , and Shank's.
Given our significant and strategic investments in our plant-based ingredients
platform, we evaluated our operating segments for financial reporting purposes
during the quarter ended December 31, 2020 . Based on our evaluation, we
determined that we conduct our operations across two primary reportable
operating segments, Tobacco Operations and Ingredients Operations. The revised
segments reflect how we manage the Company, allocate resources, and assess
business performance. Prior period segment information has been recast
retrospectively to reflect these changes.
COVID-19 Pandemic Impact
OnMarch 11, 2020 , the WHO declared COVID-19 a pandemic. Foreign governmental organizations and governmental organizations inthe United States have taken various actions to combat the spread of COVID-19 and its subsequent variants, including imposing stay-at-home orders, closing "non-essential" businesses and their operations, and restricting international travel. We continue to closely monitor developments related to the COVID-19 pandemic and have taken and continue to take steps intended to mitigate the potential risks and impacts to us. It is paramount that our employees who operate our businesses are safe and informed. We have assessed and regularly update our existing business continuity plans for our business in the context of this pandemic. For example, we have taken precautions during the pandemic with regard to employee and facility hygiene, imposed travel limitations on our employees, implemented work-from-home procedures, and we continue to assess and reevaluate protocols designed to protect our employees, customers and the public. We continue to work with our suppliers to mitigate the impacts to our supply chain due to the pandemic. To date, we have not experienced a material impact to our supply chain, although the COVID-19 pandemic resulted in delays in certain operations during fiscal year 2021. SinceMarch 2020 , we have at times also experienced increased volatility in foreign currency exchange rates, which we believe is in part related to the continued uncertainties from COVID-19, as well as actions taken by governments and central banks in response to COVID-19. We are currently seeing and monitoring some logistical constraints around worldwide vessel and container availability and increased costs stemming from the COVID-19 pandemic. We believe we currently have sufficient liquidity to meet our current obligations and our business operations remain fundamentally unchanged other than shipping delays, which could continue to impact quarterly comparisons. This is, however, a rapidly evolving situation, and we cannot predict the extent, resurgence, or duration of the COVID-19 pandemic, the effects of it on the global, national or local economy, including the impacts on our ability to access capital, or its effects on our business, financial position, results of operations, and cash flows. We continue to monitor developments affecting our employees, customers and operations. We will take additional steps and reevaluate current protocols to address the spread of COVID-19 and its impacts, as necessary, and remain thankful for the hard work of our employees and the continued support of our customers, growers, and other partners during these challenging times. 24
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The Conflict in
We are closely monitoring the tragic situation inUkraine . SinceRussia initiated its current military operations inUkraine in 2022, business globally has been directly or indirectly impacted. The region is an important supplier of fertilizer, oil, gas, and agricultural products for export to countries around the world, and disruptions in those exports have created or contributed to various economic and commercial challenges including increased energy costs, increased fertilizer costs, and other inflationary impacts. In addition, business inUkraine ,Russia and the surrounding region has been impacted by the temporary suspension of business operations by companies due to safety and security concerns, the divestiture of assets and businesses in the region by their international owners, and government imposition of sanctions targetingRussia and others, including "luxury goods" sanctions that prohibit the supply of tobacco and tobacco products toRussia . We do not have manufacturing facilities or material subsidiaries inUkraine orRussia . We do, however, have a number of customers that have historically conducted business there, and some of those customers have previously disclosed the temporary suspension of operations inUkraine or the divestiture of assets inRussia . We have worked closely with those customers to monitor and understand the impacts the conflict inUkraine has had on their operations. In some cases we have worked with customers to suspend tobacco orders until such time that customers believe it is safe to reopen their facilities inUkraine , and in other cases we have coordinated with customers to cancel orders for tobacco destined toRussia and ship some or all of that tobacco to other countries in which those customers have operations that need those quantities and qualities of tobacco. At this time, we have not experienced any material direct impact on our business from the ongoingUkraine conflict. We are unable, however, to estimate the duration or extent of any potential impact on our business from the continuation or potential escalation of the conflict. Such future impacts could be direct, such as the impact of continued or increased governmental prohibitions against shipping tobacco and tobacco products toRussia , or they could be indirect, such as contributing to or increasing costs and other inflationary pressures impacting our global operations and those of our supply chain around the world. We will continue to monitor and evaluate this complex and evolving situation. 25 --------------------------------------------------------------------------------
RESULTS OF OPERATIONS
Amounts described as net income (loss) and earnings (loss) per diluted share in the following discussion are attributable toUniversal Corporation and exclude earnings related to non-controlling interests in subsidiaries. Adjusted operating income (loss), adjusted net income (loss) attributable toUniversal Corporation , adjusted diluted earnings (loss) per share, and the total for segment operating income (loss) referred to in this discussion are non-GAAP financial measures. These measures are not financial measures calculated in accordance with GAAP and should not be considered as substitutes for operating income (loss), net income (loss) attributable toUniversal Corporation , diluted earnings (loss) per share, cash from operating activities or any other operating or financial performance measure calculated in accordance with GAAP, and may not be comparable to similarly-titled measures reported by other companies. A reconciliation of adjusted operating income (loss) to consolidated operating (income), adjusted net income (loss) attributable toUniversal Corporation to consolidated net income (loss) attributable toUniversal Corporation and adjusted diluted earnings (loss) per share to diluted earnings (loss) per share are provided in Other Items below. In addition, we have provided a reconciliation of the total for segment operating income (loss) to consolidated operating income (loss) in Note 17. "Operating Segments" to the consolidated financial statements in Item 8. Management evaluates the consolidated Company and segment performance excluding certain significant charges or credits. We believe these non-GAAP financial measures, which exclude items that we believe are not indicative of our core operating results, provide investors with important information that is useful in understanding our business results and trends.
Fiscal Year Ended
Executive Summary Our fiscal year 2022 results were generally comparable to those in fiscal year 2021. During fiscal year 2022, we continued to face a very challenging logistical environment in many of our key tobacco regions. Strong performance from our Ingredients Operations segment offset some challenges that reduced results in our Tobacco Operations segment. We believe our plant-based ingredients platform is coming together nicely and is exceeding our expectations. With the acquisition of Shank's, we are now positioned to offer our customers a broad range of products, from fruit and vegetable juices, concentrates, and dehydrated ingredients to botanical extracts and flavorings. In fiscal year 2022, the Ingredients Operations segment saw increased demand for organic-based products and continued strong volumes for human and pet food categories as well as for vanilla extracts. Ongoing shipping constraints reduced our Tobacco Operations segment results for the year endedMarch 31, 2022 , as a result of continued limitations in worldwide shipping availability stemming from the COVID-19 pandemic. Due to the logistical constraints in fiscal year 2021, we had carryover tobacco volumes which shipped in fiscal year 2022. Similar logistical constraints impacted fiscal year 2022 which led to an even larger amount of tobacco volumes, reflecting a difference of about$70 million in revenue, which did not ship in fiscal year 2022, compared to the carryover volumes from fiscal year 2021. Tobacco shipment volumes in fiscal year 2022 were also reduced due to smaller African burley crops. We experienced volatile tobacco and currency markets inBrazil during the fourth quarter of fiscal year 2022. Appreciation of the Brazilian currency coupled with strong demand for leaf tobacco led to unprecedented increases in green prices for leaf tobacco and earlier purchasing of the 2022 Brazilian crop, resulting in disruptions to market dynamics. To fulfill our customers' orders, leaf tobacco purchases from our contracted farmers this season have been at the prevailing inflated market price for all leaf tobacco regardless of the quality of leaf tobacco. This resulted in larger inventory write downs in fiscal year 2022, compared to fiscal year 2021. As we move into fiscal year 2023, we are seeing strong demand for our plant-based ingredients and tobacco products. We believe leaf tobacco supply for flue-cured, burley, dark air-cured, and oriental tobaccos to be in an undersupply position. At the same time, we continue to see opportunities to increase market share and expand the supply chain services we provide our customers. We expect continued logistical constraints as well as higher costs, particularly freight, raw materials, labor, fertilizer, and energy, in both our tobacco and ingredients businesses. We are actively working to mitigate these challenges, and we are confident that we can deliver another good year. We remain focused on returning value to our shareholders and promoting sustainability in our operations. We are extremely proud to deliver value to our shareholders through dividend increases such as our 52nd annual dividend increase announced onMay 25, 2022 . Increasing our strong dividend remains one of the strategic priorities of our capital allocation strategy. We have also achieved some important milestones in our sustainability efforts in fiscal year 2022, notably releasing goals and targets around agricultural labor practices and environmental performance and publishing our 2021 Sustainability Report in December. We were also named a 2021 Supplier Engagement Leader by CDP, earning recognition for our work in engaging our suppliers on climate change. We look forward to attaining new achievements with our sustainability programs in fiscal year 2023. 26 --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS
