Cigarette consumption has been declining at a 4% rate in the U.S. market, with recent health regulations, litigation towards tobacco companies and increased medical awareness exacerbating this trend even more. With the Food and Drug Administration now in charge of regulating tobacco consumerism and imposing taxation, which has seen 113 increases since the year 2000, industry players are struggling to maintain their earnings growth.
However, Altria Group Inc. (MO, Financial) doesn’t seem to be part of the struggles. In fact, while the company’s revenue has been almost flat year-over-year, it has managed to continue growing into a worthwhile investment. Thus, investment gurus like Sarah Ketterer (Trades, Portfolio) and Ray Dalio (Trades, Portfolio) have bought Altria’s shares last quarter, hoping to gain solid profits looking forward.
Can a Strong Brand Portfolio Fight Sales Declines?
As the largest tobacco company in the U.S., with over 50% market share, Altria has successfully built a wide moat business, with the greatest economy of scale in the industry and very high customer loyalty. In fact, 90% of Marlboro smokers purchase that brand 100% of the time and while it controls over 40% of the domestic market, it’s certainly not the company’s sole revenue stream. After shedding its international segments and all non-tobacco assets – except for a 27.1% stake in the world’s second largest brewer SABMiller – Altria now operates exclusively in the tobacco industry. It’s most popular brands include Phillip Morris USA, Smokeless Tobacco Company, John Middleton and MarkTen eCigs.
While the smokeless tobacco market, where the firm operates via its Copenhagen and Skoal brands, has shown volume increases (expected to continue over the next decade), tax bumps and regulations should stall cigarette consumption. Nonetheless, Altria’s pricing power should compensate volume declines looking forward, and management’s commitment to shareholders is impressive, with nearly 80% of net income dedicated to dividend payments, which sported a yield of 5.09% in 2013. Furthermore, the firm’s new focus on electronic cigarettes via the MarkTen eCig brand is bound to offset declines in tobacco sales, as well as CVS Caremark Corporation (CVS, Financial)’s recent announcement to retreat from tobacco product sales by October 2014.
Valuation
While 2013 showed sluggish revenue growth of 2.8%, closing at $17.7 billion, earnings per share grew at a 6.5%, closing at $2.39. However, Altria’s pricing power should allow revenue to continue growing at an average annual 2% rate and the same goes for operating profits. And while operating margins are expected to decline from fiscal 2013’s solid 45.7% to approximately 36% by 2022, consequence of the company’s shift toward the lower margin eCig category, I remain impressed by the ROE of 110.1%. Also, recent studies at the University of California, San Francisco, showed that while e-cigarettes are less harmful, they don’t necessarily help smokers kick their habit, which could be beneficial for the Altria.
Moreover, while litigation remains a significant threat to the company, I remain bullish about Altria’s medium-term future at the least. Free cash flow levels have increased by over $500 million since 2012, as well as EBITDA, which is sporting a 6.2% growth rate. The company’s stock trading price of 16.2x trailing earnings is also more than adequate compared to the industry average of 16.4x, making this a good time for investors to buy shares.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.
