Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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 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 strengthening our plant-based agri-product services platform, while maintaining our position as the leading global leaf tobacco supplier. In fiscal year 2021 we made considerable progress towards building and enhancing our plant-based ingredients platform. On October 1, 2020, we acquired Silva, a natural, specialty dehydrated vegetable, fruit, and herb processing company. We have also been working diligently on integrating and exploring opportunities for synergies between our recently acquired businesses, FruitSmart, acquired on January 1, 2020, and Silva.
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
On March 11, 2020, the World Health Organization declared the coronavirus (“COVID-19”) a pandemic. Foreign governmental organizations and governmental organizations in the United States have taken various actions to combat the spread of COVID-19, including imposing stay-at-home orders and closing “non-essential” businesses and their operations. We continue to closely monitor developments related to the ongoing COVID-19 pandemic and have taken and continue to take steps intended to mitigate the potential risks 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 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 ongoing pandemic. To date, we have not experienced a material impact to our supply chain, although the ongoing COVID-19 pandemic resulted in delays in certain operations during fiscal year 2021. In addition, our plant-based ingredients platform has seen some shifts in product mix due to the ongoing COVID-19 pandemic related to changes in customer demand. Since March 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 continue to monitor the impacts of the ongoing 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 ongoing 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.
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RESULTS OF OPERATIONS
Amounts described as net income (loss) and earnings (loss) per diluted share in the following discussion are attributable to Universal Corporation and exclude earnings related to non-controlling interests in subsidiaries. Adjusted operating income (loss), adjusted net income (loss) attributable to Universal 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 to Universal 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 to Universal Corporation to consolidated net income (loss) attributable to Universal 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 March 31, 2021, Compared to the Fiscal Year Ended March 31, 2020
Executive Summary
We are pleased to report that our net income and diluted earnings per share, and our non-GAAP adjusted operating income for fiscal year 2021, are all up over 20% compared to fiscal year 2020. Strong leaf tobacco shipments in the second half of fiscal year 2021, the addition of our plant-based ingredients acquisitions, and favorable foreign currency comparisons all contributed to this improvement in our results. We are especially proud that we were able to deliver these results in the midst of the COVID-19 pandemic, and would like to thank our employees, growers, customers, and other partners for their support, adaptability, and hard work that made this a successful year.
Leaf tobacco shipments, which started slowly in fiscal year 2021, accelerated in the second half of the fiscal year. We ended the year with leaf tobacco volumes that were just slightly below those in fiscal year 2020, in part due to some tobacco shipments that were delayed and will ship in fiscal year 2022. Despite global challenges including increased safety protocols, work-from-home mandates, and travel restrictions that necessitated adjustment to how we conduct our leaf tobacco business, we successfully delivered the leaf tobacco desired by our customers.
We also delivered on our capital allocation strategy objective to build and enhance our plant-based ingredients platform through the acquisition of Silva in the third quarter of fiscal year 2021. We are excited about the prospects for our plant-based ingredients platform and continue to progress on our integration process. In the fourth quarter of fiscal year 2021, our Ingredients Operations segment performed well against its objectives in both the human and pet food categories.
In the year ended March 31, 2021, we benefited from positive net foreign currency comparisons, mostly non-cash currency remeasurement, of $26 million, compared to fiscal year 2020. Certain currencies weakened significantly in the fourth quarter of fiscal year 2020, largely due to uncertain market conditions related to the burgeoning COVID-19 pandemic. We ended our fiscal year 2021 with a strong balance sheet and uncommitted leaf tobacco inventory levels just over our target range, at 22%. In addition to our investments in growth opportunities, we are also pleased to have announced our 51 st annual dividend increase, continuing our commitment to delivering shareholder value.
As we move into fiscal year 2022, we currently expect global supply for flue-cured leaf tobacco to be in line with anticipated demand and for burley leaf tobacco to be in a slight undersupply position. We are continuing to monitor freight costs as the COVID-19 pandemic disrupted shipping patterns, which has resulted in cost increases due to limited container availability.
