Altria - analysis

Have you ever heard of Marlboro? How about Juul? Better yet, have you ever smoked either? Don’t worry, I wont judge-- I’m the first to admit a drunk cig hits like no other. What’s incredible about cigs and juuls is they’re both made by the same company, Altria ($MO). 

Even more amazing is the fact that Altria has the best long-term stock performance of any company in US history --better than oil and tech combined. Why? My theory is that while commodities & internet fads come & go, addiction stays. Forever.

One dollar invested in Altria in 1968 would be worth nearly $6,000 (including dividends). That's an annual return of 20.6% per year for nearly half a century. No other company comes close to matching its long-term results. 

That same dollar invested in the S&P 500 over the same period would be worth $170, a return that’s 97% less. 

The first thing that caught my eye was the high dividend yield, cigarettes are normally a pretty stable and straightforward business, so I thought it was pretty wild that the market would get so pessimistic on it. Turns out, the market has mostly soured on Altria due to numerous factors. Here they are in (roughly) chronological order:

1. The uptake of Vaping/e-cigs by the public has accelerated the declines in the traditional cigarette business where Altria is dominant

2. Altria then made a decision to invest in JUUL, the dominant vape company. Altria paid $12.5bn for the stake, valuing JUUL at more than $38bn.

3. As part of the JUUL deal, Altria agreed to exit its own e-cigarette brand (MarkTen), which had ~10% market share compared to JUUL’s 30% share

4. JUUL came under fire for the emergence of 2,807 vaping related injuries and deaths. Certain cities begin to ban Vaping, and the FDA required that vape companies submit retroactive FDA approvals for vape products

5. The FTC sued Altria to unwind their position in JUUL, stating that it was anticompetitive (citing their respective market shares and Altria’s exit of MarkTen)
   
   Based on that, I can certainly see why the market has sold the stock, shares are down from $77 in 2017 to around ~$49 today, a 37% decline. 

    

What I’ll do in this analysis is break down the business segments, look at the diversification investments that were made, talk about capital allocation, and then figure out the valuation.

Business Segments

• 88% of Altria’s revenue comes from Smokeable products, mostly Marlboro, which is the largest selling cigarette brand in the US for the past 45 years with 105bn units shipped in 2020

• 9% comes from chewing tobacco, including premium brands Copenhagen and Skoal and value brands Red Seal and Husky.  830m total units shipped in 2020

• 3% comes from Wine, namely Ste. Michelle with 8.3m cases sold in 2019

Smokeable products (Cigarettes and Cigar)

Altria cigarette brands include:

• Marlboro

• Basic

• Benson & Hedges

• Cambridge

• Chesterfield

• Commander

• Dave’s 

• English Ovals 

• L&M 

• Lark 

• Merit 

• Parliament 

• Players 

• Saratoga

• Virginia Slims

Combined, Altria cigarettes command 50% of US market share, with Marlboro alone accounting for 43%.

Are cigarettes a good business? If you are purely looking at volumes sold, you’d probably say “No”. US cigarette consumption has dropped more than 50% since 1981. That looks like a business in secular decline. I don’t think anyone would say the following chart shows a healthy business.

Source: American Lung Association

Not only that, Cigarette consumption is highly regulated in America. It is taxed massively, making the product fairly expensive. Cigarette companies have extreme amounts of regulations in place to prevent any sort of advertising, and as a matter of fact they have to spend some of their profits to fund “anti-smoking” campaigns, primarily targeted at the youth to prevent them from ever becoming addicted in the first place.

Despite all of this, Altria has returned more than +71,000% from 1981 to 2017. In fact, Altria has the best long-term stock performance of any stock in US history according to Jeremy Siegel, author of “Stocks for the Long Run”. If you take nothing else away from this post, consider again that arguably the best stock performance in history has been generated by a company where the core business has been in structural decline for more than 50 years. 

What accounts for this performance?

1. Pricing power

1. Capital allocation. 

Let’s focus on Pricing Power: In my opinion, pricing power is the number 1 characteristic of a truly good business. Lots of investors talk about “competitive advantages”, but if you can raise prices and not see meaningful declines in your customer retention and sales, that is the best possible advantage to have, as it’s pure profit that accrues directly on the bottom line. 

Since 2013, Altria cigarette volumes have declined 21%, and yet revenues are up 1% over that same time period.

On the 4Q20 conference call, management noted that Altria Smokeables volume grew 3% year-on-year in Q4 2020. They also announced their 4th list price increase in the last 12 months, cumulatively totaling $0.46/pack.

For reference, 2019 price increases totaled $0.25 and 2018 was at $0.19, so this is a massive increase. MO also announced a Manufacturer Supported Off-Invoice (MSOI) rebate in select states, which means that MO is proactively making moves to protect its brands (especially market share leader Marlboro) from downtrading.

Management has mentioned multiple times that it is using consumer data to generate more targeted marketing and discounting schemes, and I think the fact that they were able to announce an annual price increase that is 2-3x above trend while simultaneously targeting discounts to select consumers shows an increasing level of sophistication in targeting that should get even more refined over time. To dive deeper into Altria, you can also check out this list of best stock research website.

