Philip Morris MO
November 29, 2017 - 8:28pm EST by
scrooge833
2017 2018
Price: 67.37 EPS 0 0
Shares Out. (in M): 1,910 P/E 0 0
Market Cap (in $M): 128,676 P/FCF 0 0
Net Debt (in $M): 11,300 EBIT 0 0
TEV ($): 117,377 TEV/EBIT 0 0

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  • Tobacco
  • Consumer Goods

Description

An investor with a ten year horizon should consider taking advantage of the recent sell-off in Altria to establish a position in this company.

 

He/She will then conservatively sleep well and will wake up 10 years from now feeling he/she will be able to afford more purchases much more ahead of the depreciation that inflation has caused to his/her dollar.  One can see an annualized 13% compounded rate of return for the next 10 years. Hence I wrote $120 as the target price. In ten years, Altria should be higher than $216.

 

Before I explain my investment thesis, let me share with you a story that will do more to give you the emotional intelligence needed to hold this stock better than any Altria Wall Street research report.

 

Buffett is oft quoted as saying, “I'll tell you why I like the cigarette business. … It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty.”   He did say that during the 1980’s as documented by the author of Barbarians at the Gate.

However, I prefer to associate the cigarette business with another quote of his.  Let me tell you why.

 

I peered over the salaries of the CEO’s of Altria, British American Tobacco.  All I can think of next is Buffett’s quote,  “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”  How hard is it really to run a cigarette business? What makes the whole situation hilarious is that despite all the egregious compensation that management has rewarded themselves, Altria was the best performing stock from 1925 to 2007..

 

The long-term story of Altria, with its growing cash flows and excellent track record of delivering shareholder returns in its history as a public company, is  still very much intact.  If you have no qualms against investing in stocks of cigarette companies, then Altria could be a three bagger 10 years from now.  If you have moral qualms, Altria can still be a 2.5 bagger in 10 years and the other 0.5 times is the tithe you give to your Church to pay for your sin.

Only a rare few public companies can be forecasted to exist 10 years from now.

Altria has dominant pricing power because it has a proprietary taste and fantastic brand loyalty that allows it to raise prices ahead of inflation of its cost of materials.   Its addictive products allow it to make for a penny and sell for a dollar.  It is surprising that in U.S. tobacco, generics have not made much of a dent in the industry as other consumer products.  The answer is, it is just too difficult to displace one’s addiction once the loyalty to the Philip Morris brands is established.

I have no doubt that the U.S. tobacco industry will still be dominated by Altria in 20 years (If I am wrong, I may be senile by that time to know that I am wrong). Advertising restrictions prohibit smaller competitors from gaining market share; the only way to gain significant share in the cigarette market is through acquisitions. Altria commands a 50% share of the U.S. cigarette market. This 50% market share is dominated by Altria's high-priced, premium brands -Marlboro (~44% share) in cigarettes, Copenhagen (34%), Skoal (17%) in smokeless  tobacco.

 

Before discussing valuation, I will discuss why Altria will be dominant 20 years from now.

A gem of a lesson from CFA curriculum is the HHI. The term “HHI” means the Herfindahl–Hirschman Index, a commonly accepted measure of market concentration.  It is a way to measure the competitive advantage of the leader in that industry.   The HHI is calculated by squaring the market share of each firm competing in the market and then summing the resulting numbers. For example, for a market consisting of four firms with shares of 30, 30, 20, and 20 percent, the HHI is 2,600 (302 + 302 + 202 + 202 = 2,600). Anything above 2,600 is considered very concentrated.  

 

The HHI takes into account the relative size distribution of the firms in a market. It approaches zero when a market is occupied by a large number of firms of relatively equal size and reaches its maximum of 10,000 points when a market is controlled by a single firm. The HHI increases both as the number of firms in the market decreases and as the disparity in size between those firms increases.

 

See generally Horizontal Merger Guidelines, supra note 2, at 15-25. The Merger Guidelines define highly concentrated markets as those with a Herfindahl-Hirschman Index ("HHI") of 1800 or above. As Table 2 indicates, the five major firms account for almost 100 percent of cigarette sales in the United States, with a HHI of 3260 in 1996.  If you still are skeptical, you will find the cigarette industry is highly concentrated enough to warrant FTC investigation in this link.