We published our second annual Sustainability Report in fiscal year 2021 on our website. The report showcases our strong commitment to our sustainability programs and initiatives which stems from our belief that sustainability is a key component of our past and future success. In fiscal year 2022, we will continue to deliver on our fundamental responsibility to our stakeholders to set high standards of social and environmental performance to support a sustainable supply chain.
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FINANCIAL HIGHLIGHTS
Fiscal Year Ended March 31, Change
(in millions of dollars, except per share data) 2021 2020 $ %
Consolidated Results
Sales and other operating revenue $ 1,983.4 $ 1,910.0 $ 73.4 4 %
Cost of goods sold 1,597.4 1,553.2 44.2 3 %
Gross Profit Margin 19.5 % 18.7 % --- 80 bps
Selling, general and administrative expenses 219.8 222.9 (3.1) (1) %
Restructuring and impairment costs 22.6 7.5 15.0 199 %
Operating income (as reported) 147.8 126.4 21.4 17 %
Adjusted operating income (non-GAAP)* 172.9 141.3 31.7 22 %
Diluted earnings per share (as reported) 3.53 2.86 0.67 24 %
Adjusted diluted earnings per share (non-GAAP)* 4.25 3.49 0.76 22 %
Segment Results
Tobacco operations sales and other operating revenues $ 1,841.8 $ 1,887.1 $ (45.2) (2) %
Tobacco operations operating income 168.8 146.6 22.2 15 %
Ingredients operations sales and other operating revenues 141.5 22.9 118.6 518 %
Ingredient operations operating income 0.4 (8.5) 8.9 (104) %
*See Reconciliation of Certain Non-GAAP Financial Measures in Other Items below
Net income for the fiscal year ended March 31, 2021, was $87.4 million, or $3.53 per diluted share, compared with $71.7 million, or $2.86 per diluted share, for the fiscal year ended March 31, 2020. Excluding restructuring and impairment costs and certain other non-recurring items, detailed in Other Items below, net income and diluted earnings per share increased by $17.6 million and $0.76, respectively, for fiscal year 2021, compared to fiscal year 2020. Operating income of $147.8 million for the year ended March 31, 2021, increased by $21.4 million, compared to operating income of $126.4 million for the year ended March 31, 2020. Adjusted operating income, detailed in Other Items below, of $172.9 million increased by $31.7 million for fiscal year 2021, compared to adjusted operating income of $141.3 million for fiscal year 2020.
Consolidated revenues increased by $73.4 million to $2.0 billion for the year ended March 31, 2021, compared to the fiscal year ended March 31, 2020, on the addition of businesses acquired in calendar year 2020 in the Ingredients Operations segment, offset in part by lower comparative leaf tobacco shipment volumes.
Tobacco Operations
Operating income for the Tobacco Operations segment increased by $22.2 million to $168.8 million for the fiscal year ended March 31, 2021, compared with the fiscal year ended March 31, 2020. Favorable foreign currency remeasurement comparisons and strong tobacco shipment volumes benefited Tobacco Operations segment results for the year ended March 31, 2021. Tobacco shipment volumes for fiscal year 2021, which were heavily weighted to the second half of the fiscal year, ended up just slightly below tobacco shipment volumes for fiscal year 2020.
In fiscal year 2021, compared to fiscal year 2020, sales volumes were up in Brazil and the United States on higher sales of carryover crop tobacco, while volumes decreased in Africa in part on weather reduced crop sizes as well as some delayed shipments that will occur in fiscal year 2022. Selling, general, and administrative costs for the segment were lower for fiscal year 2021, compared to fiscal year 2020, largely on favorable net foreign currency remeasurement comparisons, mainly in Indonesia and Brazil. A favorable product mix and continued strong wrapper demand also benefited Tobacco Operations results in fiscal year 2021. Revenues for the Tobacco Operations segment of $1.8 billion for fiscal year 2021 were down $45.2 million, compared to fiscal year 2020, on slightly lower leaf tobacco shipment volumes and sales prices.
