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Altria Group (MO)

In September 2018 we reviewed Altria's disappointing performance, dividend safety, and long-term growth outlook. Read the analysis here.

Founded in 1919 in Richmond, Virginia, Altria is America’s largest tobacco company. The business split into three separate firms in 2007 (Altria, Phillip Morris International, and Kraft), with Altria retaining all domestic tobacco operations. Altria has exclusive U.S. rights to sell cigarettes primarily under the Marlboro, Parliament, Virginia slims, and Benson & Hedges brands. 
Source: Altria Investor Presentation
The company also markets cigars (Black & Mild), chewing tobacco (Copenhagen and Skoal, Red Seal, and Husky brands), and table wines under the Chateau Ste. Michelle, Columbia Crest, and 14 Hands brands.

In recent years, Altria has been investing heavily into non-combustible products, including its MarkTen vaping products, Verve nicotine tablets, and the iQOS nicotine delivery system, which heats tobacco instead of burning it, thus releasing far less toxic and carcinogenic chemicals.
Source: Altria Investor Presentation
The company also owns a 10.5% stake (valued at more than $20 billion) in Anheuser-Busch Inbev (BUD), the world’s largest beer company.

Altria’s revenues and operating profits are dominated by its cigarette business, which accounts for approximately 89% of total sales and operating income, with almost all of the rest coming from its smokeless division. Wine represents just 2% of sales and 1% of operating income.

Business Analysis 

“It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”

This quote from Warren Buffett about the wide moat nature of the tobacco industry is precisely why Altria has been such a great high-yield dividend growth stock for so long.

Speaking of brand loyalty, the company’s Marlboro brand has grown to become the nation’s dominant cigarette brand with 44% market share and generates 87% of the company’s overall smokable volumes.
Source: Altria Investor Presentation
All told, Altria’s total market share is 51.1%, and its industry-leading brand equity means that it has strong pricing power to offset the 3% to 4% annual volume declines in cigarettes that have been the long-term industry trend. The cigarette industry’s price elasticity has ranged from -0.3 to -0.4 over time, which means that consumption declines by 3-4% for every 10% increase in price, allowing revenue to still grow despite volume decay.

In fact, over the past year Altria has increased the average price of a pack of cigarettes by close to 6%, and its Copenhagen chewing tobacco has enjoyed an even more impressive price hike north of 7%. Consistent price increases have resulted in steadily rising revenue and operating margins for the company, whose operating margins on cigarettes are now the highest in the industry at nearly 52%.

While Altria’s business is dominated by cigarettes, the company realizes that the secular decline in smoking, in which cigarette volumes are expected to decline by 3.6% annually for the next decade, is a major threat to its long-term outlook.

As a result, the company is focusing all its growth efforts on lower risk products, including smokeless tobacco products, iQOS, and MarkTen vaping products, which offer 96%, 95%, and 99% less health risks, respectively.
Source: Altria Investor Presentation
The good news for Altria is that, unlike cigarettes, chewing tobacco is still a growing industry, as smokers are increasingly shifting from higher risk to lower risk products. Altria owns Skoal and Copenhagen, which it acquired via its $10.4 billion purchase of U.S. Tobacco in 2008.

The company’s strong distribution network and industry-leading ad budget have allowed it to grow these two brands at a solid mid-single-digit pace. Altria now controls a majority of the smokeless tobacco market in the U.S. (55% market share) ind enjoys the higher operating margin in the industry (about 68%).

Going forward, Altria is expanding on the low-risk tobacco market with numerous plans to launch new products across the smokeless, vaping, and heated tobacco markets.
Source: Altria Investor Presentation
The company has invested heavily into this market and now has more than 400 employees in over 16 countries (including 195 PhDs and 65 engineers who have generated about 600 patents) working on perfecting its lower risk products and bringing them to market. In addition, the company has been aggressively acquiring fast-growing vaping companies, including:

  • NuMark (which brought with it MarkTen which controls 13.5% market share and is being rolled out to 27% of major retailing partners)
  • Green Smoke Electronic Cigarettes
  • Cync vaping device and investments in Avail Vapor (a chain of vaping stores)

While Altria’s focus on lower risk products is a good and necessary long-term step, it’s going to be a long time before these growing businesses make any meaningful contribution to the company’s bottom line.

For example, analysts expect e-cigarettes to account only for 10% of sales, at best, in 10 years. And in 2024, it’s expected that 80% of Altria’s operating income will still come from cigarettes.

That’s why Altria is focused on maximizing its competitive advantages by streamlining its supply, manufacturing, and logistics chains in order to continually boost its operating profits through cost reduction ($2.3 billion in annual savings over the past decade compared to about $26 billion in annual sales today).

The results have been impressive, with Altria growing its earnings and free cash flow consistently at a high single-digit rate despite overall flat revenues. The company's operating margin has also risen over the last decade from around 25% to close to 35% today.
Source: Simply Safe Dividends, Data as of 1/17/18

Altria’s long-term trend of steadily rising earnings and free cash flow is a strong sign of financial strength for a company that has proven itself to be extremely shareholder-friendly over the years. In fact, few companies have been as generous as Altria when it comes to returning cash to shareholders (80% Adjusted EPS dividend payout ratio policy), which has resulted in fantastic investor returns.
Source: Altria Investor Presentation
More importantly, management is confident that its strategy of increasing operational profitability, combined with steady share buybacks, can grow adjusted EPS and free cash flow per share by 7% to 9% annually over the long-term. If successful, Altria should continue to be a solid low-risk, high-yield stock.