 

https://www.ftc.gov/sites/default/files/documents/reports/competition-and-financial-impact-proposed-tobacco-industry-settlement/ndoc95_0.pdf

 

The agencies generally consider markets in which the HHI is between 1,500 and 2,500 points to be moderately concentrated, and consider markets in which the HHI is in excess of 2,500 points to be highly concentrated.  See U.S. Department of Justice & FTC, Horizontal Merger Guidelines § 5.2 (2010).  Transactions that increase the HHI by more than 200 points in highly concentrated markets are presumed likely to enhance market power under the Horizontal Merger Guidelines issued by the Department of Justice and the Federal Trade Commission.  See id.

 

With a HHI of 3200, I will explain why outside threats have no chance with Altria.

1) NO THREAT FROM EXISTING COMPETITORS

Existing competitors just do not have enough resources to outgun Altria in marketing, lobbying and overcoming advertising regulation compliances.

2) NO THREAT FROM GENERICS

According to studies like http://tobaccocontrol.bmj.com/content/11/suppl_1/i73 ,  the biggest reason generics cannot make a dent in this industry is that the brand associates positive images with its product and people gravitate towards the image.   Furthermore, never underestimate the power of corrupt people (Called lobbyists in the U.S.) to further the objectives of dominant cigarette brands with the budget to donate and buy expensive dinners to the powers that be.  For more on the power of lobbying to annihilate the generics, read this https://en.wikipedia.org/wiki/Plain_tobacco_packaging .

3) NO THREAT FROM NEW ENTRANTS SUCH AS E-CIGARETTES

https://www.fool.com/investing/2016/12/13/heres-how-the-fda-helped-philip-morris-crush-the-e.aspx  explains how the FDA is actually helping the Altria crush e-cigarettes.  Furthermore, Altria has launched their own e-cigarette brand. See here:  http://www.businessinsider.com/philip-morris-e-cigarette-2016-11 Many years will pass, and Altria will find a way to dominate the e-cigarette industry if it ever becomes big enough.

4)  HISTORY LESSON OF USA IN ONE SENTENCE: CAPITAL-ISM TRUMPS (no pun intended) REGULATORY CHANGES

There is no capitalism without capital.  Over time, I have lost more and more of my naivete in government and I believe more and more in the power of  money and lobbyists.    Regulatory changes with all their loud barks always end up getting silenced by lobbyists.  Go back to Outstanding Investor Digest's interview of Tom Russo in mid 1990s when Philip Morris was hounded by regulatory changes.  Tom Russo explained in several pages why he bought more of Philip Morris.   One can go back in Internet History Archive to read that interview and be convinced yourself.

Margins

Gross margins at Altria are 60%.  You cannot have such high gross margins in a tangible business unless you have a strong competitive advantage.   

Since the 2009 - post split from PM Int'l, and year-one of the transformative acquisition of UST in smokeless,  the company's margins are higher by 33%. Annual profits are higher by 50% in a decade.

A significant portion of its growth in profit (margins) owes to MST: Smokeless EBIT margins exceed 60%, and compare to cigarettes' above 45% (net of excise tax). Margin drag from Ste. Michelle (16% EBIT), meanwhile, is mostly muted by the wine segment's negligible sales contribution (2% of total).

And for extra gravy: In 2017, Altria will generate an extra quarter of a billion dollars from the decline of one percentage point in this year’s federal excise tax rate.   

Free Cash Flows, Debt and Returning Free Cash to Shareholders

Altria is not a capital intensive business.   Its total capital spending is close to its depreciation of past capital investment.   You do not see the type of capital spending you see in other companies where capital spending far exceeds maintenance spending and the crafty C-level team wiggles their way out of explaining why their maintenance capex should be lower, blah blah blah. Furthermore, its cross licensing to Philip Morris International helps subsidize the capital spending.