Fiscal Year Ended March 31, Change
(in millions of dollars, except per share data) 2022 2021 $ %
Consolidated Results
Sales and other operating revenue $ 2,103.6 $ 1,983.4 $ 120.2 6 %
Cost of goods sold 1,694.7 1,597.4 97.3 6 %
Gross Profit Margin 19.44 % 19.46 % --- -2 bps
Selling, general and administrative expenses 240.7 219.8 20.9 10 %
Restructuring and impairment costs 10.5 22.6 (12.1) (54) %
Operating income (as reported) 160.3 147.8 12.5 8 %
Adjusted operating income (non-GAAP)* 173.6 172.9 0.7 0 %
Diluted earnings per share (as reported) 3.47 3.53 (0.06) (2) %
Adjusted diluted earnings per share (non-GAAP)* 3.79 4.25 (0.46) (11) %
Segment Results
Tobacco operations sales and other operating
revenues $ 1,835.8 $ 1,841.8 $ (6.0) 0 %
Tobacco operations operating income 157.8 168.8 (11.1) (7) %
Ingredients operations sales and other
operating revenues 267.8 141.5 126.3 89 %
Ingredients operations operating income 16.6 0.4 16.2 4,418 %
*See Reconciliation of Certain Non-GAAP Financial Measures in Other Items below
Net income for the year endedMarch 31, 2022 , was$86.6 million , or$3.47 per diluted share, compared with$87.4 million , or$3.53 per diluted share, for the year endedMarch 31, 2021 . Excluding restructuring and impairment costs and certain other non-recurring items, detailed in Other Items below, net income and diluted earnings per share decreased by$10.8 million and$0.46 , respectively, for the year endedMarch 31, 2022 , compared to the year endedMarch 31, 2021 . Operating income of$160.3 million for the year endedMarch 31, 2022 , increased by$12.5 million , compared to operating income of$147.8 million for the year endedMarch 31, 2021 . Adjusted operating income, detailed in Other Items below, of$173.6 million increased by$0.7 million for the year endedMarch 31, 2022 , compared to adjusted operating income of$172.9 million for the year endedMarch 31, 2021 . Consolidated revenues increased by$120.2 million to$2.1 billion for the year endedMarch 31, 2022 , compared to the year endedMarch 31, 2021 , on the addition of the businesses acquired in the Ingredients Operations segment and lower tobacco sales volumes partially offset by higher average sales prices in the Tobacco Operations segment. Tobacco Operations Segment operating income for the Tobacco Operations segment decreased by$11.1 million to$157.8 million for the year endedMarch 31, 2022 , compared to the year endedMarch 31, 2021 . Tobacco Operations segment results declined largely due to tobacco shipment timing as well as some tobacco inventory write downs, partially offset by increased value-added services to customers in fiscal year 2022, compared to fiscal year 2021.Africa sales volumes were lower in fiscal year 2022, compared to fiscal year 2021, on smaller burley crops as well as slower shipment timing. Sales volumes forBrazil were lower for the year endedMarch 31, 2022 , compared to the year endedMarch 31, 2021 , in part due to lack of vessel and container availability. In addition, inventory write downs resulting from volatile market conditions inBrazil negatively impacted results for the year endedMarch 31, 2022 . InAsia , although trading volumes were down on higher freight costs, our operations saw a more favorable product mix, as well as increased value-added services for customers during the year endedMarch 31, 2022 , compared to the year endedMarch 31, 2021 . Our operations inEurope experienced significantly higher energy costs in fiscal year 2022, compared to fiscal year 2021. Selling, general, and administrative expenses for the Tobacco Operations segment were higher in the year endedMarch 31, 2022 , compared to the year endedMarch 31, 2021 , primarily due to unfavorable foreign currency exchange comparisons, mainly remeasurement, offset in part by the effects of currency hedging activities. Revenues for the Tobacco Operations segment of$1.8 billion for the year endedMarch 31, 2022 , were relatively flat, compared to the year endedMarch 31, 2021 , as higher tobacco sales prices largely offset lower sales volumes. Our uncommitted tobacco inventory levels, about 16% of tobacco inventory atMarch 31, 2022 , remained well within our target range. 27 --------------------------------------------------------------------------------
Ingredients Operations
Segment operating income for the Ingredients Operations segment was$16.6 million for the year endedMarch 31, 2022 , compared to segment operating income of$0.4 million for the year endedMarch 31, 2021 . Results for the segment include ourOctober 2020 acquisition of Silva and ourOctober 2021 acquisition of Shank's. For the year endedMarch 31, 2022 , our Ingredients Operations saw strong volumes in both human and pet food categories as well as some rebound in demand from sectors that have been impacted by the ongoing COVID-19 pandemic. In addition, the segment saw strong sales of organic-based products, certain dehydrated products, and botanical extracts and flavorings. Selling, general, and administrative expenses for the segment increased in fiscal year 2022, compared to fiscal year 2021, on the addition of the acquired businesses. Revenues for the Ingredients Operations segment increased by$126.3 million to$267.8 million for the year endedMarch 31, 2022 , compared to the year endedMarch 31, 2021 , primarily on the addition of the revenues for the acquired businesses as well as increased sales prices.
Other Items
Cost of goods sold in the year endedMarch 31, 2022 , increased by 6% to$1.7 billion , compared with the year endedMarch 31, 2021 , as a result of the acquisitions in our Ingredients Operations segment as well as variances in sales prices and volumes shipped in the Tobacco Operations segment. Selling, general, and administrative costs for fiscal year 2022, increased by$20.9 million to$240.7 million , compared to fiscal year 2021, on additional costs from the acquisitions in the Ingredients Operations segment combined with unfavorable foreign currency comparisons. In fiscal year 2022, foreign currency comparisons were approximately$8.1 million unfavorable, compared to fiscal year 2021, mainly due to currency remeasurement variances inBrazil ,the Philippines , andIndonesia , partially offset by the effects of currency hedging programs. Interest expense for fiscal year 2022, increased by$2.8 million to$27.7 million , compared to fiscal year 2021, largely on higher average debt balances and interest rates. For fiscal year 2022, the Company's effective tax rate on pre-tax income was 27.2%. In the fiscal year endedMarch 31, 2022 , the Company recognized a$1.7 million income tax benefit related to a final tax ruling at a foreign subsidiary and a$1.2 million benefit due to finalizing the prior yearU.S. tax return. Without these income tax benefits, the adjusted effective tax rate for the fiscal year endedMarch 31, 2022 , would have been 29.2%. For fiscal year 2021, the Company's consolidated effective tax rate was 23.4%. For the fiscal year endedMarch 31, 2021 , income tax expense included benefits of$4.4 million for final tax regulations regarding the treatment of dividends paid by foreign subsidiaries and$2.9 million due to amending and finalizing prior yearU.S. tax returns. Without these income tax benefits, the consolidated effective tax rate for the fiscal year endedMarch 31, 2021 , would have been approximately 29.2%. 28
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Reconciliation of Certain Non-GAAP Financial Measures
The following tables set forth certain non-recurring items included in reported results to reconcile adjusted operating income to consolidated operating income and adjusted net income to net income attributable toUniversal Corporation :
Adjusted Operating Income Reconciliation
Fiscal Year Ended
March 31,
(in thousands) 2022 2021
As Reported: Consolidated operating income $ 160,315 $ 147,810
Purchase accounting adjustments(1) 3,057 2,800
Transaction costs for acquisitions(2) 2,310 3,915
Fair value adjustment to contingent consideration for
(2,532) (4,173)
Restructuring and impairment costs(4) 10,457 22,577
Adjusted operating income Adjusted Net Income and Diluted Earnings Per Share Reconciliation
Fiscal Year Ended
(in thousands except for per share amounts) March 31,
(all amounts reported net of income taxes) 2022 2021
As Reported: Net income attributable to Universal Corporation $ 86,577 $ 87,410
Purchase accounting adjustments(1) 2,415 2,800
Transaction costs for acquisitions(2) 2,195 3,915
Fair value adjustment to contingent consideration for
(2,532) (4,173)
Restructuring and impairment costs(4) 7,879 17,800
Interest expense related to an uncertain tax matter at a foreign subsidiary
(470) 1,849
Income tax benefit from dividend withholding tax liability reversal(5)
(1,686) (4,421)
Adjusted Net income attributable to Universal Corporation As reported: Diluted earnings per share$ 3.47 $ 3.53 Adjusted: Diluted earnings per share
(1) The Company recognized an increase in cost of goods sold in the third quarters of fiscal year 2022 and 2021, relating to the expensing of fair value adjustments to inventory associated with the acquisition accounting for Shank's (effectiveOctober 4, 2021 ) and Silva (effectiveOctober 1, 2020 ). The adjustment related to the Silva acquisition is not deductible forU.S. income tax purposes. (2) The Company incurred selling, general, and administrative expenses for due diligence and other transaction costs associated with the acquisitions of Shank's and Silva. A portion of these costs is not deductible forU.S. income tax purposes.