Ingredients Operations
As part of our capital allocation strategy to build and enhance our plant-based ingredients platform, we acquired two companies, FruitSmart on January 1, 2020, and Silva on October 1, 2020. We also made the strategic decision to wind down our CIFI business in the quarter ended December 31, 2020.
Operating income for the Ingredients Operations segment was $0.4 million for the fiscal year ended March 31, 2021, compared to an operating loss of $8.5 million for the fiscal year ended March 31, 2020. Results for the segment included costs from amortization of intangibles related to the acquisitions, which totaled $6.4 million in the fiscal year ended March 31, 2021, as
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well as purchase accounting adjustments of $2.8 million in year ended March 31, 2021, and $2.7 million in the year ended March 31, 2020, that also reduced our results for the segment. Our Ingredients Operations saw some changes in product mix during fiscal year 2021 due to changes in customer demand resulting from the ongoing COVID-19 pandemic. While demand for ingredients used in products for restaurants and social venues declined, we saw demand increase for ingredients used in grocery items and pet foods. In the fourth quarter of fiscal year 2021, we began to see demand for our products recover from certain sectors, such as food service, which were negatively impacted by COVID-19. Selling, general, and administrative expenses increased in the fiscal year ended March 31, 2021, on the addition of the acquired businesses. Revenues for the Ingredients Operations segment of $141.5 million for the fiscal year ended March 31, 2021, were up $118.6 million, compared to the fiscal year ended March 31, 2020, on the addition of the revenues for the acquired businesses.
Other Items
Cost of goods sold in the fiscal year ended March 31, 2021, increased by 3% to $1.6 billion, compared with the fiscal year ended March 31, 2020, as a result of variances in tobacco shipment volumes and green tobacco prices as well as the acquisition of businesses in the Ingredients Operations segment. Selling, general, and administrative costs for the fiscal year ended March 31, 2021, decreased by $3.1 million to $219.8 million, compared to the fiscal year ended March 31, 2020, as positive comparisons on foreign currency remeasurement and exchange variances more than offset additional costs from the business acquisitions in the Ingredients Operations segment. The positive foreign currency remeasurement and exchange variances, primarily in Indonesia and Brazil, totaled approximately $26 million in the fiscal year ended March 31, 2021.
For the fiscal year ended March 31, 2021, our consolidated effective tax rate was 23%. For the fiscal year ended March 31, 2021, income tax expense included a $4.4 million benefit for final tax regulations regarding the treatment of dividends paid by foreign subsidiaries and a $3.4 million benefit due to amending and finalizing prior year returns. Without these benefits, the consolidated effective tax rate for the fiscal year ended March 31, 2021, would have been approximately 30%.
Our consolidated effective tax rate for the fiscal year ended March 31, 2020, was approximately 34%. Income tax expense for the fiscal year ended March 31, 2020 included a $2.8 million net tax accrual for a tax settlement charge related to operations at a foreign subsidiary and a $1.5 million benefit due to amending and finalizing prior year returns. Without the effect of these items, the consolidated effective tax rate for the fiscal year ended March 31, 2020, would have been approximately 30%.
