For a long time, I have been wanting to write about one of the iconic stocks in dividend growth investing: Altria (MO).
The reason I held off was that Altria was always overvalued. I like to write about stocks that are fairly priced, and it’s even better if they are bargains.
Over the past couple of weeks, the tobacco industry has sold off. As a result, Altria has suddenly fallen to fair or better pricing levels.
Let’s talk about Altria, see why it is an iconic dividend growth stock, and what gives it an attractive valuation at the moment.
Altria’s Dividend Record
Altria’s yield of 5.1% puts it into the “high yield” category for most dividend growth investors.
Its dividend increases have been solid, including a 6.1% increase earlier this year.
The trend in increase amounts has been slowly decelerating over the past few years, but they are still decent size, especially for a stock with this high a yield in the first place.
This display from a recent Altria presentation illustrates the company’s continuing commitment to its dividend. (See the right side.)
[Source of slides: Altria]
Despite what would normally be considered a high dividend payout ratio (80% of earnings), Altria’s dividend is well supported by its financial situation. It is a highly profitable company with steadily increasing earnings and strong cash flow.
The company gets a dividend safety score of 85 from Simply Safe Dividends. That rates as very safe on their rating scale, shown below. (For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)
Altria’s Business Model and Quality
Altria has a complex corporate history. The company was founded in 1919 (under a different name) and is headquartered in Richmond, VA.
Besides tobacco, Altria has been involved over the years with foods and alcoholic beverages.
The name Altria dates back to 2007, when the name was adopted for what had previously been called the Philip Morris Companies.
The tobacco business has faced, and mostly overcome, regulatory challenges over the years. Tobacco advertising was banned in 1970. Smoking began to be banned from U.S. airplane flights in the late 1980s, and it was banned from all flights by the late 1990s. Smoking is prohibited in many office buildings, restaurants, stadiums, arenas, and parks.
In 1998, Altria and other tobacco companies created the Master Settlement Agreement, with industry leaders paying more than $200 billion to settle various Medicaid lawsuits across 46 states.
Altria’s corporate predecessors included not only the global tobacco business, but also food and snack businesses. In the 1980s, Altria was attempting to diversify away from tobacco. But eventually, Altria spun off its food (2007, Kraft Foods) and international tobacco interests (2008, Phillip Morris International).
Altria’s business today is focused on the U.S. cigarette, cigar, and smokeless tobacco markets. Its 30% stake in SABMiller became a 10.5% stake in the world’s largest brewer, Anheuser-Busch InBev (BUD), when the latter took over the former.
Organizationally, these are Altria’s operating and reporting segments:
• Smokable products
• Smokeless products
• Alcohol assets
Traditional cigarettes produce the bulk of Altria’s revenue. Well-known brands include Marlboro, which is the country’s largest-selling cigarette brand, with a market share around 45% in the U.S.
Black & Mild is the largest-selling machine-made cigar, with about 25% market share.
Altria has over 50% of the domestic tobacco market. That said, cigarette usage is steadily declining, due to a falling number of smokers, increased state taxation, and tightening regulations.
While cigarette smoking is dropping off, the product’s prices are pretty inelastic. Altria has countered the general decline in smoking with programs to build brand awareness, introduce line extensions, and raise prices to offset falling volumes. Price increases tend to stick, given that the products are addictive.
Smokeless products are growing at a mid-single-digit rate. Smokeless profits in 2017 were about $1.4 billion compared to smokable products’ $8.6 billion. Altria’s noncombustible brands include Skoal, Copenhagen, MarkTen, and Marlboro Heatsticks. Skoal and Copenhagen combined account for about 50% of the domestic smokeless tobacco market.
Altria’s business strategies are shown on this slide.
Maximizing income from combustible products largely centers on brand awareness and pricing to offset declines in cigarette sales.
The strategy in smokeless products is to become the leading smokeless tobacco and oral nicotine company with products that appeal to a diverse set of adult tobacco consumers and have the potential to reduce harm. Specifically, Altria intends to lead the U.S. e-vapor category with a portfolio of superior, potentially reduced-risk products that adult smokers and vapers choose over cigarettes.
On the third strategy, Altria has targeted a 7%-9% average annual rate of growth in profits per share.
Morningstar awards Altria a wide economic moat, based on its strong brand equity and well-developed distribution network.
