Undervalued Dividend Growth Stock of the Week: Altria Group (MO)

Anything worth having is worth working hard for.

Wealth is worth having.

And it typically takes hard work to achieve significant wealth.

However, it doesn’t take as much hard work as you might think it does.

In fact, there’s a large platform already in place that can build huge wealth for you.

That large platform is the US stock market.

The US stock market is an incredible platform that has been minting millionaires and billionaires for decades.

It’s an amazing machine that can unlock compounding for you, allowing your money to work for you and build wealth on your behalf.

Yes, you have to work hard and get your hands on some capital that can be put to work.

But money can and will work harder than you ever could.

Money works 24/7.

Better yet, money is an amazing worker that replicates itself. It creates extra little worker bees all by itself.

And this process goes on and on, eventually making you very wealthy.

I’ve seen this happen firsthand.

I was unemployed, broke, and in debt at 27 years old.

But I decided to turn around my life and get the US stock market working for me.

And I found myself financially independent and retired early at 33 years old – just six years after starting to build wealth.

I lay out that entire journey in my Early Retirement Blueprint.

I now control the FIRE Fund, which is my real-money early retirement stock portfolio.

It generates the five-figure passive dividend income I live off of.

I’m now on easy street.

Jason Fieber's Dividend Growth PortfolioThere was some hard work upfront, sure. But the passive income allows me to enjoy my life these days. It’s not as hard to do this as you might think.

But intelligent investing for the long term is vital.

I used dividend growth investing to make all of this happen.

This strategy advocates investing in high-quality stocks that pay reliable, rising dividends.

Limiting yourself to only the highly profitable enterprises that are able and willing to pay growing dividends lets you home in on some of the best businesses in the world.

Check out the Dividend Champions, Contenders, and Challengers list to see what I mean.

This list contains information on more than 800 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Of course, dividend growth investing isn’t randomly picking stocks off of a list.

One must thoroughly analyze any business before investing a single penny.

And valuation at the time of investment is critical.

While price is what you pay, it’s value that you get for your money.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

This is relative to what the same stock might otherwise provide 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 correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally reduce a company’s fair value. It’s protection against the possible downside.

It’s obvious that undervaluation should be sought out by every long-term dividend growth investor.

The good news is that undervaluation is not difficult to spot and take advantage of.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, part of a larger series on DGI, is an easy-to-follow guide and template that can help you estimate the intrinsic value of just about any dividend growth stock out there.

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.

Over the course of 2018, the company acquired its 45% stake in Cronos Group Inc. and 35% stake in Juul Labs, Inc.

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.

Let me explicitly state what Altria is doing here.

The company is disrupting itself.

While I think moves like these were prescient, adaptive, and necessary, due to the secular decline in traditional cigarette unit sales, it’s been a bumpy road thus far.

That’s the way it is with disruption. It’s never a smooth transition overnight.

First, the cannabis industry is young and still figuring itself out, with major legal hurdles yet to overcome. Profits are scant, and it’s difficult to tell which competitors are properly positioned.

Second, Juul Labs has recently come under fire. A small number of consumers have mysteriously experienced lung injuries and even death after using vaping products. There are also concerns regarding dubious marketing practices.

Regarding the second issue, Altria’s Q3 FY 2019 report showed that the company recorded a non-cash pre-tax impairment charge of $4.5 billion related to its investment in Juul.

Altria might have committed some missteps here, but the core business remains steady, management is obviously willing to protect the company against business model erosion, and the stock offers a massive yield after the market brutally punished it over the last year.

With the stock down ~30% over the last 52 weeks, the yield has been pushed up to an unbelievable 7.32%.

Let me put that into context.

It’s almost four times higher than the broader market’s yield.

That’s also more than 310 basis points higher than the stock’s own five-year average yield.

It’s monstrous, no matter how you slice it.

And it’s not like we’re talking about some high-risk, unknown stock here.

This is one of the most reliable dividend growth stocks the world has ever seen.

Altria has increased its dividend for 50 consecutive years, putting it in rarefied company.

