- Altria's core business of smokeable products has the highest market share in the United States, more than any of its competitors.
- The company is trying to diversify its portfolio as its customer base burns.
- Altria stands to benefit the most from the tax reform bill, which the company can use to reward shareholders or further diversify its cash flow.
- MO's volatility is relatively lower, mainly thanks to a strong balance sheet.
- Since the spin-off, Philip Morris International became more mature and the exes might get back together.
Forgive me, Father, for I have sinned. I invested in a sin company, specifically the Big Tobacco.
Over the path month, I have been researching consumer goods companies. Initially, I believed I was going to invest in a recession-proof company like Procter & Gamble (PG) or Clorox (CLX). Not even close. I'm going to be a bad boy, set aside the social responsibility consequences, and invest in a sin stock. As Gordon Gekko said in the famous "Wall Street" movie, "greed is good."
The addictive nature of cigarettes helps make its sales insensitive to a rise in the product price, stricter regulations, or a recession. In other words, the inelastic nature of cigarettes helps the Big Tobacco companies maintain relatively stable earnings.
Out of all industries, tobacco is the best performer since the 1900s. "After 1965, when the health impact of tobacco became well known, US tobacco companies outperformed comparable firms by more than +3% per year over the period 1965-2006. Moreover, even though US tobacco companies faced a barrage of litigation during this period, they outperformed their international peers," Credit Suisse stated in its 2015 Global Investment Returns Yearbook.
Yes I know, "past performance is not indicative of future performance." Based on my research, I'm going to go ahead and invest in the tobacco industry with significant barriers to entry. I'm investing in Altria Group (NYSE:MO) for the following 5 reasons*:
* = I'm using my mental model of weighted criteria to make this investment decision (don't laugh)
1) Core Business - Smokeable Products (25% weight)
Despite shrinking U.S. smoking population, Altria's earnings have continued to grow and grow. The smoking rate fell from 42% of the US adults in 1965 to 15% in 2015, an all-time low. From 1990 to 2015, Altria's net income grew 48%, as the prices of cigarettes rose.
Prices and Taxes for a Cigarette Pack in the U.S. in 2014 dollars
Source: Dan Kopf, Priceonomics
The company gets all of its revenue from the U.S. Its sister company, Philip Morris International, who was spun off a decade ago gets all of its revenue aboard.
For years, Altria's market share accounted and still accounts for half of the U.S. cigarette market. Starting from the bottom in 1954, its leading cigarette brand Marlboro accounts for 44% retail share in the U.S.
A pack of Marlboro costs almost $7 in the United States. In countries like Canada and Australia which has a similar smoking rate as the U.S., a pack of Marlboro costs over $10 and $20, respectively. It leads me to believe Altria still has the pricing power to boost its earnings.
2) Diversification In The Long-Run (25% weight)
The company is trying to diversify its portfolio to protect against the downside of shrinking customer base. In 2016, smokeable products accounted for 86% of Altria's revenue, down from 91% in 2010. This shouldn't be much of a concern as the shrinking smoking rate is a long-term problem for Altria. The management has done an excellent job in the past, and I believe they will continue to do so over the coming years. One way they will do that is by diversifying their business segments. The company has been concentrating on three platforms; smokeless products, e-vapor, and heated tobacco.
Smokeless products accounted for 10% of revenue in 2016, up from 6% in 2010. The margins for the smokeless products are higher than it is for smokeable products.
In 2009, the company acquired UST, maker of smokeless tobacco products. The company's smokeless segment revenue as a percentage of total revenue continues to grow steadily. Because smokeless products are less risky than cigarette smoking, cigarette smokers are migrating to smokeless tobacco.
However, there's this misperception majority of tobacco consumers believe smokeless tobacco is as harmful or more harmful than cigarettes. In a 2015 federal survey, participants were asked if smokeless tobacco products were less hazardous than cigarettes,
- Only 11% of participants correctly answered "yes"
- 67% responded "no"
- 22% didn't know
In other words, 89% of Americans have no clue that dipping and chewing are 98% safer than smoking. Over time, I believe more consumers will start to realize smokeless tobacco is less dangerous, and that apparently should help the smokeless tobacco manufacturers.
Like the cigarette market, Altria accounts for half of the U.S. smokeless tobacco market. One of the smokeless tobacco brand, Copenhagen, had about 22% market share before the acquisition of UST in 2009. After acquiring the company, Altria increased the brand's market share to 34% in the third quarter of 2017. Over the coming years, the company plans to introduce more products.
