Tobacco Face-Off: PMI And Altria More Undervalued Than Reynolds American

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Includes: MO, PM, RAI
by: Takeover Analyst

One of my first articles on Seeking Alpha presented a bullish case on Philip Morris International (NYSE:PM). Since I wrote the piece, the stock has gone up by 11.7% with a strong dividend yield of 4.1%. I turn now to analyzing Altria Group (NYSE:MO) and Reynolds American (NYSE:RAI), which are both exposed to a more intrusive regulatory environment.

For context, Altria Group (MO) spun off PMI in March 2008 largely to allow for a unique geographical focus. PMI targets the markets outside of the United States, which is attractive since the penetration in high-growth emerging markets drives very sustainable free cash flow. Accordingly, much has been said about the regulatory risks that Altria and Reynolds American (RAI) face. After a judge blocked a federal requirement for smoking packages to feature emotionally-charged anti-tobacco graphics, the prospects are suddenly appearing brighter. Fortunately, both firms are committed to not being passive participants in a game of chance and are pushing a marketing agenda to drive demand.

On one side, you have Altria: the marketer of Marlboro, L&M, Virginia Slims, and Next, among others. On the other: Reynolds American, the marketer of Camel, Pall Mall, Grizzly, and Natural American Spirit. Overall, I believe that the Street has relatively downplayed the worth of Altria's brands. Marlboro's original market may be aging, but I do not foresee it losing its appeal as the go-to brand for many first-time smokers. Reynolds American's products are more speculative, in my view, although marketing has done well thus far to mitigate the effects of overall declining industry volumes. In addition, the firm's Santa Fe Natural Tobacco subsidiary has yet to be fully appreciated and could possibly benefit from a spin-off similar to PMI.

From a multiples perspective, Altria also is more undervalued. It trades at a respective 17x and 13x past and forward earnings; Reynolds American trades at a respective 18.1x and 14x past and forward earnings. PMI bests both companies with its PE ratio of 16. But the main reason why cigarette producers are attractive is because of the safety that they offer: low betas coupled with high dividend yields. PMI, Reynold Americans, and Altria have dividend yields of 4.1%, 5.4%, and 5.8%, respectively. All remain committed to aggressive share repurchase programs that will be accretive to EPS and build shareholder value. Altria has approved a $1B share repurchase program, while Reynolds American has approved a $2.5B share repurchase program.

At the third quarter earnings call, Altria's CEO, Mike Szymanczyk

Altria made significant progress in the third quarter on its plans to continue delivering strong returns to shareholders. The company increased its dividends, 7.9%. It completed its previously announced $1 billion share repurchase program. It exceeded its goal of achieving $1.5 billion of cost reductions, and it grew its third quarter adjusted diluted EPS 3.7%. And our consumer products businesses continue to expand their adjusted operating margins...

In the cigarette segment, Philip Morris U.S.A. delivered strong third quarter adjusted operating income margin growth despite difficult comparisons which were impacted by trade inventory depletions in 2011, and strong operating companies income growth in Marlboro retail share performance in 2010. PM U.S.A.'s reported cigarette volume declined 9% for the third quarter as the trade depleted inventories that had been built in the first half of this year.

It is particularly noteworthy that the company has done well despite a rough environment. In fact, over the last 12 months, the stock is up by more than 19.3% while the Dow Jones grew by only 5.6%. The company has been impressive in prevailing against lower volumes by cutting costs and is now proceeding to begin a $400M cost savings program.

Consensus estimates for Altria's EPS are that it will grow by 7.4% to $2.04 in 2011 and then by 7.4% and 6.8% more in the following years. Assuming a 17.5x multiple and a conservative 2012 EPS estimate of $2.12, the rough intrinsic value of the stock is $37.10. This implies a 30.6% margin of safety that comes on top of a 5.8% dividend yield and a beta lower than 0.5.

Consensus estimates for Reynolds American's EPS are that it will grow by 11.6% to $2.78 in 2011 and then by 6.5% and 6.1% more in the following years. Assuming a 17.5x multiple and a conservative 2012 EPS estimate of $2.87, the rough intrinsic value of the stock is $50.23. This implies a 21.7% margin of safety, which does not meet the threshold that I consider to merit calling the firm a value play. Analysts currently rate the stock between a "hold" and a "buy" while its rival receives more of a "buy". PMI receives the highest rating at a near "strong buy".

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PM over the next 72 hours.