U.S. Tobacco & Altria
The U.S. cigarette industry is in long-term decline because of health concerns and strict marketing restrictions. According to a Financial Times article, sales of traditional cigarettes are declining 3% each year, on average. This poses a serious problem for Altria (NYSE:MO) as it generates the entirety of its revenues in the U.S. Furthermore, cigarettes represent approximately 85% of its total revenues according to SEC filings. I expect the U.S. cigarette industry volume to fall 3%-4% annually which will cause Altria's Smokeable Products revenues to decline 1.5% going forward (Altria will be able to slightly offset volume decline by increasing prices). My Levered Returns revenue segment projections are shown below.
I believe the projections above are aggressive because they do not consider the possibility of additional restrictions imposed by the FDA and municipalities that may further restrict U.S. smoking in public places.
E-cigarette Movement - Threat to Altria
Electronic cigarettes "e-cigs" are rising in popularity due to their perceived health benefits which mimic the feel of a real cigarette, producing vapor, but not smoke. According to estimates from Euromonitor International, sales of e-cigs were estimated at $1 billion in 2013, increasing from $500 million in 2012. Altria has been slow to react to the e-cig trend but is attempting to catch up quickly as it began rolling out its NewMark e-cig at the end of 2013 in Indiana and Arizona. Then on February 3, 2014, Altria announced they were buying e-cig seller Green Smoke for $130 million. The Company was initially slow in penetrating the e-cig market in hopes the movement was a fad as opposed to a trend. However, Altria realized e-cigs were here to stay and are now trying to make up lost ground. E-cigs do provide a new market opportunity for tobacco companies but at the expense of cannibalizing cigarette sales. In fact, e-cigs give industry players the opportunity to steal market share from its competitors. This is great for smaller tobacco companies that haven't been able to steal market share from industry leading companies, such as Altria. Altria is the current industry leader having a 40% share of the U.S. cigarette market, according to Morningstar. The movement to e-cigs threatens Altria's U.S. market share domination if the Company can't keep up with other e-cig firms that already have a considerable lead in the space. My projections, used in the LR model shown above, are aggressive as they assume no loss in market share.
Margins Expected to Decrease Over Time
According to Morningstar, e-cig margins are slimmer than cigarette margins which explain Altria's rationale for showing up late to the e-cig game. I expect Altria's margins to decrease as the Company's e-cig sales increase over the years. In addition, selling fewer cigarettes will consequently bring down margins as the Company distributes its fixed costs over a fewer number of units. Due to these reasons, I have EBIT margins decreasing to 43% by year three shown in the LR model below.
LR Cash Flow Model
A price target of approximately $37 was concluded using Levered Returns three-year projection model which implies Altria is trading at around a 12% premium. An Enterprise Value "EV" of $66.9 billion was determined by applying a discounted cash flow approach. A total equity value $73.4 billion was concluded by deducting net debt, non-controlling interests, accrued settlement charges, dividends payable, accrued pension and OPEB costs, adding finance assets and MO's market value investment in SABMiller (OTCPK:SBMRY). The market value of the SABMiller investment equals $22.9 billion which is materially larger than its $7 billion book value.
Altria relies on the health of the U.S. tobacco market as it generates its revenues entirely in this region. It's no secret that the tobacco industry is facing headwinds related to regulatory issues and overall customer health concerns. These challenges will cause Altria's cigarette sales to decline over the next several years. Moreover, a push toward e-cigs will threaten Altria's U.S. tobacco dominance and decrease its margins over time. The company is a dividend paying machine but applying my assumptions into Levered Returns' fundamental valuation models proves that MO is currently overvalued with a fair value price target of $37. I recommend value investors stay away from Altria until its share price drops to more reasonable levels.
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.