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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 to Universal Corporation:
Adjusted Operating Income Reconciliation
Fiscal Year Ended March 31,
(in thousands) 2021 2020
As Reported: Consolidated operating income $ 147,810 $ 126,367
Purchase accounting adjustments (1)
2,800 2,700
Transaction costs for acquisitions (2)
3,915 4,668
Fair value adjustment to contingent consideration for FruitSmart acquisition (3)
(4,173) —
Restructuring and impairment costs (4)
22,577 7,543
Adjusted operating income $ 172,929 $ 141,278
Adjusted Net Income and Diluted Earnings Per Share Reconciliation
(in thousands except for per share amounts) Fiscal Year Ended March 31,
(all amounts reported net of income taxes) 2021 2020
As Reported: Net income attributable to Universal Corporation $ 87,410 $ 71,680
Purchase accounting adjustments (1)
2,800 2,133
Transaction costs for acquisitions (2)
3,915 4,668
Fair value adjustment to contingent consideration for FruitSmart acquisition (3)
(4,173) —
Restructuring and impairment costs (4)
17,800 6,283
Interest expense related to an uncertain tax matter at a foreign subsidiary 1,849 —
Income tax benefit from dividend withholding tax liability reversal (5)
(4,421) —
Income tax settlement for foreign subsidiary (6)
— 2,766
Adjusted Net income attributable to Universal Corporation $ 105,180 $ 87,530
As reported: Diluted earnings per share $ 3.53 $ 2.86
Adjusted: Diluted earnings per share $ 4.25 $ 3.49
(1) The Company recognized an increase in cost of goods sold in fiscal year 2021 and 2020, relating to the expensing of a fair value adjustments to inventory associated with the initial acquisition accounting for Silva (effective October 1, 2020) and FruitSmart (effective January 1, 2020).
(2) The Company incurred selling, general, and administrative expenses for due diligence and other transaction costs associated with the acquisitions of Silva and FruitSmart. These costs are not deductible for U.S. income tax purposes.
(3) The Company reversed a portion of the contingent consideration liability for the FruitSmart acquisition, as a result of certain performance metrics that did not meet the required threshold stipulated in the purchase agreement.
(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 attributable to Universal Corporation, and Adjusted diluted earnings per share. See Note 4 for additional information.
(5) The Company recognized an income tax benefit for final U.S. tax regulations on certain dividends paid by foreign subsidiaries in a prior fiscal year.
(6) The Company recognized an income tax settlement charge related to operations at a foreign subsidiary.
Fiscal Year Ended March 31, 2020, Compared to the Fiscal Year Ended March 31, 2019
For a comparison of our performance and financial metrics for the fiscal years ended March 31, 2020 and March 31, 2019, 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 ended March 31, 2020, filed with the SEC on May 28, 2020.
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 the Financial Accounting Standards Board ("FASB") that will become effective and be adopted by the Company in future reporting periods.
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LIQUIDITY AND CAPITAL RESOURCES
Overview
Our working capital requirements in fiscal year 2021 were lower than those in fiscal year 2020 mainly due to higher carryover crop sales of leaf tobacco, lower green leaf tobacco prices, and smaller African tobacco crops. In fiscal year 2021, we also generated $220.4 million in cash flows from our operating activities, and our liquidity was sufficient to meet our needs. We continued our conservative 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 in South America and Africa and can increase from March to September by more than $300 million. The funding required can vary significantly depending upon such factors as crop sizes, the price of leaf, the relative strength of the U.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 $35 to $45 million during fiscal year 2022 for capital expenditures to maintain our facilities and invest in opportunities to grow and improve our businesses. We also expect to provide about $7 million in funding to our pension plans. We have no long-term debt maturing until fiscal year 2024.
To date, COVID‐19 has not had a significant impact on our operations, and 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.
Cash Flow
Our operations generated about $220.4 million in operating cash flows in fiscal year 2021. That amount was about $209.5 million higher than the $10.9 million we generated in fiscal year 2020, largely due to lower working capital requirements in fiscal year 2021. During the fiscal year ended March 31, 2021, we spent $66.2 million on capital projects and $164.0 million on the acquisition of a new business, and we returned $75.2 million to shareholders in the form of dividends. At March 31, 2021, cash balances totaled $197.2 million.
Working Capital
Working capital at March 31, 2021, was about $1.3 billion, up about $50.0 million from last fiscal year's level, largely on the addition of assets from our acquisition of Silva, offset in part by lower tobacco inventories. Tobacco inventories of $640.7 million at March 31, 2021, were down $66.6 million compared to inventory levels at the end of the prior fiscal year, mainly due to higher carryover crop sales of leaf tobacco, lower green leaf tobacco prices, and lower purchase volumes of African tobacco crops in part due to weather-reduced crop sizes. Other inventories were up $46.7 million at March 31, 2021, from prior year levels largely on our acquisition of Silva in October 2020. 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 $35.8 million to $139.2 million, or about 22% of tobacco inventory, at March 31, 2021, which was slightly above our target range. Uncommitted inventories at March 31, 2020, were $175.0 million, which represented 25% 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 up $89.8 million at the end of fiscal year 2021, compared to balance at the end of fiscal year 2020, on lower working capital requirements due to the lower tobacco inventory levels and timing of customer payments.
