- Cigarette industry volumes to decline by 4-6%. Smoking was the lowest among young people. COVID could accelerate this trend further.
- JUUL and Cronos were losing investments. IQOS might be successful but would ultimately result in lower revenue.
- The company is trading at a good valuation, forward P/E ratio of 8.8 with a yield of 8.9%. However, the long-term industry decline plus high leverage make this an avoid.
I’ve discussed the over-all headwinds faced by the smoking industry world-wide in a previous article. Given my negative view on smoking trends overall, I wanted to see if there was a short opportunity / put option opportunity for Altria (NYSE:MO). I didn’t think sister company Philipp Morris (PM) was worth a short position however I view Altria to be in a much weaker position strategically.
As many of you are well-aware, Altria is the manufacturer and distributor of Marlboro and other popular cigarette brands and cigarette alternatives in the US. The company has a dominant share of the US cigarette industry with a roughly 50% market share (dominated by Marlboro which has a 43% market share).
Unfortunately for Altria, smoking rates in the US continue to decline. Looking at the latest study conducted by the CDC regarding smoking demographics in the US, we can see that cigarette smoking was lowest among people aged 18-24 years at 7.8%. The company says it expects cigarette industry volumes to decline by 4-6% in 2020. (Note: This forecast was before the coronavirus pandemic).
Despite the respiratory disease-related pandemic currently affecting everyone worldwide, I believe that smoking rates and habits wouldn’t necessarily change in the short-term. Smoking is a highly addictive substance whose health risk is already well-known. This is reflected in the Q1 2020 results. Net revenue grew was higher by 15% compared to the same period last year at $5.0 billion and EPS was up 38% to $0.83.
Despite the upbeat results in Q1 2020, in the long-term, I believe that the coronavirus would result in less smoking over-all worldwide due to changes in consumer preferences. This is especially true for the US as young consumers' attitudes were already trending in that direction. This will only exacerbate the trend previously seen trend.
Long-term effects of Coronavirus
As mentioned in my previous article, I believe that the coronavirus pandemic will make a huge impact and leave a lasting impression on young people's lives. Because of this, I believe young people will be less likely to take up smoking and will be more conscious over-all about respiratory health.
I’ve pointed to the effect of the prevalence of heart disease in the 1960s had on consumer preference. There was a large over-all shift in consumer preference away from fat and cholesterol toward more fat-free choices. I believe the coronavirus pandemic will have the same effect, and therefore, we will see further decreases in smoking among younger people. Furthermore, local governments and federal regulators may push for more aggressive moves to curb the use of cigarettes and their substitutes.
They might be emboldened to do this in the name of public health and safety especially post-coronavirus. For example in early 2019, the city of San Francisco totally banned the use of e-cigarettes in the city. It is possible that other cities follow suit. The Trump administration actually raised the minimum age required to buy a cigarette from 18 to 21. There was bipartisan support for this bill to further limit tobacco use. I expect more legislation to come up targeting cigarettes and their substitutes in the next few years.
Unlike Philipp Morris, Altria does not have the benefit of diversification of revenue by being present in multiple countries with different governments and rules and regulations. Altria has all of its eggs in the US basket and the government has shown serious desire to curb smoking over-all.
Altria's major strategic investments have been disappointing
Altria is well-aware of the long-term structural decline it faces in its industry. The company has made attempts in order to hedge against these declines by making investments outside of its core business. The most prominent ones are the purchase of a 35% stake in JUUL and a 45% stake in Cronos (OTC:CRON) both in late 2018. Both investments have failed spectacularly. Altria paid $12.8 billion for a 35% stake in the company and has now taken a total impairment charge of $8.6 billion. The remaining value of the investment is $4.2 billion on the books. Given that the FTC is suing the company to unwind the transaction, there could be another impairment charge coming. If Altria is forced to make a "fire sale" of the JUUL investment, another $1- 2 billion write-off could be possible. It's hard to now determine JUUL's value is given its legal issues and that as a private company we don't have access to its financials. Altria bought a 45% stake in cannabis company Cronos at CAD$16.25 share price. Cronos is now trading at CAD$9.32 a roughly 40% decline in value.
