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Executive summary

As most U.S. based cigarette companies and investors get jittery about the continued regulatory attacks, prevailing tax hikes and social stigma in the U.S., one company continues to stand out from the pack. As such, it has turned out to be the perfect play for those investors looking for stable income opportunity as its diversification in the industry has helped the company to continue growing its revenues and earnings in the face of significant decline in U.S. tobacco users. I am talking about Altria Group Inc. (MO). Add this to the fact that the company operates in an industry that is far less sensitive to the economy than other industries, then you have one of the best income opportunities right before you.

Operating in a unique industry

The Tobacco industry is very unique for several reasons, including the fact that it has bravely endured decades of regulatory attacks from various fronts and yet remained profitable. It faced yet another attack late July when the United States FDA made moves to regulate or even ban the use of menthol cigarettes. Once this became public knowledge, it had an adverse effect on shares of those companies that produce and sell cigarettes, especially those that derive a huge percentage of their revenues from selling menthol cigarettes.

Yes, Altria's shares plunged 2.8%, Reynolds American Inc.'s (RAI) plunged 1.9% while Lorillard Inc. (LO) took most of the heat as its shares plunged 4.1%. From the figures, Lorillard was the most affected because among the three companies, menthol-flavored cigarettes make up a huge percentage of the company's annual sales. Also, the company's products were focused more on U.S. smokers. Newport is the company's premium menthol-flavored brand, the overall second-largest selling cigarette and as such, the company's cash cow. Other brands from Lorillard include Old Gold, Mavericks, Satin, and Max.

The US FDA's argument is based on the fact that even with its excessive anti-smoking campaigns, non-smokers are being lured into the habit through flavored cigarettes, with huge emphasis on menthol flavor. Before management knew what hit them, Lorillard's shares was trading far below its industry average earnings and yielding higher dividends. Although the earnings ratio has significantly increased with less dividend yield, it is still trading at a discount when compared to S&P 500 average and industry average.

Altria's growth strategies in the tobacco industry

Considering the fact that Altria controls approximately 50% of the U.S. tobacco market, its stock should have taken more heat than it did but that was not the case. This stems from the fact that with the continuing anti-smoking regulations, bans, social stigma and prevailing tax hikes leading to a decline in the number of smokers in the U.S., the company's management diversified the company's business.

To be on the safer side, considering the decline in revenues from the U.S., the company spun off Philip Morris International, Inc. (PM) in 2008 as its international tobacco manufacturing company. It was a wise management decision since PMI is currently the world's largest producer of tobacco products and maintains over 15% of the global tobacco market, excluding the U.S. With less than 20% adult smokers in the U.S., the company projected itself to benefit from the over 50% adult smokers in the emerging markets through PMI. With this move, Altria has been growing its profit from international sales through Philip Morris International.

In the United States, Philip Morris USA serves as Altria's domestic tobacco manufacturing company as it handles production and distribution of tobacco products to wholesalers of the company's U.S. cigarette brands. By sales and volume, PM USA is the largest tobacco company in the U.S. Based on this diversification, what Altria is losing in the US through PM USA, it is gaining in the international markets through PMI.

Altria went further to dip its foot in the smokeless tobacco niche. This it achieved through an acquisition. In 2009, it acquired UST, a moist smokeless tobacco manufacturing company that is rated as the world's largest by sales. Its smokeless brands include Skoal and Copenhagen.

Another strategic move by Altria is the launch of its first electronic cigarette. It made this move after Lorillard has already entered the e-cigarette market in 2012 with its acquisition of Blu eCigs, a privately held company. The deal, which is valued at $135 million, is worth the money spent on it as it has continued to generate significant revenues for Lorillard. In the most recent reported second quarter, the company generated revenues of $57 million from eCigs with net profit of $18 million.

Back to Altria, its e-cigarette is under the MarkTen brand name. With the product's "Four Draw" technology, the company is offering users a smoking experience that is consistent with smoking traditional cigarettes. The company is not stopping there as it increases research and development on cigarette alternatives in order to maintain the company's growth in the future. This is especially necessary with the continued decline in the number of traditional cigarette smokers.

Although Altria operates in an industry that is less sensitive to economic recession unlike other industries, it still feels a little impact of any shift in consumer behavior as a good number of its brands in the US are classified as premium. The company's premium cigarettes make up more than 90% of the company's US revenues with its single value brand, Basic, making up the remaining less than 10%.

In order not to risk losing its customers in droves during economic downturns, the management makes sure to effectively manage the gap between the wholesale prices of the company's premium cigarettes and value cigarettes. This way, the company's customers don't have to switch to deep-discount brands as the price difference is not much. The company also makes sure that the price is at such level that it bridges the gap without negatively impacting on the company's profit.

The opportunity - taking a closer look

In the past two years, Altria has exhibited a positive EPS growth. In comparison to the same quarter of the previous fiscal year, the most recent quarter showed 5.0% increase in its EPS. This is a trend analysts expect to continue. The company is also known to maintain significantly increasing Return on Equity. At 111%, the company presently maintains ROE percentage that exceeds its industry and the S&P 500 average.

