Up In Smoke, Altria

12

Business Description

Altria Group Inc. is a Fortune 200 company headquartered in Richmond, Virginia. Altria is made up of five wholly owned subsidiaries, which include Philip Morris USA, Phillip Morris Capital Corp. U.S. Smokeless Tobacco Co., John Middleton, NuMark an Altria innovation company, and Ste Michelle Wine Estates and has recently acquired Nat Sherman. Through these subsidiaries, Altria Group manufactures and sells cigarettes and cigars, smokeless tobacco products, e-vapor products and wine. The company’s product portfolio consists of popular tobacco names such as Marlboro, Copenhagen, Skoal, and Black & Mild, and a 10.5% stake in AB InBev.

3

Investment Rationale

Sin Stock: Sin stocks are defined as those whose products or services are frowned upon by society because they make money by exploiting human weaknesses. The move toward socially responsible investing has caused some sin stocks to be undervalued in recent years and conversely has led to some great investment opportunities. Altria is an example, exceeding the S&P YTD by over 3.36%.

Makes Addictive Products: One advantage that Altria has over other companies is that it makes products that are addictive. This means that once Altria acquires a customer, they are likely to stay a customer for a long period of time. There is also a strong brand loyalty among smokers. Altria’s holds the largest market share of cigarette sales in the US, 42.41 %, seconded by Reynolds at a distant 31.3%.

Pricing Power: The loyalty of smokers to brands like Marlboro and the addictive nature of cigarettes have made the demand for Altria’s products relatively inelastic. This allows the company to increase the selling price of their cigarettes, with little impact on customer demand, as their cost of production increases. The power to charge higher prices for their products has allowed Altria to grow their revenue even though their volume of cigarette

Resilient Industry: Tobacco companies are highly resilient to economic downturns. This is shown by Altria’s performance in tough market years. In 2008, Altria’s share price declined by 34.8%, while the S&P 500 declined by 37%. Altria then outperformed the S&P 500 in the following year. With a beta of .46 and a dividend yield of 3.2%, investors can rest comfortably knowing that they have some protection in their portfolio if the market turns south.

Recent Performance
Over the past six months, Altria has underperformed the market and has a year to date return of -7.73% compared to the S&P 500 return of 10.49%. The stock’s recent performance can be attributed to the following factors:

4

A. RBC Capital Downgrade/AXA transaction: RBC Capital downgraded Altria to “sector underperform” on March 22nd due to rising gasoline prices and interest rates, and a high valuation based on P/E and EV/EBITDA. Altria lost 2.7%. On March 23rd, 2017 AXA, the world’s largest insurer ditched Tobacco assets worth $2 billion, saying that it can’t continue to invest in an industry that kills 6 million people per year. AXA urged other institutional investors to do the same. MO dropped 1.2%.

B. California Increases Excise Tax on Cigarettes: On March 31st, Californian lawmakers announced that state taxes levied on cigarettes would increase by 230%. The new tax rate came into effect on April 1st. Between March 27nd and April 1st, MO’s stock price dropped by 2.4%

C. FDA Moves on with IQOS: On May 24, 2017, the FDA announced that the agency will initiate a scientific review process for IQOS. In December 2016, Philip Morris applied for consideration from the FDA to put IQOS on the market as a Modified Risk Tobacco Product. If the application is approved, Altria will have the exclusive right to market IQOS domestically. IQOS are safer than cigarettes because it heats rather than burns tobacco, and they are more enjoyable to smokers than e-cigarettes are smokers because it still contains tobacco. Philip Morris’ Marlboro HeatSticks accounted for 7.6% of Japan’s cigarette market share a year after its launch. Marlboro HeatSticks would be one of the IQOS Altria would market domestically upon approval from the FDA.

D. California Increases Taxes on Tobacco Retailers and Wholesalers: On June 28, 2017, news was released that in California, the tax rate on tobacco products other than cigarettes would increase from the current rate of 27.3 to 65.08 percent of the wholesale cost. The new tax rate came into effect on July 1st. Between June 28th and July 1st, MO’s stock price decreased by 1.8%.