The 10-year dividend growth rate is 9.5%, which is a fantastic dividend growth rate on almost any yield. Coming attached to a 7%+ starting yield is beyond incredible.

That said, the most recent dividend increase came in at 5.0%.

With a payout ratio of 95.5% on adjusted TTM EPS (factoring out the Juul charge for Q3), I would expect dividend increases to be relatively muted for the near term.

But with the yield being so high, one doesn’t need big dividend raises to make sense of this investment.

Altria’s dividend resume is one of the most impressive I’ve ever seen.

But we don’t invest in the past. We invest in the future.

So let’s build out a forward-looking growth trajectory, which will later help us value the business and stock.

I’ll first show you what Altria has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a professional forecast for near-term profit growth.

Blending the proven past with a future forecast like this should allow us to extrapolate some reasonable assumptions.

Altria grew 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%.

I usually look for a mid-single-digit top-line growth rate from a mature company like this. Altria’s delivered.

Meantime, earnings per share grew from $1.54 to $3.68 over this period, which is a CAGR of 10.16%.

In my view, these are impressive numbers.

Excess bottom-line growth was driven by a combination of share buybacks and margin expansion.

Regarding the former, the outstanding share count is down by approximately 9% over the last decade.

Regarding the second point, net margin was sitting around 20% a decade ago; it came in at 35% last fiscal year.

Looking forward, CFRA is predicting that Altria will compound its EPS at an annual rate of 9% over the next three years.

They’re basically forecasting a continuation of the status quo. That’s similar to what Altria produced over the last decade.

CFRA is modeling in pricing increases to offset volume declines, since the business model benefits from price inelasticity. This is a page out of Altria’s long-term playbook.

Share buybacks will likely happen at a moderate pace. The company has a $1 billion buyback program in place, although no stock was repurchased during Q3 FY 2019.

There’s also the Cost Reduction Program the company announced in December 2018. It’s expected to deliver approximately $575 million in annualized cost savings by the end of 2019. Altria updated progress on the CRP during its Q3 FY 2019 report, noting they’re on target for their goal.

A very exciting recent development is the commercialization of the IQOS system in the US by Altria. Altria has an exclusive distribution partnership with Philip Morris International (PM) for IQOS in the US.

Philip Morris International has developed the IQOS as a reduced-risk product (RRP) alternative to both traditional cigarettes and vaping products, using heat-not-burn technology as a differentiation in the marketplace.

The IQOS has been available in select international markets for some time now, but it just recently started to be rolled out in the United States.

In September, Altria began commercialization of IQOS in the Atlanta, GA market. And there’s an expected expansion of IQOS into the Richmond, VA market beginning in Q4 2019.

Lower expectations have seemingly already been priced into the stock. I’ll remind you of the ~30% slide in the stock’s price over the last 52 weeks. This amounted to an erasure of more than $35 billion in market cap.

That’s probably why the big writedown didn’t cause much of a move in the stock.

With lower expectations already priced in, investors could have much to look forward to from the Juul investment. Altria has started to make overtures that essentially constitute a takeover of Juul, installing K.C. Crosthwaite (a major executive from Altria) as the new CEO of Juul in September.

CFRA’s forecast for 9% is, in my view, too aggressive.

Keep in mind that Altria just released new growth objective for adjusted EPS over the 2020-2022 period.

The company is targeting a compounded annual adjusted diluted EPS growth objective of 5% to 8% for the years 2020 through 2022.

That’s lower than 9%. And that’s using adjusted numbers.

Still, Altria doesn’t need to produce 9% EPS growth in order to be an attractive investment here, with a depressed valuation and sky-high yield.

Even just 5% EPS growth could allow the company to do everything it needs to go and simultaneously hand out low-single-digit dividend raises.

I think most shareholders would be happy with that, all considered.

Moving over to the balance sheet, the company has historically maintained a strong financial position and conservative capital structure.

However, its recent strategic equity investments have weakened the balance sheet.

