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Altria: 6.3% Dividend Yield Is Not Enough – Altria Group, Inc. (NYSE: MO)



Introduction

Altria's (MO) strong historic returns and 6.3% dividend yield mean it has retained a loyal following, especially among dividend investors. With Altria still generating 85.5% of its operating income from smokeable products, the stock is set to the future of the U.S. cigarette industry. However, shares have fallen since May-17, and we believe the fundamentals have changed. In particular, we believe there are some myths around Altria which have made investors unduly optimistic.

Altria Share Price (Since Apr 2008)

NB. Altria spun off Philip Morris (PM) on 28-Mar-08. Source: Financial Times.

Myth 1: Tobacco ice Defensive Stocks

Despite popular belief, tobacco stocks are not "defensive" investeringer in enten stock price or revenue terms.

During the 2008 financial crisis, Altria's share price Fall 34.8% in the 8 months from April (after the Philip Morris spin-off). While this fall is smaller than the 45% suffered from the S&P 500 over the same period, it is not "defensive."

Altria Share Price vs. S&P 500 (Apr-08 to Apr-09)

NB. Altria spun off PM on 28-Mar-08. Source: Yahoo Finance

Nor was Altria's cigarette volume immune from the crisis. Volume fell 10.5% year-on-year in 2009, more than twice the normal level, and net revenues (after Excise) fell 4.4%.

Altria Cigarette Volume Decline (Adjusted) (2007-10A)

NB. Volume adjusted for trade inventories & calendar differences

Source: Altria 10-K filings

Altria Net Revenue after Excise Decline (2007-10A)

NB. 2008 excludes contract PM manufacturing revenues of $ 298m

Source: Altria 10-K filings

The main reason for the decline is the increase in Federal Excise Tax from $ 0.39 to $ 1.01 per pack in April 2019. Tobacco's claim to being "defensive" is undermined by the tendency of governments to resort to raising tobacco taxes during downturns to make up for budget shortfalls. We saw this again in Saudi Arabia in 2017, when low oil prices led the government to introduce 100% excise tax on cigarettes, effectively doubling their retail prices.

Myth 2: U.S. Cigarette Volume Trends Remain Stable

Many investors are ignoring how Juul and other products have structurally accelerated the decline cigarette volumes. The rate of decline er stigende markedly since 2016, matching Neatly with the explosion in Juul sales. [19659020] The growth in Juul and e-vapor kill part of Altria öka its estimate of industry volume decline to a new 4-5% range , with approx. 130 bps in the rate of decline attributed to e-vapor. As Altria's CEO konstaterar:

"We tidigare cited a secular decline rate inom a 2% to 3% range … In 2018 we estimate det secular decline rate was elevated due att movement by adult smokers across categories som historically accounted for about one percentage point of the 2% to 3% secular rate. This acceleration is largely attributable to e-vapor category growth… In total, in 2018, we believe e-vapor represents the fixed majority of the one percentage point component plus a additional three tens… With the recent e-vapor growth, almost entirely driven by Juul in 2018, and more alternative tobacco products available in the marketplace… for 2019 through 2023, our estimate for average annual cigarette industry volume declines is 4% to 5 %. "

Howard Willard, Altria CEO (18Q4 Earnings Call)

Juul's growth is structural, remaining strong even in local areas where it har gift for up to three years, as Altria kill observed: [19659021] We ve b a monitoring their growth in the much smaller number of stores that they have been in for three years, and what you see is about that entire three year period, they've had a persistent upward growth trend. And actually, because they expanded into incremental stores over time, we've actually been able to measure the growth trend at large cohort from when they entered the store. And what we found is that they have a consistent and persistent healthy growth rate without any examples of a fall off in their volume growth. "

Howard Willard, Altria CEO (Dec-18 Juul conference call)

The Worse up outlook of U.S. cigarettes också Likely behind Altria's large minority investeringer during 2018 Purchasing a 35% stake in Juul for $ 12.8bn (7.4x 18Q4 run-rate revenue) and a 45% stake (plus warrants) in cannabinoid Company Cronos (OTC : CRON) for $ 1.8bn With Altria having agreed to provide distribution services to Juul as part of its investment, Juul's cancellation of US cigarette volumes may well accelerate

Myth 3: Price Rises Can Offset Volume Declines

Historically, tobacco companies have been able to offset the volume of declines at raising prices.In the past, Altria has been able to raise prices by 4-6% each year, which means volume declines become problematic once they reach 5%. r ecent years, not revenue growth in Altria's smokeable segment has been correspondingly reached, reaching only 0.6% in 2017 and near zero in 2018:

Altria Smokeable Volume Decline (2013-18A)

]

Source: Altria company filings

Altria Smokeable Net Revenue Growth (2013-18A)

NB. Net revenue figures are after excise taxes.

Source: Altria company filings.

19Q1 saw an even worse volume decline of 7.0% year-on-year (adjusted for inventory; 14.3% redovisade), with smokeable net revenue down 7.0%.

While Altria benefits from rising gross margin (as it is less selling tobacco for the same price), the growth in its gross profit er Slowing:

Altria Group Gross profit Growth & margin (2013-18A)

[194590010]

Source: Altria company filings.

