Altria Ready To Climb Higher On New Blends, Snus Brands

| About: Altria Group, (MO)

by Brian Huber

Despite the low public image for tobacco products, the brands of Altria (NYSE:MO) continue to generate significant cash flow. In addition to top selling Marlboro, the company manufactures other prevalent labels such as Virginia Slims, Benson & Hedges, and Basic. Altria also produces the most popular brands of smokeless tobacco under the names Copenhagen and Skoal. In addition, the company provides wine products such as Chateau Ste. Michelle and Columbia Crest. Holdings of Altria include a portfolio of equipment leases and real estate loans. The leases consist of both direct finance and leveraged contracts for property used in rail and transport, aircraft, electric power, and other manufacturing.

Determining where Altria is headed demands assessment of the unusual situation for the company. Altria's dominate share of a market with declining consumption means the future is threatened by elements other than competing companies. The first challenge is the impact on profit of declining tobacco sales volume. A market dominator like Altria must compete by using pricing power and maintaining costs. Fighting competitors for sales in a falling market is not how Altria confronts its genuine challenge. Secondly, Altria faces legal and regulatory threats. These are not unique to Altria, but impact all competing tobacco companies equally. This article examines the operational, legal, and financial trends at Altria.

Changes in Recent Years

In 2007, Altria announced that cigarette production for international markets would shift from US plants to facilities in Europe. The company then spun off international tobacco operations in 2008. This created Philip Morris International (NYSE:PM), an entity not impacted by the same analytical factors as Altria.

Simultaneously, Altria has expended in the US with new products and acquisitions. The company acquired John Middleton, Inc, in 2007. Middleton produces machine-make large cigars. Its Black & Mild brand is the second highest selling US product in the category. The Philip Morris USA subsidiary of Altria introduced the Marlboro Snus brand of non-spit smokeless tobacco in 2007. In addition, new blends of Marlboro cigarettes have entered the market in recent years.

Current Initiatives

Philip Morris USA has about a 50% share of the $80 billion per year cigarette market. A substantial increase in the federal excise tax on cigarettes in 2009 accelerated declining sales volume. This also depressed profit margin. Over the near-term, the expected norm of a mid-single digit decline in volume is expected. However, higher pricing and new product introductions at Altria should offset reduced consumption. Philip Morris USA increased cigarette prices in July and December of 2011.

Several factors position Altria to further increase margins. With its top selling brands, Altria is able to raise prices with little impact on volume. The tobacco industry also has little or none of the commodity cost pressures faced by other sectors of the consumer staples group. Plus, Altria is incurring growth in sales of higher-margin smokeless tobacco products.

Altria also has benefited from successful cost reduction efforts. The primary focus of these programs is infrastructure costs for cigarette production. Altria Chairman and CEO, Michael E. Szymanczyk, has stated that the company expects a new cigarette infrastructure cost reduction initiative will to generate $400 million of annual cost savings by the end of 2013. A previous cost reduction program conducted from 2007 through 2011 contributed to higher profit margins.

Litigation and Regulation

The legal environment for the tobacco industry is relative positive for the near term. This follows the past decade of litigation victories for Altria.

Positive legal standing occurred in May 2003 when the Florida Third District Court of Appeals overturned a trial verdict against Altria and other defendants. The Engle case originally awarded $143 billion in punitive damages for the plaintiffs. This was reversed by the court, which also decertified the case as a class action.

A $280 billion case against the tobacco industry by the US Department of Justice began in September 2004. The US Supreme Court disgorged the claim in October 2005, which effectively weakened the case for the Justice Department. In July 2010, the US Supreme Court rejected a Justice Department appeal for the financial damages regarding racketeering charges by the government. The court also rejected the appeal by tobacco companies of the racketeering judgment on free speech grounds. This leaves in place the court's previous ruling and prevents the government from trying to extract $280 billion of past profits from cigarette manufacturers.

Philip Morris USA is the defendant in about 130 other pending cases. This is approximately the same number as two years ago.

President Obama signed into law in June 2009 the Family Smoking Prevention and Tobacco Control Act. This legislation gives the US Food and Drug Administration authority to regulate the manufacture and sale of tobacco products. Despite the law's restrictions on advertising and packaging, an entrenched market leader like Altria actually benefits from the Act. This solidifies the company's dominance in market share and pricing power.

Altria dodged several regulatory threats in 2011. In March, the Tobacco Products Scientific Advisory Committee declined to call for an outright ban of menthol cigarettes. In November, a federal judge blocked the US government from requiring tobacco companies to display graphic warnings about the impact of tobacco use pending further review by the courts of the constitutionality of such requirements under Family Smoking Prevention and Tobacco Control Act. In February 2012, Philip Morris USA prevailed in the first federal trial stemming from the Engle case. A second federal jury found in favor of Phillip Morris USA in March 2012. Altria's co-defendant in these cases is R.J. Reynolds Tobacco Company, a subsidiary of Reynolds American (NYSE:RAI), thus illustrating a lack of distinction among the large tobacco companies regarding assessment of the legal environment.

Stock Outlook

Price appreciation for Altria shares in 2011 is at least partly attributable to the high dividend and the company's share repurchases. Despite a gain in price per share of about 20% in 2011, Altria still delivers a significant dividend yield. The quarterly dividend was recently increased 7.9% from $0.38 to $0.41 per common share. Annualizing the current dividend provides a yield of over 5% based upon early 2012 stock price. This is 50 to 100 basis points higher than the dividend yield of British American Tobacco (NYSEMKT:BTI) and Lorillard (NYSE:LO), which are much smaller than Altria. Reynolds American has a comparable dividend yield but only a little more than one-third of Altria's revenue and thus less opportunity to substantially boost cash flow with cost reduction efforts.

Cash flow at Altria has permitted a share repurchase program of $1 billion. The result in consistent growth in the company's diluted earnings per share of 6% to 9% annually. Altria expects future increases in the same range. Results in 2011 were impacted by a non-recurring charge related to leveraged lease obligations. Also detracting from financial performance last year was a non-recurring charge related to the new cost reduction program. After adjusting for these factors, Altria realized the targeted earnings per share growth and profit margin.

Altria stock is a sound addition to any equity income portfolio. Strong cash flow renders a secure dividend. Profit margin for the near term appears stable based upon pricing power and management's proven record of cost containment success. When factoring the share repurchase plan, the company is positioned to deliver steady earnings per share growth. This affirms strength in the stock price despite a substantial rise last year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.