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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 non-tobacco industries and markets 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 non-tobacco industries 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 Silva for approximately $164 million on October 1, 2020. The acquisition expanded our plant-based ingredients platform, and we expect it to enable us to offer customers a single source for vegetable and fruit ingredients. 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 51-year history of dividend increases.
Share Activity
Our Board of Directors approved our current share repurchase program in November 2020. The program authorizes the purchase of up to $100 million of our common stock through November 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 2021, we did not purchase any shares of common stock. At March 31, 2021, our available authorization under our current share repurchase program was $100 million, and approximately 24.5 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 enhance our farmer base. During fiscal years 2021 and 2020, we invested $66.2 million and $35.2 million, respectively, in our property, plant, and equipment. In the fourth quarter of fiscal year 2021, we purchased the operating and administrative facilities of our FruitSmart business, which we had previously leased, for approximately $16.5 million. Depreciation expense was approximately $38.3 million and $37.5 million, respectively, in fiscal years 2021 and 2020. Generally, our capital spending on maintenance projects is at a level below depreciation expense in order to maintain strong cash flow. 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 $35 to $45 million in fiscal year 2022 on capital projects for maintenance of our facilities and other investments to grow and improve our businesses. Typically, our capital expenditures for maintenance projects are less than $30 million per fiscal year.
Outstanding Debt and Other Financing Arrangements
We financed the Silva acquisition using cash-on-hand and borrowings under our committed revolving credit facility. On December 17, 2020, we amended our bank credit agreement, originally dated as of December 20, 2018, to increase the amount of the amount of the term A-1 loans which mature in December 2023 by an additional $75 million and the amount of term A-2 loans which mature in December 2025 by an additional $75 million. We also amended the definition of Consolidated EBITDA under the agreement to (i) exclude the effects of any non-cash purchase accounting adjustments, (ii) make pro forma adjustments for material acquisitions and material dispositions and (iii) permit adjustments for certain transaction fees and expenses related to the amendment and any material acquisition or disposition. All other material terms and conditions of the bank credit agreement remain in full force and effect. We used the proceeds from the term loans to repay borrowings under the committed revolving credit facility.
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
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consider our net debt plus shareholders' equity to be our net capitalization. Net debt increased by $81.4 million to $431.0 million during the fiscal year ended March 31, 2021. The increase primarily reflects the Silva acquisition offset in part by higher cash balances. Net debt as a percentage of net capitalization was approximately 25% at March 31, 2021, up from 22% at March 31, 2020.
As of March 31, 2021, we had $430 million available under a committed revolving credit facility that will mature in December 2023, and we, together with our consolidated affiliates, had approximately $274 million in uncommitted lines of credit, of which approximately $172 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 of March 31, 2021, we were in compliance with all covenants of our debt agreements. We also have an active, undenominated universal shelf registration filed with the SEC in November 2020 that provides for future issuance of additional debt or equity securities. We have no long-term debt maturing until fiscal year 2024.
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 $150 million of the five-year term loan and $220 million of the seven-year term loan were 3.94% and 4.26%, respectively, as of March 31, 2021. 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. At March 31, 2021, the fair value of our open interest rate hedge swaps was a net liability of approximately $26 million.
We also enter forward contracts from time to time to hedge certain foreign currency exposures, primarily related to forecast purchases of tobacco and related processing costs in Brazil and Africa, 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. At March 31, 2021, the fair value of those open contracts was a net asset of approximately $0.1 million. We also had other forward contracts outstanding that were not designated as hedges, and the fair value of those contracts was a net liability of approximately $0.4 million at March 31, 2021. For additional information, see Note 11 to the consolidated financial statements in Item 8.