Key Risks

Despite its impressive dividend and total return record over the decades, Altria faces significant regulatory risks at the local, state, and federal level.

For example, local municipalities and states desperate for revenue are more than happy to continually raise tobacco excise taxes (which now consume more than 25% of cigarette revenues).
Source: Motley Fool
And keep in mind that the above, steadily rising figures are the average tax per pack. Many states have much higher rates, including up to $4.35 per pack in New York. 
Source: Tax Foundation
In addition, cities can add on their own sin taxes. For example, New York City plans to raise its tobacco tax by $2.50 per pack, bringing the minimum cost of a pack to $13, the highest in the nation.

High taxes are just part of the ongoing war on tobacco, which also includes increasingly stringent regulations banning smoking in bars, restaurants, and in the case of New York City, even reducing the number of stores allowed to sell tobacco products by 33%.

Meanwhile, the Federal government has also been a big crusader against big tobacco, with numerous attempts to regulate the industry in ways that are designed to lower smoking rates.

For example, various politicians have called on the FDA to ban menthol cigarettes (the most popular kind), and recently the FDA announced a long-term regulatory plan to “lower nicotine levels to non addictive levels.”

However, the regulatory process is extremely long, and so any phased in nicotine restrictions aren’t likely to hurt the company over the short-term. Investors can read more about our take on this announcement, which sent Altria’s stock tumbling by nearly 20% during the summer of 2017, by clicking here.
Source: Altria Investor Presentation
That being said, this decades-long American public health crusade against cigarettes has understandably resulted in a gradual decline in smoking. For example, the U.S. smoking rate for adults declined from 42% in 1955 to just 15% in 2015 (and is projected to hit 12% in 2020).

Analysts expect cigarette volumes to decline by about 3% to 4% a year going forward. Altria investors are therefore counting on three things in particular to keep the company's earnings, cash flow, and dividend growth alive.

First, the company will need to keep raising prices to offset its falling volumes. While this is something the company has a great track record of, thanks to its wide moat and best-in-class brand loyalty, there are potentially limits to how high Altria can raise its prices.

Also keep in mind that a large chunk of those price increases are due to higher excise taxes, meaning that Altria is only getting less than 75% of the higher revenue from price increases.

Altria’s second route to continued cash flow and dividend growth is ongoing cost cutting, which raises the company's operating margins and free cash flow to fund ongoing share buybacks. 

This combination of rising cash flow and falling share count is the only way that Altria can continue sustainably increasing its payout despite falling volumes and flat sales. However, here too there may be limits to how much cost cutting can be accomplished, which could result in the company’s operating margin growth flattening in the future.

Finally, Altria’s biggest and most important growth catalyst is arguably non-combustibles such as MarkTen and iQOS. The company’s hope is that it can transition its existing customers to these lower risk, smoke-free alternatives, and thus stabilize its revenue in the long-term.

However, with vaping too, regulators are considering highly restrictive regulations. In addition, while vaping is far less risky than conventional smoking, public perception (which drives adoption rates) doesn’t necessarily reflect this.

That may explain why the U.S. vaping market has recently stalled, and it potentially means that the vaping market Altria is pursuing may not become as large as it hopes.
Source: Altria Investor Presentation
Meanwhile, iQOS has yet to receive FDA approval, a process whose success is far from assured and could end up taking far longer than the mid-2018 time horizon Altria expects. Keep in mind that even if iQOS gets approval, it’s far from certain how successful or profitable the new system will be for Altria.

That’s because Altria is an exclusively U.S. company, and so far international adoption of iQOS has varied significantly by nation. In other words, there is a fair amount of uncertainty about how popular the system will be with Americans. Factor in the higher cost of production of iQOS units and the lower operating margins they represent, and Altria’s growth path is far from certain.
Source: Philip Morris International Investor Presentation
Simply put, tobacco companies like Altria face enormous growth challenges, especially since the broad secular trend of lower smoking rates is likely to continue.

With that said, few companies have proven to be more adaptable or dividend-friendly than Altria over the years. The company’s track record of nearly half a century of growing payouts, in all manner of challenging industry conditions, still makes it a potentially attractive high-yield dividend stock, especially as its generous payout appears to remain secure for the foreseeable future.

Closing Thoughts on Altria

Tobacco stocks aren’t for everyone, especially if you have moral misgivings about investing in an industry whose products ultimately harm its customers. However, if you are comfortable with the business model, as well as the numerous regulatory and growth risks associated with it, Altria appears to represent one of the fundamentally best choices in the industry.

That’s largely due to the company’s possession of some of the strongest and most dominant tobacco brands in America. Combined with an impressive ability to cut costs, raise prices, and grow its earnings and free cash flow at solid rates, Altria could be a decent choice for dividend investors looking for higher-yielding stocks backed by relatively safe payouts.

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