Migration to Vaping is Sub-Optimal for Altria, Whose Cash Flow Driver Remains U.S. Cigarettes

Philip Gorham

Altria posted a solid second quarter that was slightly better than our estimates with flattish volumes and 6% revenue growth, but a slightly weaker-than-anticipated operating margin meant that EBIT was in line with our forecast. We are reiterating our $58 fair value estimate and wide moat rating. The stock sold off, however, because management lowered its guidance for industry volumes both for this year and in the medium term. Although we think the medium-term acceleration in volumes is not in itself a cause for alarm, given that Altria's strategic investments in JUUL and other adjacent categories is likely to cannibalize cigarettes, we remain skeptical that the company can replicate its cigarette margins in these other businesses.

The year-to-date industry volume decline of 5.5% implies a sequential slowdown, but it is still well above the decline rate of recent years of around 3% to 4%. Management has guided that the industry will be down 5% to 6% this year, down a full percentage point at both ends of the range. We believe the biggest driver of this is likely to be the raising of the minimum smoking age to 21 in 18 states--around half of the U.S. population. JUUL will also have cannibalized some cigarette volume, although it is not likely that the introduction of iQOS in September will cannibalize cigarette volumes materially this year, as we expect distribution beyond the initial test market of Atlanta to roll out fairly slowly.

The key risk to Altria's story is that margins in the emerging categories will not replicate those of its core business, cigarettes. The second-quarter operating margin was up a healthy 60 basis points, but this was boosted by a cost savings program that will have finite impact. Our base case assumption is that margins will mildly fade over the next five years due to negative mix and lower cost reduction programs, and faster migration to adjacent categories may heighten this risk. Nevertheless, we see modest upside to the shares.

Business Strategy and Outlook 28/04/2019

Altria is no longer a pure play on U.S. cigarettes. Over 15% of our valuation is derived from its 10.2% share of Anheuser-Busch InBev, and of the consolidated business, 15% of EBIT comes from smokeless tobacco and wine, while recent acquisitions in vaping and cannabis are likely to be contributors to EBIT in the near future. Nevertheless, U.S. cigarettes remains the driver of Altria's earnings power, because following the breakup of Philip Morris in 2008, Altria operates solely in the U.S., while Philip Morris International, or PMI, owns the rights to the brand portfolio elsewhere.

Although it is in secular contraction, the U.S. cigarette market is a relatively attractive one. We forecast the volume decline rate of the U.S. cigarette to be around 4% per year, a slightly faster rate of decline than most markets. However, the ability to consistently price above the rate of volume declines should ensure that Altria can continue to increase its revenue, earnings, and dividend. We estimate that the U.S. is the fourth most affordable market for cigarettes among the OECD countries, as measured by the minutes of labour required to meet the retail price of a pack of 20 sticks. This allows manufacturers ample room for raising prices over time. With a portfolio skewed to the premium segment, Altria must manage the price gap over the discount segment, so this pricing power is likely to be unleashed over many years.

The smokeless tobacco business appears to be holding up better than the smokeable division. Volume has declined by just 1% for the last two years, while revenue grew 5%. Copenhagen has performed particularly well, gaining 10 percentage points of share under Altria's ownership.

Another positive for Altria is that it has an exclusive agreement with PMI to market iQOS, the heated tobacco technology, in the U.S., subject to Food and Drug Administration approval. The iQOS revenue share between the two entities has not been disclosed, but we suspect that significant scale will be required for margins to replicate those of Altria's premium cigarette portfolio, which makes the reacquisition of Altria by PMI more likely than not in the long term, in our view.


Intangible Assets

An addictive product and almost insurmountable barriers to entry in the tobacco industry form strong intangible assets and give Altria a wide economic moat, in our opinion. Tobacco contains nicotine, an addictive substance that suppresses the cessation rate. According to data from the Tobacco Atlas, more than 60% of all smokers intend to quit, and 42% have attempted to quit over the past 12 months. Yet in most markets, the smoking rate is in only a very modest decline, implying that the majority of smokers attempting to quit fail to do so. Academic research (Lewis and others, 2015) has shown that while cessation rates are not correlated with consumer brand loyalty, premium price segments are associated at a statistically significant level with lower cessation rates. With around 90% of cigarette volumes from premium categories (primarily Marlboro), Altria has more exposure to the advantaged premium segments than its competitors.

The addictive nature of the product forms a powerful competitive advantage when combined with very tight government regulation that over the years has served to dampen market share volatility and competition on price. In the U.S., the FDA has imposed restrictions on marketing new or modified products that essentially keep new entrants out of the market. Tobacco products introduced or modified after March 22, 2011 (for some small tobacco categories, the date is Aug. 8, 2016) require pre-market review by the FDA unless the manufacturer can prove that the products are “substantially equivalent” to products commercially available on Feb. 15, 2007. Products or modifications deemed not to be substantially equivalent may only be brought to market in the U.S. following an FDA review and approval process. The substantial equivalence rule makes it extremely difficult for new entrants to launch new products, and it reduces the financial burden of investing in a fast-moving pipeline of new products that is a critical part of the business model for other large-cap consumer businesses.

