Altria (MO) faces significant growth challenges as demonstrated by its poor Q1 results. That being said, there is a strong case to be made that its lengthy track record of excellence will continue, making the current pullback in the share price a good opportunity to add shares to your portfolio. In this article, I will compare the bull and bear cases for MO, beginning with the reasons to be bullish.
Altria Group's Q1 results were quite poor as both the top and bottom lines declined. Revenue declined by 6% year-over-year to $4.39 billion, missing expectations by $210 million. Adjusted earnings-per-share, meanwhile, came in at $0.90, missing expectations by $0.03. These declines were in large part driven by a steep 14.3% year-over-year decline in cigarette volume, overwhelming the 1.1% growth seen in cigar volume. The company lowered its full-year midpoint earnings-per-shares guidance to $4.21 from $4.22 - which is now in line with our expectations as well – as the company expects full-year total domestic cigarette volume to decline by 4%-5%.
Looking ahead, Altria has a positive growth outlook, although it does face a significant headwind in the years ahead in the declining U.S. smoking rate. Management expects about 4.5% long-term annual volume declines, which has the market worried about the company's ability to grow its top and bottom lines at historical rates, especially given that Altria’s cigarette volume underperformed the broader market in Q1.
The Bull Case
- In response to this troubling consumer trend, Altria has invested heavily in new products that appeal to changing consumer preferences. Altria recently announced a $1.8 billion investment in Canadian marijuana producer Cronos Group (OTC:CRON), purchasing 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. Altria will help Cronos accelerate its research and development capabilities. Separately, Altria announced it will invest $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. Altria also recently announced a cost-cutting program designed to reduce annual expenses by $500 to $600 million
- It is also important to remember that Altria has overcome numerous growth challenges over its long history as U.S. smoking rates have been declining for the past six decades. The company endured a massive lawsuit along with its peers in the 1990s, and taxes and regulations have increasingly grown on their products. Through it all, its premium brands such as Marlboro have remained resilient and continue to enable the company to achieve strong returns on invested capital. The brands remain strong today, given the stable market share the company has enjoyed over the last two years and lower than average quit rates. As a result, Altria has generated steady earnings and dividend growth for many years in the face of these challenges.
- In addition to the unshakable customer addiction enjoyed by its premium brands, Altria also has strong and durable competitive advantages that stem from high barriers to entry thanks to its business network relationships, regulatory know-how, and economies of scale.
- Another quality that Altria has going for it is the fact that it is highly resistant to recessions. Cigarette and alcohol sales fare very well during recessions, which keeps Altria’s strong profitability and dividend growth intact.
- In reality, then, Altria's business model is not dependent on growing cigarette usage rates in the United States, but rather in its pricing power through all economic cycles while simultaneously improving efficiencies. As a result, its margin gains are able to outpace its shrinking volumes, thereby driving up revenue and earnings. The good news here is that in the U.S., cigarettes remain one of the most affordable at current price-to-hourly-wage ratios. Therefore, when combined with the stickiness of their products, they have a good runway for continuing to increase prices for years to come without risking losing their customers. Furthermore, as production and agricultural efficiencies continue to improve exponentially due to improvements in technology, costs should continue to decline as well.
- Altria is also not a one-trick pony either. Its chewing tobacco division, bolstered by its wildly popular Copenhagen brand, has seen strong results of late. Over the past two years, revenue has grown 5% thanks to strong pricing power, which showed itself in 8% income growth over the past year in this sector. Altria’s market share in this business has increased from 25% to 35% over the past decade, making it a dominant player in the industry.
- The company’s investments in vaping are also expected to fuel growth and help offset challenges to its cigarettes business. Its recent acquisition of JUUL puts it in a position to do that as the brand remains a dominant position in the US market, reporting 175% growth in liquid pod shipments in the first quarter of this year, increasing its market share to 43% while also growing its presence to nine other countries, including Canada and 8,500 stores across France, Germany, Italy, and Switzerland. JUUL plans to test several products in limited international markets this year, including a next-generation, bluetooth-enabled device testing a variety of features including user-level access restrictions. If this robust domestic and international growth continues, the vaping sector could begin contributing a substantial amount towards the company’s growth rate within a half decade or less.
