About a week ago, Financial Times and numerous other similar financial news platforms reported the updated consensus recommendation on Altria Group (NYSE:MO) by analysts following the company, with views ranging from HOLD to BUY. After doing my own research and valuation analysis, I have come to believe that the major reason for that diverging view is not as related to company's own fundamentals as it is to its equity investment in brewery… or, to be more precise, the expected value of the now-combined Anheuser-Busch Inbev (AB InBev) (NYSE:BUD) - SABMiller (OTCPK:SBMRY) company. In this report, I will provide my analysis on pure-Altria basis (net of equity investment), which will result in what I see as the pure-Altria stock value and how that value is augmented by the perceived value coming in from the AB InBev-SABMiller merger deal.
Tobacco industry is peculiar in many ways. Traditionally regarded as the "cash cow," though highly litigious one, with low price elasticity of demand, the industry is experiencing a great number of stumbling blocks these days. Plain packaging, restrictions on smoking in public places, general improvements in health-awareness and anti-tobacco campaigns world-wide - all lead to dwindling sales volumes in the developed-world countries. As a company with US-based operations, Altria Group is no exception to these issues. As the Table 1 below indicates (compiled from 10-K 2015 and 2013), smokable product segment of the company, by far the largest one representing roughly 90% of sales value (Table 3), has been on a constant downward spiral over the last 5 years, declining at an average rate of 1.7%. Even though discount brands (such as L&M) and cigars have shown signs of growth (6.8% and 1.5%, respectively), these segments represent a meager 8% contribution to total sales value (9% within smokable segment times 90% share of the smokable segment, all on 5-year CAGR basis) or a paltry 0.13% growth in sales.
As for the other segments, despite promising growth rates, they are nowhere near the share of the smokable products segment and contribute just a little to the overall sales volume and value growth rates.
With the above mentioned information at hand, we can compute average prices per each product segment. Regarding the smokable segment, I have adjusted the price to represent a standard 20-cigarette package; other segments are left intact, since they already represent per-package/-case pricing. Taking into account the addiction effect of the tobacco products (and the resulting price inelasticity of demand), it comes as no surprise that in times of declining sales volumes, Altria had no other choice but increase prices to support revenue streams. As can be seen in Table 4 (and supported by 10-K reports), smokable segment average prices have been increasing by 2.7% per year over the last five years, thus outstripping 1.7% yearly fall in sales volume over the same period. The 5-year average price elasticity of demand (PED) figure of -0.64 (computed as Δvolume/Δprice, or -1.7%/2.7%) confirms that price has indeed been relatively inelastic over the period, helping Altria keep its overall revenue growth afloat at 1.7% per year (Table 2).
Being in the tobacco industry, MO is a dividend-paying company, having posted a relatively stable 8% growth rate in dividends paid each year for the last five years (company's 10-Ks). The fact that the company pays dividends and given its sky-high ROE of 178% for 2015, or 189% for TTM, lays the foundation to consider in more detail the sources of such high returns on shareholders' equity. To complete this task, I will employ the well-known DuPont analysis by means of 3-way ROE decomposition; namely, ROE will be broken down into net profit margin, asset turnover and financial leverage ratios. It is important to note, however, that some adjustments are necessary.
First, Altria uses the equity method (reflecting only the share of the investee's earnings in the income statement with no related share of revenues figure) to account for its 27% stake in SABMiller, which renders the accuracy of the aforementioned ratios (as an example, compared to full consolidation, MO's current revenues appear to be understated, thus inflating the net profit margin ratio). In order to avoid this issue and analyze pure-Altria performance, I will exclude the investee effect and adjust the company's net income downward for the after-tax earnings from equity investment in SABMiller; I will also reduce total assets for the amount of the carrying value of the investment in SABMiller.
Second, the company's stock repurchase programme has substantially shrunk the shareholders' equity on the balance sheet, which may potentially lead to hyper-inflated financial leverage ratio. To negate this effect, I will add the cost of repurchased stock back to the shareholders' equity and, correspondingly, will make an upward adjustment to the total asset side of the balance sheet.
The computed ratios provided in Table 5 provide some interesting insights. The unadjusted financial leverage provides a massive multiplicative effect on the unadjusted ROE, with highly volatile figures of above 100% being too "muddied" to draw any meaningful conclusions. Once adjusted, we can see that rising ROE is largely influenced by improving net profit margin, reaffirming the attractiveness of the business from the profitability standpoint.
Of course, making adjustment for repurchases does not mean they do not matter; to the contrary, they do, since cash is still being used up. The adjustment is merely an accounting necessity because of the use of the book values in the ratios, exacerbated by substantial treasury stock holdings.
Given that Altria is returning cash to shareholders via dividends and stock repurchases, I have also decided to look at how liquidity is managed. Based on the information provided in Table 6, MO's liquidity is low and has been deteriorating during the last five years, as can be judged upon both current and quick unadjusted ratios; even taking into account the adjustment for the credit line of $3bln, there is only a minor improvement in ratios. With annual settlement charges of around $3.5bln, related to the "Master Settlement Agreement," constituting around half of the short-term liabilities, and more than $3bln of maturing debt in the next 4 years (10-K, 2015), current liquidity levels are way too low to provide enough safety cushion. Additionally, the last five years have shown that the company's policy of dividend payments and stock repurchases has completely used up, and even outstripped, the free cash flow to the equity (FCFE) generated by MO during the period (for more details see Table 7 in the valuation section). This implies that nothing from the core operations have been added to the cash balances after satisfying reinvestment needs, net debt repayment, dividend pay-outs and stock repurchases. As a result, to improve liquidity, I would expect the company to consider suspending its repurchase programme in the future.
