The shareholders of Altria (NYSE:MO) have enjoyed a remarkably strong decade since the Kraft spinoff in April 2007 and the Philip Morris International spinoff in March 2008. Since fully divesting itself of its food and international tobacco operations, the stock has returned 20.5% annually (meaning every $1 invested in Altria back on April 1, 2008, would now be worth $5.20). When you see sustained investment returns like that, you are right to wonder: Is Altria's decade of excellent performance something you can extrapolate from and use to justify a purchase of the stock today?
I don't think so. Since the spinoffs, Altria has grown its per share earnings from $1.66 to $2.75. That is only a growth rate of 4.7% annualized. So how does a business growing at 4.7% deliver 20.5% annual returns? Through dividends and P/E expansion.
At the time of the 2008 spinoff, Altria stock was yielding 7.8% (a figure that now seems inconceivable). There's nothing wrong with that - the dividend was supported by steady earnings - but it distorts comparisons to the present day because the stock now only yields 3.3%. When you bought the stock almost a decade ago, you were purchasing a 7.8% dividend plus earnings growth plus any changes in the P/E ratio. Today, when you buy Altria, you are already down four and a half percentage points on the dividend front.
And then there is the matter of Altria's P/E ratio. During Altria's first year as a standalone company, which occurred during the recession-ravaged year of 2009, Altria was trading at 9.9x earnings. Since then, Altria's valuation has kept inching upward over the years. Altria traded at 11.8x earnings in 2010, 16.2x earnings in 2011, stayed in that range through 2014, and then rose to 20.1x earnings in 2015. Last year, Altria saw its stock trade at 23.7x earnings. And now? With trailing 12-month earnings at $2.75, Altria's current stock price of $73 trades at a P/E ratio of 26.5.
That is wildly unsupportable on a historical basis. From 1956 through 2003, when Altria also had the benefit of diversified food operations and high international growth, the average P/E ratio of the stock was 14.2. Even if that was a little on the low side, I think it is difficult to argue that Altria's fair valuation is greater than 16x earnings given the intense regulatory environment for tobacco that has caused tobacco shipments to decline at an average rate of 3.5% per year since 1982. For Altria to return to its 2011-2014 valuation level, which was still higher than the average valuation of the half-century that preceded it, shareholders would stand to experience P/E compression of 38.5%.
And imagine if another recession hit (as an aside, did you see that recent article in the WSJ about how bankers are partying as if the financial crisis had never happened? When I look at the current valuation of Altria, I think the same thing). If 2008-2009 conditions were to hit Altria, and the stock fell below 10x earnings, the stock would fall all the way from $73 to $27. I'm not predicting that this will happen - I'm saying that tepid Altria shareholders will be in for a heck of a reckoning if it does. That is because a whole lot of wealth destruction can happen when a stock's valuation travels from overvaluation down to fair valuation and then plummets further to undervaluation.
And, like we see time and time again, Altria is currently squandering some funds by repurchasing $3 billion worth of shares right now while the stock trades at 26x earnings. How many shares do you think it repurchased during the financial crisis when the stock was trading at 10x earnings? None! In fact, Altria shares got diluted a little bit as the share count climbed from 2.06 billion in 2008 to 2.07 billion by the end of 2009. When the stock trades at historic lows, the buybacks cease. And now, with the price of Altria trading at a P/E ratio that it has literally never seen in the past two generations, it decided to announce that it would expand the share buyback authorization from $1 billion to $3 billion.
So, how did we get here? Well, Altria has benefited from a confluence of three factors that don't usually occur simultaneously. Gas prices have been low the past few years, giving the smoker demographic more disposable income to purchase cigarettes. Secondly, Republicans have taken over state governments, and the seemingly perpetual increase in excise taxes and new regulations has temporarily abated. And lastly, the low interest rate environment has sent income investors towards safe dividend-paying stocks which they consider alternatives to bond income.
Historical context is no guide for Altria anymore. The conditions that existed in 2008-high dividend yield and low valuation no longer persist. And that is a big deal because Altria has only delivered 4.7% annual earnings per share growth during this nearly decade-long period in which it has delivered over 20% annual returns. You know that mandated disclaimer "past performance is no guarantee of future returns"? Well, it will likely hold true for Altria. You can't pay a historically high premium for a business with under 5% long-term earnings growth and a dividend of only 3% (I say "only" because Altria pays out over 80% of its earnings as dividends). Domestic tobacco stocks have historically been great performers because their valuation was low. That is no longer the case, and future returns will suffer accordingly.
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.