Altria Group Inc. (NYSE:MO) is a US based holding company that manufactures and sells cigarettes and smokeless products. It sells its products mainly in the US but it does have a small international operation. Its brand profile includes Marlboro, Black & Mild, Copenhagen, Skoal, Red Seal, and Husky.
Altria is a countercyclical play with low investment needs, consistent revenue, and stable EBITDA margin. The firm has fared very well during the financial crisis. In fact, its revenue grew by 5% in 2008 and 2009. However, the addictive nature of the product and its associated long-term cash flow is being hampered by ongoing negative social attitude. Regulation and litigation remain key investment risks with several recent bills being passed curtailing tobacco firms’ business operation. While e-cigarette remains a potential opportunity, I do not believe Altria is in position to capture it.
1. Adult smokers in decline: According to data from Centers for Disease Control and Prevention, the percentage of adults who are cigarette smokers declined from 22.8% in 2001 to 19% in 2011. CDC expects this rate to further drop to 12% in 2020.
2. High school smokers in decline: Percentage of high school students who smoked cigarettes declined from 28.5% in 2001 to 18.1% in 2011. CDC expects this rate to further drop to 16% in 2020.
3. Increasing tax: Both state and federal cigarette tax have increased significantly. As an illustration, in 1970 the average tax per pack was $0.18. In 2011, the average tax per pack was $2.35. The percentage growth in average tax per cigarette pack far outstrips inflation.
4. E-cigarette in limbo: At the time of this writing, the e-cigarette is more or less in limbo with regulators. There are no specific rules regulating e-cigarettes and health agencies (FDA, WHO) do not fully know the potential risks of the product. As of now, it is buyers beware. However, there has been talks in several developed countries suggesting that e-cigarettes may lead young people to try other tobacco products due to easier access (since there is no law regulating it) and attractive flavors (fruits, chocolate, vanilla). Also, newer studies are beginning to suggest that the vapour from e-cigarette contains carcinogens and other toxins associated with tobacco smoke. Overall, I do not expect e-cigarette to be the countermeasure for traditional tobacco companies.
1. Expanding margin but unstable growth: From 2007 to 2014, Altria’s EBITDA margin has grown steadily from 33% to 48%, reflecting the success of the Marlboro brand and consumer’s price inelasticity. However, its pricing power does not translate into stable revenue growth. From 2007 to 2014, Altria’s revenue growth ranges from -2% to 5%. Majority of the revenue (about 97%) is contributed to the smokeable products segment and smokeless products segment.
2. Attractive ROE: Altria has very attractive ROE due to low capital expenditure and overall negative change in net working capital. In other words, the investment required (CAPX and NWC) to sustain the business is shrinking which leads to higher ROE.
3. Sustainable dividend yield: Altria is a great dividend stock. It has consistently increased its dividend per share. While its dividend payout ratio is reaching 90%, I believe this number is sustainable due to Altria’s low CAPX and NWC investment needs.
With limited domestic tobacco companies, I decided to go global in search of comparables. Using a filter for over $100 million market capitalization, I found a total of 25 global tobacco firms.
The key assumptions of the intrinsic valuation are as follows:
• In the short-term, the company will continue to experience favourable pricing power (ie. high EBITDA margin) and some growth in revenue due to its Marlboro brand.
•In the long-term, the company’s revenue will shrink due to declining smoking rate and higher regulatory burden in the US.
1.Tobacco-related litigation: Legal proceedings are highly uncertain and can result in significant cash outflow for Altria. Forecast of cash outflow as a result of legal risks tends to be highly volatile and inaccurate. Recent class action lawsuit in Canada against the three Canadian tobacco companies illustrates the length and extent of the potential liability. This particular lawsuit involves $17.8 billion in damage and has already been in court for over 16 years. While the US legal system differs from its Canadian counterpart, it does open the door for equally lengthy lawsuits that involve significant damage.
2.Regulatory change: Tobacco companies have been under the microscope of developed country regulators all over the world. In October 2012, Australia became the first country to enact the Tobacco Plain Packaging Act which requires all tobacco products to be sold in plain packaging. In June 22, 2009, the US enacted Family Smoking Prevention and Tobacco Control Act which puts tobacco products under greater scrutiny. Other regulatory changes we have been seeing in developed countries include indoor smoking bans, patio smoking bans, enlarged graphic warning labels, and flavored tobacco ban. All these regulatory changes tend to decrease the number of overall smokers and per capita consumption.
3.New product technologies: E-cigarette and alternative tobacco technology continues to present a threat to the traditional tobacco companies.
4.Social shift: With increasing awareness of the risks associated with tobacco usage, society’s view of the products haa become more negative in recent decades and is expected to continue. This is particularly threatening in acquiring young smokers. Research shows a strong positive relationship between smoking at an early age and difficulty of quitting. The social shift among young smokers will significantly impact tobacco companies’ long-term profit.