January 5, 2008

Value Idea: Altria

I take a look at another consumer business; this time its tobacco. I want to analyse Altria as a business notwithstanding all the ethical arguments against investing in a tobacco stock. The arguments against investing in a company like Altria are many, but I choose to think independently of them. I may not smoke or want any one I know to smoke but others choose smoke, so we will leave at that.

Company overview (source: Google Finance)

Altria Group, Inc. (MO) is primarily a holding company. The Company, through its wholly owned subsidiaries, Philip Morris USA Inc. (PM USA) and Philip Morris International Inc. (PMI) are engaged in the manufacture and sale of cigarettes and other tobacco products. Philip Morris Capital Corporation (PMCC), another wholly owned subsidiary, maintains a portfolio of leveraged and direct finance leases. As of December 31, 2006, MO had a 28.6% economic and voting interest in SABMiller plc (SABMiller), which is engaged in the manufacture and sale of various beer products. The Company operates in three segments: domestic tobacco, international tobacco, and financial services.

Business Economics Quality

  • Reduced Litigation risks: With reduced risk from US tobacco litigation some of the contingencies and reserves will be brought back to future earnings and reduce uncertainty about future charges that the company may take. Well, maybe we are not out of the woods yet, as there is the Nigerian multi trillion dollar, yes trillion, law suit against the company for health spending by the government on smoking related costs! Hmmm I am not sure what is the health care system over there but with this kind of spending I want to move there.
  • Diversified geographically: International operations accounted for 58.6% of sales and 53.4% of operating profits in the first nine months of 2007 and the balance was covered by domestic US operations. The international segment is growing at a faster pace in volume and pricing than US segment. Volume of US shipments have been declining due to high taxes and smoking bans. However the company is taking market share from competitors; MO has an outstanding market share in cigarettes of 50% as of 3rd Qr 2007.
  • New Product Lines: expansion of product line into cigars by acquiring cigar maker John Middleton, as part of Domestic Tobacco, and introducing smokeless tobacco as an extension to the Marlboro brand. The high growth market of smokeless tobacco and cigars will solidify earning growth for its US division going further. Cigars have an estimated growth rate of 4% annually while smokeless tobacco is growing faster as result of all smoking bans. MO will be able to leverage its vast distribution network to expand John Middleton products and increase revenue at an accelerated rate and even introduce the product on an international level.
  • Lingering Risks: risk of smoking bans and higher taxes and tariffs could curb revenue growth and slow international sales.
  • Overall the company is not a high growth company but it will deliver steady revenue growth and incredible free cash flows.

Competitive Advantage Quality

  • Consumer Brands: High profile and valuable brands coupled with consumer habitual purchases and strong preference to its products create strong competitive advantage for MO's.
  • Valuable Brands: The Marlboro brand is one of the top 15 valuable brands in the world with an estimated value of $21.5 Billion.
  • Market Share: A strong competitive advantage is evident in the company's strong US market share as well as internationally. the company has 50% US market share that continues to grow at the expense of competitors rather than in terms of overall volume. Its international shipments volume continue to grow at 6-7% rate.
  • Size advantage: MO is the largest cigarette maker and owns large and extensive distribution network. However size does not seem to be an advantage for Altria as its gross margins are very comparable to peers. However its distribution network is an advantage to reach potential consumer cheaply as evident by its market share.
  • To summarize MO enjoys a Strong competitive advantage evident by strong market share fueled by Strong consumer preference to the product.

Quality of Management

  • Management is very shareholder friendly and their actions are motivated by creating shareholder's value. Their actions speak louder than words. Consider the Kraft spin-off, the planned International tobacco spin-off, and the unloading of their New York head quarters to reduce costs.
  • Over the long term there was no better company in creating shareholder's value than MO. It managed to yield a stock return of 19.75% annually over the long term (1957 to 2006). Mo has beaten the likes of Coca-cola, P&G, general mills and other well established companies in shareholder's returns.
  • The company managed to raise dividends consistently even through the tough times of 1990s and the massive litigation brought against it.
  • Strong and consistent Return on equity, return on assets and return on invested capital through the years as seen in chart.
  • Barron's has consistently ranked Altria as one of the most admired companies in the US; in 2007 it was in the top 70 and it could have ranked higher. If it was in a different type of business, management would gotten more votes but since the votes against it is votes against tobacco rather than management quality per se.

