Altria: Dividend Discount Model Suggests Shares Are 10% Undervalued

Aug.18.14 | About: Altria Group, (MO)

Summary

The company has sufficient capacity to support 6%-7% dividend per share growth over the next few years through internal cash flows, additional debt borrowing, and share repurchase.

The current share price implies a perpetual dividend growth rate between 4.0% and 4.5%.

A two-stage dividend discount model suggests a fair value of $46.

The share price of Altria (NYSE:MO) has been riding on an uptrend since early 2014. Despite the 16% appreciation over the past 6 months, I believe the dividend champ remains inexpensive relative to its future dividend growth potential. In this article, I will elaborate on some cash flow and dividend analyses to support my buy thesis.

I firstly performed free cash flow projections to gauge Altria's capacity for future dividend growth in the current and next 2 years. My forecast is based on consensus EBITDA estimate, which predict the figure to grow by 5.3% from $8.1B in 2014 to $9.0B in 2016. Over the past 3 years, Altria has been able to maintain a very steady EBITDA to operating cash flow conversion rate between 50% and 51%. Given the tight range, I assumed the operating cash flow conversion rate to remain flat at 51% through 2016. For capital expenditure, I assumed the spending to steadily rise to $180M by 2016, which is consistent with current consensus estimates between $170M and $190M. Hence, free cash flow was projected to grow by 5.1% CAGR from $4.0B in 2014 to $4.4B in 2016 (see chart below).

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Given the expected EBITDA growth in the next few years and that Altria's current leverage (i.e., total debt to EBITDA multiple) of 1.6x is below its historical level at around 1.8x and peer average at 1.9x (see chart below), my view is that Altria would have sufficient room to raise more debt in the next few years and continue to maintain its leverage level within a reasonable range.

Based on current debt balance of $14.0B and consensus EBITDA estimate of $9.0B for 2016, Altria's total debt can be increased by $600M to $14.6B by 2016 such that the total debt to EBITDA ratio would remain the same at 1.6x as today. This additional borrowing can then be distributed to shareholders in the form of dividend and/or share repurchases.

By equally splitting the $600M incremental borrowing over the forecast period, I projected distributable cash flow to grow from $4.2B in 2014 to $4.6B in 2016 (see the first chart). Assuming dividend spending growth to decline from 8% to 6% over the forecast period (this will be supported by later analysis), the total dividend payment will increase from $3.9B in 2014 to $4.4B in 2016. As a result, Altria will have cash surplus of around $200M in each forecast year (see the first chart).

Assuming the entire cash surplus will be spent on share buybacks, which is consistent with Altria's historical practice, and an average buyback price of $41.5 in 2014 with a 10% annual step-up, average share count will drop to 1,948K by 2016. Based on the earlier dividend spending forecasts, dividend per share was projected to grow by 6.7% CAGR from $1.99 in 2014 to $2.27 in 2016. Compared with current EPS estimates for the forecast period, my dividend per share projections imply that the earnings dividend payout ratio will remain steadily at about 78% in the next few years, which is below its historical level in the past 5 years, meaning that Altria can tolerate a higher dividend per share growth in the period (see the first chart). Further, the current consensus long-term EPS growth estimate for the company is 7.8%, suggesting that the earnings dividend payout ratio will gradually decline if the dividend per share grows at my forecasted level of about 6.7%.

The chart below shows a quarterly breakdown of my dividend per share forecasts that are on a calendar-year basis. It is noted that the quarterly dividend is expected to rise by 7.7% in Q3 2014, 6.8% in Q3 2015, and 5.7% in Q3 2016. Yield on cost (based on the current share price of $42) will be 5.6% by Q3 2016.

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Based on the Gordon Growth Dividend Discount Model and a 9% cost of equity (CAPM model suggests a 6% cost of equity if using a 3% risk-free rate, 6% equity risk premium, and Altria's 5-year beta of 0.50), the current share price of $42 implies a perpetual dividend per share growth rate between 4.0% and 4.5% (see chart below).

I then used a two-stage Dividend Discount Model to quantify the shares' intrinsic value. The first stage reflects my quarterly dividend forecasts and the second stage incorporates the 4.25% terminal dividend growth rate that is implied by the current market price. Based on the 9% cost of equity, I calculated a fair share value of $46, which is about 10% above the current share price (see chart below).

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In conclusion, Altria's dividend growth potential is still underappreciated at the current price level. Long-term income investors are recommended to continue accumulating shares and watch for any price hiccups without material deterioration in the company's fundamentals as these present great buying opportunities.

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

Disclosure: The author is long MO. 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.