Altria has a conservative balance sheet.  Net debt to EBITDA is about 1.0 times. Company borrowed money in the past to buy U.S. Tobacco but company has trimmed down the debt with the increased cash flows from the acquisition.

Altria returns cash flow to shareholders via 2 parts dividends and  1 part, share buyback.   It raised its quarterly dividend by 8 percent to $1.07.  It expanded its repurchase program to a $1.3 billion buyback. Dividends should continue to increase by at least 5% annually.

Unique Risk:

Regulatory Change - Recent threats of regulatory change in U.S. have caused a sell off in the stock price. As history has proven, these threats will quietly be settled down in what amounts to a very good deal for Altria.

Valuation:

Altria’s Earnings Record reads like an outliar student in a College course.

ALTRIA GROUP INC  (MO) CashFlowFlag INCOME STATEMENT

 

 

 

 

 

 

 

 

 

 

Fiscal year ends in December. USD in millions except per share data.

2007-12

2008-12

2009-12

2010-12

2011-12

2012-12

2013-12

2014-12

2015-12

2016-12

Revenue

38051

19356

16824

16892

16619

17500

17663

17945

18854

19337

Cost of revenue

16547

8270

7990

7704

7680

7937

7206

7785

7740

7746

Gross profit

21504

11086

8834

9188

8939

9563

10457

10160

11114

11591

Operating expenses

 

 

 

 

 

 

 

 

 

 

Sales, General and administrative

7805

2753

2931

2904

2643

2281

2320

2539

2708

2650

Other operating expenses

464

52

441

56

228

29

53

1

45

179

Total operating expenses

8269

2805

3372

2960

2871

2310

2373

2540

2753

2829

Operating income

13235

8281

5462

6228

6068

7253

8084

7620

8361

8762

Interest Expense

653

237

1189

1136

1220

1128

1053

857

808

760

Other income (expense)

438

-3255

604

631

734

352

-89

1011

525

13850

Income before taxes

13020

4789

4877

5723

5582

6477

6942

7774

8078

21852

Provision for income taxes

4096

1699

1669

1816

2189

2294

2407

2704

2835

7608

Other income

237

 

 

 

 

 

 

 

 

 

Net income from continuing operations

9161

3090

3208

3907

3393

4183

4535

5070

5243

14244

Net income from discontinuing ops

625

1840

 

 

 

 

 

 

 

 

Other

 

 

-2

-2

-3

-3

 

 

-2

-5

Net income

9786

4930

3206

3905

3390

4180

4535

5070

5241

14239

Preferred dividend

 

 

 

15

 

 

 

12

10

24

Net income available to common shareholders

9786

4930

3206

3890

3390

4180

4535

5058

5231

14215

Earnings per share

 

 

 

 

 

 

 

 

 

 

Basic

4.66

2.38

1.55

1.87

1.64

2.06

2.26

2.56

2.67

7.28

Diluted

4.62

2.36

1.54

1.87

1.64

2.06

2.26

2.56

2.67

7.28

Weighted average shares outstanding

 

 

 

 

 

 

 

 

 

 

Basic

2100

2075

2066

2077

2064

2024

1999

1978

1961

1952

Diluted

2118

2087

2071

2079

2064

2024

1999

1978

1961

1952

EBITDA

14653

5241

6357

7135

7055

7830

8207

8839

9111

22816

Thanks to yearly price increases of 4.5%, ten years from now, MO’s revenues will be 40% higher and operating earnings will be twice its current $8.8 billion.  Shares outstanding have shrunk by 8% over a decade.  Dividends are at 4.22%.  Including dividends and repurchases, MO will be worth at least $216 per share ten years from now.   That is a 13 percent compounded annual return from here.

Before you scoff at this valuation in this low interest environment.  Let me ask you this trivia question.  Name one company that luminaries whom you and I will never outsmart such as economists Milton Friedman, Ben Bernanke, Jeremy Siegel had an investment and compounded 17% in his lifetime? Answer is: Philip Morris and its successors.  If shit hits the fan at Philip Morris, you have ex-Federal Reserve Chairmen and the country's top economic advisers who have vested interest on your team. Take that!

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Removal of Cloud of the Regulatory Risk

 

 

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