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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).

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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%.

(click to enlarge)

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.

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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.

Source: Altria: Under-Appreciated Dividend Potential And Limited Downside Suggest A Buy