A few weeks ago, we compared the two then-current Magic Formula Investing tobacco stocks, Lorillard (LO) and Vector Group (VGR). Late last week yet another tobacco firm joined the fray, the proverbial 800-pound gorilla in the space, Altria Group (MO). How does Altria fit into our comparison, and is it a buy candidate?
The Undisputed Champion
Altria, formerly known as Philip Morris, is unquestionably the No. 1 company in the domestic tobacco industry. Its Marlboro brand of cigarettes accounted for an amazing 43.6% share of the U.S. market in 2012, up 0.6% from the prior year. It has been the No. 1 selling brand in the U.S. for over 35 years. Marlboro is a category-busting brand, with offerings in almost every segment of the market including full-flavor, menthols, "light" and "ultra light" (although they can't be called that anymore), 72 and 100 millimeter, etc.
Along with other premium brands such as Parliament and Virginia Slims, and discount brands like Basic, Altria commands 50.3% of the U.S. cigarette market. Considering the next-closest firm, Reynolds, only carries 27% market share, Altria's dominance is clear.
The company also has a sizable smokeless tobacco division (just under 13% of sales), stemming from the 2009 purchase of UST. Similar to its dominance in cigarettes, Altria's Copenhagen and Skoal brands together accounted for 55.2% of U.S. chew sales last year, up from 54.8% in 2011. Reynolds, with its Grizzly and Kodiak holding 31.5% share, is a distant second. Smokeless is an attractive business. With much lower excise taxes and no settlement payments to the states, smokeless products carry immense (> 50%) operating margins. Furthermore, this is actually a growth business, with Copenhagen volume up almost 9% in the most recent quarter.
Altria isn't sitting still on the latest trends, either. The firm recently announced that it would be launching its first e-cig product (MarkTen) in August, challenging Lorillard (with blu) and several smaller manufacturers in the category. Finally, Altria has a 27% stake in SABMiller, one of the world's largest brewers. This very attractive investment has routinely generated about 10% of Altria's pre-tax profits.
Against the Other MFI Tobacco Firms
In our previous article, we concluded firmly that Lorillard was a far better choice than Vector for a variety of reasons. The same is true of Altria -- it's a far better operator, has better competitive advantages and a better balance sheet, etc. So the comparison comes down to which is a better buy: Lorillard or Altria?
By the numbers, we have two very similar firms here. Both Altria and Lorillard generate around 30% operating margins, convert 16% of sales to free cash flows, have similarly leveraged balance sheets, and carry dividend yields of 5%. Both have very strong and share-taking brands in Marlboro and Newport. Lorillard is actually generating modest revenue growth (3%-4%) as menthols continue to account for higher percentages of cigarette sales, while Altria is basically treading water (flat revenues over the last three years). On the other hand, Lorillard does not compete in the attractive smokeless market, and although Lorillard does have significant share in e-cigs (40%), the "big boys" are coming to play very soon.
The last thing we have to compare is valuation. Lorillard is cheaper. Using the our earnings yield calculation, which accounts for cash and debt, Lorillard carries a 10.9% yield while Altria's is just 8.9%. However, this has been the norm -- LO's five-year average is 11.9%, while MO's is about 10%. If investors do want one point of differentiation, Lorillard's payout of free cash flow toward the dividend is measurably lower at 71.5% vs. Altria's 92.3%.
Conclusion: Just Say No
We've made a fair amount of comparison here, but we believe that neither Lorillard nor Altria (and certainly not Vector Group) make particularly attractive investments right now. Just from what we discussed above, we can see that both stocks are trending above their historical valuations at present. Additionally, a discounted free cash flow calculation gives a fair value of $47 for Lorillard and $35 for Altria -- both right around current prices. Investors should look elsewhere for opportunities.