Debates rage on in the US about the merits of capitalism.
I can tell you from firsthand experience that capitalism is wonderful.
However, it’s not perfect.
And it won’t do everything for you.
You have to get in the game before you can hope to win it.
Capitalism is practically begging you to take advantage of it.
Yet so many people completely ignore it.
Well, I can understand that.
I was once of those people who totally ignored the market.
And I was broke, unhappy, and without opportunities in my life because of that ignorance.
But I decided in my late 20s that I could no longer ignore this fabulous compounding machine staring me in the face.
I decided to live below my means and get in the game by investing my hard-earned savings into high-quality stocks for the long run.
And I went from below broke at 27 years old to financially free at 33, as I lay out in my Early Retirement Blueprint.
Capitalism radically changed my life.
But you have to step up to the plate and swing at the right pitches.
Undervalued high-quality dividend growth stocks are probably the “fattest pitches” you’ll see.
That’s because dividend growth stocks are some of the bluest blue-chip stocks in the market, as you can see by checking out the Dividend Champions, Contenders, and Challengers list.
And the growing cash dividends these stocks pay out can constitute the passive income that underpins your financial independence.
Indeed, that’s exactly what I’ve done.
My FIRE Fund, which is my real-money early retirement dividend growth stock portfolio, produces the five-figure dividend income I need to cover my essential expenses in life.
High-quality dividend growth stocks can be excellent long-term investments, but undervaluation is what can make them the “fat pitches”.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
Price and yield are inversely correlated.
All else equal, a lower price will result in a higher yield.
That higher yield leads to greater long-term total return potential.
That’s because total return is simply the sum of capital gain and investment income.
A higher yield boosts the possible investment income.
However, capital gain is also given a possible boost.
That occurs via the “upside” available between a lower price and higher intrinsic value.
Taking advantage of a temporary mispricing that’s favorable could lead to additional capital gain if/when the market realizes that pricing error.
This should reduce risk, too.
An investor introduces a margin of safety, or a “buffer”, with undervaluation.
The margin of safety protects the investor’s downside against unforeseen events that can erode value.
Since value is always an estimate, it’s smart to be conservative and introduce a sizable margin of safety.
These dynamics are clearly favorable.
And they’re desirable.
Fortunately, estimating value is actually not that difficult.
Fellow contributor Dave Van Knapp has made this easier than ever.
He put together a great valuation template that can be applied to just about every dividend growth stock.
That template can be accessed through Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Altria Group Inc. (MO)
Altria Group Inc. (MO) is one of the world’s largest tobacco companies. It is the largest cigarette manufacturer in the United States.
The company operates across the following subsidiaries: Philip Morris USA, U.S. Smokeless Tobacco, John Middleton, Ste. Michelle Wine Estates, Nu Mark, Nat Sherman, and Philip Morris Capital. The company holds a 10.2% interest in Anheuser-Busch InBev (BUD). They also own 45% of Cronos Group Inc. (CRON). And they have a 35% stake in private e-cigarette maker Juul Labs, Inc.
FY 2018 revenue broke down as following: Smokeable Products, 88%; Smokeless Products, 9%; Wine, 3%; and All Other, less than 1%.
Marlboro, the company’s flagship US cigarette brand, has a ~43% share of the market.
In total, Altria Group Inc. controls just over 50% of the US cigarette market, making them the largest domestic player. They have no international cigarette sales.
For perspective on how important the Marlboro brand is to the the company, this single brand accounted for 86% of the company’s total cigarette unit sales in 2018.
While Altria Group Inc. is largely concentrated on the US cigarette market, which is in secular decline, it’s a cash cow that remains attractive due to entrenched brands, limited competition, inelastic pricing properties, and the addictive nature of the products.
Furthermore, the company has been making moves to diversify its business and hedge its bets against a declining customer base.
2018 was a milestone year in this regard, as the company acquired its 45% stake in Cronos Group Inc. and 35% stake in Juul Labs, Inc. toward the end of the year.