Another alternative to cigarettes and smokeless tobacco is e-vapor. Like smokeless tobacco, electronic cigarettes are safer than the traditional cigarettes. They generate cigarette-like margins at scale. The U.S. is the largest e-vapor market in the world, with about 10 million consumers who account for about 37% of the world's vapers. Altria's retail market share in the e-cigarette market recently has climbed to 14% due to the continued expansion of the brand MarkTen XL.
The U.S. e-cigarette grew $1.2 billion between 2013 and 2016 and is expected to grow at a CAGR of just over 22% to reach $50 billion by 2025, with the U.S. leading the way. While e-cigs are not a big part of Altria at this time, they plan to concentrate on it and are planning to introduce more vaping products to enhance its portfolio.
And the significant potential of all is the heated tobacco. Philip Morris's tobacco device called iQOS has seen tremendous growth in the international markets the product launched. It claims to eliminate 90 to 95% of the toxins found in traditional cigarettes. Instead of burning tobacco, it heats it.
How IQOS smokeless cigarettes work
Source: Washington Post
The sister company is licensing IQOS to Altria for use in the U.S. FDA is expected to decide this year whether the "game-changing" product should be marketed and sold nationwide. IQOS has been very successful for Philip Morris International and can be the same for Altria.
Philip Morris has launched IQOS in more than 30 markets internationally. Since it launched in spring of 2017, 72% of smokers in Japan completely migrated to IQOS. That's 10-12 times the quit rate of vaping and smokeless tobacco.
In the third-quarter, PM's market share in Japan increased 5.2% from a year earlier, with 8.4% increase from the heatsticks (so basically the market share from cigarettes alone fell 3.2% as consumers quit the traditional cigarettes and switched to IQOS). In South Korea, 83% converted to IQOS and PM's market share in heatsticks jumped 2.3% to 2.5% in a year. PM's market share in heatsticks increased in other markets as well, including European countries.
One study disagreed with Philip Morris's claims. The study found that IQOS produced 295% more of one hazardous compound than cigarettes (to be specific, the compound is called "acenaphthene," which is used to make dyes, plastics, and pesticides). More negative studies can be found here, here, here, and for an easier read, Reuters article.
Afterwards, Philip Morris published academic countering the study's claims and questing the study's methodology and interpretation. Positive studies can be found here, here, and the millions of documents PM submitted to FDA.
The point is nobody really knows if FDA will approve the "game-changing" tobacco product. It's 50/50 here, and the Altria's share-price really hasn't priced in anything. FDA will have the final say. It's all speculation right now, and I'm not buying the stock solely based on the speculation (buying the stock for 5 reasons). The point I'm making is that the Altria's management is trying to diversify the business over the long-run. It won't happen overnight.
To make things interesting, Altria has a small exposure to beer and wine, unlike other tobacco companies. The company owns 10% of AB InBev (BUD), the world's first global and largest brewer. Like Altria, BUD also has a strong track record of dividend growth. From the dividends alone, the tobacco company collected $739 million in 2016, about 4% of revenue which is pretty significant.
Altria's wine division accounted for almost 4% of total revenue in 2016, up from 2% in 2010. It's not that big of a deal at the moment. What's more important is the Altria's corporate strategy, to diversify income streams.
Like cigarettes, alcoholic drinks' demand is less sensitive to price changes. Like cigarettes, I don't consume wine. However, I do drink beer.
3) Tax Cuts, Strong Balance Sheet, Dividends (25% weight)
Over the past years, the effective tax rate for Altria was close to 35% (Philip Morris is close to 27%). Altria stands to benefit more from the Tax Cuts And Jobs Act which will cut the corporate tax rate to 21%.
Because there are many moving parts with taxes and accounting, I won't be doing analysis in-depth here. I read a fellow Seeking Alpha contributor article solely focused on how the new tax plan will impact Altria. His analysis is top-notch!
MO's current dividend yield is 3.71%, double the size of British Amercian Tobacco (BTI). MO's dividend yield is pretty impressive for a company with low leverage. Altria's current total debt-EBITDA is 1.4x, which is much lower than its competitors* of 3.12x. PM's leverage 2.9x and BTI is at 3.4x.
* = Vector Group, Imperial Brands, Japan Tobacco, Turning Point Brands, BTI, and PM.
Over the past 47 years, MO has increased dividend 50 times. The profit boost from tax cuts can also be used to increase buybacks. From 2011 to 2016, the company returned $28 billion to shareholders. About 80% of it came from dividends and the rest from share repurchase. The $28 billion figure is larger than Clorox's market cap., which is one of the recession-proof stocks I researched for potential investments and decided a "no-no."