Value Line gives Altria a middling Financial Strength Grade rating of B+. I would give them a higher grade. Let’s take a look at the company’s financial situation.
Return on Equity (ROE) is a measure of financial efficiency. ROE indicates how much return a company is generating per dollar invested in it. Per Bloomberg, the average ROE of the 10 largest companies in the S&P 500 is 19%. The following chart shows Altria’s ROE in recent years.
[Source of all yellow-bar graphs: Simply Safe Dividends]
Altria’s ROE is extremely high.
Often, a very high ROE appears when a company has lots of debt, because its returns are being generated on the total capital structure (equity + debt), while ROE only measures the return on equity. Let’s see if Altria’s high ROE is partly the result of high debt.
I use the Debt-to-Capital (D/C) ratio to measure financial leverage: How much does the company depend on borrowed money to finance its activities? Most companies borrow money routinely, financing their operations through a mixture of debt and equity (shares sold on the open market) as well as their own cash flows.
While leverage can help a company grow faster, too much debt can weaken a company or even make its financial structure untenable. The D/C ratio examines how big a percentage of the mixture of debt and equity is debt. All else equal, the higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt repayments create a constant draw on the company’s cash flows.
Altria’s D/C ratio is under 50%, meaning that it finances itself with less debt than average. A typical D/C ratio is 50%. Altria has actually cut its debt ratio over the past couple of years.
So high debt is not the reason for Altria’s high ROE. In my experience, Altria’s combination of high ROE with moderate debt is unusual. It means that Altria is a highly profitable company. The tobacco business, by its nature, does not have high capital requirements compared to many other industries.
And to be sure, that profitability shows up in Altria’s margins.
Per Investopedia, operating margin measures how much profit a company makes per dollar of sales, after accounting for the costs of production, but before accounting for interest or taxes. Operating margin is a good measure of a company’s efficiency and profitability.
According to CSIMarket.com, S&P 500 companies have an average operating margin of around 11%. A high-quality company like Johnson & Johnson (JNJ) runs in the mid-20s. Altria’s operating margin is much higher at 51%, and it has climbed in 8 of the last 9 years.
Independent analyst provider CFRA states that over the next several years, Altria’s margins are likely to get even better as a result of higher pricing, restructuring actions, and facility consolidation. Altria is actively focused on productivity and cost management improvements after reducing its cigarette-related infrastructure during the past few years.
Earnings per Share (EPS) – that is, a company’s officially reported profits per share outstanding – is always of interest.
Altria has an outstanding earnings record. EPS has increased in 8 of the last 9 years. Analysts’ forward earnings estimates are for 8% growth per year, which is right in the middle of Altria’s estimated range (see the left side of the slide below).
Free Cash Flow (FCF) is the cash a company has left over after paying its expenses. Excess cash flows allow a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends. As with earnings, the significant number to examine is the per-share amount.
Altria has generated positive FCF per share over the past 10 years, even during the Great Recession. Growth has been erratic (up in 6 of the past 9 years), but the amount has always been positive.
The strong cash flow record is one of the major reasons that Altria’s dividend is considered to be safe, as dividends are paid out of cash flow.
As I stated earlier, I would give this record a higher grade than Value Line, probably an A or A+.
Altria’s Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation. Let’s go through the steps for Altria.
Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic valuation estimate uses a reference price-to-earnings (P/E) ratio of 15, which is shown by the orange line on the following chart. P/E x E = P, so the orange line shows what would be a fair price for Altria.
The black line shows Altria’s actual price.
Altria’s price is slightly above the orange line, suggesting that the company is slightly overvalued.
The orange line was drawn using the reference P/E of 15, whereas Altria’s actual P/E is 15.4 (circled).
If we make a ratio out of those P/Es, we can calculate the degree of overvaluation: 15.4 / 15 = 1.03. In other words, Altria’s current price is 3% above the fair price as estimated by this first method.
The fair price is calculated by dividing the actual price by the ratio 1.03. We get $55 /1.03 = $53 for a fair price. Note that I round all dollar amounts off to the nearest dollar. That’s to avoid creating a false sense of precision in making valuation assessments.
I consider any price within +/- 10% of fair value to be “fair.”
