Altria (NYSE:MO) recently reported its results for the second quarter that saw revenues come in flat (missing by $130 million) and EPS of $0.81 beat estimates by $0.01. Cigarette volumes resumed their downward slide after last year's modest increase that resulted from low oil prices, but the company managed to increase profitability through higher prices and productivity initiatives. Adjusted operating margin in the smokeable products division increased 2.6 percentage points in Q2 and now sits above 50%, while margin in the smokeless products business expanded almost 3 percentage points. Management expects full year EPS to come in between $3.01-$3.07, which equates to growth of 7.5% - 9.5% over last year. Altria's ability to consistently grow earnings in the high single digits despite a secular decline in cigarette consumption is impressive, but share repurchases have played a big role. Altria's valuation has become a bit stretched, in our opinion. The stock trades at a trailing P/E of 23.4, a 31% premium over MO's 5-year average multiple of 17.8. However we think the stock will climb higher in 2016. Altria is one example of a stock that has a big divergence between fair value and price target, and we discuss the assumptions built into our valuations.
Our fair value estimate falls in the $56 - $59 range, and reflects a forward P/E of 18.4 - 19.4 that is much more in line with historical levels. The estimate assumes that cigarette consumption will decrease 3-4% annually, as the percentage of the smoking population in the US declines 10-30 basis points each year. We expect market share to remain stable so that MO's volumes will track the overall rate of consumption declines. MO will continue to offset these declines through higher pricing, which we believe will allow it to grow sales in its smokeable products division 1% annually, on average. Innovation within the smokeless products business will further boost growth, and we see total company revenues averaging 2-3% growth over the next ten years. Recent productivity programs have been paying off and we think margins can expand further. Management plans to create $300 million in cost savings each year, and the firm has ample leverage to raise prices. We believe that Altria can eventually sustain a 50% margin in its smokeable products division (up from 48%), and that smokeless product margin can reach 65-67%. However an increasing portion of lower-margin smokeless and alternative tobacco products in the mix will limit the extent to which margins can expand. Margins will likely peak within the next few years before falling off slightly towards the end of the forecast period. Consequently, we expect EPS to grow 7-9% annually over the next few years, before dropping to 4-5% growth around 2019.
While MO trades at a premium to our fair value estimate that is based on fundamentals, we believe the stock will go higher within the next year. Our one-year price target falls in the range of $70 - $72, which equates to a forward P/E of 23 - 23.7. We believe the combination of buybacks and low interest rates will drive MO's valuation higher this year. In July of last year the board approved a $1 billion share repurchase program to be completed by the end of 2016. Over the last twelve months MO has spent $440 million on share repurchases, so there is plenty of room for more buybacks. The other catalyst will be low interest rates. Many investors buy Altria for the dividend, but the rising stock price has suppressed yield in recent years. However the current yield of 3.34% is still an attractive alternative to bonds. We believe that the Fed won't raise rates for the rest of 2016 and expect rates to stay low through 2017 as well. Many investors still anticipate rate hikes from the Fed, and the Fed's refusal to "lift-off" should drive demand for MO's dividend and bid up the stock price.
Altria is overvalued based on underlying fundamentals and we believe the current price is too steep to pay for a company that generates EPS growth primarily through buybacks rather than organic sales growth. However, Altria will go higher this year thanks to more repurchases and investor demand for yield. The extent to which Altria can sustain its lofty valuation will depend on interest rates, and it seems increasingly likely that we have entered a "new normal" period of low long-term rates. If this is the case, it may be a long time until Altria drops down to a more justifiable price.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.