Altria Group Inc. (MO) recently raised the dividend 5% to $0.84 cents per share per quarter. This is the 50th straight year of the company raising the dividend making the company the newest Dividend King. The annual dividend for 2019 is now $3.24. The current dividend yield is now over 8.0% with a payout ratio of roughly 80%. This combination of predictable and persistent dividend increases, and high yield have made this stock a favorite among dividend growth investors and those seeking income. But saying that, much of the increase in the yield is due to a falling stock price resulting from investor worries. Altria is facing a decline in consumers smoking cigarettes, FDA action to curb nicotine and menthol in cigarettes, and poor capital allocation with JUUL, and possible FDA action on e-cigarettes. This combination makes me pause despite Altria’s past history as an excellent dividend growth and income stock. In my opinion, it is probably better to wait on the sidelines for now.
Overview of Altria
Altria manufactures and sells cigarettes, smokeless products, and wine in the U.S. The company’s brands include Marlboro, Copenhagen, Skoal, Black and Mild, IQOS, and Chateau Ste. Michell (wine) and several others. Altria’s business operations consist of PhilipMorrisUSA, US Smokeless Tobacco, John Middleton, Nat Sherman, Ste. Michelle Wine Estates, and Philip Morris Capital. Altria also has several large investments including a ~10.2% stake in AB InBeV, the global beer company; a 35% stake in JUUL, the U.S. e-vapor leader; and a 45% stake Cronos Group, a cannabis company. Altria has a warrant to purchase an additional 10% stakes in Cronos.
Altria’s tobacco brands are market leaders. The Marlboro brand is the number one selling cigarette in the U.S. with over 40% market share based on sales in 2017 as seen in the chart below. This far exceeds the number two brand, Newport, which only has 14% U.S. market share. In fact, Marlboro has more market share than the next seven competitors combined. Similarly, the Copenhagen brand has over 34% retail market share in 2017 to 2018. IQOS is the global leader in the heat-not-burn tobacco category and Altria has the rights to market it in the U.S., subject to FDA approval.
The main interest for most investors is Altria’s dividend. The company is now a Dividend King having raised the dividend for 50 consecutive years. Historically, the small investors could count on Altria raising the dividend annually combined with some appreciation in stock price. In fact, the trailing 20-year returns are over 14% with dividends reinvested and 7.67% without dividend reinvested trouncing the S&P 500. This is even after accounting for the recent downturn in stock price.
Altria’s 20-year Returns
Source: Dividend Channel
Atria was able to payout much of its earnings and cash flow due to its market dominance in cigarettes, pricing power, and high cash flow. Altria typically maintains an 80% payout ratio. Currently, the forward payout ratio is based on a dividend of $3.36 per share and consensus 2019 EPS of $4.19 per share is about 80.2%. On an FCF basis, the dividend is also well covered. In 2018, operating cash flow was roughly $8.39B and capital expenditures were $0.24M not including purchase/sale of businesses and equity. This gives FCF of $8.15B. The dividend required $5.42B giving a dividend-to-FCF ratio of ~66.5%, below my threshold of 70%. Once concern is that Altria’s debt has risen considerably due to the recent 35% equity stake in JUUL for $12.8B. Total debt was only about $13.89B at end of 2017 and it hit $25.75B at end of 2018. In Q2 2019, total debt was $29.24B. This places the D/E ratio at 2.02, which is above my threshold of 2.0. Altria only has $1.8B in cash, cash equivalents, and short-term investments on hand. But the company should be able to pay its obligations due to high cash flow generation.
Risks For Altria
Altria is faced with long-term decline in sales for cigarettes. This has only accelerated in recent years as consumers have switched to e-cigarettes. The chart below suggests that as e-cigarette volumes increase regular cigarette pack volumes decrease over time. Furthermore, the decline in traditional cigarette pack volumes seems to be accelerating. Recent headlines suggest that the declines will continue and possibly accelerate further as there continues to be pressure on traditional cigarette volumes. A long-term and accelerating decline will eventually impact Altria’s top and bottom lines.
Altria is facing regulatory risk from the FDA on regular cigarettes. In mid-2017, the FDA announced a comprehensive regulatory plan related to nicotine in an attempt to curb tobacco-related disease and death. Specifically, “The U.S. Food and Drug Administration today announced a new comprehensive plan for tobacco and nicotine regulation that will serve as a multi-year roadmap to better protect kids and significantly reduce tobacco-related disease and death. The approach places nicotine, and the issue of addiction, at the center of the agency’s tobacco regulation efforts.” Since then Altria’s stock has been trending down. The main issue here is that the FDA is moving towards implementing a rule about the maximum level of nicotine in combustible cigarettes. There is a lot of uncertainty here on what may be implemented and how the industry may adapt. But a reduction in nicotine will certainly negatively impact industry sales.
The second regulatory risk from the FDA is the potential ban on menthol in cigarettes. This will have a major effect on the industry if fully implemented, as this type of cigarette makes up about one-third of the $100B cigarette market. However, some communities, such as San Francisco, are already implementing local bans. Canada has already imposed a ban on menthol cigarettes, and the European Union’s ban will go into effect in 2020.
The third regulatory risk faced by Altria is increased regulation and outright bans on e-cigarettes reducing the value of the company’s equity investment in JUUL. Altria made a significant bet on JUUL and e-cigarettes with its equity investment. But recently the FDA has sent a warning letter to JUUL on the sale and distribution of e-cigarettes. The FDA is also proposing draft rules for e-cigarettes that would let it restrict sales that could appeal to children. This is still a couple of years away. But saying that, some states and cities including Michigan, New York, New Jersey, California and San Francisco have restricted the use or sale of e-cigarettes. This movement to restrict e-cigarettes is not limited to the U.S as India recently announced an outright ban. The worst case here is that e-cigarettes are banned in more states in the U.S. and in other countries. There is again a lot of uncertainty here but increasing restrictions and bans would be a net negative for Altria and possibly lead to a write down on the JUUL equity investment.
Final Thoughts On Altria
Altria has provided most small investors solid past returns and income, but the future may be different and is certainly cloudier. The forward P/E ratio is about 9.9 based on consensus 2019 EPS. This is well below the 5-year average P/E ratio of 16.5 and the broader market average P/E ratio. This undervaluation and over 8% yield make the stock seem like a bargain, especially for a Dividend King. But Altria is facing uncertain times right now from the perspective of lower future sales and increased regulation. Additionally, the JUUL investment may not work out as planned. Altria paid about 40X sales valuing JUUL over twice previous valuations. The added debt caused the S&P to downgrade Altria to BBB, which will lead to higher interest payments. There is also the possibility of a future write down on the equity investment of JUUL due to the threat of increased regulation on e-cigarettes leading to less sales growth. For these reasons, I am taking a wait and see approach on Altria despite the current high yield and past dividend growth.
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