US tobacco company Altria Group (MO) has been in the news recently with multiple reports of various merger and acquisition talks. The company appears to be addressing a troubling trend that has seen its Marlboro market share stagnate over the past handful of years. The company's flagship brand had been gobbling up market share for years, which has helped offset macro-level trends of declining cigarette use. With this market share growth reversing, the company is being pro-active in diversifying its business to strive for long term growth. While there are reasons to get excited about future prospects, investors should pump the breaks a bit. There are some things that investors should keep in mind as these ventures play out further.
Smoking Is Declining In America
The concept of fewer Americans smoking cigarettes is nothing new. A declining smoking rate has been a known trend for years. This doesn't mean that smoking is dead however. According to the CDC, there are still approximately 38 million Americans that smoke cigarettes.
In recent years this trend has accelerated for a couple of reasons. Years of anti-smoking propaganda combined with alternatives to smoking such as vaporizers and electronic cigarettes have reduced the "start up rate". In other words, people aren't necessarily quitting - simply smokers are dying faster than new smokers are picking up the habit.
Altria Has Thrived Despite This
Altria has countered this trend for years in two ways. First, the addictive nature of tobacco gives Altria the ability to consistently raise prices without suffering much pushback from customers. People are simply going to find a way to fund their smoking habit.
Net Price of Marlboro Cigarettes as of 3rd Quarter Per Pack (by Fiscal Year)
Second, the company has done a masterful job of gaining market share over the years. Even though the overall demographic of smokers has shrunk, Altria has managed to thrive because it has been able to grab a bigger slice of the demographic to counter this shrinkage.
The issue has become the sustainability of this pattern. Since hitting retail share of 43.8% in 2014, market share growth of the Marlboro brand has stagnated. Share has drifted slightly lower to 43.4% in September of last year, and this past quarter (Q3 FY18) showed market share of 43.1%.
This is significant because the Marlboro brand is the primary revenue driver for the company. Despite Altria's other businesses and investment interests, cigarettes still account for 86% of operating income. Of this segment, about 86% of Altria's total shipment volumes are of Marlboro brand cigarettes. As Marlboro goes, Altria's earnings move with it. If it wasn't for Altria receiving a huge boost from the tax reform laws, this would probably be more discussed than it is.
Addressing The Issue
Big tobacco management is regarded in the investment community as some of the brightest minds in corporate management. These facts are obviously not lost on them. That is why it is encouraging to see the company making moves to address it in a meaningful way. Altria has made it known that the company is looking to extend its reach into other industries in order to diversify its business with synergistic interests.
Altria has recently been linked to two different industries in these efforts. About a week ago, the Wall Street Journal reported that Altria was looking into a significant (yet non-controlling) stake in Juul Labs. Juul Labs manufactures the number one selling electronic cigarette in the US. Juul products have come under scrutiny from regulators because of how popular they have become with younger demographics, specifically teenagers.
This interest makes sense for a couple of reasons. Juul's popularity with youth is an obvious attractor for Altria, whose cigarettes are losing mindshare among teenagers. Juul could stand to benefit from Altria's "expertise" in navigating regulatory hurdles.
In addition to electronic cigarettes, Altria has begun to formally explore the cannabis market. This has long been speculated, as the marriage between tobacco and cannabis seems obvious for logistic and synergy reasons. The other day, a report came out that Altria has begun early discussions to acquire Canada based Cronos Group (CRON). Cronos Group has since confirmed these talks. Each of these scenarios makes sense for Altria given the business models involved, and their similarities to tobacco.
Pumping The Breaks
Before Altria shareholders pop the champagne, however, there are some key things to keep in mind regarding each possible deal. There are a lot of moving parts within both the cannabis and electronic cigarette industry, so Altria needs to stay disciplined and not do something "silly" with its cash.
Juul Labs is estimated to have annual sales of approximately $1.8 billion, and the company raised capital at a $15 billion valuation earlier this year. A "significant" interest likely means a hefty price tag of several billion dollars. Juul is rapidly growing as the runaway leader of market share in the e-cig market, so a large premium will likely be paid.
The company has the financial chops to afford such a deal with $2.39 billion in cash, but plenty of room on the balance sheet. Altria's leverage ratio of 1.4X EBITDA is well under the 2.5X ratio that I use as my "warning sign" threshold. In addition, Altria is a cash flow machine with very high margins. The company turns every sales dollar into $0.18 of free cash flow. The dividend uses only 72% of these cash flows, so there would be funds available to pay down debt over time. Still, Altria has to be careful not to drastically overpay to the point that the debt overshadows the benefits Juul would bring to Altria's financials.
When looking at the cannabis industry, there is risk in that the industry is much less proven out compared to Juul. Because of the growth prospects of the industry, there are a handful of smaller players trading at hefty premiums. Looking at Cronos Group, the company has done only about $9 million in revenues over the TTM period, yet commands a $1.8 billion market cap.
Not only does this set Altria up to overpay for Cronos (given what little the business will impact Altria's bottom line), but the company is currently investing into its capacity to grow more cannabis, meaning Altria may need to spend CAPEX to continue growing Cronos post acquisition.
All of these moving parts equate to execution risk, and this still doesn't factor in the fact that cannabis is still illegal at the Federal level in the US. With Cronos being a Canadian company, this acquisition would obviously be an experiment/gateway into an American venture into cannabis down the road (when it inevitably becomes legal). When you add all of this together, it becomes evident that cannabis is still years away from being a significant profit center for Altria.
Are Shares A Buy Today?
With shares at just over $55 per share, Altria stock is at the low end of its 52 week range. The company will make just about $4 per share for the full fiscal year, placing Altria at an earnings multiple of 13.75X. This is right in line with Altria's 10 year median multiple of 14X.
To gain additional perspective on Altria's valuation, we will review the free cash flow yield. Cash flow is an organic measure of a company's performance, so it makes for a great valuation tool. The more cash we can receive per dollar invested, the stronger the return on our investment we stand to generate.
With a free cash flow yield of 6.86%, the stock is yielding the most cash flow it has since the recession. With an earnings multiple in line with historical norms and a robust FCF yield, share of Altria are attractively priced at current trading levels. Analyst consensus estimates that Altria will grow earnings at a CAGR of just under 10% over the next five years. With a 5.74% yield from the dividend combined with an attractive valuation, total returns are poised to surpass the market over the next five years.
Altria is a fantastic company that has managed to thrive despite strong macro-level headwinds as fewer adults smoke in the US. It's encouraging to see that Altria is being proactive in exploring revenue diversification while the core business is still strong. However investors cannot give Altria a blind pass on how to undertake this task.
Both the Juul and Cronos Group deals (should they happen) would present risks in their own right to what is currently an asset light, high margin business in Altria. Regardless of how these scenarios play out, time will be needed to truly alter Altria's revenue makeup. As this plays out, investors can currently take advantage of a strong cash flow generating stock with a high yielding dividend, and an attractive price tag.
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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.