The market is sometimes so fixated on earnings per share -- EPS -- that it overlooks hidden assets, which can only be parsed out via a discounted cash flow analysis -- where the value of the owned stake in a company can be added to the operating enterprise free cash flow of the underlying core business. To us, Altria (NYSE:MO) was a slam-dunk, and we continue to like the firm's dividend strength. Let's take a look at shares in this article.
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 (OTCPK:SBMRY), 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 positively.
• 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 ratio remains above 1 (which is good). We expect continued growth in its dividend payout for many years to come. Very few firms have Altria's financial flexibility.
• At the Valuentum Buying Index methodology's core (see here), 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 Group posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. A 6 is not bad, and in fact, is at the higher end of the range.
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 9.9%. 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 $38-$56 each. Shares are trading at the midpoint of the range at present. 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.
Our fair value estimate is $47 per share. 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%, 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 9.9% weighted average cost of capital to discount future free cash flows. Our fair value reflects the fair market value of the company's equity stake in SABMiller.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Altria Group to peers Lorillard (NYSE:LO) and Philip Morris Intl (NYSE:PM).
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 $47 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 $38 per share (the green line), but quite expensive above $56 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 $47 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 $57 per share in Year 3 represents our existing fair value per share of $47 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.
Valuentum Buying Index Performance
In the spirit of transparency, we show the latest study of the Valuentum Buying Index here. Past results are not a guarantee of future performance. Thank you for reading!
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 newsletter portfolios.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.