Even if new entrants were to receive FDA approval for a new product, other regulations make it difficult to build market share. Tobacco advertising is severely restricted in the U.S., with bans on most forms of mass marketing. This not only makes it very difficult for hypothetical new entrants to gain the attention of smokers, but it also dampens competition between incumbent manufacturers. Volume shares at the manufacturer level have been very stable for decades, primarily, we believe, because the lack of marketing communication has discouraged brand switching. It is also significant that participating manufacturers are due a rebate on a proportionate amount of their Master Settlement Agreement, or MSA, payments should their market shares fall below a threshold based on shares in 1997.

Despite consumer segmentation in other consumer product categories amid eroding brand loyalty, brand equity remains relevant in tobacco. This is in no small part due to the absence of challenger brands because of high regulatory barriers to entry, and because of the tight restrictions on marketing. Brand loyalty tends to be higher in premium price segments, which benefits PMI disproportionately.

Cost Advantage

Unlike larger peers PMI and BAT, we do not believe Altria has a cost advantage over incumbent large-cap cigarette manufacturers. Recent consolidation in the industry (Lorillard was acquired by Reynolds in 2015, with some assets from both companies also going to Imperial, which gave Imperial access to the U.S. market at scale, and then Reynolds itself was acquired by BAT in 2017) has meant that Altria’s closest two competitors are now global players, rather than domestic pure plays. We believe this has eroded Altria’s cost advantage because its competitors are procuring tobacco leaf from a global platform.

This plays out in the relative average cost data. Even after adjusting for the Master Settlement Agreement, or MSA, payments, which are not payable outside of the U.S., Altria’s total operating costs in its combustible business averaged $0.58 per pack in 2017, above the range of $0.36-$0.48 per pack within which the other four large publicly traded manufacturers under our coverage operate. We think this is most likely because of its lower volume. Altria’s 2018 smokeable volumes of 111 billion sticks are half Imperial’s volumes of 255 billion, and only a fraction of the volume of PMI (782 billion sticks) and BAT (701 billion), and the procurement advantage of the larger players allows them to manufacture at a lower average cost. Relative to a new entrant, of course, Altria’s annual volume in excess of 50 billion sticks would prove to be a significant cost advantage. However, because we think new entrants are highly unlikely because of the U.S. regulatory environment, we see intangible assets as the true source of Altria’s economic moat, not a cost advantage.

Wide Versus Narrow

Though it may seem counterintuitive in a declining industry, we have conviction that our wide moat rating is appropriate because we believe Altria is very likely to continue generating excess returns on invested capital for the next 20 years. The sustainability of current levels of profitability and returns on capital depend on the positive impact of price/mix being at least in line with the annual volume decline. At some point in the future, we expect there to be a tipping point at which the consumer is no longer willing to continue accepting price increases above the broader rate of inflation, leading to an increase in price elasticity. The example of Australia gives some insight into how such a kink in the demand curve might occur globally. Since 2011, a series of Draconian anticigarette measures in Australia have led to the introduction of plain packs and tax increases that caused the doubling of the retail price of cigarettes in just six years, which in turn has led to the smoking rate falling from 16% to 13% over the same period, and to significant trading-down between price segments. A pack of 20 cigarettes (equivalent; a standard pack contains 25 sticks in Australia) now costs roughly USD 14.50, well above the USD 5.50 in the U.S., according to the World Health Organization. We analyzed the affordability of cigarettes by estimating the number of minutes of labour required, on average, to purchase a pack of 20 cigarettes, and found that the U.S. was the fourth most affordable market for cigarettes among the 35 OECD nations.

Fair Value and Profit Drivers 28/04/2019

Our fair value estimate is $58, which implies a 2020 price/earnings ratio of 14 times, a 2019 enterprise value/adjusted EBITDA multiple of 13 times, and a near-5% dividend yield. These multiples are essentially in line with the tobacco peer group, which we believe is appropriate. Altria's footprint of a single market gives it elevated market concentration risk, but we believe this is offset by the attractiveness of the market. Our base case is based upon the existing business, and does not assume migration to heated tobacco in the next five years. After a modest decline this year, our top-line growth estimate hovers around 1.75% in our five-year forecast period and is 1.7% in the steady state. In the smokeable segment, we forecast around 1% average growth, driven by a 4% annual decline in volumes, offset by 5% steady-state pricing. Our volume assumption is roughly in line with historical trends and is derived from a decline in the smoking population of around 0.25% annually and a 4% decrease in consumption per smoker. At an industry decline rate of 3.5%-4.0%, this implies little to no market share loss. The mid-single-digit revenue growth achieved in the smokeless business over the past few years has been impressive, but we expect the growth rate to fade to the low single digits, more in line with the smokeable division. The share gains made by Copenhagen seem likely to moderate, causing volume growth to decelerate. In fact, we forecast a steady state volume decline of almost 2%, offset by 4% pricing. We forecast Altria's normalized operating margins to reach just over 50%, a touch below the expected margin this year. Following several recent cost-savings plans, we believe the low-hanging fruit has been picked, but Altria does have some plants it could close (it has separate smokeless manufacturing facilities, for example) for future rounds of manufacturing consolidation. Our view implies that Altria will not meet management's expectations of 7%-9% EPS growth over the next several years. We believe the earnings of the underlying business will grow at around 3% in the medium term, although the equity income from AB InBev will drive this into the mid-single-digit range.