(3) The Company reversed the contingent consideration liability for the
(4) Restructuring and impairment costs are included in Consolidated operating income in the consolidated statements of income, but excluded for purposes of Adjusted operating income, Adjusted net income available toUniversal Corporation , and Adjusted diluted earnings per share. See Note 4 for additional information. (5) The Company recognized income tax benefits related to a favorable final income tax ruling at a foreign subsidiary (fiscal year 2022) and finalU.S. tax regulations on certain dividends paid by foreign subsidiaries (fiscal year 2021).
Fiscal Year Ended
For a comparison of our performance and financial metrics for the fiscal years endedMarch 31, 2021 andMarch 31, 2020 , see "Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the fiscal year endedMarch 31, 2021 , filed with theSEC onMay 28, 2021 . Accounting Pronouncements See "Accounting Pronouncements" in Note 1 to the consolidated financial statements in Item 8 of this Annual Report for a discussion of recent accounting pronouncements issued by theFinancial Accounting Standards Board ("FASB") that will become effective and be adopted by the Company in future reporting periods. 29 --------------------------------------------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES
Overview
In fiscal year 2022, we generated$44.9 million in cash flows from our operating activities, and our liquidity was sufficient to meet our needs. Our working capital requirements in fiscal year 2022 were higher than those in fiscal year 2021 mainly due to tobacco shipment timing and higher green leaf tobacco prices. We continued our financial policies and returned funds to shareholders. Our liquidity and capital resource requirements are predominately short-term in nature and primarily relate to working capital for tobacco crop purchases, and our primary sources of liquidity are net cash flows provided by operating activities and our committed revolving credit facility. Working capital needs for tobacco crop purchases are seasonal within each geographic region. The geographic dispersion and the timing of working capital needs permit us to predict our general level of cash requirements, although tobacco crop size, prices paid to farmers, shipment and delivery timing, and currency fluctuations affect requirements each year. Peak working capital requirements are generally reached during the first and second fiscal quarters. Each tobacco production region follows a cycle of buying, processing, and shipping tobacco, and in many regions we also provide agricultural materials to tobacco farmers during the growing season. The timing of the elements of each cycle is influenced by such factors as local weather conditions and individual customer shipping requirements, which may change the level or the duration of tobacco crop financing. In contrast to our tobacco operations, working capital requirements for our ingredients operations tend to be lower and less seasonal. Despite a predominance of short-term needs for working capital, we maintain a portion of our total debt as long-term to reduce liquidity risk. We also periodically may have large cash balances that we utilize to meet our working capital requirements. We believe that our financial resources are adequate to support our capital needs for at least the next twelve months. Our seasonal borrowing requirements primarily relate to purchasing tobacco crops inSouth America andAfrica and can increase from March to September by more than$350 million . The funding required can vary significantly depending upon such factors as crop sizes, the price of leaf, the relative strength of theU.S. dollar, and the timing of shipments and customer payments. We deal with this uncertainty by maintaining substantial credit lines and cash balances. In addition to our operating requirements for working capital, we expect to spend around$40 to$50 million during fiscal year 2023 for capital expenditures to maintain our facilities and invest in opportunities to grow and improve our businesses. We have no long-term debt maturing until fiscal year 2024. To date, the COVID19 pandemic has not had a material impact on our operations, although we are continuing to see logistical constraints around worldwide vessel and container availability and increased costs stemming from the COVID-19 pandemic. We currently anticipate our current cash balances, cash flows from operations, and our available sources of liquidity will be sufficient to meet our cash requirements for at least the next twelve months. This is, however, a rapidly evolving situation, and we cannot predict the extent, resurgence, or duration of the COVID-19 pandemic, the effects of it on the global, national or local economies, including the impacts on our ability to access capital, or its effects on our business, financial position, results of operations, and cash flows. We continue to monitor developments affecting our employees, customers and operations. Cash Flow Our operations generated about$44.9 million in operating cash flows in fiscal year 2022. That amount was about$175.5 million lower than the$220.4 million we generated in fiscal year 2021, largely due to higher working capital requirements in fiscal year 2022. During the fiscal year endedMarch 31, 2022 , we spent$53.2 million on capital projects and$102.5 million on the acquisition of a new business, and we returned$79.5 million to shareholders in the form of dividends and share repurchases. AtMarch 31, 2022 , cash balances totaled$81.6 million . Working Capital Working capital atMarch 31, 2022 , was about$1.2 billion , down about$32.9 million from last fiscal year's level, largely on higher working capital usage due to tobacco shipment timing, higher green tobacco costs, and earlier purchasing of the 2022 Brazilian tobacco crop, offset in part by the acquisition of Shank's. Tobacco inventories of$822.5 million atMarch 31, 2022 , were up$181.9 million compared to inventory levels at the end of the prior fiscal year, mainly due to delayed tobacco shipments and higher green leaf tobacco prices. Other inventories were up$48.2 million atMarch 31, 2022 , from prior year levels largely on our acquisition of Shank's inOctober 2021 and higher crop input costs. We generally do not purchase material quantities of leaf tobacco on a speculative basis. However, when we contract directly with tobacco farmers, we are obligated to buy all stalk positions, which may contain less marketable leaf styles. Our uncommitted tobacco inventories decreased by approximately$9.1 million to$130.1 million , or about 16% of tobacco inventory, atMarch 31, 2022 , which was within our target range. Uncommitted inventories atMarch 31, 2021 , were$139.2 million , which represented 22% of tobacco inventory. The level of these uncommitted inventories is influenced by timing of farmer deliveries of new crops, as well as the receipt of customer orders. Cash and cash equivalents were down$115.6 million at the end of fiscal year 2022, compared to balance at the end of fiscal year 2021, on higher working capital requirements due tobacco shipment timing and higher green leaf tobacco costs as well as the Shank's acquisition. 30 --------------------------------------------------------------------------------
Capital Allocation
Our capital allocation strategy focuses on four strategic priorities:
•Strengthening and investing for growth in our leaf tobacco business;
•Increasing our strong dividend;
•Exploring growth opportunities in plant-based ingredients businesses that utilize our assets and capabilities; and
•Returning excess capital through share repurchases.
Our mission is to remain the leading global leaf tobacco supplier. We will continue to make disciplined investments within our leaf business and taking advantage of growth opportunities in tobacco as well as in plant-based ingredients businesses and markets that utilize our assets and capabilities. Through these actions, we believe that will be able to deliver enhanced shareholder value through earnings growth and the generation of free cash flow despite operating in a mature industry. In line with our capital allocation strategy, we acquired Shank's for approximately$100 million onOctober 4, 2021 . The acquisition expanded our plant-based ingredients platform adding valuable capabilities, including flavors and botanical extracts, custom packaging, bottling, and product development. As we look ahead, we will continually evaluate opportunities to return capital to shareholders. At the same time, we remain committed to maintaining our investment grade credit rating and extending our 52-year history of dividend increases. Share Activity Our Board of Directors approved our current share repurchase program inNovember 2020 . The program authorizes the purchase of up to$100 million of our common stock throughNovember 15, 2022 . Under the current authorization, we may purchase shares from time to time on the open market or in privately negotiated transactions at prices not exceeding prevailing market rates. Repurchases of shares under the repurchase program may vary based on management discretion, as well as changes in cash flow generation and availability. During fiscal year 2022, we purchased 58,264 shares of common stock at an aggregate cost of$3.1 million (average price per share$52.41 ). AtMarch 31, 2022 , our available authorization under our current share repurchase program was$97 million , and approximately 24.6 million common shares were outstanding.