Cronos Group Inc. is a global cannabinoid company.
Juul Labs, Inc. is the dominant US e-cigarette manufacturer with a ~72% market share as of 2018.
This gave Altria Group Inc. immediate and large exposure to two businesses that are growing and producing the products that are most likely to disrupt the US cigarette market.
Essentially, the company is disrupting itself.
Altria Group Inc. is hedging its bets with these strategic investments, which I applaud.
These changes move the company away from its reliance on a product that is in secular decline, all while injecting some exciting growth prospects.
This bodes well for their ability to grow its dividend well into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, the company has increased its dividend for 49 consecutive years.
That’s impressive by any standard, but I think it’s particularly impressive in this case since we have to remember that the company has been navigating a tightly regulated market in secular decline.
The 10-year dividend growth rate stands at 9.5%.
Again, that’s a great number by any standard.
But it’s especially great when you consider the fact that the stock yields 6.17% right now.
It’s very rare that you find a stock yielding over 6% and growing its dividend near double digits.
This yield, by the way, almost 200 basis points higher than the stock’s five-year average yield.
The payout ratio, at 82.7% of adjusted TTM EPS, is high.
However, that’s fairly close to management’s targeted payout ratio of 80% of adjusted EPS.
These are fantastic dividend metrics.
It’s just not common to find a yield this high with this kind of dividend growth track record.
Adding to the company’s bright future is the recent decision by the FDA to approve the sale of the IQOS heated tobacco system in the US market.
Altria Group Inc. has the exclusive licensing agreement with Philip Morris International Inc. (PM) to market and sell this product in the United States.
What this means is, Altria Group Inc. now has exposure to a product that sits between its traditional cigarette offerings and e-cigarettes, since IQOS utilizes heat-not-burn technology.
They can offer products across the market spectrum, catering to a much wider swath of clientele.
The outlook today is more exciting, if a bit more complicated, than it’s been in some time for Altria Group Inc.
Time will tell how these changes shake out, but I think we have a lot to go on in terms of estimating the future growth trajectory of the business.
And that estimate of future earnings growth is very important as it relates to estimating future dividend growth and the value of the business.
Revenue and Earnings Growth
In order to build this estimate, we’ll first look at the top-line and bottom-line growth the company has produced over the last decade.
Then I’ll compare that to a near-term professional forecast for profit growth over the next three years.
The company increased its revenue from $16.824 billion in FY 2009 to $25.364 billion in FY 2018.
That’s a compound annual growth rate of 4.67%.
Meanwhile, earnings per share grew from $1.54 to $3.68 over this period, which is a CAGR of 10.16%.
A combination of share buybacks and margin expansion helped to drive that excess EPS growth.
Very solid results here.
And the company took hits to FY 2019 EPS that actually dragged the number down a bit. Adjusted EPS for FY 2018 came in at $3.99, which would bring the 10-year CAGR over 11%.
There are companies out there operating in expanding industries that don’t grow like this, so to grow at a 10%+ annual rate when your industry is in secular decline is beyond amazing.
Looking out over the next three years, CFRA is forecasting a 9% compound annual growth rate for Altria Group Inc.’s EPS.
This would be roughly in line with what’s transpired over the last decade.
CFRA is modeling in pricing increases to offset volume declines, since the business model benefits from price inelasticity.
In addition, Altria Group Inc. continues to buy back stock. If the stock is undervalued, which is the thesis of this very article, that’s a great use of capital. For reference on the buybacks, the company bought back 2.7 million shares at an average price of $56.34 during Q1 FY 2019.
There’s also the Cost Reduction Program the company announced in December 2018, which is expected to deliver approximately $575 million in annualized cost savings by the end of 2019.
If anything, the 9% forecast could be argued as conservative, since the CRP and strategic equity investments are just starting to rev up.
However, the possibilities of additional regulation (such as raising the minimum age to purchase tobacco products to 21 across more states) are looming. And negatively affecting cash flow is the reduction in dividends from the Anheuser-Busch InBev stake.
