Is Altria Headed For A Big Fall On New Regulations?

Summary

• The Food and Drug Administration is looking to set a maximum nicotine level in cigarettes.
• The FDA is also looking to create new rules on menthol tobacco.
• The FDA is also pursuing revised rules for e-cigs.
• Will this spell the end of Altria as we know it? Not likely.

By The Valuentum Team

We’ve liked Altria (NYSE:MO) for a long time. Way back in October 2011, we wrote that "Altria Is a Dividend Seeker’s Dream." At the time, we thought the company had “over 25% valuation upside,” and the stock has more-than-delivered since then. Altria has a nice recurring revenue stream thanks in part to the addictive nature of its products, and it boasts a solid dividend yield (4.5%+) that remains comfortably above that of the competing 10-year Treasury yield.

What has made Altria such a fascinating idea in years past, however, has ironically been the threat of regulation, which has acted as a ballast to shares, allowing investors to continue to reinvest dividends, further compounding returns. The stock, as a result, has worked wonders for many retiree accounts. From Marlboro to Copenhagen to Skoal, Altria’s brand portfolio is among the best in Big Tobacco. The company has been able to handle declines in the cigarette category quite well, too.

But what has been happening of late? Having jumped to the mid-$70s per share in mid-2017, Altria’s stock is stuck in the doldrums. Could it be a function of more socially-conscious investing, with large funds selling “sin" stocks? Is it because of shifting millennial preferences? Or something else? The concern for investors in Altria’s shares has always been whether this time is different. Will regulation finally end Altria’s profitable business model? Will investors finally say "no more" and run away from its equity?

A Hugely Profitable Business Model

Image Source: Altria

Very few companies can put up the type of operating margins that Altria can. At a 41.2% adjusted operating-income margin for its Smokeable Products division during 2017, Altria was already turning heads, but during the past 5 years, the company has expanded the division’s profitability by 10 percentage points thanks in part to one of the most valuable business attributes any company can have: pricing power. The ability to raise prices on products to handle adverse cost or demand shocks is perhaps the most tell-tale sign of a company with significant competitive advantages, and Altria has many. Adjusted operating-income margins in its Smokeable Products segment stood at 51.2% at the end of 2017. Simply incredible.

Image Source: Altria

But if you like what has happened to margins during the past five years in its Smokeable Products division, you must love the magnitude of its adjusted operating-income margins in its Smokeless Products operation. At 67.8% during 2017, Altria is pulling in a considerable amount of operating income for every dollar in sales in the division, and the segment’s bottom-line is growing at a very nice high-single-digit clip, too (7.4%). There’s more upside to levels of profitability as there continues to be room for further pricing expansion, in our view. Altria sells products with inelastic demand, and we generally believe that the outlook for smokeless is better than smokeable.

But What About the Regulatory Environment?

On the surface, things look okay, but could excess regulation lead to a massive fall in the price of Altria’s shares? For starters, the Food and Drug Administration (FDA) is looking to set a maximum nicotine level in cigarettes, and while this initiative may help with reducing the “addictive” nature of Altria’s products, we don’t think it will have much of an impact on “behavior” smoking, and therefore the recurring nature of Altria’s revenue. The habitual motion of bringing a cigarette to one’s mouth, for example, may be more addictive than nicotine, itself. The government cannot legislate against this.

The FDA is also looking to creating new rules on menthol tobacco, but such concerns have seemingly been around for ages, and operating income has only expanded at Altria during the past many years. The FDA is also pursuing revised rules for e-cigs, but we're not reading too much into this either. The war against Big Tobacco may be alive and well, but while smoking is on the decline, we don’t think any new regulations will derail Altria’s economic resilience facilitated by pricing power. We think the worst-case scenario could only occur if the FDA bans smoking and smokeless products outright, but we’re not even sure that this has a non-zero probability. The U.S.’s great experiment with Prohibition (alcohol) was a colossal failure, and this brings us to what we think the market is missing with the Altria story.

A Huge Unmonetized Asset

Image Source: Altria

Even if you don’t like Altria’s outlook with respect to smokeless or smokeable products due to the potential for increased regulation, Altria has exposure to alcohol assets in its operations, and the company probably made one of the best beer investments in history, now with a ~$22 billion stake in Anheuser-Busch InBev (BUD). Altria’s market capitalization, itself, is ~$115 billion, so Altria has a huge financial asset that many may be overlooking. Consensus numbers for 2019 put Altria’s non-GAAP earnings per share at $4.36. Backing out the market capitalization of its stake in Anheuser-Busch InBev, we estimate Altria is trading at about 11-13 times 2019 earnings, also adjusted for the equity method contribution of Anheuser-Busch InBev (or about a $0.25-$0.30 per-share adjustment). That’s not too bad of a deal in today’s frothy marketplace.

But offering an overlooked asset isn’t all that Anheuser-Busch InBev provides Altria. If it so chooses, the company can liquidate the stake to pursue new opportunities, further support the dividend, or even deleverage the balance sheet. Altria’s financial health is much stronger than the financial statements suggest, in our view, as Anheuser-Busch InBev offers 1) a nice strategic cushion to achieve its adjusted diluted earnings per share goal of 7%-9% per annum and 2) a nice “optional buffer” to help cover the dividend, even as it targets a rather “full” dividend payout ratio of 80% of adjusted diluted earnings per share. Recent tax reform will only help with earnings expansion and dividend coverage, too. Altria, for example, anticipates 2018 adjusted earnings-per-share expansion in the range of 15%-19%, above long-term targets.

Image Source: Altria

Conclusion

The recent influx of newly proposed regulations on tobacco is creating an overhang on Altria’s stock, but the company has been dealing with overhangs for decades, if not longer. This is, in part, what has made Altria one of the finest dividend growth investments of all time. Savvy shareholders with an appetite for risk-taking are able to scoop up depressed equity and reinvest the dividends. We fully expect the FDA to continue to take a hard line against smoking, but we don’t think smoking will be prohibited, and that’s a big difference. Altria has been dealing with smoking category declines for some time, and it has priced its way to a strong future.

We’re not going to say Altria’s shares are “dirt cheap,” but for long-term dividend growth investors, they could become a favorite in time (if they haven't already been). If the market is overreacting to newly proposed regulations in the pipeline, this again could be present an opportunity for long-term dividend growth investors. We estimate Altria’s Dividend Cushion ratio at 1.1, suggesting that it has flexibility to meet its future dividend obligations, by our estimates (including the flexibility of the Anheuser-Busch InBev stake). Altria doesn’t have a very strong Valuentum Buying Index rating because its technicals have been under pressure, but a solid pace of earnings growth and continued dividend expansion may change that. The headlines are scary, but we still like Altria.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Analyst’s 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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