Altria’s investment in JUUL is especially disappointing. I remember the whole value proposition of Altria investing in the then rapidly growing e-cigarette company was to assist it with regard to distribution as well as provide regulatory assistance. Given the decades-long experience Altria has had with the government regulators, it should have known that teen use of JUUL is going to be a huge problem as far as the FDA and other non-profit groups are concerned. While JUUL did initially vow to limit teen use, its moves were seen as not nearly aggressive enough.
As such the regulator felt the need to step in with the ban of certain flavors, and raising the possibility of rejecting the approval of the product altogether. Altria and JUUL should have taken more aggressive steps to get ahead of the problem. Instead, they ended up relying on the regulator which tends to solves problems with excessive/heavy-handed government control. The JUUL and Cronos debacles have unnecessarily raised the debt levels of the company without much return to show for it.
Altria’s cigarette alternatives and the threat of cannibalization
On the plus side banning JUUL means less cannibalization of cigarette sales. Remember that Altria took a 35% stake in the company which means that it is entitled to 35% of the company’s income. Altria currently has an operating margin of roughly 50% based on its latest financials (2019 revenue of $19.7 billion and operating profit of $10.8 billion). I am not aware of JUUL’s operating margin but most analysts believe it is higher. For benchmarking, IQOS has an operating margin 30-50% higher than cigarettes. Assuming JUUL and IQOS have the same operating margin and using the higher end of that range we can assume that JUUL will have an operating margin of 75%.
Let’s do the math on this, $10,000 worth of cigarette revenue is worth $5,000 of operating earnings to Altria. While $10,000 worth of JUUL revenue will result in $7,500 operating earnings of JUUL. Altria is entitled to 35% of JUUL earnings which means that Altria will get at most $2625.
A person giving up smoking to use JUUL would in theory cause Altria to make less money given Altria’s dominant market share. At around a 50% market share, roughly half of all smokers use Altria products. Sure Altria would want JUUL as a hedge (better a portion of income than zero) but the company would still prefer if people smoked cigarettes. Altria is still primarily a cigarette business and any success of alternatives represents cannibalization for the brand and business.
The company has not disclosed details of Altria’s new IQOS distribution and marketing deal with Philipp Morris. I doubt though that it will be a 50-50 split. Therefore it is likely, given Altria’s dominant market share, that a cigarette smoker that switches over to IQOS is lost revenue for Altria as well. In order for JUUL and IQOS to actually add to Altria's revenue and be a growth driver these products need to be able to attract new customers. This is difficult to do though given the "regulatory handcuffs" being imposed on e-cigarettes/ vaping products. This is the reason I don’t believe that IQOS will be a growth driver for the company in the future.
In terms of valuation, Altria is trading at a forward P/E ratio of 8.8 with a yield of 8.9%. The company is trading at a P/E ratio close to the lower end of its 10-year historical P/E ratio range. The company is growing its revenue at a 5-year CAGR of 1.0% which can be a sign that smoking trends are beginning to catch up to the company. Cash flow from operations grew at a 6% CAGR during this time period however there is only so much growth to be obtained from operational efficiency at some point revenue growth is needed. Given the P/E ratio of the firm, the market is essentially signaling that it doesn’t believe the company has a lot of future growth. I am inclined to agree given my analysis above.
The company has immediate liquidity with $5.6 billion in cash currently but, like sister company Philipp Morris, it is highly leveraged with long-term debt of $27.0 billion. The bulk of this long-term debt taken on by the company ended up in its investments of JUUL and Cronos and therefore was ultimately value-destroying.
Altria bulls would like to point out that the company generates a lot of cash from its operations and that is true to the tune of $7.8 billion. However, it also pays out the bulk of it in cash roughly $6.07 billion in dividends paid in 2019. This implies a payout ratio for the company of 78% (CFO/dividends paid). That is not a lot of wiggle room should the top-line revenue start declining. If growth were to start declining, as outlined above, I believe this dividend could be at risk.
Despite being bearish on the long-term outlook of the company, I would not short the stock. At these levels, the price is too low and the company can still pay out its dividends as revenue has remained steady. Given the headwinds and risks the company faces in the next few years though, this is an easy avoid for me.
This article was written by
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