Capital Spending
Our capital expenditures are generally limited to those that add value, replace or maintain equipment, increase efficiency, or position us for future growth. In deciding where to invest capital resources, we look for opportunities where we believe we can earn an adequate return, leverage our assets and expertise, and support our farmer base. During fiscal years 2022 and 2021, we invested$53.2 million and$66.2 million , respectively, in our property, plant, and equipment. In the third quarter of fiscal year 2022, we purchased the real property assets related to the Shank's acquisition, for approximately$13 million . Depreciation expense was approximately$41.3 million and$38.3 million , respectively, in fiscal years 2022 and 2021. Generally, our capital spending on maintenance projects is at a level below depreciation expense in order to maintain strong cash flow. Typically, our capital expenditures for maintenance projects are less than$30 million per fiscal year. In addition, from time to time, we undertake projects that require capital expenditures when we identify opportunities to improve efficiencies, add value for our customers, and position ourselves for future growth. We currently plan to spend approximately$40 to$50 million in fiscal year 2023 on capital projects for maintenance of our facilities and other investments to grow and improve our businesses.
Outstanding Debt and Other Financing Arrangements
We consider the sum of notes payable and overdrafts, long-term debt (including any current portion), and customer advances and deposits, less cash, cash equivalents, and short-term investments on our balance sheet to be our net debt. We also consider our net debt plus shareholders' equity to be our net capitalization. We financed the acquisition and real property assets of Shank's using cash-on-hand and borrowings under our committed revolving credit facility. Net debt increased by$202.3 million to$633.3 million during the fiscal year endedMarch 31, 2022 . The increase primarily reflects the Shank's acquisition, tobacco shipment timing, and earlier purchasing of the 2022 Brazilian tobacco crop. Net debt as a percentage of net capitalization was approximately 32% atMarch 31, 2022 , up from 25% atMarch 31, 2021 . As ofMarch 31, 2021 , we had$330 million available under a committed revolving credit facility that will mature inDecember 2023 , and we, together with our consolidated affiliates, had approximately$283 million in uncommitted lines of credit, of which approximately$200 million were unused and available to support seasonal working capital needs. The financial covenants under our committed revolving credit facility require us to maintain certain levels of tangible net worth and observe restrictions on debt levels. As ofMarch 31, 2022 , we were in compliance with all covenants of our debt agreements. We also have an active, undenominated universal shelf registration filed with theSEC inNovember 2020 that provides for future issuance of additional debt or equity securities. We have no long-term debt maturing until fiscal year 2024. 31 --------------------------------------------------------------------------------
Derivatives
From time to time, we use interest rate swap agreements to manage our exposure to changes in interest rates. Currently, we have interest rate swap agreements that convert the variable benchmark LIBOR rates on$370 million of our two outstanding term loans entered to fixed rates. With the swap agreements in place, the effective interest rates on$220 million of the five-year term loan and$295 million of the seven-year term loan were 3.36% and 3.84%, respectively, as ofMarch 31, 2022 . These agreements were entered into to eliminate the variability of cash flows in the interest payments on our variable rate five- and seven-year term loans and are accounted for as cash flow hedges. Under the swap agreements, we receive variable rate interest and pay fixed rate interest. AtMarch 31, 2022 , the fair value of our open interest rate hedge swaps was a net liability of approximately$1 million . We also enter derivative instruments from time to time to hedge certain foreign currency exposures, primarily related to forecast purchases of tobacco, related processing costs, and crop input sales inBrazil , as well as our net monetary asset exposure in local currency there. We generally account for our hedges of forecast tobacco purchases as cash flow hedges. AtMarch 31, 2022 , the fair value of those open contracts was a net asset of approximately$7.8 million . We also had other forward contracts outstanding that were not designated as hedges, and the fair value of those contracts was a net asset of approximately$13.0 million atMarch 31, 2022 . For additional information, see Note 11 to the consolidated financial statements in Item 8.
Pension Funding
The funds supporting our ERISA-regulatedU.S. defined benefit pension plan during fiscal year 2022 were approximately$250 million . The accumulated benefit obligation ("ABO") and PBO were both approximately$231 million and$237 million , respectively as ofMarch 31, 2022 . The ABO and PBO are calculated on the basis of certain assumptions that are outlined in Note 13 to the consolidated financial statements in Item 8. We expect to make no contributions to our pension plans during the next year. It is our policy to regularly monitor the performance of the funds and to review the adequacy of our funding and plan contributions.
Off-Balance Sheet Arrangements
We do not have any off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Contractual Obligations
Our contractual obligations as of
(in thousands of dollars) Total 2023 2024-2025 2026-2027 After 2027 Notes payable and long-term debt (1)$ 761,645 $
204,803
57,370 16,069 22,528 10,053 8,720
Inventory purchase obligations:
Tobacco 722,822 598,506 113,316 11,000 -
Agricultural materials 64,692 64,692 - - -
Other purchase obligations 67,437 56,682 7,355 3,400 -
Total $ 1,673,966 $ 940,752 $ 396,537 $ 327,957 $ 8,720
(1)Includes interest payments. Interest payments on $333.0 million of variable
rate debt were estimated based on rates as of March 31, 2022 . We have entered
into interest rate swaps that effectively convert the interest payments on
$370.0 million of the outstanding balance of our two bank term loans from
variable to fixed. The fixed rate has been used to determine the contractual
interest payments for all periods.
In addition to principal and interest payments on notes payable and long-term
debt, our contractual obligations include operating lease payments, inventory
purchase commitments, and capital expenditure commitments. Operating lease
obligations represent minimum payments due under leases for various production,
storage, distribution, and other facilities, as well as vehicles and equipment.
Tobacco inventory purchase obligations primarily represent contracts to purchase
tobacco from farmers. The amounts shown above are estimates since actual
quantities purchased will depend on crop yield, and prices will depend on the
quality of the tobacco delivered. We have partially funded our tobacco purchases
in some origins with short-term advances to farmers and other suppliers, which
totaled approximately $130 million , net of allowances, at March 31, 2022 .
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CRITICAL ACCOUNTING ESTIMATES AND ASSUMPTIONS
In preparing the financial statements in accordance with GAAP, we are required
to make estimates and assumptions that have an impact on the assets,
liabilities, revenue, and expense amounts reported. These estimates can also
affect our supplemental information disclosures, including information about
contingencies, risks, and financial condition. We believe, given current facts
and circumstances, that our estimates and assumptions are reasonable, adhere to
GAAP, and are consistently applied. However, changes in the assumptions used
could result in a material adjustment to the financial statements. Our critical
accounting estimates and assumptions are in the following areas:
Inventories
Inventories of tobacco are valued at the lower of cost or net realizable value with cost determined under the specific cost method. Raw materials are clearly identified at the time of purchase. Other inventories consist primarily of unprocessed and processed food and vegetable ingredients, extracts, seed, fertilizer, packing materials, and other supplies. We track the costs associated with raw materials in the final product lots, and maintain this identification through the time of sale. We also capitalize direct and indirect costs related to processing raw materials. This method of cost accounting is referred to as the specific cost or specific identification method. We write down inventory for changes in net realizable value based upon assumptions related to future demand and market conditions if the indicated value is below cost. Future demand assumptions can be impacted by changes in customer sales, changes in customers' inventory positions and policies, competitors' pricing policies and inventory positions, and varying crop sizes and qualities. Market conditions that differ significantly from those assumed by management could result in additional write-downs. We experience inventory write-downs routinely. Inventory write-downs in fiscal years 2022, 2021, and 2020 were$19.9 million ,$13.5 million , and$10.3 million , respectively.
Advances to Tobacco Suppliers
In many sourcing origins, we provide tobacco growers with agronomy services and seasonal crop advances of, or for, seed, fertilizer, and other supplies. These advances are short term in nature and are customarily repaid upon delivery of tobacco to us. In several origins, we have also made long-term advances to tobacco farmers to finance curing barns and other farm infrastructure. In some years, due to low crop yields and other factors, individual farmers may not deliver sufficient volumes of tobacco to repay maturing advances. In those cases, we may extend repayment of the advances into the following crop year. We will incur losses whenever we are unable to recover the full amount of the loans and advances. At each reporting period, we must make estimates and assumptions in determining the valuation allowance for advances to farmers. AtMarch 31, 2022 , the gross balance of advances to tobacco suppliers totaled approximately$153 million , and the related valuation allowance totaled approximately$19 million .