Step 2: FASTGraphs Normalized. The second valuation step is to compare Altria’s price to its own long-term average P/E ratio. This gives us a valuation estimate based on the stock’s own long-term valuation instead of the market’s long-term valuation.
Altria’s 5-year average P/E ratio is 19.3 (circled), so the blue fair-value reference line is drawn using that ratio rather than the 15 that was used in the first step.
This shifts the reference line higher, and therefore Altria looks undervalued using this second method.
The degree of undervaluation is calculated the same as in the first step: Make a ratio out of the P/Es. We get 15.4 / 19.3 = 0.80. So when viewed from this perspective, Altria is 20% undervalued.
The fair price suggested by this 2nd approach is $69.
Step 3: Morningstar Star Rating. Morningstar uses a discounted cash flow (DCF) process for valuation. Their approach is comprehensive and detailed. Many investors consider DCF to be the best method of assessing stock valuations.
In their DCF approach, Morningstar ignores P/E ratios. Instead, they make a detailed projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar considers Altria to be undervalued, as shown by the 4-star rating on their 5-star scale.
Morningstar estimates that Altria’s fair price is $64, which makes the stock 14% undervalued.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield.
This is an indirect way of calculating fair value. It is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa).
Altria’s 5-year average yield is 4.0%, while its current yield is 5.1%. Again, we use a ratio to compute the degree of undervaluation: 4.0% / 5.1% = 0.78, or 22% undervalued.
When using this method, I cut off undervaluations at 20%, because this is an indirect way to approach valuation. Using 20% undervaluation, we get a fair price of $69 per share.
Now let’s average the 4 valuation methods.
Thus, I conclude that Altria’s current price is about 14% below the stock’s fair price. That is an attractive situation.
As a comparison point, CFRA has a 12-month price target of $80 on Altria, which is much higher than our fair value estimate of $64 and 45% above the stock’s current price.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility, because they present fewer occasions to react emotionally to rapid price changes, especially sudden price drops that can induce a sense of fear. There is also academic research that suggests that low-volatility stocks outperform the market over long time periods.
Altria’s 5-year beta of 0.7 compared to the market as a whole (defined as 1.0) means that its price has been 30% less volatile than the index. This is a positive factor.
In their report on Hasbro, CFRA shows the recommendations of 14 analysts who cover the company. Their average recommendation is 4.1 on a scale of 5. This translates to “buy.” This is a positive factor.
Share Count Trend
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend.
Altria’s share count declined in 8 of the past 9 years.
In February 2017, Altria’s board approved a $1 billion repurchase program to kick in after completion of its prior $4 billion program. CFRA expects Altria to complete those repurchases by the end of 2018.
From a shareholder perspective, this is a positive factor. That is especially true with Altria’s recent price drop, because the $1 billion will be able to take more shares off the market.
What’s the Bottom Line on Altria?
Here are Altria’s positives:
• High yield at 5.1%
• Good dividend resume: Besides the high yield, Altria has a stated and proven commitment to its dividend; 49 straight years of increases; solid dividend growth record; and strong dividend safety.
• Stock is around 14% undervalued.
• High quality company with wide moat.
• High profitability business.
• Good financials, including steadily positive earnings and cash flows, combined with moderate debt. Good credit rating.
• Steadily declining share count for the past decade.
• Generally low-volatility stock.
And here are Altria’s drawbacks:
• Smoking is slowly but steadily declining in the USA (where Altria does all of its business).
• Government regulation could accelerate at any time, effectively reducing the demand for cigarettes.
• Litigtion risk, while less significant over the past few years, could heat up again. Morningstar states, “Thousands of individual lawsuits and numerous class-action lawsuits are pending against Altria. While litigation is unpredictable, Altria has a very capable legal team, and recent cases and settlements have not had a material impact on the firm’s operations.”
Overall, I see Altria as a very good candidate for dividend-growth investment. It will be in the running for the next dividend reinvestment in my Dividend Growth Portfolio in May.
As detailed in recent Dividend Growth Stock of the Month and Valuation Zone articles, recent price declines in the stock markets have brought a number of good dividend growth stocks back into decent valuation range. Altria is now one of them.
This is not a recommendation to buy, hold, or sell Altria. Any investment requires your own due diligence. Always be sure to match your stock picks to your personal financial goals.
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