Description

Business overview

Altria owns various smoking and tobacco assets. Its primary asset is Philip Morris USA which primarily sells Marlboro branded cigarettes.  Altria also sells the Parliament, Virginia Slims and L&M brands.  The combined cigarette retail share of these brands is 50%, of which Marlboro’s 43% is larger than twice the share of its two largest competitive brands combined.  It also owns various other tobacco assets (primarily cigars and smokeless tobacco products like Copenhagen and Skoal), as well as $15 billion in ABI shares net of taxes, and a 35% economic stake in JUUL. Almost all of Altria’s net revenues are from the US.

Last year’s net revenues were $25.4 bn of which $22.3 bn came from smokeable products.

Thesis

Over the past two years Altria’s headline valuation (not including anything for ABI stake or JUUL) has declined from 23x NTM P/E to 10x.  If cigarette volumes continue their historical decline rate instead of significantly worsening (which looks less likely given recent developments around the perceived dangers of e-cigarettes), then this looks like a clear opportunity.

I think operating profit will grow 3% per year through 2021 which results in $8.4 billion in 2021 NOPAT using a 25% tax rate.  Using a 14x multiple which I think is fair for a consumer staple that has demonstrated a track record of long-term growth, the value of the core business around YE 2020 will be $117 billion, or a market cap of $103 billion (netting out debt and the ABI stake, while giving no value to JUUL). Assuming shares outstanding decline to 1.85 billion (based on $1 bn of share repurchases) results in a target price of $56. Combined with ~$3.6/share of dividends, the total return on the stock over a year should be approximately 42%.

Note that I do not add the JUUL stake value to my valuation because I think it provides a hedge to the company’s core business.

It is also important to remember that Altria has been a secular volume decliner for a long time now, but the current price is at the low-end of its historical P/E range and looks like a trough valuation.

Altria’s growth algorithm

Over the last several years, in its smokeable segment Altria has been offsetting low to mid-single digit volume declines with corresponding price increases, such that revenues have bene roughly flat while operating income grew +MSD as a result of higher prices but lower volumes.  I think it’s reasonable to assume that a continuation of this algorithm will result in at least +LSD EBIT growth, which combined with share repurchases would yield +MSD EPS growth.

Altria estimates that through 2023 the industry will decline at a 4-6% CAGR. This is driven by ~2.5% secular decline rate, ~1.3% shift to other forms of tobacco usage, and ~1% of price elasticity.

My estimate is that the retail price of Altria’s packs is $7 vs. a net price to Altria of $3.07 after intermediary margins and excise taxes of ~$2.8.  The large amount of fixed excise taxes means that if Altria raises its net prices by 7%, which may seem like a large price increase, the retail price to the consumer would increase only a low to mid-single digit amount.  As a result of this dynamic, despite substantial Altria-level price increases, Marlboro’s retail share has stayed roughly flat over the last few years.

Variant perception

A few things make Altria different from other secular decliners.

We can invert this question – how does a secular decliner produces horrifically bad financial results?  One way is if the existing business was always bad even before the secular decline started – as is true for physical retail, which has high operating leverage, low margins, and intense competition. As Buffett said: “I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy.”

Another reason a secular decliner could collapse quickly is if a clearly superior product comes along – for example, smartphone cameras and smartphone GPS vs. traditional cameras and traditional GPS systems. It’s very understandable why in those cases the traditional business would reasonably quickly go away.

Additionally, management could make bad capital allocation decisions in an attempt to diversify itself out of the declining business.

By contrast, tobacco doesn’t suffer from any of these problems. The business is very good with high & stable margins (last quarter adjusted operating margin in the smokeable products was 54%).  Furthermore, there is no clearly superior alternative for cigarette smokers. To the extent JUUL is a superior offering, management has hedged itself by owning 35% of it.  Management compensation is focused on total shareholder returns, EPS growth, and maintaining a high dividend payout (~80% of Adjusted EPS) which is positive for a company facing capital misallocation risks.

The most significant reason for Altria to not be valued as a secular decliner is that it has demonstrated consistent growth in the face of volume declines because of price increases. The combination of higher prices while costs fall as volumes fall results in favorable operating income growth. This is different than most secular decliners which are unable to increase prices as their value proposition to the consumer declines.

Other points

A lot of the recent price weakness can be attributed to increased regulatory attention because of vaping health concerns (and the read-through to Altria’s investment in JUUL) and the FDA’s efforts to reduce nicotine consumption.  I view the JUUL investment as a reasonable hedge to Altria’s core business. To the extent that JUUL has lower sales as a result of new regulations, I think Altria’s core business will benefit from a lower secular decline rate.  

Additionally, the FDA is also supposed to put out a new rule soon that would lower nicotine levels in cigarettes to make them less addictive, or ban menthol flavors.  I think any such initiatives would take a very long time to work through the rulemaking process and then would face an uncertain outcome in the courts.

On September 25^th, Altria announced that its discussions to merge with Philip Morris International have ended. There was a lot of industry chatter about why the companies wanted to engage in this deal and the strategic implications for their portfolio of products. I think the talks were driven by the companies’ desire to become more diversified given the rising regulatory and business risks. That said, while the merger didn’t happen, I think we are well compensated for these risks given the current share price (10x P/E).

In April, the FDA authorized the sale of Philip Morris International’s IQOS heated tobacco system in the US.  Altria began the US commercialization of IQOS under its exclusive agreement with Philip Morris International last week.  IQOS heats specially designed heated tobacco units up to 350°C, without combustion, fire, ash, or smoke.  This generates a flavorful nicotine-containing vapor with the taste of heated tobacco.  The experience lasts about six minutes or 14 puffs, comparable to that of a cigarette.  Because there is no burning, the levels of harmful chemicals are significantly reduced compared to cigarette smoke.  Philip Morris International had 11 million IQOS users as of quarter-end; this could be quite a significant product, though it’s yet to be seen how uptake ends up being in the US.

Risks

Poor capital allocation. I think this is mitigated by management’s compensation (focused on shareholder returns), as well as the fact that to date the only very questionable investment is Cronos which is fairly small.  Given recent developments it looks like they may have overpaid for JUUL, but it still seems like a reasonable hedge to the business.

Accelerating tobacco declines or move to discount tobacco. The mitigant to this is that outside of recent movement to vaping (where I view Altria as hedged), I don’t see reasons for the category’s decline curve to accelerate. With respect to the move to discount tobacco, Marlboro has kept its market share roughly flat for an extended period of time and I don’t think a dramatic change will occur.

Disclaimer: This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation.  This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

Cigarette volume decline rate stabilizes and Altria returns to recent historical multiples.