E. FDA Nicotine Announcement: On July, 28th, the FDA announced that the agency is going to take steps to reduce the amount of nicotine in tobacco products to non-addictive levels. The addictive nature of tobacco products is the primary reason for the large pricing power that

Divestment Rationale
FDA’s Plans to Regulate Nicotine Levels: On July 28th, 2017, the FDA announced that it is going to take steps that would reduce nicotine levels in tobacco products to non-addicting levels. The significance of this statement is that if the FDA were to implement this regulation, for which they have the authority, the addictiveness of most of Altria’s products would sharply decrease as nicotine is the addicting substance in tobacco. This would have severe consequences to a business which model relies on the addictive nature of its products. Even though it is not certain when the FDA is going to aggressively press for the regulation, getting the conversation flowing will continue to hurt an industry that has already been under fire.  Diminishing Pricing Power: One of the main aspects of the tobacco industry that have made companies in the industry such attractive investment opportunities is the pricing power big tobacco firms enjoy. Altria is no exception. Exhibit 2 shows that Altria has been able to make up for significant decreases in cigarette sales volume by increasing its prices. This has led to stable growth in revenues. When the FDA regulates nicotine levels to the point where they are non-addictive for all tobacco products, Altria’s pricing power will greatly diminish as the company’s current customers will lose their addiction to Altria’s products. The result is that the decline in volume can’t be made up for, and future revenues will start to decline rapidly.

Limited Power of Once-Influential Tobacco Lobbying Groups: In 2009, the FDA obtained the authority to directly and independently regulate the manufacturing, marketing, and distributing process of tobacco products. This means that efforts of groups lobbying against FDA regulations have a smaller chance of succeeding than when the FDA needed approval from congress for certain regulations. Furthermore, as exhibit 3 presents, funds spent on tobacco lobbying have steadily decreased over the last five years to the point where they are currently less than half of the funds spent on tobacco lobbying 5 years ago. Between 1998 and 2016, the decrease of money spent on tobacco lobbying adds up to 73%.

Accelerated Future Decline in Volume: Without a continuous decline in the quantity of cigarettes sold, Altria would not necessarily be hurt by a diminishing pricing power. Long-term trends however, show that the quantity of cigarettes sold, Altria’s main source of revenue, have decreased consistently over time. This trend is only likely to accelerate in the future for the following reasons:

Rising popularity of e-cigarettes: Exhibit 3 shows the inverse trend in the years 2011-2015 between the use of e-cigarettes and cigarettes in high schools. High schoolers will be the next generation of customers for Altria and it looks like they prefer e-cigarettes. According to the U.S. Department of Health and Human Services, 90% of adults who smoke started when they were 18 or younger. As the current high school population smokes less than ever, Altria will face a rapid decline in cigarette sales in the future, when the current adult population ages, starts having health complications, and eventually passes away.

The FDA ruling on nicotine: When the FDA regulates tobacco products to a level at which the products won’t be addictive, the number of cigarettes sold will decrease. Consumers who are strongly addicted to cigarettes might turn to a black market for cigarettes with original levels of nicotine, but for Altria, it will have a severe negative impact on the volume of cigarettes sold.  Solely Relying on Pricing will pay its Toll: The current average cost of a pack of cigarettes in the United States is $7.19 including taxes. The average minimum wage is $8.47. In 8 states, a pack of cigarettes costs more than the minimum wage. According to the Center for Disease Control and Prevention (CDC), cigarette smoking is much more prevalent among adults living below the poverty level than among adults living at or above the poverty level. From a survey taken in 2012, the CDC concluded that 33% of adults living below the poverty line smoked cigarettes compared to 20% who lived above the poverty line. With the average price of a pack of cigarettes at a level near the average minimum wage, it is not sustainable for Altria to keep raising prices in the long run. Eventually, Altria will see an extraordinarily sharp declines in volume, simply because people will not be able to afford the amount of cigarettes they want to buy, or they will switch to cheaper brands that Altria doesn’t offer.