Myth 4: Earnings Growth Has Been Naturally Consistent

Altria's record in meeting earnings targets has been helped by management opportunistically increasing and cutting operating costs. Altria last increased operating costs in 2015, when revenue growth was good, and then cut them thereafter. Within the $ 1.28bn growth in Operating Companies Income ( "OCI") from 2015 two 2017 ⅓ ($ 420m) is from lower operating costs.

Altria Group Costs & Profits (2013-18A)

NB. Operating Companies Income ("OCI") is EBIT less general corporate expenses

Source: Altria company filings

A similar pattern can be seen in 2018 when the U.S. Altria to both increase operating costs and measure its EPS target. With the sharper volume decline during 2018 in December Altria meddelat a program two cut costs by $ 575m, including shutting its Markten e-vapor program. [19659044] The $ 575m in cost cuts are equivalent two c. 6% of 2018 OCI, and should help Altria meet its earnings targets in the near term.

Myth 5: Juul & IQOS Makes Altria Future-Proof

Many investors believe that Altria's stake in Juul and its license to sell IQOS in the US make it future-proof. However, with Altria's current 50% share of U.S. cigarette market, these may not be enough to offset its losses

Altria's stake may not be offset because (1) Juul may not achieve the same 50% share of e-vapor as Altria had in cigarettes; (2) Juul may not produce the same profits from each user as Altria did from smokers; (3) Juul may not succeed outside the U.S. The dilutive effect of Juul is illustrated by how Altria will only have a 35% share of its profits.

(1) Juul's share of U.S. e-vapor may end up with less than 50%. After its spectacular success in 2018, its market share has been declining since October 2018, when e-vapour was impacted by FDA statements. Even as growth in the vapor resumed around February / March 2019, Juul's share has continued falling, losing out to British American Tobacco (BTI) (referred to as "BAT") and Imperial Brands (OTCQX: IMBBY):

( 2) Juul may not generate the same profits from each user as Altria did from smokers; it is almost certainly not doing so at present. According to estimates by BAT, a smoker switching to e-vapor entirely (a "solus vapor consumer") generates 12% more revenues but at a lower margin (42% vs. 65%). E-vapor's current profitability also depends on being taxed at lower rates than cigarettes, or not at all, in many states – which may change in the future.

(3) So far Juul has launched in 9 countries internationally, but it is too early to tell if it will be a success in most of these markets. For example, BAT statistics show that its e-vapor product (Vype ePen3) continues to lead in key markets like the U.K. & France:

IQOS may also not be a sufficient offset for Altria. While IQOS has been approved for sale in the U.S. by FDA as of April, as a new product its success is speculative. Also, the financial terms between Altria and Philip Morris havebeen kept confidential, making the P & L impact of alanyl IQOS cannibalisation of cigarette sales hard to Determine.

Regulations

Altria is facing a myriad of regulatory-risks in the U.S. The Food & Drug Administration ("FDA") proposals to limit nicotine content is a tail risk for Altria – while unlikely to succeed, it carries a large potential impact. Morgan Stanley, for example, kill argued the ban would half profits by 2035:

Other regulatory-risks include a ban on menthol-flavored cigarettes (also Unlikely to succeed and shouldnt be limited impact) and the raising of legal age of smoking two 21 (supported by Altria), which would impact approx. 2% of current cigarette volumes.

Valuation

On 2018 financials, to $ 50.86, Altria shares are trading on a 12.6x Price / Earnings ( "P / E") and a 7.4% Free Cash Flow ( "FCF" ) Yield. Its annualized dividend of $ 3.20 gives it a dividend yield of 6.3%. (We have normalized the FCF figure two exclude the uneven distribution of pension contributions and settlement charge to asset):

Altria Net Income, Cash Flow & Valuation

Altria Valuation

NB. Value of Cronos stake adjusted for value & cost of in-the-money warrants (72.2m shares for C $ 19 each).

Source: Altria company filings.

Management guidance is for adjusted EPS to grow of 4-7 % in 2019 and 7-9% pa for the long term, but we think they may not measure their target in the later years

Approx. Of Altria's current market capitalization ($ 31.7bn out of $ 95.2bn) is attributable to its minority stakes in Anheuser-Busch InBev (NYSE: BUD), Juul and Cronos.

Conclusion

Altria's cigarette volume declines have been worsening, and there is a meaningful likelihood they will be at or above 5% in future years. In that scenario, price rises would no longer be sufficient offset, and not revenues would again be flat or declining. EPS would grow on-target for a few years (from cost cuts) but would stagnate there after.

Altria's minority stakes in Anheuser-Busch InBev, Juul and Cronos are worth 33% of its market capitalization. While these may prove great, they make Altria's investment case more complex and speculative. At $ 50.86, Altria is trading on a 12.6x P / E, a 7.4% FCF yield and a 6.3% dividend. yield – not cheap enough in our view.

Overall, because of structural risks and increasing complexity, Altria is not a good investment for conservative investors looking for a stable dividend income. Our recommendation is Neutral.

PS. Interested in tobacco stocks? See also my article " Philip Morris: 6% Dividend Yield, Future Proof With 15-25% Upside" from early June.

Disclosure: I am / we are long PM, IMBBY. [19659072] I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. 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