Altria's increasing need for liquidity is also evidenced by longer cash conversion cycle, which rose from 63 to 79 days, on average, during the last five years and to 82 days on TTM basis. As can be seen in Table 6, the lengthening has been driven by both declining inventory turnover, or rising DOH (quite unsurprising, given dwindling tobacco volume sales in the US), and falling number of days to pay suppliers.
Altria Group is a dividend-paying company. As such, there is a choice of using either the free cash flow to the equity (FCFE) or the dividend discount model (DDM) in estimating company's value. One way to check whether selecting the DDM path is prudent is to look at what portion of free cash available to the equity holders is distributed in the form of cash returns, which is measured by the ratio of dividends and repurchases to the FCFE. Should the ratio be consistently well below 100%, it would imply that the DDM model does not capture excess free cash left over in the company and, thus, understate the value; the opposite is true, in the case of ratio being well above 100%.
As can be seen, cash returns have been relatively close to the FCFE during the last five years, including the trailing twelve-month period, except for the year 2015. Consequently, I will use the DDM model to value the company, considering the last full year reading as an outlier rather than a trend breaker.
Before I show the model results, I will go through some of the adjustments and assumptions I used, as listed below:
- The value per share is to be pure-Altria net of equity investment in SABMiller;
- Earnings per share, as a result, are to be adjusted down for investee effect and equal $2.62 per share;
- TTM adjusted ROE of 21% (Table 5) and TTM retention rate of 15.36% (computed as 1-2.22/2.62, where $2.22 is a TTM dividend per share) will be used to compute the fundamental growth rate of earnings of 3.23% (21% * 15.36%). Taking into account the fact that earnings have grown at 5-year CAGR of 11%, the computed figure is rather conservative but consistent with the fact that reaching, let alone beating, the 11% growth pace in the next 5 years is highly unlikely for, at least, two reasons: first, the traditional smokable tobacco industry is declining in the US; second, given 90% share of the smokable segment in annual sales (Table 3), any considerable sales growth in non-smokable segment will have only a negligible effect on the company's top and bottom lines;
- The length of the "high" growth period will be five years, after which it will linearly decline for another five years to the long-term economic growth rate, approximated by 10-year Treasury note rate, of 1.6% (stable growth period);
- The dividend payout ratio in the stable growth period will reach the target payout ratio stipulated by the company's management of 80% (10-Q, 2015);
- The CAPM-based cost of equity will be 4.89% during the "high" growth period, based on the risk-free rate of 1.6% ( 10-Year Treasury Note, as of October 1, 2016), company's regression beta of 0.67 (Morningstar), and (implied) equity risk-premium of 4.91% (Damodaran, as of October 1, 2016);
- The CAPM-based cost of equity during the stable growth period will be 6.51%, based on the revised beta of 1.0 under the assumption that beta in stable growth period should be somewhere around 1.0 - again, assuming a market-like stock price volatility in stable growth is a rather conservative but prudent assumption.
As can be seen from the table above, the pure-Altria stock value is $53.23. Unsurprisingly, it is lower than the price of $61.92, as of October 7, 2016, market closure, since it does not take into account MO's equity investment in SABMiller, or to be more precise the expected value of the combined AB InBev-SABMiller firm. Here comes the most interesting part: depending on what value investors attach to the combined new brewery firm (let us call it NewBrewCo), the value of Altria stock will vary. Since I am not going to value the NewBrewCo, I will assume that October 7, 2016, market capitalisations of the two companies (at market closure) reflect their true values. Based on the premise that the value of the combined firm equals the value of each constituent plus synergies resulting from the deal net of cash spent, I will also assume that the latter will be zero:
NewBrewCo value = AB InBev market cap + SABMiller market cap = $90.444bln + $202.997bln = $293.441bln.
Given that Altria, according to its own estimates, will have 10.5% stake in the combined firm as well as receive $3bln in cash (which I will presume to be taxable at the marginal and state corporate tax rate of about 40%), the value per share attributable to Altria would be:
Value per share to Altria = [10.5%*$293.441 + 3*(1 - 40%)] / 1.958 = $16.65
Total Altria stock value is thus $69.88 ($53.23 + $16.65), which is about 13% above the current market price.
However attractive the above estimate may be, as the title of my report suggests, the caveat is in the way investors value the NewBrewCo. For instance, my previous assumption of synergies just covering the cash spending of $104bln may be too optimistic. In fact, should synergies cover just less than 84% of the cash spent on the deal, Altria's stock value will dip below current market price. Additionally, history has shown that acquirers usually tend to overpay and underperform in the long run, failing to fully capture potential synergies. As a result, despite being a dividend income generator, my overall stance on Altria Group based on its liquidity issues and value proposition is rather cautious.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
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