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Investing  | February 12, 2019


  • Skepticism over equity purchases of Juul and Chronos, as well as fears about menthol bans, have driven Altria’s share price to 5-year lows.
  • There is no evidence that the company’s earnings power is impaired, and a streak of 53 dividend increases in 49 years is certain to continue.
  • Altria’s share price already reflects enormous amounts of pessimism. It’s time to think about what can happen if things go well.

Most investors don't respond well to negative headlines or negative price action. When they see headlines that a company they own has potentially made a huge error or faces serious problems and they see the value of their shares decline, they panic. They tend to believe the worst. Often they sell, or at the very least, they fail to take advantage of what could be a wonderful buying opportunity. Altria (MO) is no doubt facing such an environment right now.

Everyone has now convinced themselves that Altria's $12.8 billion investment in Juul is a disaster. Everyone expects that the FDA will ban menthol cigarettes. Everyone thinks that smoking rates will go to zero. Everyone thinks Altria overpaid for its 45% stake in Chronos. No one seems to think that the company has a future.

If I truly believed these things, I'd sell too. Fortunately, I've been investing for too many decades. I've been there to witness Altria and Philip Morris (PM) being attacked by Bill Clinton, by angry jurors who awarded tens of billions in punitive damages in lawsuits that made front-page headlines. I've seen Altria trade with a dividend yield so high that one could buy them and not even care if the price ever rose again. I've also been there to watch Altria maneuver these problems, typically buying back its undervalued shares through the entire process, and absolutely increasing its dividend every year like clockwork. So, with the stock price where it is, I wanted to begin this article by looking at some emotionless facts.

Fact #1: Even if menthol is banned, it will take years to play out.

The concerns about the FDA banning menthol cigarettes began to hit Altria's share price last fall when the FDA announced it was considering such a ban. Altria and others saw their share prices punished as a result. But let's face it, banning menthol, even if it happens, is likely a multi-year discussion that the company will be very much involved in. On top of this, any new laws that are finalized - if any are ever finalized - will take time to implement. The fact that it will take many years to enforce a full menthol ban will allow Altria to react and respond.

And let's be realistic, banning menthol doesn't stop menthol smokers from being addicted to nicotine, it only stops them from being able to easily purchase menthol cigarettes. Smokers will certainly hoard menthol cigarettes in anticipation of the ban, and then, they will most likely switch to a different delivery device to get their nicotine fix. Altria is unlikely to lose these customers, and may even gain customers considering that Newport, the number one brand in menthol, is not made by Altria.

Fact #2: The market has already punished Altria for its Juul investment.

For those that argue that a huge writedown is coming, I would respond by saying that the market has already beaten the accountants to it. That is, assuming that there actually will be a writedown at all, which I disagree that there will be. The value of Altria declined by $13 billion in the weeks following the announcement of the transaction, which is more than the amount the company is paying for 35% of Juul. Shares have rebounded somewhat, but make no mistake, the market has punished Altria for this move, and there’s no evidence that it was not the correct move to make.

Fact #3: Altria's cash flow will not be impacted by Juul in the near term.

This is an important point. Altria's 35% ownership in Juul will result in equity accounting rather than consolidated accounting. Therefore, Juul's revenues and cash flows will be off of the company's financial statements. The only direct impact would be the interest cost of financing the deal (which will largely be negated by cost-cutting elsewhere) and dividends to Altria, if and when Juul pays a dividend in the future.

Put simply, Juul could disappear tomorrow and the impact to Altria's profitability and cash flow, all other things being equal, would be di minimis.

Fact #4: Altria's investment in Chronos has nearly doubled in value, and its warrants to buy a controlling stake in the company are in the money.

Altria is paying CAD $16.25 per share for its 45% equity stake in Canadian marijuana producer Chronos. As of the time of this writing, Chronos is trading at CAD $28.05 per share, implying the market values the company significantly more now that it has Altria as a partner. Altria also owns warrants to acquire another 10% of Chronos' shares for CAD $19.00 per share, which is exercisable over the next four years. This warrant, already in the money, would allow Altria to gain control of Chronos, which is a rapidly growing company in a rapidly growing space.


Fact #5: Altria has a partner in Philip Morris International, and there is no reason why these two companies won’t cooperate to ensure domination of the industry.

Philip Morris is the owner of the heat not burn IQOS device. Altria has commercialization rights for IQOS inside the United States, and Philip Morris has the commercialization rights for Altria's e-cigarette products outside of the United States.

The two companies have always worked together closely. After all, they were the same company until last decade. Former CEO Louis Camilleri split the company up to allow the international and food divisions to operate without the litigation risks that Altria was facing in the United States. Today, litigation is hardly even talked about. It has been my opinion that the two companies would always reconsider merging back together if it were in their best interests to do so.

Whichever company ends up with the #1 products in the nicotine delivery world, I believe Altria or Philip Morris will work together, or merge, so that both companies can benefit.

Fact #6: Altria has increased its dividend 53 times in the past 49 years.

This is one of the most well-known facts about Altria, but it’s worth repeating and is worthy of a chart. There are few companies on earth that can compete with this level of consistency in returning increasing amounts of cash to shareholders.


