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Income, Stocks  | January 14, 2019

Altria Group (MO) has plunged 23% in the last two months. This is an unusual stock price movement for this low-beta 5%+ yielding stock. The tobacco giant is now trading around a 4-year low level and is offering an 8-year high dividend yield of 6.4%. In this article, we will analyze whether investors should take advantage of this extraordinary yield.

Reasons For The Recent Plunge

Altria has underperformed the market by a wide margin over the last two years. During this period, the stock has shed 26% whereas the S&P has gained 11%. A major reason behind this underperformance is the environment of rising interest rates. Most of the shareholders of Altria hold the stock for its attractive and growing dividend, and hence, the aggressive interest rate hikes of the Fed have rendered the dividend of Altria less attractive, as investors can now find decent yields elsewhere. Consequently, the valuation of Altria has been under pressure.

However, given the panic caused by the latest interest rate hike by the Fed, there seems to be limited room for rate hikes in the near future. In addition, if the economy significantly slows down or a recession shows up, interest rates will decrease. Therefore, there is limited potential for further pressure on Altria from rising interest rates.

The steep decline of Altria in the last two months has mostly been caused by its acquisition of a 35% stake in Juul (JUUL). The tobacco giant paid $12.8 B for a 35% ownership stake in the e-vapor leader, thus valuing the company at $38 B. As this valuation is more than twice as much as the valuation Juul received in a private round about six months ago ($16 B), the market punished the stock of Altria harshly while Citi downgraded the stock from "neutral" to "sell" and slashed its price target from $67 to $45 due to "shareholder value destruction".

As Juul generated approximately $1 B revenues last year, Altria valued Juul at approximately 38 times its annual revenues. Therefore, it is evident that Altria was willing to acquire a major stake in the e-vapor leader at almost any price, so it essentially admitted that it could not stop the migration of its traditional customers to the vaporizing product of Juul.

Altria also announced a $1.8 billion investment in Canadian marijuana producer Cronos Group (OTC:CRON). Altria will acquire a 45% equity stake in Cronos and a warrant to acquire an additional 10% ownership interest in Cronos Group at a price of C$19.00 per share, exercisable over four years.

Benefits Of Strategic Investments

While Altria paid a hefty premium for its stakes in Juul and Cronos, it essentially hedged its portfolio, as it reduced the impact of the transition of some customers away from conventional cigarettes.

Moreover, the company enjoys excessive free cash flows and hence, it can easily service the increased amount of debt that will result from the deal. In the last 12 months, Altria has generated free cash flows of $7.1 B whereas its annual dividend payments will be approximately $6.0 B this year. As its annual interest expense currently stands at $232 M, it is evident that Altria has ample room to increase its interest expense without any problem. In addition, its management recently announced a cost-cutting program, which will aim to reduce its operating costs by about $500 M per year in order to offset the impact of the hefty premium it paid.

Furthermore, Altria has a strong balance sheet, as its interest expense currently consumes only 2.4% of its operating income. The company will thus easily service its debt, though we expect management to reduce its target dividend payout ratio from its long-term stated goal of 80% to approximately 70-75%.

Growth Prospects

Apart from the high growth potential of the 35% stake in Juul, which has dominated the vaping product category, investors should not forget the growth potential of Altria's core business. On the one hand, the percent of the smoking population has been in a steady decline in the last 53 years. More precisely, the percent of the U.S. smoking adult population has steadily declined, from about 42% in 1965 to 18.8% lately.

On the other hand, Altria has always managed to grow its earnings at a significant rate thanks to the meaningful price hikes it has implemented year after year. The company has always been able to implement these hikes thanks to the inelastic demand for its products.

Moreover, as its produced volumes have been declining, its production costs have been on a steady downtrend. As a result, Altria has consistently enhanced its operating margin, from 29.7% in 2012 to 37.8% last year. During the last decade, Altria has grown its earnings per share at a 9.2% average annual rate. Overall, the company is likely to continue to grow its earnings via price hikes and margin expansion in the upcoming years, just like it has done for several years.

Dividend Analysis

Altria has raised its dividend 53 times in the past 49 years. Thanks to the tailwind from its reduced tax rate, the company raised its dividend twice last year. As a result, given also the poor recent stock price performance, the stock is now offering an 8-year high dividend yield of 6.4%.

As shown in the above chart, the current yield is twice as much as the yield the stock was offering about one and a half year ago. This is a rare move of the dividend yield of this slow-moving, low-beta stock. Moreover, as the current payout ratio stands at 80%, the dividend can be considered safe for the foreseeable future.

Valuation

Due to the environment of rising interest rates and the negative market's perception of the recent deal with Juul, the valuation of Altria has come under great pressure. To be sure, the stock is trading at a forward price-to-earnings ratio of 11.7, which is half of the earnings multiple of the stock one and a half year ago.

Investors should take note of the cheap valuation of the tobacco stalwart. Last time the stock was trading at such low valuation levels was in the aftermath of the Great Recession and the stock more than doubled in just a few years after that crisis.

Final Thoughts

The recent plunge of Altria has led the stock to a forward price-to-earnings ratio of 11.7 and an 8-year high dividend yield of 6.4%. Investors should not expect to find this exceptional dividend stalwart at such a bargain level without any negative news weighing on the stock. However, we view the market's concerns as overblown and hence, we believe that this is a rare investing opportunity.

Altria undoubtedly paid a hefty premium for its stake in Juul, but it made its portfolio much more defensive via this stake. In other words, it insured itself to a great extent against a future decline of its core business. As insurance is never free, the company was forced to pay a generous premium. Although this premium will increase the amount of debt of Altria, the company will easily service its debt thanks to its ample free cash flows. It will also continue to grow its earnings via meaningful price hikes year after year thanks to the inelastic demand for its core products. Overall, we expect the stock to highly reward investors from its current stock price.


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