Pension Funding
The funds supporting our ERISA-regulated U.S. defined benefit pension plan during fiscal year 2021 were approximately $261 million. The accumulated benefit obligation (“ABO”) and the projected benefit obligation (“PBO”) were both approximately $244 million and $250 million, respectively as of March 31, 2021. 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 contributions of about $7 million 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.
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Contractual Obligations
Our contractual obligations as of March 31, 2021, were as follows:
(in thousands of dollars) Total 2022 2023-2024 2025-2026 After 2026
Notes payable and long-term debt (1)
$ 705,905 $ 126,015 $ 263,775 $ 316,115 $ —
Operating lease obligations 34,893 11,074 12,130 6,389 5,300
Inventory purchase obligations:
Tobacco
564,987 441,544 123,443 — —
Agricultural materials
36,846 36,846 — — —
Other purchase obligations 65,678 50,843 8,035 6,800 —
Total
$ 1,408,309 $ 666,322 $ 407,383 $ 329,304 $ 5,300
(1) Includes interest payments. Interest payments on $251.0 million of variable rate debt were estimated based on rates as of March 31, 2021. 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 $122 million, net of allowances, at March 31, 2021.
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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. 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 2021, 2020, and 2019 were $13.4 million, $10.3 million, and $4.0 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. At March 31, 2021, the gross balance of advances to tobacco suppliers totaled approximately $144 million, and the related valuation allowance totaled approximately $18 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, 2021, the gross balance of recoverable tax credits (primarily VAT) totaled approximately $49 million, and the related valuation allowance totaled approximately $19 million.
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,
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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.
Goodwill
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, 2021 and 2020, 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 2021. 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 recent acquisitions of FruitSmart (January 1, 2020) and Silva (October 1, 2020).
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, 2021. 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 2021, the evaluation of the contingent consideration for the FruitSmart acquisition resulted in the reduction of $4.2 million of contingent consideration of the original $6.7 million liability recorded in fiscal year 2020.
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 the U.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.
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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 the U.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 the U.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 the Finance 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.
• 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.
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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 of March 31, 2021, 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.
(in thousands of dollars) Effect on
2021 Projected
Benefit Obligation
Increase
(Decrease) Effect on
2022 Annual Expense
Increase
(Decrease)
Changes in Assumptions for Pension Benefits
Discount Rate:
1% increase $ (32,905) $ (2,624)
1% decrease 40,554 2,885
Expected Long-Term Return on Plan Assets:
1% increase — (2,459)
1% decrease — 2,458
Changes in Assumptions for Other Postretirement Benefits
Discount Rate:
1% increase (2,462) (264)
1% decrease 2,923 177
Healthcare Cost Trend Rate:
1% increase 190 62
1% decrease (175) (58)
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 of China in countries that are key export markets for tobacco, on average a little over a third is purchased directly by major manufacturers. Global leaf suppliers also usually purchase a little over 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 of China has been declining at a compound annual rate of about 1% 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, and grower support services in multiple origins in response to customer demand. We have increased our product offerings to meet demand for shisha (water pipe) style leaf tobacco for customers in the Middle East and North Africa (MENA) region and natural wrappers in the United States and Europe. As we look at non-tobacco 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,
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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 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, processing, and other supply chain 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 over 70 countries around the world, and burley tobacco is grown in over 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 electronic nicotine delivery systems (“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
Flue-cured tobacco crops grown outside of China declined in fiscal year 2021 by about 13% to 1.7 billion kilos compared to fiscal year 2020. Global burley tobacco production decreased by about 16% to about 457 million kilos in fiscal year 2021, largely due to smaller crops in Africa and Brazil. Flue-cured tobacco crops grown outside of China are projected to increase by about 5% to 1.8 billion kilos in fiscal year 2022. Burley volumes are also forecast to decrease further to about 431 million kilos in fiscal year 2022. We estimate that as of March 31, 2021, industry uncommitted flue-cured and burley inventories, excluding China, totaled about 94 million kilos, a decrease of about 30% from March 31, 2020 levels. At this time, we believe that flue-cured tobacco supply is in line with anticipated demand and burley tobacco supply is in a slight undersupply position.