Combined with price increases, this meant Smokeables revenues and adjusted EBIT were both 9% higher year-on-year in Q4. For full-year 2020, Smokeables volume was down 0.4% (again helped by inventory), revenues was up 6.5% and adjusted EBIT was up 10.2%: 

Altria Smokeables P&L (Q4 & FY 2020)

NB. OCI = "Operating Company Income", and is equivalent to EBIT.

Source: Altria results release (Q4 2020).

Altria's own full-year volume decline in 2020 was 2%, which marked a significant improvement from the accelerating decline during 2016-19:

Altria Cigarette Volume Growth Y/Y (Adjusted) (Since 2013)

Source: Altria company filings.

The key idea here is they are raising prices in a direct relationship to volume losses, so when volumes decline 8% for example, Altria can, in aggregate, typically push through an 8% pricing increase. This accounts for the big uptick in gross margin while keeping revenues flat. 

But will there be a point where cigarettes become so expensive that you can no longer raise prices? The first thing to mention is that tobacco prices vary widely depending on which state you live in due to local taxation rules.

Here is a chart from fairreporters.net. I don’t know how reputable that particular source is, but some quick spot checks indicate that these prices are relatively accurate and actually skew a bit higher than other average prices reported on the internet. It’s important to note this isn’t the price of Marlboro’s necessarily, but just cigarettes overall. 

So assuming that these prices approximate Marlboro’s, how much of a pricing increase could the average user withstand before it would hurt their budget?

The chart below looks at the price by state and compares it to Median Household Income for that state.

There are a few interesting takeaways from this.

The first is, that if we assume that a typical consumer uses 5 cigarettes a day, every single day, that would equate to 91 packs consumed per year. At that rate, cigarette expenditures would total about $635 on average per year, and that equates to 1.3% of estimated net median income per household. That is not a very big expenditure, and I’d suspect therefore that most people don’t blink an eye when a pack of cigarettes increases a few percentage points per year. Even a heavy smoker, who smokes 1 pack per day (20 cigarettes), would spend roughly $2500 per year, or 5% of their net income, assuming they made a median income. If you are smoking that much, you are probably so heavily addicted that you also won’t flinch much if your carton of cigarettes is 5% more expensive every year. 

The second thing to notice here is that median incomes have been growing at a 3% CAGR for the last 5 years. That further negates the impact to overall household budgets, because if the price per pack goes up 5% this year and your paycheck goes up 3%, that means you only truly saw a 2% real increase to your cigarette expenditures. That is pretty insignificant in the scale of things. Again this is just a high-level analysis, but the point is that the consumer base can likely absorb some decent pricing increases without it breaking the bank for them. When you consider that Marlboro is considered a “premium” cigarette, it probably equates to more stickiness with the customer base who is even less likely to care about price increases because they feel they are smoking a superior product. 

That’s not to say Altria is immune to recessions. In fact on the Q1 conference call early in 2020, they noted that older customers were “downgrading” to discount brand cigarettes, and this was a real near-term threat when the economy first took a hit from Covid-19. 

CEO William Gifford: “Based on our adult smoking demographics, smokers over the age of 50 have a greater propensity to purchase discount cigarettes than younger adult smokers. In the first quarter, gross shipment volumes to retail moderated for the premium and branded discount segments,declining by 1.5% and 3.8%, respectively. However, we observed a significant increase in deep discount volumes as its growth rate nearly doubled from the prior quarter to 14.4%. We believe this rapid rise in deep discount volumes is partially due to the influx of older adult smokers returning to the cigarette category and contributed to Marlboro’s first quarter retail share performance.”

So Altria is certainly seeing a shift to discounted cigarettes as a result of the recession, but Altria actually sells discount cigarettes itself. Altria’s discount brands account for ~8% of total Altria cigarette volumes and have 4.2% market share. So if a temporary shift away from Marlboro’s occurs, Altria will recoup some of that through its discount brands. 

In fact, in the last recession Altria created Marlboro Special Blend specifically as a way to capture customers who were downgrading to discount cigarettes but still wanted to smoke Marlboros. So while a recession is not a positive short term, I care more about the long-term, and with a 45% market share Marlboro and the 2020 recession more or less being over, the health of Marlboro looks good long term.

In addition to selling discount brands, Altria has spent the last decade investing in analytics that let them fine tune pricing down to the ZIP code level.

Wine 

The wine segment, although minor at 3% of Altria’s sales, is a bit interesting. Ste. Michelle is Washington State’s oldest winery. It’s seen pretty steady growth since it was established back in the 1960’s, and from when Altria bought it in 2008 all the way up to 2017 it has posted pretty consistent mid-single digit sales growth at ~20% operating margins. However, sales have recently hit a skid, with volumes down -9% in 2017, and -3.5% in 2018. During that time Altria brought in a new executive named Jim Mortensen who had previous experience at Miller Brewing. Mortensen has replaced some of the senior management, announced plans to pare back product offerings, and rolled out an aggressive marketing campaign. 

Overall, it’s not worth spending much time on this category other than to say I think Altria will likely either turn this business around or sell it for a nominal price at some point in the future, depending on how well the turnaround goes.

Most of the data for this article is researched using AlphaResearch - Edgar Company Search. They apply AI and machine learning to help users like you and me search efficiently across SEC filings such as 10 k, 10q, form 8k, 13f filings, sec form 4,