Recoverable Value-Added Tax Credits
In many foreign countries, we pay significant amounts of value-added tax ("VAT")
on purchases of unprocessed and processed tobacco, crop inputs, packing
materials, and various other goods and services. In some countries, VAT is a
national tax, and in other countries it is assessed at the state level. Items
subject to VAT vary from jurisdiction to jurisdiction, as do the rates at which
the tax is assessed. When we sell tobacco to customers in the country of origin,
we generally collect VAT on those sales. We are normally permitted to offset our
VAT payments against those collections and remit only the incremental VAT
collections to the tax authorities. When tobacco is sold for export, VAT is
normally not assessed. In countries where our tobacco sales are predominately
for export markets, we often do not generate enough VAT collections on
downstream sales to fully offset our VAT payments. In those situations, we can
accumulate unused VAT credits. Some jurisdictions have procedures that allow
companies to apply for refunds of unused VAT credits from the tax authorities,
but the refund process often takes an extended period of time and it is not
uncommon for refund applications to be challenged or rejected in part on
technical grounds. Other jurisdictions may permit companies to sell or transfer
unused VAT credits to third parties in private transactions, although approval
for such transactions must normally be obtained from the tax authorities, limits
on the amounts that can be transferred may be imposed, and the proceeds realized
may be heavily discounted from the face value of the credits. Due to these
factors, in some countries we can accumulate significant balances of VAT credits
over time. We review these balances on a regular basis, and we record valuation
allowances on the credits to reflect amounts that we do not expect to recover,
as well as discounts anticipated on credits we expect to sell or transfer. In
determining the appropriate valuation allowance to record in a given
jurisdiction, we must make various estimates and assumptions about factors
affecting the ultimate recovery of the VAT credits. At March 31, 2022 , the gross
balance of recoverable tax credits (primarily VAT) totaled approximately $67
million , and the related valuation allowance totaled approximately $21 million .
33
--------------------------------------------------------------------------------Business Combinations
From time to time, we may enter into business combinations. In accordance with ASC 805, "Business Combinations", we generally recognize the identifiable assets acquired and the liabilities assumed at their fair values as of the date of acquisition. We measure goodwill as the excess of consideration transferred, which we also measure at fair value, over the net of the acquisition date fair values of the identifiable assets acquired and liabilities assumed. The acquisition method of accounting requires us to make significant estimates and assumptions regarding the fair values of the elements of a business combination as of the date of acquisition, including the fair values of identifiable intangible assets, deferred tax asset valuation allowances, liabilities including those related to debt, pensions and other postretirement plans, uncertain tax positions, contingent consideration and contingencies. This method also requires us to refine these estimates over a measurement period not to exceed one year to reflect new information obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date. If we are required to adjust provisional amounts that we have recorded for the fair values of assets and liabilities in connection with acquisitions, these adjustments could have a material impact on our financial condition and results of operations. Significant estimates and assumptions in estimating the fair value of developed technology, customer relationships, and other identifiable intangible assets include future cash flows that we expect to generate from the acquired assets. If the subsequent actual results and updated projections of the underlying business activity change compared with the assumptions and projections used to develop these values, we could record impairment charges. In addition, we have estimated the economic lives of certain acquired assets and these lives are used to calculate depreciation and amortization expense. If our estimates of the economic lives change, depreciation or amortization expenses could be increased or decreased, or the acquired asset could be impaired.
We review the carrying value of goodwill for potential impairment on an annual
basis and at any time that events or business conditions indicate that it may be
impaired. As permitted under Accounting Standards Codification Topic 350 ("ASC
350"), at March 31, 2022 and 2021, we elected to base our initial assessment of
potential impairment on qualitative factors. Those factors did not indicate any
impairment of our recorded goodwill in fiscal year 2022. In fiscal years prior
to basing our initial assessment on qualitative factors, we followed the
quantitative approach in ASC 350 in assessing the fair value of our goodwill,
which involved the use of discounted cash flow models (Level 3 of the fair value
hierarchy under GAAP). Under our current qualitative assessment, we would also
use those discounted cash flow models to measure any expected impairment
indicated by the assessment. The calculations in these models are not based on
observable market data from independent sources and therefore require
significant management judgment with respect to operating earnings growth rates
and the selection of an appropriate discount rate. Significant adverse changes
in our operations or our estimates of future cash flows for a reporting unit
with recorded goodwill, such as those caused by unforeseen events or changes in
market conditions, could result in an impairment charge. A majority of our
consolidated goodwill balance relates to our reporting unit in Brazil and the
acquisitions of FruitSmart (January 1, 2020 ), Silva (October 1, 2020 ), and
Shank's (October 4, 2021 ).
Fair Value Measurements
We hold various financial assets and financial liabilities that are required to
be measured and reported at fair value in our financial statements, including
money market funds, trading securities associated with deferred compensation
plans, interest rate swaps, forward foreign currency exchange contracts, and
guarantees of bank loans to tobacco growers. We follow the relevant accounting
guidance in determining the fair values of these financial assets and
liabilities. Money market funds are valued based on net asset value ("NAV"),
which is used as a practical expedient to measure the fair value of those funds
(not classified within the fair value hierarchy). Quoted market prices (Level 1
of the fair value hierarchy) are used in most cases to determine the fair values
of trading securities. Interest rate swaps and forward foreign currency exchange
contracts are valued based on dealer quotes using discounted cash flow models
matched to the contractual terms of each instrument (Level 2 of the fair value
hierarchy). We incorporate credit risk in determining the fair values of our
financial assets and financial liabilities, but that risk did not materially
affect the fair values of any of those assets or liabilities at March 31, 2022 .
We estimate the fair value of acquisition-related contingent consideration
obligations by applying an income approach model that utilizes
probability-weighted discounted cash flows. Each period we evaluate the fair
value of the acquisition-related contingent consideration obligations.
Significant judgment is applied to this model and therefore acquisition-related
contingent consideration obligation is classified within Level 3 of the fair
value hierarchy. In fiscal year 2022, the evaluation of the contingent
consideration for the FruitSmart acquisition resulted in the reduction of the
remaining $2.5 million of contingent consideration of the original $6.7 million
liability recorded in fiscal year 2020.
34
--------------------------------------------------------------------------------Income Taxes
Our consolidated effective income tax rate is based on our expected taxable income, tax laws and statutory tax rates, prevailing foreign currency exchange rates, and tax planning opportunities in the various jurisdictions in which we operate. Significant judgment is required in determining the effective tax rate and evaluating our tax position. We are subject to the tax laws of many jurisdictions, and could be subject to a tax audit in each of these jurisdictions, which could result in adjustments to tax expense in future periods. In the event that there is a significant, unusual, or one-time item recognized in our results, the tax attributed to that discrete item would be recorded at the same time as the item. Our consolidated income tax expense and effective tax rate are heavily dependent on the tax rates of the individual countries in which we operate, the mix of our pretax earnings from those countries, and the prevailing rates of exchange of their local currencies with theU.S. dollar. The mix of pretax earnings and local currency exchange rates in particular can change significantly between annual and quarterly reporting periods based on crop sizes, market conditions, and economic factors. Our effective tax rate can be volatile from year-to-year and from quarter-to-quarter as result of these factors. We have no undistributed earnings of consolidated foreign subsidiaries that are classified as permanently or indefinitely reinvested. We assume that all undistributed earnings of our foreign subsidiaries will be repatriated back to their parent entities in theU.S. where the funds are best placed to meet our cash flow requirements. In addition, we strive to mitigate economic, political, and currency risk by following a disciplined annual approach to the distribution of excess capital back to theU.S. Based on these assumptions, in our income tax expense for each reporting period we fully provide for all applicable foreign country withholding taxes that are expected to be due on these distributions. Our accounting for uncertain tax positions requires that we review all significant tax positions taken, or expected to be taken, in income tax returns for all jurisdictions in which we operate. In this review, we must assume that all tax positions will ultimately be audited, and either accepted or rejected based on the applicable tax regulations by the tax authorities for those jurisdictions. We must recognize in our financial statements only the tax benefits associated with tax positions that are "more likely than not" to be accepted upon audit, at the greatest amount that is considered "more likely than not" to be accepted. These determinations require significant management judgment, and changes in any given quarterly or annual reporting period could affect our consolidated income tax rate. Tax regulations require items to be included in taxable income in the tax return at different times, and in some cases in different amounts, than the items are reflected in the financial statements. As a result, our effective tax rate reflected in the financial statements is different than that reported in our tax returns. Some of these differences are permanent, such as expenses that are not tax deductible, while others are related to timing issues, such as differences in depreciation methods. Timing differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred or income taxes related to expenses that have not yet been recognized in the financial statements, but have been deducted in our tax return. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future tax returns for which we have already recorded the tax benefit in our financial statements. We record valuation allowances for deferred tax assets when the amount of estimated future taxable income is not likely to support the use of the deduction or credit. Determining the amount of such valuation allowances requires significant management judgment, including estimates of future taxable income in multiple tax jurisdictions where we operate. Based on our periodic earnings forecasts, we project the upcoming year's taxable income to help us evaluate our ability to realize deferred tax assets.
