By Bob Ciura
After several years of strong performance, Altria Group Inc. (MO) shares turned in a disastrous 2018. The stock remains down 25% in the past 12 months. It appears that Altria is a prime example of what happens when sentiment turns, and fear takes over. Declining smoking rates are nothing new, yet investors have suddenly panicked over the state of the company’s future direction.
Altria has made large moves in recent months to prepare for a post-cigarette world, but investors remain unconvinced. However, as rare as it is for the stock to have performed so poorly in the past year, another rare event has occurred: Altria is finally undervalued. And it is now a high-yield dividend stock. The dividend yield is up to 6.5%, after spending much of the past five years below 4%.
The company did not have a favorable valuation and dividend yield from 2015 to 2018. But now that headline risk has reared its ugly head, investors can take advantage of Altria while it offers a low P/E ratio and a high dividend yield of 6.5%.
Altria Group was founded by Philip Morris in 1847. Today, it is a consumer staples giant. It sells the Marlboro cigarette brand in the U.S. and a number of other products, such as cigars, chewing tobacco, and wine. Altria also has a 10% ownership stake in global beer giant Anheuser-Busch InBev (BUD).
The company’s fundamentals remained in good shape last year. It reported fourth-quarter revenue, net of excise taxes, of $4.8 billion, up 1.5% from the same quarter a year ago. Net revenue increased 0.4% in the core smokeable products segment, as price increases more than offset the impact of falling shipment volumes. Adjusted earnings per share of $0.95 increased 4.4% from the same quarter a year ago.
(Source: Altria Q4 2018 Earnings Presentation)
If one were to judge Altria by its share price performance over the past year, the conclusion would likely be that the company performed very poorly. However, the fundamentals certainly do not paint such a pessimistic picture. Altria reported adjusted earnings per share of $3.99 in 2018, a 17.7% increase from the previous year.
Earnings growth in the high teens would normally result in an increase in a company’s share price. But in Altria’s case, it seems sentiment is driving the share price, not the fundamentals.
Changing Consumer Trends
The simple fact is that smoking is on the decline in the United States. After adjusting for trade inventory movements, Altria’s cigarette shipment volume declined by 5.5% in the fourth quarter, worse than the estimated industry decline of 5.0%. For the full year, domestic cigarette volume declined 5.5%, a full percentage point worse than the industry decline.
Smoking volumes have been on the decline for some time and should not be a surprise to investors. Historically, Altria was able to continue increasing revenue by raising prices at a higher rate than volume declines. But the company was relying on increasing its revenue from a shrinking customer base. This strategy could not last forever. Making matters worse is that cigarette volume declines are accelerating. Altria’s domestic cigarette volumes fell 2.5% in 2016, but the decline exceeded 5% in 2017 and 2018. Going forward, Altria expects the industry to continue declining at a 4-5% annual rate through 2023.
A New Direction
Altria has taken drastic steps to adapt to the changing environment. First, the company announced a $1.8 billion investment in Canadian marijuana producer Cronos Group (OTC:CRON). Altria purchased a 45% equity stake in the company, as well as a warrant to acquire an additional 10% ownership interest in Cronos Group at a price of C$19.00 per share, exercisable over four years from the closing date.
Separately, Altria invested $12.8 billion in e-vapor manufacturer Juul Labs for a 35% equity stake in the company, valuing Juul at $38 billion. It appears likely from the Juul investment that Altria will discontinue its own e-cigarette brand MarkTen. In light of these investments, Altria announced a cost-cutting program designed to reduce annual expenses by $500 million to $600 million. And the company continues to wait for the green light on its own non-combustible line, IQOS.
Altria believes Juul deserved the hefty premium, and it's easy to see why. The e-vapor industry is growing at a rapid pace, and Juul is by far the industry leader.
(Source: Altria Q4 2018 Earnings Presentation)
The Juul investment is probably the most concerning for investors, both for the huge premium as well as regulatory risk. Regulatory agencies have pounced recently because of the increase in vaping among teenagers. Both the CDC and the FDA have intensified their criticism of companies like Juul due to the rise in number of teens addicted to nicotine.
Considering how much Altria spent to acquire a stake in Juul, investors are right to be concerned. However, I do not see the FDA outright banning e-vapor products. Instead, I see Altria changing the marketing of e-vapor to focus on their potential as a way to quit smoking. Television advertising for Juul has begun to emphasize this. The CEOs of both Altria and Juul are set to meet with the FDA to further discuss the issue, and I believe it is likely both executives will pitch e-vapor products on the grounds of cessation from traditional cigarettes.
Altria has come out in support of raising the legal age of all tobacco purchases to 21. Furthermore, the company will likely stress recent findings (such as this study) that support the overall case that e-cigs can actually help people quit cigarettes. Altria said it is looking forward to its upcoming meeting with the FDA. The company has an experienced management team that knows what it is doing. I doubt they would have just wasted nearly $13 billion investing in a company whose product was about to be banned.
Sense Of Urgency Is Understandable
It is true that Altria paid a hefty price for both investments. Investors can consider this the cost of not acting sooner. But put differently, the company needed to address the reality that cigarettes as we know them are on the way out. To that end, it’s better late than never. Altria is doing what it needs to do to adapt. Investors seem to doubt the recent investments it has made, but this spending could be necessary to ensure future growth.
Altria expects the U.S. e-vapor market to grow at a 15-20% annual rate over the next five years, with Juul enjoying the lion's share of that growth. Furthermore, Altria expects profit margins on e-vapor products to grow to meet those of traditional cigarettes within five years. And Juul opens up the international markets for additional growth. Altria expects the international e-vapor market to be comparable in size to the U.S. market by 2023.
(Source: Altria Q4 2018 Earnings Presentation)
The company is paying a high price for its strategic investments because it knows how important it is to get ahead of the competition. Cannabis and e-vapor are fairly new categories. Altria is happy to pay a premium now to enjoy industry dominance later. If there is any company that understands the value of brand power, it's Altria.
Over the past several decades, what separated Altria from the rest of its industry was Marlboro, the unquestioned leader in the U.S. cigarette industry. Marlboro alone controls over 40% of domestic retail market share. This is what drove the company's ability to raise prices, a crucial peg of its earnings growth strategy.
Valuation and Expected Returns
The good news from the 25% decline in Altria shares over the past year is that they are now attractive from a valuation and dividend perspective. Altria expects adjusted EPS of $4.21 at the midpoint of 2019 guidance. As a result, the stock trades for a forward P/E ratio of 11.6, meaning it is significantly cheaper than it has been in the past few years.
Our fair value estimate for Altria stock is a P/E ratio of 15, which would still be a modest valuation for a highly profitable company with growing earnings. But even a P/E of 15 would boost annual shareholder returns by 5.3% over the next five years.
In addition, future returns will be augmented by Altria's EPS growth. The company might not reach 17-18% EPS growth going forward, but a forecast of mid-single digit EPS growth is not unreasonable. Altria still expects 4-7% EPS growth in 2019. We view 4% EPS growth over the next five years as a reasonable base case, through modest revenue growth and share repurchases.
Lastly, Altria's share price decline has pushed its dividend yield up to 6.5%. Therefore, adding it all together, the company's five-year expected returns are 15-16%, a highly attractive rate of return.
investor sentiment has turned highly negative toward Altria, but the company is doing what is necessary to position itself for the future. In the meantime, investors are paid well to be patient, with a 6.5% dividend yield. We expect 15%+ annual returns for Altria stock over the next five years, which earns the stock a Buy recommendation.
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.