Risk and Uncertainty 28/04/2019

Investors in tobacco companies should have the stomach for fat-tail risk, particularly those holding shares in a single-market pure play like Altria. Overall, we believe the risk of a significant adverse event is lower than it was one or two decades ago, but the shifting sands of regulation have created some new risks to Altria's business model in recent years.

Litigation risk still remains, but adverse judgments have been manageable recently. While it is almost impossible to forecast the magnitude of any awards against the tobacco industry, we expect payouts to be within Altria's annual free cash flow.

Regulation also remains a risk. The potential introduction of plain packaging would be detrimental to Altria's wide economic moat because it would limit the company's ability to communicate its brand identity (one of the sources of its intangible asset moat source) with adult smokers. Evidence from Australia suggests that plain packs could encourage trading down and add pressure to the smoking rate. We regard such regulation as being unlikely in the U.S., however, at least in the medium term. RJ Reynolds, now owned by BAT, is more highly leveraged to menthol than Altria.

Other regulatory risks include a clampdown on the use of menthol and an enforced reduction of the level of nicotine in cigarettes. The menthol category has had the sword of Damocles hanging over it for several years, with no restrictive access yet coming to fruition. The FDA did not take the opportunity to curb the use of menthol when it abolished other flavours in cigarettes in 2009, and we still view the risk to the menthol category as limited. The potential for limits on the nicotine levels in cigarettes is a relatively new risk, however, with the FDA announcing in the summer of 2017 that it will investigate the potential for nicotine control. We do not believe such controls are a foregone conclusion, however, because it could have unforeseen consequences such as increasing cigarette volumes.

Stewardship 28/04/2019

We are lowering our stewardship rating to Poor from Standard in light of the unjustifiable valuation paid for JUUL. The $12.8 billion investment valued the vaping competitor at a whopping $38 billion, or 40 times sales and 150 times EBITDA, according to Pitchbook data, and only several months after a previous capital raising round had valued the company at less than half this level. Even if management's long-term cash flow targets, largely driven by international expansion, are met, we find it difficult to justify this valuation.

The JUUL acquisition is a blot on the copybook of an otherwise strong management team. We applaud the company's focus on maximizing cash flow from the declining cigarette business while maintaining market share and leveraging pricing power. The management team also paid a high price for the U.S. Smokeless Tobacco acquisition in 2009 by issuing $7 billion in noncallable debt at coupon rates close to 10%, but this was executed by a former management team, and in the years since, the acquisition has proved to have added some valuable assets to the portfolio. Altria has extracted a strong performance from the brands, particularly Copenhagen, which has grown volume at a high-single-digit rate during the past decade, and won share.

Altria has bought back over $1 billion in shares on average every year since 2012, but has not been particularly opportunistic, with a large buyback program occurring at the peak of the market price in 2017. Dividends are the company's top capital-allocation priority. The stated payout ratio target is 80% on an adjusted basis, which is probably appropriate, given the very few M&A alternatives in the tobacco space. It leaves little room for maneuver, however, if the firm wished to engage in one of the few legitimate targets such as Juul, or to step up its investment in next-generation products.

While we prefer to see separate CEO and chairman roles, we appreciate that 10 of the 11 members of Altria’s board are independent. Additionally, with about 65% of CEO compensation focused on long-term performance metrics (40% of which is equity-focused), we believe management is encouraged to expand the firm in the best interests of shareholders. Former CFO and COO Howard Willard took the reins in May 2018, succeeding Marty Barrington.

Altria comprises Philip Morris USA, U.S. Smokeless Tobacco, John Middleton, Ste. Michelle Wine Estates, Nu Mark, and Philip Morris Capital. It holds a 10.2% interest in the world's largest brewer, Anheuser-Busch InBev. Through its tobacco subsidiaries, Altria holds the leading position in cigarettes and smokeless tobacco in the United States and the number-two spot in machine-made cigars. The company's Marlboro brand is the leading cigarette brand in the U.S. with a 40% share.