Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Best Pick In The Tobacco Industry

|Includes: BTI, Altria Group, Inc. (MO), PM

Summary

Altria Group, Philip Morris International, and British American Tobacco seem to be the most similar in regards to size and products for U.S. public tobacco companies.

Altria Group represents the most undervalued out of the three tobacco companies from my DCF and DDM models.

Philip Morris International seems to be underwater and fighting a negative equity problem and British American Tobacco is running its business as a serial acquirer to fight slow organic growth.

     With the news of Juul being accused of potentially marketing to minors or their products just ending up in their hands and as well as investors' perceptions on the rising competition stemming from Juuls and other similar products, I thought going through the tobacco industry in search of the best company would be a worthwhile quest. The three companies that I came up with as my comparables universe when looking through the industry were: Altria Group (ticker: MO), Philip Morris International (ticker: PM), and lastly British American Tobacco (ticker: BTI).

     The tobacco industry is one that has been around for centuries and in my opinion, will be around for centuries to come as well due to the allure it has to some people as well as the scientifically proven addiction it causes to users. With the recent success of more modern methods and products for inhaling tobacco smoke or vapor, it will be important for the big tobacco companies to align themselves with the future and look to make a push into newer technologies for smoking or vaping. That being said, I still see younger people still smoking cigarettes and also using smokeless tobacco as well. Tobacco has an advantage over some other consumer products because of the scientific nicotine addiction that takes place keeping customers users for sometimes indefinite periods as well as users having a brand loyalty preferring a certain taste or brand in general.

     When you take a look at the brands of each of the companies, Altria Group (ticker: MO) has many tobacco brands that are familiar to most people including: Marlboro, Black & Mild, Copenhagen, and Skoal. Philip Morris International (ticker: PM) was spun-off from Altria Group in around 2008 and so Philip Morris International still has the rights to Marlboro's international sales, L&M, and many other international tobacco brands that are less known here in the United States. British American Tobacco (ticker: BTI) has popular brands such as: Camel, American Spirit, Newport, Pall Mall, and Grizzly chewing tobacco.

     I made DCF and DDM models for Altria Group, Philip Morris, and British American Tobacco and from my analysis both the Altria Group and Philip Morris are the most undervalued. According to my DCF models, in which I modeled out both companies as mature companies with stable low growth rates and historical margins, Altria Group is undervalued by about 60% and Philip Morris is undervalued by about 57%. British American Tobacco was overvalued by -31% (after normalizing their financial statements to USD from GBP).

https://media.licdn.com/dms/image/C5612AQHwcX8ko4OYIg/article-inline_image-shrink_1000_1488/0?e=1547078400&v=beta&t=_cGmBWmaxsRUAGK98OSJ5ILuboSQU0HKBg06zsqZYiM

     From the DDM both Altria Group and Philip Morris were undervalued by over 100% (future dividends were determined using a historical payout ratio).

https://media.licdn.com/dms/image/C5612AQFF5nU4o2B3Qw/article-inline_image-shrink_1000_1488/0?e=1547078400&v=beta&t=17NA_4stha5xT6z-grQWChCGtNt8Uv47-vv8OLHiebs

     From the information given about the DCF and DDM models Philip Morris and Altria Group seem to be quite similar in the amount by which they are undervalued and the opportunity they present but I do not believe this to be the case. The first thing that I noticed in Philip Morris' historical data, and the data I projected into the future, is that Philip Morris has had a problem with negative equity for many years. The next thing I noticed was Philip Morris International's rising debt with lowering revenues over the past few years. Altria Group actually had declining debt balances and more stable and less volatile revenues. Another thing that I noticed was that Philip Morris International's payout ratio had an average of 87% over the past 5 years compared to around 80% for Altria Group. I think being closer to 100% payout ratio is not a good sign especially as debt balances are increasing meaning interest payments will increase at some time and will most likely increase the payout ratio if earnings do not start kicking up.

     Altria Group also has the best financial position as far as debt and interest coverage goes as you can see in the table below:

https://media.licdn.com/dms/image/C5612AQF3yN2oIHDu2w/article-inline_image-shrink_1500_2232/0?e=1547078400&v=beta&t=0vBpf9VOfQFPIhK2Xg8_QdsqmsmCajiKxcabMuwQ3EA

     Debt to equity is N/a for Philip Morris International because they have negative equity.

     Looking at some enterprise value multiples, British American Tobacco seems to have the lowest multiples (which is to be expected given the characteristics of the business: no organic growth, high and steeply rising debt to pay for acquisitions, and the steep rise in the dividend puts the dividend at jeopardy of being cut in the future as it is around 100% of earnings in my model which assumes no growth through acquisitions). Philip Morris International and Altria Group again here look to be neck-and-neck but it is the negative equity and mounting debt for Philip Morris International that makes Altria Group the best pick in the tobacco industry.

https://media.licdn.com/dms/image/C5612AQFBNaoHGcu2wQ/article-inline_image-shrink_1500_2232/0?e=1547078400&v=beta&t=ThOB-yP0hsBUrOL_0s7ZE06FFwUM3Qe2eZN4fzTMv1E

     Overall I believe that the best pick in the tobacco industry is Altria Group (ticker: MO). The reason for this is the values I derived using conservative assumptions for my DCF and DDM models, Altria's superior financial position compared to peers, and in-line multiples with Philip Morris International even though Philip Morris has much more risk of dividend cut, debt problems, rising interest payments, and marginally lower profitability. Gross Profit percentages for Altria have been rising and at the same time Philip Morris' has been decreasing showing Altria Group's pricing power in the industry. Altria's relative strength was shown over the past month as markets sold off around 8% and Altria Group's stock rose 6%. A dividend yield of 5% is the icing on the cake. Thank you for reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.