Altria Up In Smoke

Sep. 24, 2019 7:30 AM ETAltria Group, Inc. (MO)PM94 Comments

Summary

  • Altria has been faced with a level of uncertainty recently surrounding a possible merger with PM, as well as negative headlines regarding its stake in e-cigarette leader JUUL.
  • The stock is trading at an extreme discount that could prove to be a quality entry point for long-term investors looking to add stable income to their portfolio.
  • The potential merger with PM could provide a boost to the MO balance sheet, but dividend investors have their questions, as PM utilizes a different dividend growth strategy than Altria.
  • Looking for a helping hand in the market? Members of High Yield Landlord get exclusive ideas and guidance to navigate any climate. Get started today »

Altria Group, Inc. (NYSE:MO) is the leading US cigarette manufacturer that, for decades, has also been the darling of dividend investors. Over the past few years, the company has been under intense pressure from continued declines in cigarette volumes to FDA attacks on e-cigarettes for which MO purchased a stake in.

Over the course of the last two years, MO stock has decreased 35%, putting investors in a tough spot based on uncertainty surrounding the company. A potential merger back with Philip Morris International (PM), has been discussed, which could have a big impact on valuation. Is this once dividend darling dead in the water or is it trading at an extreme discount, which would allow an amazing entry point for long-term investors? Let’s take a look!

Is The Drop In Stock Price Warranted Based On Recent Results?

As I mentioned above, Altria shareholders have been on a long downward trend, with the stock losing 35% of its value over the course of the last 48 months. Looking a little further back, the stock is trading at levels not seen since May 2014. The questions investors are now asking is whether or not the drop is warranted.

Let’s first take a quick look at the company’s most recent results.

(Chart created by author)

As you can see from Altria’s Q2 2019 results, revenues have seen an increase of 5%, mainly due to a solid quarter from the company’s primary segment: smokeable products. This segment alone saw an increase of 5.5% in revenues, which was due to slightly higher volume sales combined with higher pricing compared to the prior year. However, over the course of the first six months, volumes are down 7%.

The company continues to have the premier brand in terms of cigarettes, which gives it the pricing power it continues to utilize to offset declining volumes. The narrative when it comes to Altria over the years has been that the new generations are more “health conscious” than those in the past, which has become evident in the volume declines we have seen in cigarettes, at least in the US.

According to Morningstar, they forecast the volume decline rate in U.S. cigarette consumption to be around 4% annually, a faster rate of decline than most global markets. However, the company, due to its pricing power based on having premier products, has had the ability to consistently price above the rate of volume declines.

When looking at the company’s volume guidance, it is a little more conservative, as it estimates the decline rate to be in the range of 5-6%, but the reasoning is more based on adult smokers moving from cigarettes to e-vapor. However, e-vapor products have come under intense scrutiny of late from the President to the FDA, so that will be something to keep a close eye on as well, especially since Altria owns a stake in market leader JUUL.

The smokeless products segment continues to perform well, with revenue up 4% and adjusted OCI margins gaining 410 basis points to 74%. The growth was again primarily due to increased pricing compared to the prior year.

As mentioned a second ago, MO owns a stake in e-cigarette leader JUUL, which has been on the wrong end of negative headlines recently. Altria already received backlash from investors based on the valuation it assigned JUUL when it purchased a 35% stake in the company late last year for $12.8 billion. JUUL has been under fire from FDA regulators as well as Washington, including the President, for the rise in vaping-related incidents and deaths. Regulators have called into question the company’s marketing tactics towards teenagers, as well as the safety of its products. Just in the past few weeks, eight e-cigarette related deaths have taken place, in addition to at least 530 people with known vaping-related illness, according to the CDC. More than half of the 530 patients being treated for the illness are under the age of 25.

Corporations and countries around the world have taken notice and have either banned the e-cigarettes or stopped selling them in their stores. Walmart (WMT), the largest retailer in the US, just last week announced it will stop selling e-cigarettes in all its stores in the wake of vaping-related deaths. India also announced a ban on the production, import and distribution of electron cigarettes.

In the wake of these events and pending crackdown expected from regulators, one would have to expect the company to write-down the investment in the near future. However, what investors are failing to remember is JUUL is a very small piece of the pie when it comes to Altria as a whole.

The other acquisition the company made recently was to take out a stake in a leading global cannabis company, Cronos Group (CRON). Altria invested $1.8 billion for a 45% interest in the company, with warrants to increase ownership to 55% over the next four years. CRON stock is about even since the company announced the acquisition back in December 2018, but was up as much as 125% in March 2019.

(Photo Credit)

The Cronos acquisition helps further diversify the company and move closer to a Marlboro green. Should cannabis become legal in the US, at a federal level, Altria will be better positioned with this acquisition. Through this acquisition, the company has ample time to set up a proper supply chain, and once the Feds do make cannabis legal in the US, Altria will be ready to pounce quickly, which will add quality returns for shareholders.

A Possible Merger On The Horizon

After weeks of rumors, Altria and Philip Morris confirmed that the two companies have indeed been discussing talks of a potential reunion. Shares of Altria jumped 8% during the pre-market session on the news, only to end up falling roughly 4% by the end of the day.

Altria shareholders are now dissecting whether or not the merger would be positive for them. From a balance sheet perspective, the merger with PM would significantly improve this area and in return allow the company to gain access to low-cost of capital to spark growth.

For comparative purposes, Altria currently maintains an effective interest rate of 4.3% with an S&P credit rating of BBB, whereas PM has an effective interest rate of only 2.0% with a credit rating of A. Altria has utilized a lot of debt in its recent acquisitions, so this would instantly be a benefit for the new company.

Considering both companies are extremely similar, synergies in a merger would take place fast from an operations standpoint. The two companies both generate strong free cash flows that would further turn the combined company into a free cash flow giant.