The long-term debt/equity ratio (as of the end of Q3 FY 2019) is 2.53, while the interest coverage ratio is now hovering around 4.

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 it’s clear that Altria is paying up for growth and using the balance sheet toward that end.

While I wouldn’t say the balance sheet is in immediate danger, the company is far less flexible than it used to be. They basically fired one of the biggest bullets they had. This is why Altria has been so keen to protect its Juul investment with its recent overtures.

Profitability has long been impressive both for this company specifically and the industry in general. It’s the nature of the business model.

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.

Notably, net margin has actually been expanding over the last decade. Altria’s margins have gone from amazing to more amazing.

Overall, there’s so much to like about this stock.

It’s tough to find a better dividend package.

The high yield. Five decades of dividend growth. Huge dividend raises.

Ordinarily, this is a slam dunk. A no-brainer.

Brand name recognition, pricing power, addictive products, distribution capabilities, and massive barriers to entry are attractive competitive advantages.

However, the company is in a state of flux right now. The strategic equity investments were arguably necessary, but they’ve not been successful thus far.

And there are other risks to consider.

Competition, regulation, and litigation are omnipresent risks in every industry.

In this particular case, regulation and litigation are significant issues in the tobacco industry. Competition, on the other hand, is limited and entrenched due to the sizable barriers to entry.

The continued acceleration of volume declines could have a material effect on earnings.

And if the large bets on Juul and Cronos proceed to disappoint, the company will be impaired by the associated debt without the related growth to offset it.

At the right valuation, though, this could be an outstanding long-term investment.

With the stock down ~30% over the last year, wiping out over $35 billion in market cap, the valuation is very attractive…

The P/E ratio (using adjusted TTM EPS to factor out the Juul writedown) is sitting at 13.04.

That’s markedly lower than the broader market’s P/E ratio.

It’s also well off of the stock’s own five-year average P/E ratio of 17.0.

If we look at cash flow, which factors out the GAAP messiness, the current P/CF ratio of 12.1 is half that of the stock’s three-year average P/CF ratio of 25.1.

And the stock’s yield, as noted earlier, is substantially higher than its recent historical average.

So the stock does look cheap. But how cheap might it be? What would a reasonable 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 I assumed a long-term dividend growth rate of 3.5%.

This long-term dividend growth rate assumption is nearly 1/3 that of Altria’s own proven 10-year dividend growth rate.

It’s even lower than the most recent increase, which was announced in the same quarter as the Juul writedown.

But I think it makes sense to be cautious here.

Their payout ratio is about as high as I’ve ever seen it. The strategic equity investments have been anything but magnificent thus far, which has put pressure on the balance sheet and the remainder of the business. This led to a reduction in the company’s near-term growth aspirations. And the core traditional cigarette business, while fairly stable, remains in a slow, secular decline.

But we have to keep perspective here.

It’s a cash cow. Altria brings in billions of dollars in free cash flow every year. This management team, even with the recent missteps, is one of the best to ever do it. The loss in market cap over the last year is pricing in more than a total loss in its Cronos and Juul moves. Furthermore, the IQOS commercialization is a bright spot with tremendous possibility.

So it’s definitely not a dire situation. It’s simply not as appealing a business as it once was.

The DDM analysis gives me a fair value of $77.28.

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 what I think was a conservative valuation model, the stock appears to be extremely 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 $56.00.

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 $50.00.

I came out high. But that’s why it’s great to have the additional perspective. Averaging out the three numbers gives us a final valuation of $61.09, which would indicate the stock is possibly 33% undervalued.

Bottom line: Altria Group Inc. (MO) possesses one of the best dividend growth resumes in existence. The company is in a state of transition, but the valuation and yield have priced in undeservedly low expectations. With a 7%+ yield, 50 consecutive years of dividend raises, a huge long-term dividend growth rate, and the potential that shares are 33% undervalued, dividend growth investors should be taking a very close look at this stock right now.

-Jason Fieber

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 55. 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 Borderline Safe with a low risk of being cut. Learn more about Dividend Safety Scores here.

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