5

Growth Drivers
Brand Loyalty: Altria benefits from a strong brand loyalty that will automatically boost the sales of innovative products that Altria is developing once they hit the market. For example, if the IQOS are approved, Altria will market them under their Marlboro brand. Marlboro is the principal brand of cigarettes that Altria sells, and as exhibit 5 presents, it currently has a 44% share of the $816B cigarette market, which is more than the next 10 cigarette brands combined. The second-largest brand is Newport, with a market share of 13%. Marlboro is a great representation of brand loyalty in this industry as it has been the leading cigarette brand for the last 40 years. Restrictions on marketing of tobacco products make it hard for less popular brands to break through and create a barrier of entry. Altria will benefit from their market power even when people are looking for new tobacco/smoking products to consume.
IQOS: In December 2016, Philip Morris applied to have one of its products labeled as a Modified Risk Tobacco Product. Altria has obtained the exclusive right to market this product in the domestic market. The product in question is IQOS, which is a combination of an e-cigarette and a traditional cigarette. It contains tobacco just like a regular cigarette, but it heats up the tobacco instead of burning it. The result is that the consumer inhales much fewer toxic substances than with a cigarette. The purpose is to put a product on the market that is safer than a cigarette, but still offers an experience closer to smoking a real cigarette than e-cigarettes do. If the FDA approves the IQOS, Altria will be the only player in the market with such an advanced tobacco product which will fuel growth in the future.
Smokeless Products: Altria’s subsidiary U.S. Smokeless Tobacco Co. (USSTC) is the leading manufacturer and distributer of smokeless tobacco in the United States with a market share of 55.6% (exhibit 6). The primary brands Copenhagen and Skoal accounted for 33.8% and 18.4% of the market respectively. Smokeless products are addictive due to the nicotine they contain so these products also benefit from brand loyalty and pricing power. USSTC’s market share of smokeless products ranged from 54.9% to 55.6% over the last 5 years while volumes increased by 12%. As the consumption of smokeable products decreases, the consumption of smokeless products increases. Altria’s impressive brand loyalty for these products means that if people step away from smoking to smokeless products, they are likely to still stay with Altria’s brands.
Risk Factors
(FDA) Regulations: In July, 2017, the FDA showed the damage it can do to Altria by making a single statement about regulating the nicotine level in tobacco products. After the announcement, MO’s stuck plummeted by 10%. The FDA has authority to regulate the content and marketing of tobacco products. Not only do statements like these affect the stock price, but if the FDA enforces such regulations, future cash flows of Altria will be negatively affected.

Dependency on Smokeable Products: In 2016, 86.2% of revenue consisted of the sales of smokeable products and cigarettes sales made up 51% of total revenues. Even though right now this is an $816 billion market, which is 115 times as large as the market size of e-cigarettes, it presents a risk. If external factors lead to an abnormal decrease in the demand for cigarettes, the value of Altria will decline sharply as future cash flows will face downward pressure.

6
Development of Innovative Products: With the market size of cigarettes shrinking and the one of alternative smoking methods growing, many tobacco manufacturers have started to invest in the development of innovative tobacco products. If IQOS are approved, Altria will have the sole right to distribute IQOS in the United States. Upon the news that the FDA started the research process of IQOS, Altria’s stock jumped 3.5%, indicating that an FDA approval of the request submitted by Philip Morris would be highly advantageous for Altria. Risks associated with IQOS is that it is uncertain when and if the FDA will approve the request and whether approval of the request would change the customer’s buying behavior. Failure to successfully develop and commercialize innovative products would put Altria in a disadvantageous competitive position if its competitors are able to capitalize on their investments in new product development.

