"The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business."
- Warren Buffett
Last month, I explained why U.S. tobacco giant Altria (MO) would outperform the S&P 500 going forward. The basic thesis said that, despite headline fears of a regulatory crackdown in the vaping space, Altria's core tobacco business had successfully offset cigarette volume declines with higher prices and lower operating costs over the last two decades. And as long as this trend continued, the company's shares were wildly undervalued based on its tobacco business alone - regardless of where the vaping industry went from here.
This bullish view was confirmed when Altria reported its Q3 financial results last week and delivered double-digit profitability growth within the core tobacco business. This came despite an accelerated decline in cigarette volumes, thanks to Altria's decades-long campaign of successful operating cost reductions and price increases.
That was the good news. For the bad news, Altria management confirmed what anyone following this space closely knew what was coming: the recent regulatory crackdown has dramatically slowed the broader vaping industry's growth. Not only have regulators and media outlets given consumers pause regarding the relative safety of e-cigarettes, but major retailers like Wal-Mart and Krogers have pulled all e-cigarettes off the shelves (while continuing to sell the old fashion cancer causing cigarettes).
Given that Altria paid an eye-watering 20x sales for it's 35% Juul stake last December, the slower growth rate resulted in Altria's management taking a $4.5 billion write down on its Juul stake. I warned about such an outcome in a follow-up podcast from my original Altria article in mid-October, and it appears that the market was also anticipating a significant Juul impairment - evidenced by the fact that shares only declined by a modest 2 - 3% in the wake of the report.
While no one enjoys seeing a management team incinerate billions on an overpriced, and in hindsight ill-timed, acquisition... that's now in the rearview. And as I explained in my original bullish article on the company, this one-time hiccup created a tremendous opportunity to purchase Altria's world-class underlying tobacco business at a steep discount. In today's analysis, I'll show why Altria's Q3 results confirm that the original bullish thesis remains very much intact based on the ongoing profit growth in the core tobacco business.
But first, let's start with the high level overview...
Altria's Q3 Overview
The combination of the $4.5 billion non-cash charge from the Juul impairment, plus a roughly $400 million charge for its Cronos acquisition, reduced Altria's Q3 net income to -$2.6 billion, or -$1.39 per share. But if you look past these one-time expenses, the company's core business generated $2.2 billion in adjusted net income, or $1.19 per share. That's a 10.2% increase from the $1.08 in adjusted net income earned in last year's Q3 2018 period.
But these numbers were weighed down by rising interest expense from Altria's elevated debt burden. In order to get a clear view of the core business trends, let's examine the operating income growth across the company's four key segments, which include:
Combustibles - primarily Marlboro branded cigarettes and Black & Mild cigars.
Smokeless - Coppenhagen and Skoal chewing tobacco.
AB Inbev - Altria owns 9.6% of Anheuser-Busch InBev (NYSE:BUD), and thus receives income from AB Inbev’s dividend.
Wine - Ste. Michelle Wine Estates (Ste. Michelle), a premium wine producer that includes the Chateau Ste. Michelle, Columbia Crest and 14 Hands brands.
The table below shows the latest operating income trends within the context of the last five years of comparable quarters:
Record Profitability in Core Tobacco Business
As you can see, Altria posted an impressive 15% jump in core operating income, driven by record profitability in both the combustibles and smokeless segments, plus greater dividend income from its AB-InBeV stake. Growth in these three segments offset a nearly 50% drop in operating income from its relatively small wine segment. Altria's Ste Michelle wine operations have disappointed for the last two years, and I would like to see management liquidate the stake to free up resources and operational focus on its much more profitable tobacco segment.
I'll save the deeper dive analysis of Altria's 9.6% stake in AB-InBev (BUD) for a future articles, but for now, I'll simply note that the value of the BUD stake has fluctuated between roughly $15 - $25 billion based on BUD's market cap fluctuations over the last five years. And that's what gives me full confidence in the balance sheet and dividend resiliency, despite the company's elevated long-term debt position of $27 billion. Altria is prohibited from liquidating its BUD stake until 2022 due to a lock-up provision. But if you assume Altria's BUD stake maintain its historical valuation range through 2022, management could significantly pare down its debt through liquidating the BUD stake, while only giving up about 10% of its operating income. Again, I'll have more to say about this in future articles.