The merger would also help the global expansion JUUL is currently going through. In addition, cigarette declines overseas has been below average compared to those within the US.

However, the biggest benefit to an Altria/PM (re)merger is the fact that 20% of PM's revenue is now in reduced-risk products, or RRPs (heat sticks, vaping and oral nicotine replacement pouches). The PM iQOS products have been hugely successful for the company and account for roughly 14% of its total sales.

The global nicotine market outside of the US is $465 billion in size and growing at a 3% clip per year. When you look at the total market, RRPs account for only 4% of that, which speaks to the potential for the products.

https://static.seekingalpha.com/uploads/2019/9/4/47572571-1567609678218614.png

(Source: PM Investor Relations)

Philip Morris expects to grow its smoke-free product volumes nearly 400% between 2018 and 2025, which it believes will allow RRP revenues to grow to about 40% of total company sales.

Overall, the merger would create a very strong company where Altria shareholders would certainly benefit. PM management has slowed the growth in the dividend as they try to rein in the payout ratio more within a reasonable range, thus this would be a change for MO shareholders.

PM management is also not prone to share buybacks like Altria management has been, so that will be another change for MO shareholders as well. As PM management tends to focus more on investing in growth as a priority over dividend growth, and based on the rumored (early stages) merger deal, Altria shareholders could, in fact, see a dividend cut, which would not make us too happy. In the end, I think we are still a ways away from any kind of merger taking place, but it is fun to play “What if?”

Can The Dividend Continue To Grow At A Reasonable Clip?

Turning to the dividend, which is a big reason Altria investors have invested in the company over the decades. Currently, shareholders receive an annual dividend of $3.36, which equates to a dividend yield of 8.4%. Just this past month, Altria raised its dividend 5%. Over the course of the past five years, the board has raised the dividend an average of 10.3% per year. The most recent dividend hike marked the 54th increase over the course of the past 50 years for the company, which it touched upon in its press release:

Over the past half century, Altria has demonstrated its steadfast commitment to rewarding shareholders despite numerous shifts in the tobacco landscape. Today, we remain focused on our shareholders as we lead the industry through a period of evolution.

Source: Altria Investor Relations

Over the course of the first six months of the year, Altria management has bought back 3.7 million shares of company stock at an average price of $52.93, for a cost of 195 million. Thus far, management is down about 23% on those shares. The buybacks in Q2 completed the company’s $2 billion share repurchase program, thus the board authorized a new $1 billion share repurchase program starting in Q3, which is expected to be completed by the end of 2020.

Altria is targeting a payout ratio of 80% and an EPS growth rate in the mid-single digits propelling future dividend growth. Here is a look at the company’s recent payout ratio.

Despite all the negative news between declining cigarette volumes and electronic cigarette-related illnesses, Altria continues to generate healthy levels of FCF, which have aided in keeping the payout ratio within the planned levels of management. Its latest dividend hike featuring a $0.04 quarterly increase per share marked the 54th dividend increase in the past 50 years, a milestone for the company:

Over the past half century, Altria has demonstrated its steadfast commitment to rewarding shareholders despite numerous shifts in the tobacco landscape. Today, we remain focused on our shareholders as we lead the industry through a period of evolution.

Based on the company’s ability to generate strong free cash flow on a consistent basis, I believe the dividend is still well-covered, and investors should not expect a slowdown in dividend growth in the near future. The current yield above 8% is a great entry point for investors looking to add stable income to their portfolio for the long term.

Investor Takeaway

As it stands right now, Altria has been hit with some uncertainty that has created a buying opportunity for those looking to get in on the name - uncertainty around a potential merger with Philip Morris, as well as regarding the company's investment in JUUL. However, one thing remains constant, which is the company’s ability to maintain increasing cash flows that lead to a growing dividend.

For some investors, the thought of investing in a tobacco company goes against their morals and beliefs, though that is always something I believe needs to be separated when it comes to investing - but that's just me, and to each their own. If you are able to get past this fact, tobacco companies have been the best-performing industry for quite some time and offer recession-proof investing models.

The merger sell-off when the news of talks was reported has created an opportunity for those looking to add shares of a blue-chip company with a strong dividend track record. The stock currently trades at a P/E level of 9.9x, which is well below its five-year average of 19.3x. Whether or not the Altria and Philip Morris merger takes place, both companies are well-run, and based on their proven track records, I expect both to deliver shareholder growth for years to come.

As always, I recommend buying in tranches as uncertainty around the merger and negative headlines regarding JUUL (which, remember, is a small piece of the Altria pie) illnesses continue.

Note: I hope you all enjoyed the article and found it informative. As always, I look forward to reading and responding to your comments below and feel free to leave any feedback. Happy Investing!

Author’s Disclaimer: This article is intended to provide information to interested parties. I have no knowledge of your individual goals as an investor, and I ask that you complete your own due diligence before purchasing any stocks mentioned or recommended.

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This article was written by

Mark Roussin profile picture
7.69K Followers
Author of iREIT on Alpha
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Mark Roussin is an active Certified Public Accountant (CPA) in the state of California. Mark has worked as a CPA, serving both public and private Real Estate corporations for over 10 years. Today, he provides his followers insights to both undervalued dividend stocks mixed with high-growth opportunities with a goal of them reaching financial freedom in the long-term. Mark tends to invest primarily in dividend stocks with a strong emphasis on Real Estate Investment Trusts (REITs). 


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DISCLAIMER: Mark is not a Registered Investment Advisor or Financial Planner. The Information in his articles and his comments on SeekingAlpha.com or elsewhere is provided for information purposes only. He asks that you perform your own due diligence or seek the advice of a qualified professional. You are responsible for your own investment decisions. 

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.

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