Increase in Excise Taxes: Over the last 5 years, individual state taxes on cigarettes have increased 29 times. The average state cigarette tax is currently $1.71 per pack. Since 2001, the increase in average state tax on a pack of cigarettes is 293%. The adverse effect that tax increases on cigarettes have on Altria can be seen in the performance of Altria’s stock over the last 6 months. The state of California increased state taxes levied on cigarettes twice in the past half year and these two tax hikes combined shaved of 2.4% and 1.8% of Altria’s market capitalization at the announcements of the tax increases. The loss of market capitalization due to tax increases of only the state of California adds up to nearly $7 billion. To conclude, the impact of tax rate increases have to be considered as a risk.
Pro Forma

9
Revenue: The historical high revenue growth rate may be threatened and reduced by the “War on Tobacco” and the “War on Addiction” in the distant future. In order to estimate the future revenues, I conducted a financial forecast for Altria for the next four years. I used this time period because the FDA’s policy statement of “continuum risk” suggests a longer timetable for the regulatory changes to restrict nicotine level. More importantly, I do not think that smokers’ addiction can be controlled in the short run. As a result, I did not factor in these risks into the pro forma income statement for the next four years (Table 1).
Without FDA regulations and dramatic decreases in smoking volumes, annual growth rates of revenue for the next 4 years lay between 2% and 5%. The annual growth rates include the possibility of the FDA’s approval of Philip Morris’ IQOS as a Modified Risk Tobacco Product, as well as expected price increases of around 6% and volume decreases for cigarettes around 2.5% each year. The forecasted revenue growth rates also reflect the increasing revenue share of smokeless products from current 22% to 32% four years from now.

Dividend: The dividends per share are dependent on the company’s earnings per share, which is partially dependent on the company’s revenue. Consequently, if revenue decreases, earnings per share will decrease, and this will trickle down to decreasing dividends per share. Notice that the average annual dividend growth rate is approximately 8%. As my valuation will show, Altria is a classic example of a “two-stage dividend growth” model, because over the last 8 years Altria has paid a high dividend and after 2020, dividends will move towards “normal” levels as the FDA regulation will kick in in the long term.
8

The valuation method I used to compute the fair value of Altria is the “two-staged dividend growth” model, which is used to calculate the present value of future dividends with two different growth rates. In Equation (1), DPS1-3 is the annual dividend per share 1 to 3 years from now. “g” is the long-term normal dividend growth rate, and “k” is required rate of return or discount rate. This approach recognizes the fact that virtually no company will pay perpetual, constant dollar dividend nor will grow its dividend at a constant growth rate. Thinking of a product life cycle, a typical company will pay dividend in two distinctive stages, a short-term high growth rate and eventually a long-term normal growth rate.

10
Computing DPS 1-3 is simple as that is the 8% that can be derived from the average dividend growth rates in the pro forma income statement. Estimating the terminal value, the last term, in Equation (1) requires more careful considerations. Assuming the FDA’s policy finally kicks in by 2020, Altria’s dividend growth rate will drop to a “normal” level. As Altria dividend growth rates have fluctuated between 8% and 10% in the last 8 years, I will assume that the normal growth rate will drop to 2.5%.
Combining the previous growth rate estimates, I used Equation (1) to compute the corresponding fair values. In Table 2, I present Altria’s current fair value based on various scenarios of discount rates and future normal dividend growth rates. In order to valuate Altria, I used a discount rate of 8%.

At a long-term normal dividend growth rate of 2.5% and a discount rate of 8%, the fair value of Altria is $54, which means that its current price of $62.39 is an overvaluation of 13.45%
A discount rate of 8% might seem low for a company that has a business model that is defensive in nature and that pays stable dividend, but a discount rate of 8% is reasonable for the following reasons.