In the most recent reported quarter, the company's net operating cash flow increased over 36% when compared to the same quarter of the previous year. It also exceeded the industry's average CF growth rate of -8.59%. Reports also show that Altria currently maintains gross profit margin of over 57%. Its net profit margin stands at 27.97%, which exceeds the industry average.

The company also maintains a steady net income growth. In the most recent quarter, its net income growth exceeded the industry's average but below the S&P 500 average. Presently, Altria maintains a dividend yield of over 5.0% and increased its dividends 47 times in the last 44 years. Its stock is currently trading at a P/E ratio of 15.0 times trailing twelve months.

The company has been able to grow its revenues YoY with a significant reduction in the percentage of sales devoted to COGS (cost of goods sold) and SG&A. This trend led to a significant improvement to the company's bottom line growth as it reported net income of $4.2 billion in fiscal year 2012 as against the $3.4 billion reported in fiscal year 2011.

In all, Altria has exhibited significant strength in growing its EPS, solid expansion in profit margins, maintained significant ROE, commendable operating cash flow and net income growth. Even though there is a significant downtrend in the number of smokers in the U.S. leading to a 2.5% decrease in revenues in the reported second quarter, the company still reported an increase in net income and operating income. The company's diverse business model will continue to fuel its growth and make up for the losses in the U.S. tobacco market.

How Altria stands with its peers

Through Philip Morris, Altria maintains approximately 50% overall share in the United States tobacco market. In the premium brand segment, it maintains a 60% market share. Its top-selling brand is Marlboro, which accounts for more than 80% of the company's total revenues. Other brands from the company include the smokeless Skoal and Copenhagen. Added to the list are its Black & mild cigars.

Apart from its diversification into smokeless tobacco through UST, the world's largest moist smokeless tobacco manufacturer by sales, Altria also has a stake in other businesses. It maintains a financial services business, wine business and also owns a stake in SABMiller, a brewing company.

Reynolds American on the other hand maintains approximately 29% of the U.S. tobacco market share. Its brands include Pall Mall, Kool, Carnel, and Winston. It favorably competes with Altria as its product offerings include deep-discounted brands. What this means is that both companies will be competing for sales from consumers who are reacting to a downturn in the economy by making a switch from premium brands to value brands.

With its Newport, Old Gold, Mavericks, Satin, and Max cigarettes, Lorillard accounts for 10% of the total tobacco sales in the industry. Newport, just as I mentioned above, is the -company's cash cow and the most popular among menthol-flavored cigarettes in the market. Even though the company is presently making a headway with the e-cigarette segment, it is still not on par with Altria, especially in terms of market size, popularity and revenues.

Risks facing the company

The major risks facing Altria are from the U.S. market. First is the fact that the industry it operates in is heavily taxed in the U.S. and as such, has led to significant increase in cigarette prices. The result is that some of the consumers shifted focus towards deep-discount brands as against the premium brands. With a good number of the company's cigarettes being premium, it has felt the impact of this shift in consumer behavior more than other tobacco companies who produce more of value-priced brands than premium brands.

The next one is the risk of the FDA finally succeeding in outright ban of the use of tobacco or traditional cigarettes. This is one of the reasons why the company keeps researching on more cigarette alternatives in order to continue boosting revenues in the face of a ban on tobacco use.

Another risk is that the company is susceptible to litigation. If the company is targeted in a large lawsuit, not only will it tell on the company's purse if any damages are awarded, it will also affect its image and create negative publicity for the company.

With the increase in public awareness concerning the health risks of smoking, there has been a continued decline in the number of smokers in the U.S. As at 1950s, the percentage of adult smokers in the U.S. stood at approximately 40% but presently, adult smokers in the U.S. is less than 20%. With this decline, it will be difficult to generate reasonable revenues from the U.S. as far as traditional cigarettes are concerned.

Finally, with the prohibition on smoking in public places, which includes workplaces, mass transits and restaurants leading to limitation on when and where to smoke, the small percentage of smokers are consuming fewer cigarettes. This means less sales in the U.S. when compared to the years before the prohibition when people smoked when and where they wanted.

Bottom line

Over the years, Altria has succeeded in spinning off subsidiaries, which have turned out to be well positioned in the U.S. tobacco market. With Philip Morris controlling 50% of the U.S. tobacco market share, UST is also a leader in the moist smokeless tobacco segment. These two segments are currently the largest and most profitable in the industry.

A leader in premium tobacco brands, Altria has set itself apart from its peers with its unique and diverse business model. In the face of the ensuing regulatory attacks, Altria's management has proven their worth by standing up to the various regulatory and litigation challenges strewn across the company's part.

For a company which has continually raised its dividends for over 40 years with over 11% dividend growth rate, maintained almost flat Cost of Goods Sold (COGS) which has resulted in significant increase in gross profit, operating income, strong balance sheet and free cash to distribute among shareholders, Altria has really come a long way.

The company is projected to grow its top and bottom line at an average rate of 7.5% in the next five years. Considering that it is a well managed and profitable company with huge revenue and dividend growth potentials, there is more to gain from owning shares of this great tobacco company.

Source: Altria: Benefiting From Prevailing Trends In Tobacco Use