- Altria's tobacco products performed well in the first COVID-19 quarter.
- The company is a leader in non-combustibles, giving it some long-term footing, and it's a product portfolio that also performed well in the COVID-19 environment.
- There are concerns around the company's US-centricity and the quality of its equity investments.
- Nonetheless, Altria has some strong brands and continues to generate lots of cash even now, making it an attractive pick.
Altria (NYSE:MO) had a strong quarter, where for the first time in years COVID-19 was able to stem the decline in the cigarette business by keeping stressed people idle at home. We were not surprised that the results of this Dividend Aristocrat would be of some quality, with strong performance across almost all segments. The only underperformers were its vaping and e-cig products, which were hampered by delayed commercialisation efforts and regulatory headwinds. Overall, we think that Altria is attractive due to its strong non-combustible portfolio, giving it an out for the long term, and the attractive cash generation that we can expect to continue even in this challenging environment. For that reason, we think that this is an appropriate pick for income investors.
(Source: Altria Q1 2020 Presentation)
The Positives: Resilience
In the most recent quarter, Altria proved its resilience with 18.5% growth in EPS, driven primarily by volume. For the first time in a while, the COVID-19 environment afforded Big Tobacco a reason for stemmed decline in smokeables after years of a continued secular downturn. Essentially all smokeable products saw substantial growth, including Middleton Cigars, which grew at 13% in volume, and deep discount cigarettes, which grew at 14.4%.
Although some of this growth was provoked by tailwinds in e-cigs, where negative publicity might have had people switch back to smokeable options, much of the volume growth is a consequence of pantry loading. This is a trend that's become quite familiar in the COVID-19 environment in food staples companies like Danone (OTCQX:DANOY) and Unilever (UL), and now it's manifested in tobacco with trips to the tobacco shop happening on more of a weekly rather than daily basis. For the moment, this stocking activity has front-loaded sales into the Q1, but management has not yet seen any evidence that total purchases are changing. So, we take the pantry loading as evidence of the importance of these products to their markets and can predict resilience forward.
Another pleasant development was the volume growth in the non-combustible portfolio as well. This portfolio is a critical prong of Altria's long-term strategy, as although regulated, the social stigma around non-combustible products is less pronounced, mainly because the use of the products is less obvious. This is especially critical given Altria's US-centric presence, where anti-smoking sentiment is very pronounced. Indeed, non-combustibles have succeeded in other countries where a progressive distaste of smoking is prominent, like with snus in the Nordic countries.
(Source: Altria Q1 2020 Presentation)
Overall, robust portfolios should sustain the selling point of this issue, which is its juicy dividend. With a reasonable leverage of 2.3x EV/EBITDA and a fair payout ratio on net income of ~80%, Altria's dividend is not in peril with respect to its incoming obligations related to Juul. With limited downside risk on the business, even in a recessionary environment where the inelasticity of tobacco products should hold true now as they always have, we can expect that this Dividend Aristocrat can keep up its run to 55 consecutive annual dividend increases.
Although the situation looks good for Altria, there are some threats. The first is that there is a possibility that we enter into a downtrading environment, where smokers might switch to less-premium products where the company cannot command as high a margin leveraging its US Marlboro franchise as well as its cigar brands. This could further push the retail share away from even its branded discount products to deep discount products.
(Source: Altria Q1 2020 Presentation)
Moreover, Altria's first-mover positioning in both e-cigs and vape products could become impacted by the COVID-19 situation. Because commercialisation efforts of these products relied heavily on point-of-sale contact with customers, these efforts have had to be paused, giving competitors time to catch up with their own products.
Another concern is related to its geographic presence, which is highly US-centric. This is a concern due to the hostility of many urban Americans to the tobacco industry. Being diversified across geographies is valuable, as it exposes your business to various smoking cultures. Although this risk is somewhat mitigated by the fact that Altria has made moves in non-combustibles as well to deal with the American animus towards smoking.
The last concern is one that may actually give dividend investors the most pause, as the previous risks are nonetheless fairly limited due to the intrinsically profitable nature of the product. This is the concern regarding Altria's equity investments, which have really not been well-placed. Ste. Michelle has been heavily written down due to a failure to read developments in consumer tastes, AB InBev (BUD) is unfortunately suffering substantially due to the shutdown of food service operations, and Cronos (CRON) has some alarming lapses in internal accounting practices. These investments, some rather careless, may afford some optionality but demonstrate a penchant to use funds from operations for less-than-optimal means - a concern for investors looking for a payout.
The business has proved resilient, and although downtrading is a risk to its marginality and there are other concerns outlined, Altria has a fair margin of safety to pay its dividend given its payout ratio and debt capacity.
Moreover, it's worth mentioning that Altria has some margin of safety in terms of valuation. To value a company in steady secular decline, given the fact that all stocks have received a discount due to non-fundamental and impertinent technical changes to cash flow models, we will use a historical multiples method. Consider the chart below:
This is a 10-year chart showing Altria's EV/EBITDA multiple. We chose 10 years because it reflects a good chunk of the period in which people looked unfavourably upon smoking. The historical multiple here was around 10.7x, which is more or less in line with competitor Philip Morris (PM). The current multiple is 7.1x, which is 30% less than what it was from its historical average and incidentally its pre-lockdown price. Given that tobacco is likely to be entirely stable, or even experience tailwinds from the current situation, we can assume that cash flows should be more or less the same this year as it was last. This implies that the company is undervalued.
This may seem simplistic, but it is nonetheless powerful, as it helps look past the fact that analysts simply post price targets based on the general level of markets and the general level of perceived risk which impacts discount rates. Do not forget, we are in a TINA environment, and it is for this reason that we see Altria as an attractive dividend play, for the payout it provides is far above general levels of interest rates.
This article was written by
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