Valuation

The separation of International Tobacco (PMI) is beneficial for several reasons:

  1. PM-USA and PMI will each be able to use its financial strength with more flexibility if each were a separate entity. For example, PM-USA may set a higher dividend payout policy, while PMI may be inclined to have a lower pay-out ratio and instead buyback more stock and/or make acquisitions.
  2. By separating the two divisions you can isolate the risk of a potential Food and Drug Administration regulation in the U.S. away from the business practices at PMI. Also if the litigation environment to become onerous again, PMI would be away from any potential liability.
  3. PMI should trade at a higher multiple due to PMI ability to grow operating profit and earnings at a faster rate than PM-USA with a very attractive return on investment and significant free cash flow generation potential. In fact international tobacco companies have an Enterprise Value/ EBITDA multiples much higher than US companies; internationals have multiples of 14.7 as opposed to 7-8 for US companies.

A sum of the parts valuation of MO indicates that the company is fairly valued at current market levels. A dividend discount model also yield that MO fair value is $75, assuming a growth rate of $4 and cost of capital of 8%.

EBITDAMultipleEVLess:LTD$ Per share
PMI7,512.3114.7110,4306241.9349.38
PM-US6,555.697.7150,5575447.0721.38
Middleton184.8711.92,2001.04
SABMiller5.97
Total$77.77

However, sum of the parts and multiple valuation is a point of time look at the company and only tell relative valuation today. I use asset reproductive value and Earning Power Valuation analysis to ascertain my results. The valuation also yields a comparable figure of $79 per share.

Item based on 3rdQBVAdjustmentAdj. FigureNote (amounts in millions of dollars)
Current Assets20,7471720,764To add allowance for doubtful debts
Fixed Assets8,0748,09716,171Adjust for properties and plants owned by the company to yield market value of these assets
Intangibles8,57414,80021,500to add the value of the brand of Marlboro its flagship product. BusinssWeek estimates its value to be $21.5 B
Other Assets10,422010,422No adjustment needed
SABMiller Investment3,911-3,911-A competitor would not reproduce this investment as it is not required to compete in the tobacco business. However I will add it as separate item in the final valuation
Total Assets51,728114,143
Current Liabilities19,184019,184No adjustment needed
Long term liabilities34,489034,489No adjustment needed
Shares outstanding2,110
BV per share$8.17$37.75
EPV Valuation
EBT12,658.4Adjusted for economic cycles by applying the 10 yr average EBIT margin to current revenues- 2006
Earnings8,481.15Less 33% taxes to eliminate any tax schemes
Add Depreciation1,804need to deduct actual capital expenditure that the company spends to maintain its revenues rather than meaningless accounting depreciation
Deduct Capex2,454
Adjusted Earnings7,831.12
Cost of Capital9%I estimate it is 9% given uncertainty about litigation, however if this uncertainty to be removed it should be lower.
EPV per share41.24
Intrinsic Value per share78.99it would be BV of assets plus EPV
Value of SABMIller per share5.97
Total84.96

In summary the valuation techniques used resulted in intrinsic value per share between $75- 85 per share. The current price of MO sits at the low end of the valuation spectrum. The company does not offer any margin of safety. Moreover the company breakup will not unlock any significant value. It seems that the market got this one correct. However I do believe that the shares will go higher due to speculation of PMI spin-off and new share buy backs that management has announced. But that is not enough of a reason to buy the stock, any stock for that matter.

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Sources: Altria web site, BusinessWeek, Barron's, Forbes, Yahoo Finance, MSN Money, Google Finance

4 comments:

Jeff said...

My compliments- very well done article on MO. Thorough analysis.

Sami said...

Thanks Jeff for reading and for the complement.

$ Mad Money Renato $ said...

nice website an articale on mo

http://www.madmoneyfund.blogspot.com/

Sami said...

Thanks Mad Money