But even a 9% EPS growth rate could allow for similar dividend growth, as the targeted payout ratio is already in place.
Even a lower dividend growth rate – say, in the mid-single-digit range – would still be awfully appealing here when you’re putting that on top of a 6%+ starting yield.
Moving over to the balance sheet, the company has historically maintained a strong financial position.
However, its recent strategic equity investments have weakened the balance sheet.
The long-term debt/equity ratio (as of the end of Q1 FY 2019) is 1.92, while the interest coverage ratio is now hovering around 5.
The former number isn’t necessarily insightful because of low common equity (due to a large amount of treasury stock).
And I think the latter number is artificially low because the numbers are messy right now.
But there’s no doubt that Altria is paying up for growth, and the balance sheet is being used as a pawn in that game.
While I don’t think the balance sheet is in any danger, the company is far less flexible than it used to be. They basically fired one of the biggest bullets they had, so there must be significant confidence in the equity investments.
Profitability has long been a strong suit of this company. It’s the nature of the business model. Cigarettes are highly profitable.
Over the last five years, the company has averaged annual net margin of 32.80% and annual return on equity of 124.15%.
ROE is boosted by the low common equity, which ends up as a function of the buybacks.
But the margin is incredible, although this number is slightly inflated by anomalous results in FY 2016 and FY 2017.
It’s also worth considering that net margin has actually been expanding over the last decade. Margin has gone from great to even greater.
Overall, this is a high-quality company that lays claim to one of the best long-term dividend growth track records out there. Simultaneously, it’s one of the highest-yielding dividend growth stocks out there.
Ordinarily, this is a slam dunk. A no-brainer.
However, the company is in a state of transition right now. The strategic equity investments were arguably necessary, for volume declines have been accelerating of late.
And there are other risks to consider.
Competition, regulation, and litigation are omnipresent risks for every company.
In this case, regulation and litigation are substantial issues in the industry, while competition is more or less muted.
The continued acceleration of volume declines could have a material effect on earnings.
And if the large bets on Juul Labs, Inc. and Cronos Group Inc. do not pan out as expected, the company will be severely weakened by the associated debt without the related growth to offset it.
At the right valuation, though, this could be an outstanding long-term investment.
Stock Price Valuation
With the stock down more than 20% from its fall 2018 highs, it looks downright cheap here…
The P/E ratio, using adjusted TTM EPS, is coming in at 13.41.
That’s well below the broader market’s earnings multiple.
It’s also substantially lower than the industry average P/E ratio of 16.6.
So you’re getting a yield at 3x the market on a below-market multiple.
So the stock does look undervalued. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of just 4.5%.
This DGR is less than half that of what the company has produced over the last decade.
And with the forecast for EPS to compound at 9% annually for the next three years, the odds are good that dividend growth will far exceed this mark.
However, I’m erring on the side of caution here.
There are a lot of question marks regarding the strategic investments, the balance sheet, and volume decline acceleration.
As such, I think it’s sensible to be very cautious with the valuation.
The DDM analysis gives me a fair value of $95.54.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
Even with a highly conservative model that almost completely disregards this company’s proven long-term dividend growth track record, the stock still appears to be very cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates MO as a 4-star stock, with a fair value estimate of $58.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates MO as a 3-star “HOLD”, with a 12-month target price of $52.00.
I’m surprised I came in high. I was very reasonable with expectations. Regardless, averaging out the three numbers gives us a final valuation of $68.51, which would indicate the stock is possibly 32% undervalued.
Bottom line: Altria Group Inc. (MO) is a high-quality company that has adeptly navigated a challenging industry and produced outstanding metrics over the last decade. With a 6%+ yield, almost 50 consecutive years of dividend raises, an on-target payout ratio, and the potential that shares are 32% undervalued, this high-yield stock should absolutely be on every dividend growth investor’s radar right now.
Note from DTA: How safe is MO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 65. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, MO’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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