For additional disclosures on income taxes, see Notes 1 and 6 to the consolidated financial statements in Item 8.
Pension and Other Postretirement Benefit Plans
The measurement of our pension and other postretirement benefit obligations and costs at the end of each fiscal year requires that we make various assumptions that are used by our outside actuaries in estimating the present value of projected future benefit payments to all plan participants. Those assumptions take into consideration the likelihood of potential future events such as salary increases and demographic experience. The assumptions we use may have an effect on the amount and timing of future contributions to our plans. The plan trustee conducts an independent valuation of the fair value of pension plan assets. The significant assumptions used in the calculation of our pension and other postretirement benefit obligations are:
•Discount rate - The discount rate is based on investment yields on a hypothetical portfolio of actual long-term corporate bonds rated AA that align with the cash flows for our benefit obligations.
•Salary scale - The salary scale assumption is based on our long-term actual experience for salary increases, the near-term outlook, and expected inflation.
•Expected long-term return on plan assets - The expected long-term return on plan assets reflects asset allocations and investment strategy adopted by theFinance and Pension Investment Committee of the Board of Directors. •Retirement and mortality rates - Retirement rates are based on actual plan experience along with our near-term outlook. Early retirement assumptions are based on our actual experience. Mortality rates are based on standard industry group annuity mortality tables which are updated to reflect projected improvements in life expectancy. 35 -------------------------------------------------------------------------------- •Healthcare cost trend rates - For postretirement medical plan obligations and costs, we make assumptions on future inflationary increases in medical costs. These assumptions are based on our actual experience, along with third-party forecasts of long-term medical cost trends. From one fiscal year to the next, the rates we use for each of the above assumptions may change based on market developments and other factors. The discount rate reflects prevailing market interest rates at the end of the fiscal year when the benefit obligations are actuarially measured and will increase or decrease based on market patterns. The expected long-term return on plan assets may change based on changes in investment strategy for plan assets or changes in indicated longer-term yields on specific classes of plan assets. In addition to the changes in actuarial assumptions from year to year, actual plan experience affecting our net benefit obligations, such as actual returns on plan assets and actual mortality experience, will differ from the assumptions used to measure the obligations. The effects of these changes and differences increase or decrease the obligation we record for our pension and other postretirement benefit plans, and they also create gains and losses that are accumulated and amortized over future periods, thus affecting the expense we recognize for these plans over those periods. Changes in the discount rate from year to year generally have the largest impact on our projected benefit obligation and annual expense, and the effects may be significant, particularly over successive years where the discount rate moves in the same direction. As ofMarch 31, 2022 , the effect of the indicated increase or decrease in the selected pension and other postretirement benefit valuation assumptions is shown below. The effect assumes no change in benefit levels. Effect on 2022 Projected Effect on Benefit 2023 Annual Obligation Expense Increase Increase (in thousands of dollars) (Decrease) (Decrease) Changes in Assumptions for Pension Benefits Discount Rate: 1% increase$ (29,959) $ (2,582) 1% decrease 36,753 2,921 Expected Long-Term Return on Plan Assets: 1% increase - (2,461) 1% decrease - 2,461 Changes in Assumptions for Other Postretirement Benefits Discount Rate: 1% increase (2,006) (159) 1% decrease 2,365 181 Healthcare Cost Trend Rate: 1% increase 153 43 1% decrease (141) (41) A 1% increase or decrease in the salary scale assumption would not have a material effect on the projected benefit obligation or on annual expense for the Company's pension benefits. See Note 13 to the consolidated financial statements in Item 8 for additional information on pension and other postretirement benefit plans.
Other Estimates and Assumptions
Other management estimates and assumptions are routinely required in preparing
our financial statements, including the determination of valuation allowances on
accounts receivable and the fair value of long-lived assets. Changes in market
and economic conditions, local tax laws, and other related factors are
considered each reporting period, and adjustments to the accounts are made based
on management's best judgment.
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OTHER INFORMATION REGARDING TRENDS
AND MANAGEMENT'S ACTIONS
Our financial performance depends on our ability to obtain an appropriate price
for our products and services, to secure the product volumes and quality desired
by our customers, and to maintain efficient, competitive operations. As the
leading global leaf tobacco supplier, we continually monitor for issues and
opportunities that may impact the supply of and demand for leaf tobacco, the
volumes of leaf tobacco that we handle, and the services we provide. We have
also been building a plant-based ingredients platform and monitor issues and
opportunities that may impact these businesses as well.
Tobacco Operations Trends
We believe that a key factor to perform successfully in the tobacco industry is our ability to provide customers with the quality of leaf and the level of service they desire on a global basis at competitive prices, while maintaining stability of supply. We add significant value to the leaf tobacco supply chain, providing expertise in dealing with large numbers of farmers, efficiently selling various qualities of leaf produced in each crop to a broad global customer base, and delivering products and services produced in a sustainable manner that meet stringent quality and regulatory specifications. We also make the tobacco markets more efficient and provide crop development guidance at the farm level. As part of our commitment to our customers, we adapt our business model to meet their evolving needs and monitor new product developments in the tobacco industry to identify areas where we can provide additional value to them.
Mature Leaf Tobacco Markets
Leaf tobacco is sourced directly by product manufacturers, by global leaf suppliers such as ourselves, and by other smaller, mostly regional or local, leaf suppliers. We estimate that, of the flue-cured and burley tobacco grown outside ofChina in countries that are key export markets for tobacco, on average about a third is purchased directly by major manufacturers. Global leaf suppliers also usually purchase about a third of the tobacco, and the remainder is sourced by the smaller regional or local suppliers. In some markets the tobacco purchased directly by manufacturers is processed by the global leaf suppliers. Although we operate in a mature industry, where demand for the end products outside ofChina has been declining at a compound annual rate of about 0.6% over the last three years, our mission is to remain the leading global leaf tobacco supplier. In recent years, we have been and believe that we will continue to be able to grow parts of our business, and maintain performance despite declines in demand for leaf tobacco from product manufacturers. We have done this by continuing to increase our delivery of services, driving supply chain efficiencies, enhancing the range of services we provide to certain customers, including direct buying, agronomic support, and specialized processing services, and improving our market share. We intend to continue to work to expand our business while at the same time maintaining an appropriate return for the services we provide and believe that there are several longer term trends in the industry, such as a focus on sustainability, that could provide additional opportunities for us both to offer additional services to our customers and to increase our market share. We continually explore options to capitalize on the strengths of our core competencies and seek growth opportunities related to leaf tobacco and our operations around the world. For example, we have expanded our leaf purchasing, processing, value-added services, and grower support services in multiple origins in response to customer demand. We have increased our product offerings to meet demand for natural wrappers inthe United States andEurope and shisha (water pipe) style leaf tobacco for customers in theMiddle East andNorth Africa (MENA) region. As we look at ingredients investments and explore new growth opportunities within tobacco, Universal is dedicated to remaining the leading global leaf tobacco supplier and building on our strong history.
Focus on Cost Management
Manufacturers naturally seek to mitigate raw materials cost increases, and they
are placing increased emphasis on cost containment as they address declining
demand. While this is not a new trend, it continues to offer opportunities to us
as we bring supply chain efficiencies to the leaf markets. We believe that
global leaf suppliers add efficiencies to the markets through economies of
scale, as well as through the vital role played in finding buyers for all styles
and qualities of leaf tobacco, which achieves overall cost reductions. To
understand our business, it is important to note that tobacco is not a commodity
product. Flavor and smoking characteristics as well as chemistries of tobacco
vary based on the type of tobacco, the region where the tobacco is grown, and
the position of the leaf on the stalk of the plant. Many different styles and
grades of tobacco may be produced in a single tobacco crop. A particular
manufacturer may only want and have use for certain leaves of a plant. The leaf
tobacco supplier plays a vital role in the industry by finding buyers for all of
the leaf grades and styles of tobacco produced in a farmer's crop. This role
helps to improve leaf utilization.
