Altria Group (MO) has been on the news more than most investors wished for. From the failed merger talks with Philip Morris International (PM) to JUUL Labs' regulatory troubles and change of CEO. Many investors are now looking at Altria’s dividend yield of 8.3% and outstanding past performance and jumping with both feet to purchase shares. This is worrisome to me because I see very few people paying attention to Altria’s amount of debt.
Buy it now, pay comfortably in 30 years
By 2018, it became clear that Juul’s new vaping pods were taking a big chunk of Altria’s cigarette business. Although Altria tried to compete with its own e-cigarettes, Juul had already taken over 50% of the US market with no sign of slowing down. Altria saw its growth prospects evaporate and decided to make two big purchases. It acquired 45% of Cronos Group (OTC:CRON) for $1.8 billion, and 35% of JUUL Labs for $12.8 billion. The problem is that since Altria distributes most of its earnings on dividends, it didn’t have enough cash at hand for the purchases. Issuing bonds was inevitable.
Source: Altria’s fixed income information page.
In the previous graphic, you can see how Altria borrowed over $15.8 billion in 2019, adding to a total of $29 billion debt. Its first debt payment of $1 billion is coming up on January 14, 2020, and to the tune of $1 to $2 billion every year after for 30 years. Altria has more than doubled its debt from previous years and increased its debt cost to over 4.1%.
This move did not fare well with the credit rating agencies. Moody’s Investors Service revised the outlook to negative from stable, while S&P Global Ratings downgraded Altria two notches to BBB. Just two notches above junk status.
Can Altria repay its debt?
There is little doubt that, if required, Altria could pay in full its debt. The issue is the measures required to do so. Let me look at 2 scenarios:
The growth scenario
Altria’s long-term goal is to achieve 7-9% EPS growth while maintaining an 80% dividend payout ratio. Management’s compensation is tied to the achievement of this.
In the above image, I assumed that Altria can achieve these numbers in the best possible way. Altria would grow its Net Income 7% annually, pay 4% interest on its debt and make the principal payments due from 2020 to 2023. Altria would also pay 80% of Net Income on dividends and repurchase shares at the tune of $1 billion annually. Since the company would be growing earnings 7% annually, I would expect a P/E ratio of 15. Adding dividends and share appreciation, the result is an annual return on your investment of 19.86%.
I suspect this is what most investors are expecting based on past performance. Nevertheless, let’s look at what happens with the debt. If you pay attention to the “total” row, you will see the result is always negative. The total represents how much cash the company would have after using all of its available cash and Net Income. What this means is that if they continue their current capital allocation structure (share repurchases, 80% dividend pay-out, and so on), they will never end any year with a positive cash balance. The only possible way to keep this going would be by borrowing again, year after year. This is clearly shown on the first row “debt” where it keeps growing, albeit, slowly.
Source: Company Reports and Wells Fargo Securities estimates. Impact of recessions and e-cigarette entrance in the U.S. market.
While earnings keep growing, Altria can keep without reducing its debt for years. But the moment we hit a recession or, for whatever reason, a couple of bad years on the industry, their debt burden would hit them hard, forcing them to reduce dividends or sell assets.
The no-growth scenario
Source: Author’s calculations based on company reports.
The problem with debt is more apparent in the no-growth scenario. In this case, I assume that management will pursue its long-term goal of achieving 7-9% EPS annual growth, but the Net Income is not growing. Additionally, management will not want to reduce the dividend payout ratio of 80%. The only way to achieve EPS growth in this scenario is by increasing the share repurchase program to the tune of $19 billion by 2023. To fund this share repurchase program, Altria would need to increase debt by up to $46 billion. This is clearly not sustainable.
Altria has bet the house on Juul’s growth prospect. Altria and its investments would need to obtain growth of well over 7% to Net Income. The company won’t be able to sustain its dividend policy and current debt burden otherwise. There is a high risk involved in these assumptions, mainly that we don’t hit any recession until 2023. The moment that Altria has a drop on earnings, it will be forced to increase borrowing, sell assets, issue shares or reduce its dividend. In the event of a recession, increasing debt would be very costly; therefore, I would expect some of the other options with the subsequent price drop.
My personal opinion is that I would look for other investment options in the tobacco industry less tied to the US market. Philip Morris International would be the most likely candidate. Once we have more clarity on what regulation changes are expected in the U.S. for Juul and its e-cigarettes, I would come back to Altria and analyze its impact. Until then, it remains a highly speculative bet for my taste.
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.