So, taking these facts into consideration and looking forward, how should investors view Altria as an investment? With investing, it's all about what you give and what you get. Most investors equate a falling stock price with a stock being more risky. But truthfully, the fact that Altria share price has declined significantly over the past year (down 30% as of the time of this writing) means that the troubles and concerns that investors have about the company have been discounted, and the share price reflects the current consensus of fears among investors. But the future is not known yet, and while the market has punished Altria for all of the things that can go wrong, the opportunity for investors is very real if things improve going forward. So, let's look at what can go right that will likely drive the share price higher.

Altria is almost certain to increase its dividend in 2019

Altria has increased its dividend 53 times in the last 49 years, including two separate increases in 2018 alone. The company has already given 2019 guidance for earnings of $4.15-4.27 per share. With a current dividend of $3.20 per share and a targeted payout of 80% of earnings, the probability of another dividend increase in when the board meets in August of this year is extremely high. Using the mid-point of that earnings forecast, an 80% payout would equate to a $3.36 annual dividend, which would represent a 6.75% yield on today's share price. This level of payout is historically high and unlikely to last for long before buyers step in to capture it. At the very least, it puts a level of support in the stock that completely changes the risk/reward at current prices.

For example, if one were to look at a chart of Altria and extrapolate the current downtrend, they wouldn't have a hard time envisioning a $40 stock in the near future. But at $40, Altria would yield 8%. And remember, Altria is almost certain to increase its dividend this year, probably to the $2.36 range. This puts the yield on a cost of $40 per share at 8.4%. That type of dividend yield typically puts a rock-solid floor under a stock so long as the company can maintain it, which Altria can.


IQOS should finally receive FDA approval in the near future

It's been far too long since Philip Morris and Altria submitted their data and application for IQOS to be commercialized in the United States. On the year-end conference call, Altria's CEO stated that Altria was ready to hit the ground running, and he expects approval in the very near term. Altria has locations across the United States ready for the initial launch of the product, and the company believes that it will be a success.

Menthol may not be banned after all, but even if it is, smokers are unlikely to quit

It's been three months since we had the statement from the FDA that it was considering a ban on menthol cigarettes. While the market has already priced in the loss of revenue and profits from menthol, it may be another year or longer before there is any resolution to this issue. In fact, it's entirely possible there will not be a ban on menthol cigarettes at all, especially considering the fact that smoking rates are already at an all-time low and falling in the United States.

Even if there were to be a ban on menthol cigarettes, we cannot naively assume that all menthol smokers will simply quit. To assume that is what will happen is to forget that the reason people smoke is for the nicotine. A smoker who finds non-menthol cigarettes intolerable will quickly find them acceptable when faced with no ability to purchase their preferred menthol cigarettes.

Chronos will experience significant growth. Altria could exercise its warrants, take control of the company, and realize massive growth over time.

While many critics have voiced their opinions of the Chronos investment, I believe that Altria jumping into the marijuana space is wildly positive. After all, this is a market that is projected to be in the hundreds of billions of dollars per year in the future. For Altria, its infusion of cash into Chronos gives Chronos all the capital it will need to expand much more rapidly than it would have otherwise been able to. The warrants Altria has to buy 10% more equity in Chronos over the next four years gives Altria a path to control, as well as giving Chronos a path to more capital if needed. The significant growth Altria realizes from Chronos should be a welcome relief to investors who have witnessed tobacco consumption rates declining for generations in the United States.

Juul will expand globally. Its margins will expand as it grows. It will one day begin paying dividends to Altria, and in time, could become a subsidiary of Altria.

Altria owns 35% of Juul. Today, Juul is in the hyper-growth phase of its life and needs to retain all its cash flows to grow. But as Juul expands, both within the United States and abroad, the company is likely to begin paying dividends to Altria the same way that Anheuser-Busch InBev (BUD) does. And for now, Altria is obligated to remain just a 35% owner of Juul, but there is no reason to think that years down the road Altria wouldn't take control of the company.

The Federal Reserve, which has recently paused its interest rate increases, could reduce rates, making high-yield dividend growers much more appealing.

Many high-yield consumer staples stocks like Altria hit their peaks at the end of 2016/beginning of 2017. This coincided with the point at which the Federal Reserve began its aggressive interest rate increases. Obviously, the steady decline in Altria’s share price has been caused by more than just rising interest rates, but there is no doubt some level of capital flows out of dividend stocks and into fixed-income has taken place as bond yields have risen.

The same is true in reverse. Strong dividend paying stocks typically perform very well when interest rates are trending lower. If you believe, like I do, that the current economic cycle is winding down and a recession is on the horizon, then you likely believe that interest rates will fall once again. Perhaps more QE will follow, and perhaps interest rates will turn negative as they did a few years ago. In this situation, a 6.5%-yielding dividend grower like Altria could become a magnet for capital.

Putting it all together

One of the most important things to remember in investing is that news, headlines, and sentiment are mostly driven by price action. Most investors today are bearish on Altria due to the confluence of negative events that have taken place over the past year. But these negative events have very much been priced into the share price, and investors today are able to buy Altria with a historically high dividend yield, and with major upside potential should sentiment turn more positive for the company. I believe that the bad news is fully priced in, and Altria shares, at current prices, represent one of the better risk/reward opportunities in the market today.


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