Altria (MO) is a prominent player in the tobacco business. It has one of the top brand lines in the cigarette sector. Parliament, Marlboro, Virginia Slims, L&M are among the several cigarette brands offered by the company. Altria is also engaged in the production and marketing of smokeless tobacco products, as well as wine products. The industry is going through changes as the Food and Drug Administration (FDA) emphasizes its authority over the tobacco companies. The regulations within the sector are getting stricter, but investors are confident that Altria has a great moat in its business. Amidst the uncertain future of the tobacco industry, Altria has been one of the best performers in the market. It returned almost 30% in a year.
As of the time of writing, Altria stock was trading at $30 with a 52-week range of $23.20 - $30.40. It has a market cap of $61.9 billion. Trailing twelve month P/E ratio is 18.3, and forward P/E ratio is 12.9. P/B, P/S, and P/CF ratios stand at 16.8, 3.8, and 17.3, respectively. Operating margin is 36.5% and net profit margin is 20.4%. The company has some serious debt issues. Debt/equity ratio is 3. Altria has been one of the best dividend payers among its peers. Based on a quarterly dividend of 41 cents, current yield is 5.5%.
Altria has a 2-star rating from Morningstar. Out of six analysts covering the company, four have buy, one has hold, and one has underperform ratings. Wall Street has diverse opinions on Altria's future. Average five-year annualized growth forecast estimate is 7.9%. This is a very reasonable estimate given the increase in cigarette prices, along with efficient cost reduction.
What is the fair value of Altria given the forecast estimates? We can estimate Altria's fair value using discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.
E0 = EPS = ($1.64 + $2.36) / 2 = $2
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 7.9%. Book value per share is $1.81. The rest is as follows:
Fair Value Estimator | ||
V (t=0) | E0 | $2.00 |
V (t=1) | E0 (1+g)/(1+r) | $1.94 |
V (t=2) | E0((1+g)/(1+r))2 | $1.89 |
V (t=3) | E0((1+g)/(1+r))3 | $1.84 |
V (t=4) | E0((1+g)/(1+r))4 | $1.79 |
V (t=5) | E0((1+g)/(1+r))5 | $1.74 |
Disposal Value | E0(1+g)5/[r(1+r)5] | $15.78 |
Book Value | BV | $1.81 |
Fair Value Range | Lower Boundary | $27 |
Upper Boundary | $28.8 | |
Minimum Potential | -10% | |
Maximum Potential | -4% | |
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Altria is between $27 and $28.8 per share. At a price of $30, Altria is a little bit overpriced. However, with a solid yield of 5.5%, it is natural for the stock to be priced with a slight premium.
Peer Performance
Altria is not only the tobacco company that outperformed the broad market indices. Cigarette companies were among the top performers of the last year. Star Scientific (CIGX), a company that specializes in smokeless tobacco products, more than doubled in the last 12 months. The stock returned almost 84% since January. Lorillard (LO) was the second best performer among its peers, retuning 75% in a year, and 14% in 2012. Phillip Morris (PM), British American Tobacco (BTI), Reynolds American (RAI), and Vector Group (VGR) returned around 39%, 34%, 29.5%, and 20.3%, respectively.
Ticker | Performance (Week) | Performance (Month) | Performance (Quarter) | Performance (Half Year) | Performance (Year) | Performance (YTD) |
BTI | 0.14% | 7.98% | 11.47% | 10.99% | 33.83% | 5.28% |
CIGX | 2.30% | 83.94% | 69.92% | 28.94% | 133.14% | 83.94% |
LO | 3.18% | 13.64% | 21.87% | 19.62% | 74.49% | 14.04% |
MO | 1.52% | 4.60% | 11.07% | 16.65% | 28.66% | 1.15% |
PM | 1.32% | 8.08% | 16.47% | 21.00% | 38.95% | 5.78% |
RAI | 0.68% | 2.38% | 3.95% | 15.53% | 29.49% | -0.34% |
VGR | 1.81% | 5.82% | 8.93% | 3.92% | 20.31% | 4.39% |
Based on the forward P/E ratio, with a forward valuation of 12.7 times earnings, Altria is the cheapest one among tobacco companies. Vector Group has the highest yield of 8.63%, but, given the high debt load and low cash flow, I highly doubt that it can keep paying dividends at the current rate. Altria's yield of 5.5% is pretty safe. The company generated a free cash flow of $3.5 billion, which is more than enough to cover the dividends.
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Summary
From a technical perspective, Altria is trading at the middle of an upward sloped trading range. There was a gap between the $29-$28 range, which was recently filled by the market forces. The previously strong resistance level of $26.5 turned out to be a strong support level. Thus, it is very unlikely that Altria will fall below $26.5. However, at a price of $30, it is on the pricey side of the market. A price level of around $27 offers a better price.
From an investor's perspective, Altria's closest alternative is Phillip Morris International. Not only there is a high correlation between the market performance of the two stocks, but their balance sheets also show significant similarities in terms of fundamental ratios.
Most investors stand indecisive when it comes to choosing one over the other. In my opinion, compared to Altria, Phillip Morris is a high-risk, high-reward type of stock. Phillip Morris operates mainly overseas, whereas the U.S. market is Altria's primary focus. By investing in Phillip Morris, investors are betting on increased consumer spending on tobacco products in overseas markets. While that is true, the variety of national rules and regulations puts Phillip Morris into a more risky category. I would consider Altria as a bond alternative and Phillip Morris as a dividend-growth type of stocks. Both of them are slightly expensive though. A pullback might create a better entry point.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