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We also forecast that oriental and dark air-cured tobacco production will both decrease by about 5% and 6%, respectively, in fiscal year 2022. Over the long term, we believe that global tobacco production will continue to decline slightly in line with slightly declining total demand. South America, Asia, Africa, and North America will remain key sourcing regions for flue-cured and burley tobaccos.
China is a significant cigarette market. However, most of the cigarettes consumed in China 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 in China over the last several years as China’s domestic leaf production has exceeded their domestic needs for the local cigarette market. China is continuing to 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.
Leaf Tobacco Demand
Industry data shows that over the past three years, total world consumption of cigarettes fell at a compound annual rate of about 1%. We believe that growth in world consumption of cigarettes 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 and burley tobaccos. Those types of tobacco, along with oriental tobaccos, are used in American-blend cigarettes which are primarily smoked in Western Europe and the United States. English-blend cigarettes which use flue-cured tobacco are mainly smoked in the United Kingdom and Asia and other emerging markets. Industry data shows that consumption of American-blend cigarettes has declined at a compound annual rate of about 1% for the three years ended in 2020. 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 in China 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 is in line with anticipated demand, and the supply of burley tobaccos is in a slight undersupply. 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 and U.S. machine-made cigar markets. While we expect demand for oriental tobaccos and 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 in the United States and the European 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 World Health Organization’s (“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
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increasing global participation. As the ninth Conference of the Parties approaches in November 2021, 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 FDA’s Continued Enforcement of the Tobacco Control Act
In 2009, the U.S. Congress passed the Family Smoking Prevention and Tobacco Control Act (the "Act”). This legislation authorizes the U.S. Food and Drug Administration (“FDA”) to regulate the manufacturing and marketing of tobacco products. The Act additionally prohibited characterizing flavors in cigarettes, restricted youth access to tobacco products, banned advertising claims regarding certain tobacco products, and established the Center for Tobacco Products.
Over the past decade, the FDA has focused on establishing the scientific foundation and regulatory framework for regulating tobacco products in the United States. On May 10, 2016, the FDA released “deeming” regulations to extend FDA oversight over all tobacco products, including electronic nicotine delivery systems, cigars, hookah tobacco, pipe tobacco, dissolvables, and “novel and future products.” The regulations require tobacco product manufacturers to register tobacco products that were on the market on February 15, 2007, and to seek FDA authorization to sell any products modified or introduced after such date. All submissions require manufacturers to list ingredients in their products. Per an order issued by the U.S. District Court for the District of Maryland in July 2019, the deadline for all pre-market tobacco application submissions moved to May 12, 2020. However, due to the global COVID-19 pandemic, the Court extended this deadline to September 9, 2020. The Agency was given one year to approve or deny the marketing applications under consideration.
Although less than 5% of cigarettes manufactured worldwide are consumed in the United States, the FDA is widely considered a global leader in the “science-based” regulation of tobacco products. The FDA operates in stark contrast to the World Health Organization’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 Act in the 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 the FDA, 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, the FDA approved the first “heat-not-burn” and “very-low nicotine” premarket tobacco applications to permit the sale of these products within the United States. Furthermore, FDA approved their first modified risk tobacco products applications (“MRTPs”) 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 in the United States and the European 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.
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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 like the United States, European Union, and Brazil have initiated substantial steps in combating illicit trade. In 2012 the WHO 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.
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 and 2021. We acquired FruitSmart in January 2020 and Silva in October 2020. 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, and dehydrated products. 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.
One of the markets our plant-based ingredients business serve is the growing Global Health and Wellness 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 is 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 utilizing FruitSmart 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.
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