Tobacco giant Altria (NYSE:MO) is one of our favorite dividend growth ideas. Let's go beyond traditional valuation measures like the price-to-earnings ratio and dividend safety metrics like the dividend payout ratio to find out why.
On Dividend Growth Investing
We're huge fans of dividend growth investing. Individual investors that apply this strategy find strong, stable, dividend-paying companies such as Johnson & Johnson (NYSE:JNJ) or Procter & Gamble (NYSE:PG), and this is great. It prevents them from getting involved in speculative, high-risk companies (remember the dot-com craze), which in many cases is the last thing a retiree is interested in doing.
But on the other hand, dividend-paying companies have in many cases been transforming into speculative companies. Many MLPs and mortgage/residential REITs remain overly-dependent on the healthy functioning of the capital markets, necessitating global credit health for survival. And many investors are stretching for those 10%+ yielding entities that may not survive for long -- the income associated with double-digit yielding firms is often fantasy. This is not a good thing at all.
We have no qualms with investors seeking yield and income, but an understanding of the inherent risks to the dividend/distribution as a result of the business-structures of non-corporate entities cannot be ignored. Boardwalk Pipeline (NYSE:BWP) should have changed all of this for dividend growth investors of MLPs. American Capital Agency (NASDAQ:AGNC) and other mortgage REIT peers should have changed all of this for the mortgage-REIT dividend growth investors. And Exelon (NYSE:EXC) and First Energy (NYSE:FE) should have changed all of this for utility-focused dividend growth investors (utilities are corporates but their balance sheets and regulated returns leave little room for exogenous shocks or operating error). Non-traditional corporate business models have tremendous risk.
In our view, dividend growth investors can often find the safest dividend growth ideas by sticking with pure corporate entities that have tremendous transparency when it comes to performing equity analysis. Simply looking at the firm's dividend growth track record, its dividend yield and the payout ratio is not enough to assess safety. A comprehensive cash-flow-based dividend growth analysis that considers the health of an entity's balance sheet is vital to assessing the true risks of a dividend. We seek to properly assess dividend growth risk via the Valuentum Dividend Cushion methodology (click here). The cash-flow-based dividend coverage ratio has an enviable track record of predicting dividend cuts.
Altria is one of the strongest, highest-yielding corporate dividend payers on the market today. It is neither a MLP, a mortgage REIT, nor a regulated utility by definition -- yet it still yields close to 5%.
Understanding How the Stock Market Works
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
Altria's Valuentum Buying Index Score
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Altria posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. A firm that registers a 9 or 10 on the index is closely considered by our team for addition to the Best Ideas portfolio or Dividend Growth portfolio, depending on its attributes. For a company such as Altria that is already included in both the Best Ideas portfolio and Dividend Growth portfolio, our team would only consider removing it when/if it scores a 1 or 2 on the index (the equivalent of a "we'd consider selling" rating).
Altria Group's Investment Considerations
• Altria makes and sells cigarettes and smokeless products in the US. It owns the Marlboro brand, which holds 43%+ retail cigarette share, and the Copenhagen and Skoal brands, which own more than 50% retail smokeless share. The company also has roughly a 27% economic and voting interest in brewer SABMiller, the stake of which we value at more than $20 billion.
• Altria Group's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very highly.
• Altria Group has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 37.6% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 77.9%.
• We're huge fans of Altria's long-term goals: grow adjusted diluted EPS at an average annual rate of 7%-9% and maintain a dividend payout ratio of approximately 80% of adjusted diluted EPS. Though cigarette volumes continue to decline in the US, the profit pool of tobacco makers has not thanks to material pricing gains.
• Altria boasts a hefty dividend yield, and its Valuentum Dividend Cushion score remains above 1 (which is good). We expect continued growth in its dividend payout for many years to come. Regarding dividend safety, Altria can slowly liquidate or otherwise monetize its stake in SABMiller to support its dividend payout. Very few firms have Altria's financial flexibility, and this is the main reason why Altria is our favorite dividend growth idea in tobacco.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Altria Group's 3-year historical return on invested capital (without goodwill) is 46.6%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Altria Group's free cash flow margin has averaged about 22.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Altria Group, cash flow from operations increased about 21% from levels registered two years ago, while capital expenditures expanded about 25% over the same time period.
Our discounted cash flow model indicates that Altria Group's shares are worth between $33-$49 each. Shares of Altria are trading at roughly $42 each at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Investors should interpret this fair value range in the context of the timing of any monetization of its stake in SABMiller.
The estimated fair value of $41 per share (the midpoint of the range) represents a price-to-earnings (P/E) ratio of about 18.1 times last year's earnings and an implied EV/EBITDA multiple of about 10.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.5%.
Our model reflects a 5-year projected average operating margin of 47.1%, which is above Altria Group's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1% for the next 15 years and 3% in perpetuity. For Altria Group, we use a 9.7% weighted average cost of capital to discount future free cash flows. In the second image below, we consider the value of its stake in SABMiller (with an appropriate discount to its trading value to account for transaction costs under any monetization scenario).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $41 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Altria Group. We think the firm is attractive below $33 per share (the green line), but quite expensive above $49 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Altria Group's fair value at this point in time to be about $41 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Altria Group's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $49 per share in Year 3 represents our existing fair value per share of $41 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Performance of the Valuentum Buying Index in the Best Ideas Portfolio
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Pro Forma Financial Statements
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: MO is included in the Dividend Growth portfolio and Best Ideas portfolio. JNJ and PG are included in the Dividend Growth portfolio.