In addition to bringing supply chain efficiencies to the leaf tobacco markets,
we bring operational efficiencies to the industry, which in turn help reduce
costs. These efficiencies include economical utilization of processing capacity,
an established and scalable global network of agronomists and technicians
helping to maintain a stable, productive, and sustainable farmer base, as well
as agronomic and production improvements to optimize leaf yields and qualities.
In addition, we are able to offer manufacturers a complete range of services
from the field to the delivery of the packed product that benefit from our
efficiencies. These services include such things as buying station optimization,
processing and blending to specific customer specifications or
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needs, storage of green or packed leaf tobacco, and logistical services. In
recent years, there has been an increase in the level of direct purchasing,
sorting, processing, and other value-added services that we provide our
customers, notably in the United States , Mexico , Brazil , Poland , Guatemala , the
Dominican Republic , and the Philippines . We believe this increase acknowledges
the efficiencies and services that we bring to the entire supply chain.
We have also seen some reductions in sourcing from lower-volume tobacco growing
origins by both global leaf suppliers and major manufacturers. Flue-cured
tobacco is produced in about 70 countries around the world, and burley tobacco
is grown in about 45 countries. However, over 80% of both the flue-cured tobacco
grown outside of China and the worldwide burley tobacco production is sourced
from the top ten growing areas for each type of tobacco. We believe that these
moves to reduce sourcing areas and concentrate on major tobacco export markets
are another way for the industry to increase efficiency and to reduce costs. We
have contributed to cost reduction and elimination of excess capacity in the
supply chain through the closure or realignment of programs in Argentina ,
Canada , Germany , Italy , Hungary , Malawi , Nicaragua , Switzerland , Tanzania , and
Zambia . We maintain a strong presence in all of the major tobacco sourcing areas
and believe that any growth in these areas would favor global leaf suppliers
such as ourselves. In the future, we expect that increased regulations requiring
stringent monitoring and testing of leaf chemistry and compliant sourcing
documentation will place greater emphasis on major sourcing areas.
Importance of Compliant Leaf
As we have said for many years, the production of compliant leaf for the tobacco industry continues to grow in importance. To be considered compliant, leaf tobacco must be grown in a traceable, sustainable manner utilizing GAP. We have long invested significant resources in the programs and infrastructure needed to work with growers to produce compliant leaf and continue to enhance our ability to monitor and demonstrate this compliance for our customers. Our GAP focus on implementing international principles of sustainability by encouraging and training our farmers to employ sound field production and labor management practices that promote farmer profitability and minimal environmental impact. To assist farmers, Universal provides comprehensive training, technical support in the field, and crop analytics through ongoing research and development. Our commitment to compliance is reinforced through MobiLeaf™, our proprietary mobile device platform that captures and shares data in real-time, embedding sustainability throughout our supply chain and providing monitoring of GAP efforts, compliance with labor standards, and opportunities to enhance efficiencies. We believe that compliant leaf will continue to grow in importance to our customers and, as a result, will favor global suppliers who are able to deliver this product.
Growth of Alternative Tobacco Products
Most of the major tobacco product manufacturers have been developing next generation and modified risk products. These include ENDS, oral tobacco and nicotine products, and heated tobacco products. ENDS use liquid nicotine, which is predominately derived from leaf tobacco, and heated tobacco products use leaf tobacco. Oral tobacco and nicotine products may use liquid nicotine or leaf tobacco. At this time, it is unclear how these new products will affect demand for leaf tobacco. However, as our customers have been developing these products, we have been working with them to make sure we are able to meet their needs for both their traditional and new products. This is consistent with our commitment to efficiently and effectively adapt our business model to meet our customers' evolving needs. Specifically, we have expertise in tobacco seed development, crop production methods, crop sourcing, processing, and manufacturing of reconstituted sheet tobacco, which is beneficial to our customers as they continue to develop alternative tobacco products. We also are able to provide high quality, traceable and sustainable liquid nicotine through our subsidiary, AmeriNic. We continue to monitor industry developments regarding next generation products, including consumer acceptance and regulation, and will adapt accordingly.
Leaf Tobacco Supply
Although flue-cured tobacco crops grown outside ofChina increased in fiscal year 2022 by about 4% to 1.7 billion kilos compared to fiscal year 2021, production levels remain below historical averages. In addition, these crops are projected to revert back to lower production levels, decreasing by about 4% to 1.7 billion kilos in fiscal year 2023. Global burley tobacco production also remains below historical levels and decreased by about 10% to about 398 million kilos in fiscal year 2022. Burley volumes are forecast to increase slightly to about 404 million kilos in fiscal year 2023. We estimate that as ofMarch 31, 2022 , industry uncommitted flue-cured and burley inventories, excludingChina were at historically low levels, totaling about 62 million kilos, a decrease of about 34% fromMarch 31, 2021 levels. At this time, we believe that both flue-cured tobacco and burley tobacco supply are in undersupply positions. We also forecast that oriental and dark air-cured tobacco production will decrease by about 21% and increase by about 4%, respectively, in fiscal year 2023. We believe both oriental tobaccos and dark air-cured tobaccos are in undersupply positions. Over the long term, we believe that global tobacco production will continue to move in line with slightly declining total demand.South America ,Asia ,Africa , andNorth America will remain key sourcing regions for flue-cured and burley tobaccos.China is a significant cigarette market. However, most of the cigarettes consumed inChina and the leaf tobacco used in those cigarettes are produced domestically. Therefore, we normally view the Chinese market independently when evaluating worldwide leaf tobacco supply and demand. Domestic leaf tobacco inventories have built up inChina over the last several years asChina's domestic leaf production has exceeded their domestic needs for the local cigarette market.China is continuing to 38 -------------------------------------------------------------------------------- demonstrate efforts to re-align their domestic leaf production and inventories to balance their needs, and inventories have started to come down. These efforts could influence global supply/demand in the short term.
Industry data shows that over the past three years, world consumption of cigarettes outside ofChina fell at a compound annual rate of about 0.6%. We believe that growth in world consumption of cigarettes outside ofChina peaked several years ago and is declining. As a result, we expect that near term global demand for leaf tobacco will continue to slowly decline in line with declining global cigarette consumption. Our sales consist primarily of flue-cured, burley, and dark air-cured tobaccos. Flue-cured and burley tobaccos, along with oriental tobaccos, are used in American-blend cigarettes which are primarily smoked inWestern Europe andthe United States . English-blend cigarettes which use flue-cured tobacco are mainly smoked in theUnited Kingdom andAsia and other emerging markets. Industry data shows that consumption of American-blend cigarettes was flat for the three years ended in 2021. If demand for American-blend cigarettes declines at a higher rate than reductions in demand for English-blend cigarettes, there may be less demand for burley and oriental tobaccos and more demand for flue-cured tobacco. However, demand is affected by many factors, including regulation, product taxation, illicit trade, alternative tobacco products, and Chinese imports. To the extent that domestic leaf production and inventory durations inChina do not meet requirements for Chinese cigarette blends, that tobacco could be sourced from other origins where we have major market positions. On a year-to-year basis, we are also susceptible to fluctuations in leaf supply due to crop sizes and leaf demand as manufacturers adjust inventories or respond to changes in cigarette markets. We currently believe that the supply of flue-cured tobaccos and burley tobaccos are in an undersupply relative to anticipated demand. However, inventories held by our customers may affect their near-term demand for leaf tobacco. We also sell oriental tobaccos, which are used in American-blend cigarettes, and dark tobaccos, which are used in cigars and other smokeless products. In recent years, we have seen increased demand for natural wrapper tobacco particularly for the European andU.S. machine-made cigar markets. While we expect demand for dark tobaccos used in cigar filler to be generally in line with supply, we are continuing to see strong demand for wrapper tobacco.
