Published on July 7th, 2015
Don’t let the rumors fool you – the cigarette industry’s decline is greatly exaggerated. The tobacco industry is truly massive, and dominated by a few large players.
Altria (MO) is the 3rd largest publicly traded cigarette corporation in the world by market cap.
- Philip Morris International (PM) market cap: $126 billion
- British American Tobacco (BTI) market cap: $101 billion
- Altria (MO) market cap: $96 billion
Before 2003, Altria was known as Philip Morris. The company changed its name and spun-off much of its portfolio. In 2007, the company spun-off Kraft.
Philip Morris International (PM) was spun-off in 2008. Philip Morris International sells the same tobacco brands as Altria, but it sells them internationally. Altria sells its tobacco products only in the Untited States.
Toda, Altria owns the Marlboro, Skoal, Copenhagen, and Black & Mild tobacco brands, among others. In addition, the company owns 27% of beer giant SAB Miller, St. Michelle Winery, and Nu Mark e-vapor.
Altria’s Growth Can’t be Stopped
Altria’s investor day presentation reaffirmed the company’s growth target: 7% to 9% annual earnings-per-share growth. Businesses in decline simply don’t target earnings-per-share growth in the high single digits.
Since the Philip Morris International spin-off in 2008, Altria has grown its earnings-per-share at a compound rate of 7.5% a year. Not bad for a ‘declining’ business.
What makes this growth more impressive is the high payout ratio Altria has maintained since 2008. The lowest the company’s payout ratio has been since 2008 is 75%. Altria has managed to grow earnings-per-share while investing very little into growth.
Some people have the perception that Altria’s growth is smoke-and-mirrors. Share repurchases are often cited as a source of ‘fake’ growth for the company since 2008. In total, share repurchase have accounted for 0.8 percentage points of growth for Altria each year since 2008. That is meaningful, but not the company’s growth driver.
Altria’s Main Growth Driver
Altria’s real growth driver since 2008 has been rising operating margins. The company had operating margins of 26.6% in 2008. Most businesses would be very happy with such high operating margins, but Altria has pushed to become more efficient.
By 2014, operating margins grew to 31.9%. The company has squeezed out an extra 5.3 percentage points of margin from its operations over the last 6 years.
Paradoxically, heavy regulation may be causing rising margins. In the past, making money was easy for Altria. The company relied heavily on its advertising expertise to grow sales. Aiming for ever greater operating efficiency wasn’t necessary.
Since heavy regulations and industry scrutiny, Altria has done everything it can to continue rewarding shareholders. The drive for higher margins is an integral part of the company’s strategy.
Altria has managed to grow margins in two ways. First, the company sells a highly addictive product with excellent brand recognition.
Marlboro is the biggest cigarette brand in the United States – and it isn’t close. The Marlboro brand sells more cigarettes than the next 10 brands combined. With severe advertising restrictions in place, the Marlboro brand is relatively safe from competition.
Strong brand awareness and nicotine addiction means consumers will pay higher prices for cigarettes. Price increases have been a significant source of margin gains for Altria.
The company has also streamlined its operations to become more efficient. A focus on cost has also helped boost margins.
How Cigarettes Pay Big Dividends & High Total Returns
Altria is the tobacco market leader in the United States. The company’s focus on margins helps Altria grow with little money reinvested into the business.
This frees management to use the company’s cash flows to return money to shareholders. Altria’s management targets an 80% payout ratio. Every time someone buys a pack of cigarettes, 80% of the profits go to Altria shareholders in the form of dividends.
It is no surprise that Altria is a high yield stock. The company currently has a dividend yield of 4.2% – more than twice the S&P 500’s dividend yield.
Altria’s 7% to 9% target earnings-per-share growth rate combined with its 4%+ dividend yield gives investors expected total returns of 11% to 13% a year.
Altria Valuation & Final Thoughts
Altria is currently trading at a P/E ratio of 18.6 (using adjusted earnings). The S&P 500 is currently trading at a P/E ratio of 20.2. Altria is currently trading at a lower P/E ratio than the S&P 500, despite having a higher expected total return.
Altria is not a deep value stock, but the company’s strong brand based competitive advantage makes it likely Altria will continue to reward shareholders with rising dividends. The company has paid increasing dividend payments for 45 consecutive years, excluding the effects of spin-offs.
Altria sells tobacco and alcohol products. The company operates in slow changing industries. People will very likely continue to smoke Marlboro cigarettes and drink Miller beer. Altria’s relatively inexpensive addictive products tend to do well during both recessions and times of prosperity.
The company’s management is laser-focused on rewarding shareholders. The company doesn’t have many other uses for cash since it can’t expand internationally and has severely restricted advertising possibilities.
The one area Altria is investing for future growth is in heated tobacco and e-vapor products. E-vapor growth has not met industry expectations. E-vapor products tend to be used in addition to cigarettes, not instead of them. The newest attempt at a less harmful tobacco product is the heat-not-burn system, which heats tobacco and releases nicotine without burning it, thus releasing less carcinogens. Altria and Philip Morris International have partnered in researching heat-not-burn and e-vapor products. Philip Morris recently released its heat-not-burn iQOS system in Japan and Italy. Altria will likely release similar products in the United States in the next few years.
Altria is currently a favorite of The 8 Rules of Dividend Investing. The stock’s 4%+ yield should appeal to income oriented dividend investors. In addition, the company should continue compounding earnings-per-share at 7% to 9% a year giving high yield investors solid growth as well. There is some possibility for more rapid growth if heat-not-burn products take off in the United States.