High Chance of FDA Regulations: The primary reason investors and analysts overvalue Altria is that they believe that Big Tobacco and their lobbying groups will be able to postpone FDA regulations until far into the future. More realistic is that the FDA regulations will kick in within the next five years. That is because lobbying groups and Big Tobacco lost a lot of political territory when the FDA received the authority to regulate the tobacco industry without consent from congress. A good indicator of the diminishing power of tobacco lobbying groups is the amount of money that those group have spent on lobbying which exhibit 3 shows so clearly.

Innovative Products Might not Make up for Losses in Cigarette Volumes: The power of new tobacco products is overestimated. Management of tobacco companies like to stress how their innovative products counter the losses of their business due to declining sales of cigarettes. In reality, the experience of smoking cigarettes seems to be very different from, and suboptimal to the experience of smoking e-cigarettes or consuming alternative tobacco products. A National Health Interview Survey from 2014 and 2015 showed that from 15,532 current smokers or those who quit in 2010 or later, 52.2% of people who quit were E cigarette users vs. the 28.2% who quit that were traditional smokers. This indicates that in the future, alternative forms of smoking will not be able to cover up the losses due to declining cigarette sales.

Conclusion

Altria has long been a defensive, growing company that paid out consistently growing dividends to its investors. As a sin stock profiting from a variety of addicting products, Altria’s business model has presented few risks historically and generally looked like a solid investment opportunity. Times change however, and where there is smoke, there is fire. Altria’s stock price decrease on July 28th after the FDA announcement about regulating nicotine was the smoke that led me to believe there was fire in the tobacco industry, and there is.
The following is a summary of the fundamental issues that support the divestment.

Rationale:

1. The FDA has stated that it is going to take steps to regulate nicotine levels in all tobacco products as well as e-cigarettes. The trend of the FDA imposing more stringent regulations on the tobacco products led me to believe that this is not just an idle threat, but that the FDA will indeed impose the nicotine regulation. Due to the decreasing power and funds of tobacco lobbying groups in the United States, this regulation will not be pushed off until the long-term future. Instead, levels of nicotine in tobacco products and e-cigarettes are assumed to be regulated by late 2020 to early 2021.

2. Lowering levels of nicotine in tobacco products and e-cigarettes to a non-addictive level will lead to a major decrease of long-term growth for Altria. The reason for this is that most of Altria’s pricing power stems from the addictive nature of its products, which can be seen in the products’ brand loyalty. Cigarettes are the largest segment of Altria’s revenue and the only reason this segment has remained profitable is because Altria has been able to raise its prices. In the future Altria will run out of this ability, both because of content regulations of tobacco products that will decrease their addicting aspect, and because of cigarette prices rising to the point where a lot of smokers will not be able to afford the amount of cigarettes they demand.

3. Due to FDA regulations, excise tax increases, and social pressures, there has been a trend to consumption of alternatives to cigarettes and e-cigarettes. Management of big tobacco companies like to stress how much they’re investing in leading innovative solutions to declining volumes of cigarette sales. In reality, these alternatives to traditional smoking will not be able to fill the vacuum. The rate at which people quit smoking e-cigarettes is twice the rate at which traditional smokers quit smoking cigarettes. Clearly, alternatives to traditional cigarettes are not satisfactory enough to ensure long-term revenue growth for companies like Altria. Intuitively this makes sense too. The reason the FDA has regulated cigarettes much more than other methods of tobacco consumption and smoking, is that the content of cigarettes, and the way consumers inhale that content is inherently different. By substantially changing that content and the way of “smoking”, it is still impossible to replicate the experience of smoking a traditional cigarette.

It is not worth hanging on to Altria only for its dividend payments. When the growth rate of future revenues starts to decrease, so will Altria’s dividend payouts. Despite the company’s 8% dividend growth rate, for the reasons explained in the divestment rationale and listed above, I assumed the long-term dividend growth rate to decrease to 2% and I assumed a required rate of return of 8%.
With those assumptions, I came to the conclusion that the fair value of Altria is $54, which means that at the current price of $62.39, the company is overvalued by 13.45%.
The overvaluation of 13.49% is the direct reason that I recommend to sell Altria.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s