Pricing
Factors that affect green tobacco prices include global supply and demand, market conditions, production costs, foreign exchange rates, and competition from other crops. We work with farmers to maintain tobacco production and to secure product at price levels that are attractive to both the farmers and our customers. Our objective is to secure compliant tobacco that is produced in a cost-effective manner under a sustainable business model with the desired quality for our customers. In some areas, tobacco competes with agricultural commodity products for farmer production. In the past, leaf shortages in specific markets or on a worldwide basis have also led to green tobacco price increases.
Global Regulation of Tobacco Products
Public Acceptance of Increased Global Regulation on Tobacco Products
Diminishing social acceptance of tobacco use and increasing pressure from anti-smoking groups have cultivated a political environment that accepts greater regulations on tobacco products, particularly inthe United States and theEuropean Union . While the impact of this cultural trend on our business is uncertain, the global acceptance of stringent regulations could reduce demand for tobacco products and have a material adverse effect on our results of operation.
Strengthened Global Cooperation in the Regulation on Tobacco Products
The WHO Framework Convention on Tobacco Control ("FCTC") was ratified in 2005 to become the world's first international public health treaty. Since its inception, the FCTC has continued to strengthen international cooperation and collaboration in tobacco control by advancing the implementation of the treaty's 38 articles and increasing global participation. As the tenth Conference of the Parties approaches inNovember 2023 , the FCTC is working diligently to consider amendments to the agreement and track progress in the treaty's implementation.
While we cannot predict the extent or speed at which the efforts of the FCTC will reduce tobacco consumption, a proliferation of national laws and regulations spurred by the recommendations of the FCTC would likely reduce demand for both tobacco products and leaf.
United States
In 2009, theU.S. Congress passed the Family Smoking Prevention and Tobacco Control Act (the "Tobacco Act"). This legislation authorizes theU.S. Food and Drug Administration ("FDA ") to regulate the manufacturing and marketing of tobacco products. The Tobacco Act additionally prohibited characterizing flavors in cigarettes, restricted youth access to tobacco products, banned advertising claims regarding certain tobacco products, and established theCenter for Tobacco Products . 39 -------------------------------------------------------------------------------- Over the past decade, theFDA has focused on establishing the scientific foundation and regulatory framework for regulating tobacco products inthe United States . OnMay 10, 2016 , theFDA released "deeming" regulations to extendFDA oversight over all tobacco products, including electronic nicotine delivery systems, cigars, hookah tobacco, pipe tobacco, dissolvables, and "novel and future products." Additionally,Congress extendedFDA 's authority to include regulation of tobacco products using synthetically manufactured nicotine in addition to naturally derived nicotine inMarch 2022 . The regulations require tobacco product manufacturers to register tobacco products that were on the market onFebruary 15, 2007 , and to seekFDA authorization to sell any products modified or introduced after such date. All submissions require manufacturers to list ingredients in their products. InApril 2022 ,FDA released two proposed rules to advance product standards intended to ban menthol in cigarettes and characterizing flavors in cigars. The flavored tobacco product category accounts for a significant percentage of the U.S. market, and these product standards would likely impact future leaf demand if adopted. It is also expected that if these bans are adopted, they will be challenged in the legal system so it is not possible at this time to predict when and if these bans become effective. Although less than 5% of cigarettes manufactured worldwide are consumed inthe United States , theFDA is widely considered a global leader in the "science-based" regulation of tobacco products. TheFDA operates in stark contrast to the WHO's "emotion based" approach to nicotine use. The WHO is reluctant to accept one nicotine product as more/less risky than another, and their suggested solution is either rigorous regulation or outright prohibition. The continued implementation and enforcement of the Tobacco Act inthe United States is likely to influence the tobacco control measures considered by other countries and international bodies, including the WHO. It is impossible to predict the ultimate impact these developing regulations will have on our business, but any reduction in the demand for our customer's products will adversely impact the demand for leaf tobacco.
Global Acceptance of the Continuum of Risk in the Regulation of Novel Tobacco Products
As novel tobacco products, such as e-cigarettes and heat-not-burn devices, emerge in the global market, governments are tasked with developing the appropriate, science-based approach to regulation. In 2017, then Commissioner of theFDA ,Scott Gottlieb , announced a new regulatory approach for the regulation of tobacco products that embraced the placement of each product somewhere along a "continuum of risk". This comprehensive plan on nicotine use sought to facilitate an adult tobacco consumer's switch from combustible cigarettes to less risky products found lower on the continuum. As part of this regulatory scheme, theFDA approved the first "heat-not-burn" and "very-low nicotine" premarket tobacco applications to permit the sale of these products withinthe United States . Furthermore,FDA approved their first modified risk tobacco products applications to permit certain products in the heat-not-burn and smokeless categories to make modified exposure or risk claims. Although the WHO FCTC does not include specific harm-reduction provisions in the language of the treaty, a growing number of countries have established tobacco control strategies incorporating a continuum of risk concept. In addition, the global tobacco product market is continuously diversifying to include a wide array of novel tobacco products to serve as alternatives to combustible cigarettes. Regardless of the type, it is generally understood that most novel products on the market contain less leaf tobacco than combustible cigarettes. Therefore, the market-driven rise of novel products alongside a regulatory scheme designed to facilitate an adult tobacco consumer's switch from combustible cigarettes could affect global leaf demand. It is presently difficult to predict whether this will result in a decrease or an increase in requirements for leaf tobacco production in the long or short terms. Since they are marketed as replacements for combustible tobacco products, the question remains whether novel products will replace traditional cigarettes in the future, add to the market, or have a balancing effect. Increased Taxation A number of governments, particularly federal and local governments inthe United States and theEuropean Union , impose excise or similar taxes on tobacco products. Further legislation proposing new or increased taxes on tobacco products is likely to continue. In some cases, proposed legislation seeks to significantly increase existing taxes on tobacco products, or impose new taxes on products that have not been subject to tax (e.g. ENDS products and liquid nicotine). Increases in product taxation may reduce the affordability of, and demand for, tobacco products, which will affect requirements for leaf tobacco by tobacco product manufacturers.
Illicit Trade
Illicit trade is another factor which influences demand for legally and sustainably produced leaf tobacco. The WHO estimates that one in every ten cigarettes consumed globally is illicit. Individual governments likethe United States ,European Union , andBrazil have initiated substantial steps in combating illicit trade. In 2012 theWHO Framework Convention on Tobacco Control adopted an illicit trade protocol which has been so far ratified by only one third of its 182 parties. We continue to support both governmental and industry efforts to eradicate illicit trade. 40
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Ingredients Operations Trends
Following our capital allocation strategy, we have made disciplined investments within our leaf business to take advantage of growth opportunities in tobacco as well as in plant-based ingredients businesses and markets that could utilize our assets and capabilities. Through these actions, we believe that we will be able to deliver enhanced shareholder value despite operating in the mature leaf tobacco industry. We made significant strategic investments in our plant-based ingredients platform in fiscal years 2020, 2021, and 2022. We acquiredFruitSmart inJanuary 2020 , Silva inOctober 2020 , and Shank's inOctober 2021 . Our ingredients businesses provide our business-to-business customers with a broad variety of plant-based ingredients for both human and pet consumption. A variety of value-added manufacturing processes are used in these businesses to convert raw materials into a wide spectrum of fruit and vegetable juices, concentrates, dehydrated products, and botanical extracts and flavorings. These businesses provide value-added agricultural processing, part of the agricultural value chain where we possess significant business expertise. We consider the agricultural value chain to consist of agricultural inputs, crop production, agricultural processing, manufacture and distribution, and retail sales. We are pleased with the ongoing integration of our plant-based ingredients platform, and we are ahead of our capital allocation strategy objectives. With the acquisition of Shank's, we are able to expand the products that we offer by adding Shank's portfolio of high-quality botanical extracts and flavorings to our plant-based ingredients platform. One of the markets our plant-based ingredients business serve is the growing Global Health andWellness Foods Market . According to industry estimates this market is projected to grow at an annual rate of 4%-6% over the next several years. In addition, with the COVID-19 pandemic, there has been and continues to be strong consumer demand for healthy foods.FruitSmart is seeing growing consumer interest in better-for-you premium ingredients, including custom blends, not-from-concentrate and dry products. It is also seeing strong growth in targeted end markets utilizingFruitSmart products, including ciders, purees and nutraceuticals. Silva is well positioned to take advantage of increasing demand for natural and clean-label products across the end markets it serves, including within the attractive and growing savory and pet food end markets. Industry estimates project annual growth of about 5% over the next several years for the pet food market in theU.S. 41
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