- Given these factors, Altria's valuation appears attractive. A reasonable growth projection is that MO can continue to grow its earnings-per-share at a 4% annual clip over the next half decade, which is conservative relative to management’s mid-point expectation for this year of 5.5% growth and 8% annually over the long term. With this growth outlook, Altria's valuation is attractive at its current price-to-earnings ratio of 12.3. While its 10-year average price-to-earnings multiple is 16.2, the company’s current growth challenges warrant a discount to historical averages. However, the current discount is likely oversized, as a well-covered dividend with such an impressive half-century plus growth streak yield and a yield of over 6.2% is incredibly attractive and should result in double-digit returns if even low single-digit annual growth rates are achieved over the long term.
The Bear Case
The bear argument rests on the fact that the company’s best growth days are behind it, warranting its lower valuation multiple for the following reasons:
- As already mentioned, the cigarette industry continues to decline.
- Management took on heavy leverage and considerable risk of value destruction with its ambitious $12.8 billion investment in JUUL, which valued the company at a sky-high sum of $38 billion. For perspective, this is 40 times sales and 150 times EBITDA, and only a few months earlier other investors bought stakes in the company that gave it a valuation of less than $19 billion. As a result, this gives a very narrow margin of safety for the investment creating value for investors and makes management's long-term international expansion and profitability targets appear quite ambitious. Furthermore, while the heavy debt burden from this investment does not threaten the dividend at present, it could if the cigarette business continues to flounder and the JUUL investment does not pan out as expected.
- The company has also spent over $1 billion on share repurchases since 2012, with a lot of that money spent at share prices much higher than today’s. Therefore, management has once again shown that it is not the most skilled capital allocator with retained earnings, which is something investors need to keep in mind when evaluating the current valuation.
- Investors also need to be wary of regulatory risk. While the company has weathered this challenge successfully over the decades and the current environment does not appear particularly threatening, it is still a factor that needs to be taken into account. In particular, any attempts to regulate advertising could reduce the strength of the company’s brand-driven moat, which could prove to be very detrimental to results. Another regulatory risk is that the company could be forced to reduce the use of addictive substances in its products such as menthol and nicotine. This in turn would reduce their stickiness, also negatively impacting results.
- Another risk that many may not think of is rising gas prices. Since many cigarettes in the U.S. are purchased at gas stations, the higher the gas prices, the less drivers are likely to spend extra on cigarettes. Altria’s management even includes the gas price as a slide on their company presentations and have blamed elevated gas prices in the U.S. during Q1 of this year for their reduced full-year guidance.
- Finally, litigation is a risk as evidenced by the over $200 billion lawsuit brought against the tobacco industry in the 1990s.
One thing is certain: the business currently faces a slowdown as earnings are actually declining even as the global economy and U.S. companies continue to grow. Therefore, somewhere along the line their business is failing to generate the same response from the customer as it has in the recent past. Cigarettes unquestionably continue to decline in popularity among the broader population and rising healthcare costs and improving health literacy across the globe only increase the incentive to stop and/or avoid smoking.
On the other hand, the company's moat among committed smokers remains robust, it is diversifying into ancillary businesses, it is a great defensive play at this point in the cycle, the balance sheet remains investment grade, management remains very excited about the opportunity to market Philip Morris' (NYSE:PM) IQOS heat-not-burn product in the U.S. after the FDA approved the sale of this product in a long-awaited decision, and its valuation looks dirt cheap by any historical measure.
That being said, management have been questionable in allocating capital in recent years and has appeared a bit desperate in efforts to diversify away from their core cigarette business.
The dividend is likely safe for the foreseeable future, making MO especially attractive for conservative income investors. However, its total return potential remains questionable given the extensive risks. Furthermore, the ethical problem of profiting from selling a product that is known to lead to health problems and early death is repugnant to me, personally. Therefore, though I view the stock as a speculative buy from an investment standpoint, I am personally remaining on the sidelines in favor of other defensive investments such as precious metals, MLPs, and REITs.
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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.