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2019-10-18 22:26:58

Investing in tobacco, much like investing in arms or oil stocks, is a bit of a thing . Some people don't do it. Me, for instance, I haven't yet invested in outright arms/weapons stocks, though the reason for it is lack of opportunity rather than actual moral quandary in doing so. I think in similar ways when it comes to tobacco stocks, like Altria (NYSE:MO).

Today, I went ahead and increased my portfolio allocation to the tobacco giant to a full position.

I don't smoke. I've never smoked a single cigarette or used a tobacco product in my entire life (I'm 33). Nor will I. Despite this, I'm bullish on the company and believe you should be as well.

Here's why.

Altria - ~7.8% yield from Tobacco?

As always, I'm beginning my articles, when I write about a company for the first time, with a bit of an overview.

(2Q19 Earnings Call Slides)

Altria is one of the world's largest producers and marketers of tobacco, cigarettes, and related products. It's also the parent company of Philip Morris USA. Aside from this, Altria also maintains some minority stakes in international companies such as Anheuser-Busch (BUD), Cronos Group (OTC:CRON), and JUUL Labs (JUUL) as well as some alcohol companies (Wine).

Its history as its own company isn't actually all that long. Altria came from Philip Morris as part of the company's aim to show that the portfolio consisted of more than just tobacco. The rebranding happened at a time of chaos for the company, and chaos continued for some time after the spin-off. Altria held a large stake in what was then known as Kraft Foods Inc, and this was spun off to shareholders - the same happened with the company's stake of Philip Morris International (PM). Altria then went on a bit of an M&A tour, buying John Middleton Company, a cigar manufacturer, and UST Inc., the world's largest producer of snuff and smokeless tobacco (and wine).

The latest purchases of a 45% and 35% stake, respectively, in Cronos Group and JUUL labs are merely the latest in the company's purchases.

Like other tobacco companies such as Swedish Match (OTCPK:SWMAF), Altria's claimed focus is on tobacco harm reduction. The difference to this company is that Altria still sells cigarettes. The company's business model, as such, needs little introduction. Its aim is marketing and selling of cigarettes and tobacco products, something it does well.

How well?

(Source: Altria Investor Presentation)

History speaks for itself - really well. Since its creation, Altria has clearly outperformed the broader S&P 500, averaging 15.3% annualized rates of return, including the generous dividends which have grown on average 29.0% per year since 2011.

(Source: Altria Investor Presentation)

And it's not as though the company lives under some sort of deluded belief that traditional tobacco products like cigarettes will continue to hold sway over most in the long term. The company's own expectations are for the consumption of cigarettes to sequentially go down - and this has been the case since at least 2007.

As shown, the current product portfolio is appealing.

(Source: Altria Investor Presentation)

It's appealing to me as an investor because I see the value in the brands. It may be personally appealing to some who use the products the company sells. Me, I see others using them.

The company's operations are going well from a historical perspective, and profitability is significant.

(Source: Altria Investor Presentation)

The company's long-term goal is an EPS growth at 7-9% annually, with a payout target of about 80% of diluted EPS. The company's strategy going forward, no surprise, includes many of what the company calls adjacent investments with global opportunities . Here, we find Cronos and JUUL.

The company's ambitions with JUUL have born some fruit, with excellent results in the UK, Italy, and Germany as well as Canada. The company sees the investment as key up to 2023, with 15-20% five-year CAGR, with similar operating margins as cigarettes, and targets international revenue on the level of domestic revenue.

The company is also targeting its traditional demographics and product consumers with programs such as the Marlboro rewards program, which has shown some results - driving brand growth through digital seems to be a thing even in the tobacco sector, which isn't really a thing for similar Swedish competitors. In addition, Altria simply has Marlboro, which is the leading brand among smokers in most age groups.

(Source: Altria Investor Presentation)

Altria's cigarettes also remain purchasable by the average consumer, far easier than in most other nations, giving the company access to a large demographic, even with the new age restrictions, of smokers with easy access to its products.

(Source: Altria Investor Presentation)

So, the company is in the business of marketing and selling cigarettes and tobacco products. It seems to do so well.

How are the recent finances and results?

Finances

During the latest investor presentation, the company reaffirmed 2019 guidance at a range of $4.15-4.27/share

The company, despite some claiming the contrary, has a net debt/EBITDA that's actually pretty acceptable. In terms of a certain peer comparison, Altria actually looks quite good.