Now, let's turn our focus towards a deeper dive into Altria's most important segment - the combustibles business.
Pricing Power Continues Offsetting Volume Declines in Altria's Core Tobacco Business
The table below shows Altria's latest volume trends in both cigarettes (primarily Marlboro branded products) and cigars (primarily Black & Mild branded products):
While the company's relatively small cigar segment continues generate mid-single digit volume growth, the far more important cigarette business suffered an accelerating decline rate that reached -6.6% in Q3. Now it's important to note that the single biggest factor driving this acceleration - the meteoric rise in vaping as an alternative to traditional cigarettes - will lessen materially going forward. Remember, we're still lapping the explosive growth in Juul from 2018, where sales grew by 5x in a single year. But now, with the vaping category growth slowing to a crawl, it's likely that we see the core cigarette declines stabilize, or even possibly improve going forward.
That said, even with a massive 6.6% drop in cigarette volumes, Altria successfully raised prices and cut operating expenses at a significantly faster rate than the decline in volumes. The following excerpt from Altria's latest 10-Q shows the steady pace of price increases the company took across its combustibles portfolio over the last couple of years:
That's the primary driving force behind the following chart, which shows Altria's remarkable 10.6% compounded annual growth rate (OTCPK:CAGR) in per-unit operating profit versus a -3.4 CAGR in volumes for its combustibles segment over the last five years:
So despite the accelerating 6.6% drop in year-over-year volumes, Altria's per-unit operating profit grew by 12.5% in Q3 - it's fastest pace in four years. So not only is the core cigarette business hitting new record levels of per-unit profitability, but this trend shows no signs of slowing. That's why, despite management's projection for long-term volume decline rates of 4 - 6% in combustibles, I believe Altria will continue generating robust profit growth from this segment going forward.
Moving on to the smokeless segment, here again, the growth in the vaping category has contributed to volume declines in recent years, including a 2.5% decline in Q3 2019 versus Q3 2018:
However, strong pricing power in Altria's smokeless business has also more than offset flat-to-down volumes. The excerpt from Altria's latest 10-Q filing shows the pricing power the company's smokeless segment commands, which is on par with the pricing power of the combustibles business:
Persistent price hikes has allowed Altria to grow the per-unit profitability of its smokeless segment at a 7.8% CAGR over the last five years, despite flat-lining volumes:
Meanwhile, despite these persistent price hikes, Altria has maintained remarkable resiliency in market share for its key combustible and smokeless brands:
Altria Poised for 12% Compounded Returns Going Forward
Add it all up, and the numbers show that Altria's core tobacco business continues generating robust profit growth, even in the face of accelerating volume challenges. That's why management reiterated their 2019 guidance for $4.19 - $4.27 in adjusted EPS, which reflects mid single digit growth from 2018's adjusted EPS of $3.99.
Of note, management did reduce their forward 2020 - 2022 outlook to a range of 5 - 8% EPS growth, down from a prior range of 7 - 9%. However, for those who tuned in to the recent podcast follow-up from my original article, I have projected a more modest growth rate of roughly 4 - 5% EPS growth as a margin of safety going forward.
Given that Altria's management is committed to raising the dividend in line with EPS growth, and the fact that the BUD stake serves as a backstop to the elevated debt load on its balance sheet, I think investors can count on the company maintaining its current 7.5% dividend yield. Plus, factoring in roughly 4 - 5% long-term growth in both EPS and the yield going forward, that implies Altria shares should deliver a roughly 12% compounded returns on a total return basis, assuming no increase in share prices from here.
In summary, Altria's Q3 results confirm the resiliency of the company's world-class tobacco business with tremendous pricing power. Considering the backdrop of excess valuation across much of the broader market, I continue to believe Altria will deliver significant outperformance of the broader stock market going forward.
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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.