Description

This is a simple arbitrage-type trade that should produce attractive risk-adjusted returns. In addition, unlike many posting on this site, the underlying securities are very liquid, making entry and exit easy for those wishing to put on larger positions.

BUSINESS OVERVIEW:
I won’t go into much detail on the businesses, since I assume that everyone knows these household name companies, but rather highlight a few points. In addition, as you will see, this trade does not require a detailed understanding of the underlying businesses for it to work.

MO owns Phillip Morris tobacco, Kraft foods, an interest in SABMiller (beer) and a financial business. The beer and financial business contribute a very small % of operating profits (1.6% and 0.3% respectively), so I will ignore them for the remainder of the analysis. The Phillip Morris tobacco business derives roughly 50% of profits from the U.S and 50% of profits outside the U.S.

RJR is a pure-play U.S. tobacco company. It previously owned Nabisco, but has spun that business out. In addition, its international tobacco operations were sold to Japan Tobacco

TRADE MECHANICS:
Buy 100 MO (Altria Group – formerly Phillip Morris)
Short 70 KFT (Kraft Foods)
Short 30 RJR (RJR Tobacco)

The long MO short KFT isolates the tobacco business “MO Stub” by shorting out MO’s ownership interest in KFT. The math behind the MO stub follows:
MO owns 84% of KFT (rest is public)
KFT has 1,732m shares outstanding
So MO owns 1,455m shares KFT
Divided by 2,069m MO shares outstanding
Equals 0.70
Using 3/18/03 closing prices, the net price for MO Stub is $12.35

Using 2003 First Call estimates of $4.62 and $2.13 for MO and KFT, respectively, the implied EPS for MO stub is $3.13 ($4.62-($2.13 x 0.7)).

Therefore, MO stub is being “created” at 3.9x EPS

RJR 2003 EPS is $4.66, so using the 3/18/03 closing price, the P/E is 7.2x.

Dividends: LTM dividends are $2.56, $0.60 and $3.80 for MO, KFT and RJR respectively. So the position gives you a positive dividend carry of $1.00 per every share of MO ($2.56 - $0.60 x 70% - $3.80 x 30% = $1.00)

The net effect of the position is that you are buying the Phillip Morris tobacco business at 3.9x and shorting the RJR tobacco business at 7.2x with basically no net exposure and a positive dividend carry.


TRADE RATIONALE:
Why does this valuation discrepancy exist?

Most owners who own MO or RJR look at them as tobacco companies, and very few owners of these stocks (aside from hedge fund managers) look at MO on a MO Stub basis. When a bad piece of news comes out (like today’s NY Times article concerning a DOJ investigation into tobacco companies), the selling tends to hit both stocks (MO and RJR) roughly equally. But since MO owns non-tobacco businesses, the implied value of its tobacco business gets hit much harder than the value of the RJR business, making the “spread” on this trade widen considerably. On a P/E multiple basis, MO Stub currently trades at a 45% discount to RJR. This P/E multiple disparity has ranged from 45% discount to a 1% premium (with a mean of 28% and median of 33%) since June 2001 (when KFT was IPOed).

Why should this valuation discrepancy narrow?

MO’s tobacco business is better than RJR’s. In fact I would argue that in an efficient market, MO’s tobacco business should carry a higher multiple than RJR’s for the following reasons:
1) 50% of MO Stub’s business comes from U.S. tobacco vs 100% for RJR. This is important because the U.S. tobacco business carries the litigation risk and RJR has much higher exposure to adverse developments in the litigation/legislative environment.
2) MO has better brand names (e.g. Marlboro vs Camel).This is important from an intangible value, but also from a practical standpoint. As MO has gained share over the years, it is actually better positioned to satisfy adverse litigation/legislative developments as claims are driven by past levels of market share but ability to pay is driven by current and future market share.
3) MO Stub generates 8x the revenues of RJR, and size matters for consumer goods companies.

Why short RJR?

Some would argue that if you can buy a consumer franchise like Phillip Morris at less that 4x earnings, why not just buy the MO Stub on a “naked” basis. I don’t disagree with this. If you have more comfort in the prospects for the U.S. tobacco business or want to take on a bit more risk, this is also a good trade. I am focusing my write-up on the fully hedged position as I think it offers a pretty compelling risk/reward.

What is the price target?

Depends on what multiple you think the MO Stub deserves. Remember that current “creation” multiple is 3.9x and the current RJR multiple is 7.2x. Here is the sensitivity table. (I have rounded price numbers for presentation purposes, but the MO Stub EPS is $3.13)

Stub Multiple 3.5x 4.0x 4.5x 5.0x 5.5x 6.0x 6.5x
Stub Price $11 $13 $14 $16 $17 $19 $20
Upside / Stub Value (11)% 1% 14% 27% 39% 52% 65%
Upside / Long Value (4)% 1% 5% 10% 15% 20% 25%

I have presented % upside as % of stub value and % of long value because I know that people have differing opinions on whether you should credit short capital employed into returns calculations. Either way, the returns are compelling for a very low-risk trade.

Catalyst

1) Improvement in sentiment for tobacco stocks. MO Stub can be viewed as a leveraged tobacco play with much more upside than RJR given its 50% valuation discount.
2) Major adverse development in legislation/litigation would hurt RJR more that MO as RJR as much more exposure to the U.S. market. Note that a development of this nature would probably make the trade go against you in the short run, but would hurt the economics of the business you are short more than the business that you are long.
3) Full spin-off of KFT. I view this as a long-shot but it would certainly highlight the valuation disparity in the tobacco businesses. MO mgmt has not actively talked about this, so this is NOT part of the thesis, but rather, "pie in the sky" upside potential.