(Source: Altria Investor Presentation)

And as far as the second quarterly - the last quarterly we currently have - the company is delivering on its promises and guidance.

EPS expansion of almost 9%, YoY and 2% increase compared to the 6-month period in 2018.OCI (Other comprehensive income, including revenue, expenses, gains and losses that have yet to be realized) increase of 11% on YoY comparison, 5.7% on half-year.Despite continued decline rates, smokable adjusted OCI growth increase of 50 bps compared to 2014-2018 CAGR.Smokeless product OCI growth of 10.8% YoY, and 9.4% on half-year comparison.M&A of on!, commercializing oral nicotine pouches (similar to Swedish snuff/snuff pouches sold by Swedish Match).Continued growth in the number of vapers.Continued JUUL expansion, including 13 new markets.

So, overall and beside the positive quarterly, the company's plans for 2019 are on track, despite the rapid industry changing with customers adopting new products that carry, or at least are supposed to carry, lower risk. The company reaffirmed guidance, as mentioned earlier, and traditional products, including Marlboro, remain at an unchanged retail level, giving credence to the company's own guidance that the smokable segment will remain relevant for a long time yet. The company's non-combustible IQOS also received premarket authorization, and the company began commercializing the product in September.

The company increased the expected compound decline rate (annually) during the year in part due to IQOS being approved, which Altria believes will accelerate people quitting cigarettes and moving to alternatives. More than that perhaps, with the legal age limit for purchase now increased to 21, it changes the consumer dynamic with only 50% of the US population in the legal age limit for cigarette purchases.

None of these comparatively small headwinds, however, explain why a company with this sort of portfolio is being punished by the market in a fashion such as this.

(Source: Seeking Alpha)

For these explanations, we must look at other things. Before we look at these other things, there are a few reasons I'd like to point out, however - or emphasize.

The company has averaged 10% dividend growth for the past 5 years and has a 50+ year streak of uninterrupted dividend increases (depending on how you calculate this in relation to the company's existence).The >75% payout ratio isn't something new - payout in terms of earnings has been on this level for over 10 years.Earnings show a virtually stair-step tendency, growing from $1.75/share in 2009, to $4.03/share in 2018 - again, impressive growth.The company has bought back shares during that time, reducing shares outstanding to 1.88B.Sales have increased, over time, almost year by year.The operating margin has increased, nearly year by year.Despite increased debt, interest coverage remains at a conservative 10.87X.Vaping Problems

The primary reason for the undervaluation is current NA and, one could say, a coming global regulation crackdown on vaping devices. This, among other things, has caused a stock price decline of nearly 50% in not only Altria but similar development in competitors as well.

Why is Altria affected so heavily?

Because Altria acquired JUUL Labs for $12.8B, which came to a not-inconsiderable amount of debt and cash compared to the company's market cap. It's not an M&A that will decide the future of the company as a whole, but if JUUL were to be made worthless because it somehow was decided that vaping was more deadly than traditional tobacco, making its product pointless, this would, of course, affect Altria, and not just in the short term.

I'm no doctor, nor any sort of healthcare professional. I won't go heavily into the current research either discussing for or against this.

What I will say is that initial reports show that the majority of those suffering from what we can call vaping illness are using juices that contain THC. More and more sources (source, source, source) are linking the vaping illness to what's known as Vitamin E-oil, used as a cheap filler when selling THC oil. Likening all vaping products/oils to products filled with garbage such as this would be like likening all food products to those illegally supplemented with other, lower-grade ingredients.

While it's a worrying thing, it showcases the need for larger companies and regulatory bodies to go in and safeguard the production of vaping devices/cartridges and their juices. It shows that licensing and production/sale safeguards may be necessary - it does not equate to the entire vaping industry being a literal deathtrap - especially not compared to smoking cigarettes the traditional way.

There's also the second part where more and more states, nations and organizations are introducing limitations or restrictions as a safeguard toward minors.

Let me be clear - I applaud this. Adults are free to choose what they put in their bodies. Children are not. In fact, this hits particularly close to home because I grew up in Germany. One thing I thought odd when I moved to Sweden was the absence of products targeting children here, such as chocolate cigarettes - which were a huge thing back there. Moreover, in Germany, you can find vending machines like this on the streets in most cities.

