Altria (MO) is effectively a vice fund

by vipnasty

This post is meant to be a follow up to what I wrote roughly 7 months ago. www.reddit.com/r/investing/comments/a4esl5/the_case_for_altria_mo/

I want to preface this by saying that I understand those who have a moral objection to investing in tobacco. I’m trying to write about this purely from an investment standpoint.

The stock dipped earlier this year and is now trading at a price similar to when my previous post was made while the rest of the market has gone up by roughly 20%. What’s changed since then is the JUUL stake. This has doubled the Net Debt/EBITDA to 2.7 and halved the interest coverage ratio to ~7. I wouldn’t call this a fortress balance sheet anymore, but I think the debt is manageable.

MO currently has a market cap of $95B and one share trades for approx $50.

AbInBev

BUD currently has a market cap of $160B and accounts for roughly one in three beers sold across the world everyday. MO owns 10% of BUD, which means $16 billion of MO’s market cap is their stake in BUD. While I’m not a fan of 3G’s management style (KHC has turned out to be a mess), I do think they know what they’re doing when it comes to the beer business. BUD is up 45% ytd compared to SPYs 20%. Management is taking steps to clean up their balance sheet after their acquisition of SABMiller.

Here’s a book that goes over their takeover of Anheuser Busch. 3Gs initial investment of $50 million into Companhia Cervejaria Brahma in 1989 is worth approximately $40 billion in their BUD stake today. While I think their management style is too aggressive for my comfort, I’m perfectly fine with MO just holding their BUD stake and collecting the dividends. MO initially purchased Miller Brewing Company for $300 million in 1970. Today it’s worth $16 billion through their BUD stake. They receive approx $550 million a year in dividends from BUD after the dividend cut. I don’t expect people to stop drinking beer anytime soon, so even with little to no growth, this investment will continue to add cash to shareholders pockets for decades to come.

JUUL

MO paid $13 billion for their 35% stake in JUUL. At the time of the purchase, MO valued JUUL at roughly 36x sales ($38 billion for the entire company), which seems very expensive. Here are my thoughts on the matter

– MO had to admit defeat in the vaping space. Their vape products were getting crushed by JUUL and cigarette smokers were switching over as well. I think it was smart of management to stop fighting a losing battle and just use their balance sheet to team up with the winners instead. It reminds me of a time when RIM didn’t think AAPL was a threat. Where would blackberry shareholders be today if RIM had decided to buy 35% of AAPL in 2007?

– MO had an insight into JUULs growth trajectory because they invested in a vape shop roughly a year before announcing their JUUL stake.

– JUUL realized their advantageous position when their biggest competitor came to them looking to team up. This allowed them to command a hefty premium.

– Sales grew 23% from Q12018 to Q12019 and showed strong international growth.

It’s hard to tell if the $13 billion price tag was justified, but I think it was a smart move from MO to hedge their bets while they could still afford to do it. There’s been rumors that JUUL is now valued at $50 billion, so we’ll assume $13 billion was a reasonable price to pay for the 35% stake. So $13 billion of the $95 billion is their stake in JUUL.

CRON

MO also paid approx $2 billion for their 45% stake in CRON with warrants to up their stake to 55%. I don’t follow the marijuana industry closely and I think it’s too early to predict where CRON will be 20 years from now. I think the emphasis for the company will be on cannabinoid extracts to be used in vapes, edibles etc. For what it’s worth, I think MO is probably best suited to roll out marijuana products on a large scale when we see legalization at a federal level. They have a pretty lucrative tobacco business, extensive experience dealing with US lawmakers and an established relationship with retailers. So $2 billion of the $95 billion is their stake in CRON.

Philip Morris USA, US Smokeless Tobacco and the rest

These are the wholly owned businesses that manufacture cigarettes, chewing tobacco, snus, cigars etc. These businesses account for all of the cash flow provided by operations on the balance sheet. Taking out the equity holdings mentioned above from the market cap puts the value of these businesses at approx $64 billion.

– Cigarette volumes have been declining at a faster rate than previously expected. Smokeable volumes declined by 7% compared to Q12018 as opposed to 4% as most analysts had predicted.

– MO’s smokeless tobacco unit has shown growth in the past and is poised to show growth over the next 5 years.

– IQOS has been approved in the US which will offset some of the declines in cigarette volumes.

– TTM free cash flow from aforementioned operations is approx $7.7 billion of which $5.6 billion were paid in dividends. Keep in mind MO targets a payout of approx 80% of earnings in dividends.

This gives us a current free cash flow yield of approx 11% for the operating business as of today. This is a rough estimate of what the shareholders are paying for because this is money that goes towards paying dividends, paying off debt, buying back shares or making acquisitions.

Some rough back of the envelope math tells us that assuming the cash flows show no growth and stay stable through price hikes and cost cutting at roughly $7.5 billion, we get our initial investment back in approx 10 years and anything following that is free money. If it declines at 7-8% a year, it’ll take approx 20 years before the operating businesses reach 0 and we are left with the equity holdings for BUD, JUUL and CRON.

Risks to consider

Here are some risks to keep in mind

– Cigarette volumes decline at a double digit rate.

– More regulations/lawsuits against e-cigs if teen vaping isn’t brought under control

– CRON and/or JUUL investments turn out to be duds and lose market share to competitors.

– IQOS doesn’t gain traction in the US.

There’s a good chance we’ll see the share price drop to the low 40s in the near future if any of the above happen.

Conclusion

I’m pretty optimistic and I think the dividend is safe for the foreseeable future. The dividend hike this year will probably be low (around 4%), but with a yield over 6%, I’m happy to sit and wait to see how things pan out. (It’s been raised 53 times in the last 49 years).

It is often joked that Altria is a law firm/lobby group that sells cigarettes on the side. I actually think they might have played a role in Dr. Gottlieb stepping down has head of the FDA. Especially since he’d recently said he had no plans of doing so. After the master settlement debacle of the late 90s, I think tobacco companies have learned to tread very carefully moving forward. I think they’ll continue to generate profits and reward shareholders in the long run. I also think it’s likely PM might buy PM USA from MO as more people switch from cigarettes to IQOS (Their current agreement is to split the revenues on IQOS sales). PM has over $35 billion in treasury stock, so they won’t have too much trouble paying for the deal (I’m just speculating here). PM and MO are well known for being extremely shareholder friendly. I don’t expect this to change going forward.

I am long PM and MO.

 

 

Disclaimer: Consult your financial professional before making any investment decision.