## Summary

- Valuation seems reasonable relative to peer and market levels.
- On a sustainable basis, annual dividend per share will grow from $1.84 in 2013 to $2.26 in 2016, by a 7% CAGR.
- However, current valuation only implies a 5% dividend per share growth rate.
- There seems to be a price floor at ~$35 which is supported by a 5.8% dividend yield ceiling and future dividend growth.

The share price for **Altria** (NYSE:MO) has gone up by almost 8% year to date, outperforming a 4% gain for the S&P 500 Index. Despite trading at its five-year high, I believe a buy rating is still warranted for the dividend king given its inexpensive valuation and limited price downside.

At ~$40, Altria's 10.6x forward 2015 EV/EBITDA multiple is 3% over the average of its North American tobacco peers and its 14.8x forward P/E ratio is at a 7% discount (see chart below).

I view this relative valuation to be inexpensive for Altria because 1) the company's consensus long-term earnings growth estimate of 7.7% is in line with peer average, as such the stock's PEG ratio of 1.9x is below peer average at 2.2x due to its lower P/E multiple; 2) both Altria's gross and EBITDA margins are on par with peer averages; and 3) the stock offers the highest dividend yield among the group. Compared to the overall market, Altria's 14.8x forward P/E is close to the S&P 500's 14.9x (see chart below), which seems reasonable to me given that Altria's long-term earnings growth potential (i.e. 7.7%) is below the average estimate of 8.9% for S&P 500 companies, but the company provides robust free cash flow (32% unlevered free cash flow margin on trailing 12-month basis) and a 4.7% dividend yield that is considerably above S&P 500's average at just 1.9%.

Based on Altria's current annualized dividend of $1.92 per share and a 10% cost of equity (the CAPM model would suggest a lower cost of equity at ~6% based on 3% risk-free rate, 6% equity risk premium, and Altria's 5-year beta at 0.51), one would calculate the dividend growth rate implied by the current share price ($40) to be approximately 5.0% using the Gordon Growth Dividend Discount Model (see chart below). To gauge whether the 5% implied rate is reasonable, I have performed a cash flow analysis to illustrate a potential dividend growth scenario that Altria can sustain at least over a medium term (i.e. from 2014 to 2016) (see chart below).

My analysis was based on consensus estimated revenues which predict the top line will reach $18.0B by 2016. Based on historical data and the fact that consensus estimates expect EBITDA margin to rise from 44.9% in 2013 to 49.0% in 2016, I assumed operating cash flow margin to increase from 24.8% in 2013 to 27.8% with a magnitude that is lower than the predicted EBITDA margin expansion. For capex, I assumed the figure to reach $180M and stay flat through 2016. Based on these assumptions, free cash flow was projected to grow from $4.2B in 2013 to $4.8B in 2016, representing a 4.3% CAGR. Given these free cash flow forecasts, I estimated that growth for an annual dividend payment will decelerate from 8.0% in 2014 to 5.5% in 2016 in order for Altria to maintain a somewhat stable free cash flow payout ratio at 89%-90% over the forecast period. In this case, the company would have approximately $450M-$500M excess free cash flow per annum.

Assuming that these excess cash flows are all spent on repurchasing shares and the buyback price will increase by 7.5% per annum from the current $40, I estimated that the total share count will decrease to 1.93B by 2016 (see chart below). As such, dividend per share was projected to reach $2.26 by 2016, representing a 7% CAGR since 2013. Given the consensus estimated EPS from 2014 to 2016, my estimated dividend per share in those years would imply an EPS payout ratio at 78%-79%, which is close to management's 80% target. In all, my analysis suggests that growth for dividend per share will decelerate from ~8% in 2014 to ~6% in 2016, meaning that the 5% growth implied by the current valuation is completely achievable over the medium term.

Altria's price downside would seem limited from a dividend yield perspective. Since 2012, there has been a technical ceiling at 5.8% as the yield has tried to surpass that level three times but never exceeded it (see chart below). Also, a 5.8% dividend yield for Altria would likely attract significant buying interests given that peer average yield is currently only 4.3%. Assuming a one-year investing period, 5.8% dividend yield, and 5.0% dividend per share growth in the next annual cycle, this scenario would result in a share price of ~$35, which represents 10% downside from the current level after factoring the 4.7% dividend income.

In summary, investors are recommended to accumulate Altria at this level, as the shares remain reasonably priced and downside is protected by dividend yield and future dividend growth.

*All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.*

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