The company aims to maintain a dividend payout ratio of approximately 80% of adjusted diluted EPS, which is close to what REITs distribute. While paying high dividends, the company managed to keep its balance sheet healthy.
In addition to the low leverage, the company has an average annual free cash flow of over $4.5 billion. The company currently has $2.6 billion in cash and $13.9 billion in debt. All of the debt is fixed-rate, unsecured, and with long maturities. 90% of the debt is not due until 2044. A 1% increase in interest rates would decrease the fair value of total debt by approximately $1.2 billion. They also have a revolver of $3 billion, which expires in August 2020.
4) High Stock Return and Low Volatility (20% weight)
For the past 2 years, I have been trying to reduce the volatility of my passive portfolio. Before any new investment, I check their historical returns and volatility. MO's daily, monthly and annualized standard deviations are lower than its main peers while having greater returns. In theory, the higher risk, the higher return should be.
Source: Portfolio Visualizer
MO's 0.61 beta is lower than its peers mainly thanks to its strong balance sheet, with PM at 0.91 and BTI at 1.04. SD and beta is not the same thing.
By buying MO, portfolio beta will increase by 0.07 to 0.43, mainly because MO will have the third largest weight in the portfolio. However, the standard deviation is expected to decrease as this is the first consumer goods stock for the portfolio that is uncorrelated to the majority of holdings.
In times of financial crisis, correlations across many securities and asset classes tend to increase. However, more broadly diversified equity portfolio should be able to stay more resilient to the downside. By investing in MO, the portfolio's total risk decreases.
5) M&A (5% weight)
There have been rumors that Altria's sister company might acquire them (at a premium of course). In my experience, rumors that takes place continuously tend to become true some months and years later.
One of the primary basis is that PM would want access to the United States market if FDA approves IQOS. If their competitors were to merge with other competitors, that would increase the probability of PM and MO getting back together. Except, a major merger already took place. Last year, BTI acquired Reynolds Americans at 26% premium.
By getting back together, MO and PM will lower their risk profile, especially from the negative foreign-exchange impact. In 2015 and 2016, strong dollar shaved off $1.19 and $0.43 per share in earnings for PM, respectively. Altria's dollar-denominated $25 billion annual revenue would dilute the fluctuations from Philip Morris Internationa's non-dollar-denominated $75 billion annual revenue.
At the time of the spin-off, the U.S. market was seen as a saturated market at high risk of litigations with little room for growth. Meanwhile, the international market offered room for growth. Now the latter is more mature; maybe the exes will get back together. The stronger connection will provide some cost synergies.
Altria is the leading company in an industry with significant barriers to entry. Its core business of smokeable products has the highest market share in the United States, more than any of its competitors. The company is trying to diversify its income streams in the longer-run, as the smokeable products slowly become saturated. While the smoking demographic continues to burn, the company is trying to diversify its business with smokeless products, e-vaping, heated tobacco, and alcoholic beverages.
Altria stands to benefit the most from the tax reform bill. The increase in earnings from a cut in corporate taxes might reward shareholders in the form of dividends or buybacks. It can also be used to diversify its cash flow further. In addition to benefiting the most from the tax reform compared to its peers, the tobacco company also has greater financial flexibility.
Altria's lower leverage with manageable debt profile will be an advantage in a rising interest rate environment, as its relatively higher leveraged peers' financial flexibility are limited. Altria's healthy balance is the main reason its share-price is not as much volatile as its competitors.
While Altria operates only in an advanced country with slowing smoking geographic and stricter regulations, it shouldn't be a concern in the medium-term. In addition to trying to diversify its cash flow, the company does not experience adverse foreign exchange effects as its sister company Philip Torres does.
If Altria were ever to find itself in a deteriorating financial condition, it is possible its sister company rescue us the shareholders with an acquisition at a premium.
I believe MO is a great vice stock that will appreciate over longer-term, in addition to its growing dividends. Every time a person coughs after inhaling the chemicals, we collect a dividend payment. Through sickness and health, it's a beautiful symbiotic relationship.
Author's note: If you have any questions/comments/suggestions, feel free to contact me personally and/or leave a comment below. Thank you for reading. Don't forget to subscribe.
This article was written by
Analyst’s Disclosure: I am/we are long MO. 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.
All the data comes from Altria and Philip Morris's investor relations website, S&P Capital IQ, Finviz, Portfolio Visualizer, and few websites which are linked in the article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.