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Altria Group Inc.


Positive Review

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Stock Review

Altria Group (MO) consists of a number of entities, namely Philip Morris USA, U.S. Smokeless Tobacco Company, John Middleton, Ste. Michell Wine Estates, and Philip Morris Capital Corporation. The company also owns a 27.3% interest in the world's second-largest brewer, SABMiller. Altria has been transformed over the past 5 years, spinning off packaged foods maker Kraft (KFT) in 2007 and then Philip Morris International (PM), the international cigarette business, in 2008. On the other hand, the firm acquired UST, the largest domestic maker of smokeless tobacco, in 2009, and John Middleton, which sells machine-made cigar brand Black & Mild, in 2007.

Today, Altria is largely leveraged to the domestic U.S. market for cigarettes. Fortunately, this is a market the firm absolutely dominates, with about 50% market share. Marlboro is by far the best selling brand in the U.S., accounting for about 42% of all packs of cigarettes sold. Other well-known brands include Virginia Slims and Parliament.

As I've covered in reviews of fellow Magic Formula stocks Reynolds American (RAI) and Lorillard (LO), the domestic cigarette industry has a poor outlook. Volume declines have been averaging around 3% per year. Higher excise taxes, combined with more restrictions since the FDA was given regulatory power in 2009, has accelerated this to above 5% in 2010. Additional regulations are forthcoming, and the industry still has a lot of court cases outstanding against it.

Still, Altria has 3 ways it can grow revenues. First, it can raise prices. Cigarette price hikes have outpaced volume declines since the 1970's (by a 3-to-1 ratio). Even since the large excise tax hike in 2009, Altria has been able to raise prices enough to actually *increase* gross margin. Being an addictive product, consumers have proven to be willing to pay almost whatever it takes to buy a pack.

The 2nd avenue is cigarette market share gains, particularly in the premium priced segment. Given the astounding regulation and scrutiny around the industry, it is almost inconceivable that new competition would enter the market. This leaves the large domestic cigarette market to 3 companies. Marlboro is by far the strongest brand, and continues to take market share, gaining another 0.8% in 2010. Expect this to continue.

The 3rd way to grow is through acquisitions and growth in auxiliary businesses, particularly smokeless tobacco. Like Marlboro, Altria's Copenhagen smokeless brand dominates, with 26% share. The firm commands 50% of the total overall market (and rising). Chew volumes are rising impressively, too - up 12% for Altria in 2010, vs. 7% industry growth. Still, smokeless only makes up around 6% of revenues at present.

This should all add up to meager 2-4% top line growth for Altria going forward. Operating margins may be able to expand some from current 40% levels, but not by more than a percentage point or two.

The big attraction to the stock, of course, is its dividend, currently yielding over 6.4%. It was hiked twice in 2010, by a total of 12%. I am a little concerned about the future for dividend growth, frankly. First, it represents a 114% payout of trailing twelve month free cash flow. Second, Altria's balance sheet is far from conservative. Only $2.3 billion in cash offsets $12.2 billion in debt, much financed at high rates to buy UST. Interest coverage is ok at 6 times, but not luxurious. While no debt is due in the next 12 months, at some point cash flow will have to be allocated to paying down debt. Since Altria generally doesn't buy back a significant number of shares (not withstanding a new $1 billion authorization), it seems like future dividend hikes may have to be either at lower rates or possibly even skipped.

That said, Altria has hiked its dividend for 43 straight years, so what do I know?

A blended valuation of discounted free cash flow and multiple analysis gives me a fair value on the stock of about $26. Along with the dividend, that represents 17% upside over the next year, so I've tagged Altria with a positive rating. While that return is not bad, there appear to be several higher upside but equally limited risk picks in the large cap Magic Formula screens today.

Steve does not own MO.

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