(Source: BMJ Blogs)

These could even be close to pre-schools. It's obvious to me that safeguards to protect those not yet legally able to make this choice need to be made.

Regarding the safety of vaping vis-á-vis tobacco, I'm going to stick to the actual scientific studies performed which are relevant in my geography.

Public Health England determined in a study published during the late summer of 2015 that e-cigarettes and vaping products at the time with standard nicotine levels are 95% less harmful than traditional cigarettes. This study has been internationally recognized and oft-quoted when speaking to the dangers of vaping. I am not aware of any study as recognized/valid that's being put forward to contradict these results - if you are, feel free to let me know. And just to be clear - adding what is essentially poison to THC products isn't a contradiction of these results.

The solution to reaching the desired vaping industry/regulation, I believe, is similar to what we see in Scandinavia and other European regions. Strict regulation as to who's allowed to purchase and use tobacco, nicotine and other substances - including the vaping products spoken to here. Just like with similar substances, such as alcohol.

So, what are the reasons for Altria's share price drop? Well, apart from the overall volatility in the market and macro, the primary reason is the increasing regulations, the news about bans, and the fear that Altria's huge investment into JUUL is, for lack of a better describing word, worthless.

This brings us to the company valuation and the fear that the JUUL investment, under the wrong conditions, may be worth less , or actually worthless.

Valuation

To which I say - so what if it is?

Sure - a $12B+ investment being worthless is undoubtedly terrible news. But what would be the overarching effect of a nationwide vaping ban, if indeed we believe that such a ban is possible even in the USA?

Look at today's stock valuation.

(Source: F.A.S.T. Graphs)

The company is priced as though it's either in a recession or about to go bankrupt, at a current 10.3 times earnings. Since the beginning, Altria has lost a significant amount of company market capitalization - more in fact by far than the entire value of the JUUL acquisition. Some investors may argue that the risk is now priced in . To this, I pose the following question:

Do you believe that Altria will not fall in share price as a result of the potential NA vaping ban?

Because if you believe it will, obviously, the risk isn't completely priced in. In my limited experience, risks such as that are never priced into company share prices. They might be cushioned, but any such development will still cause a share price drop.

To which I again say - so what if it does?

Even if vaping products were banned, people would still require their fix of nicotine - they would likely return/go to one of my many tobacco/nicotine alternatives, many of which are held in Altria's portfolio. The idea that there's a population that only vapes only began using tobacco because of vaping, and that would stop using tobacco if vaping was banned borders on absurdity.

(Source: F.A.S.T. graphs)

At today's valuation, a simple return to standard valuation would yield annual returns of clear, market-beating proportions. Even if the entire vaping portfolio was removed from Altria, and even if they had to do a dividend cut as a result of this, the long-term appeal of the investment is, to me, still undeniable at these valuations. There is so much downside priced in at these valuations, for a company with a decades-long dividend streak, that the risk-reward ratio is extremely favorable.

Even assuming merely a fair value of 15 times earnings for Altria as a company, the potential upside in today's share price is just north of 33%. That's an awful lot of downside risk included here, especially with a company that during the latest quarterly, reaffirmed annual guidance.

Would you also, perhaps, like to see how Altria has done compared to the broader market since ~2000?

(Source: F.A.S.T. Graphs)

Nearly tripling the S&P 500, that's how. In terms of dividends, the returns compared to the broader index have been amazing, turning $10,000 into a total of ~$132,000, including dividends. And yet there are investors who cite that Altria will be unable to maintain the current dividend of nearly 8% as an argument against investing here.

Altria's current valuation, all things considered, is simply very appealing. But it doesn't take a value investor to show this. The on-paper valuation isn't the problem - it's the perceived risk to the company. So, let's focus on those.

Risks

The fact of the matter is, as I see it, Altria and similar companies, cannot truly lose long-term, regardless of the outcome to the risk on a local and international level.

If we assume that there's an outright vaping ban - for some reason, let's even say it's international - and JUUL and similar companies is/are worthless, the following things are likely/consequences.

Altria needs to cut the dividend to pay down the debt.Vaping stops being a public/widely accepted practice, and the legal consumer-selling of the products ceases/becomes very limited.Development goes backward , with traditional cigarettes and tobacco products coming back into style - because let's face it, people aren't going to stop smoking.

Well, in this case, Altria, and similar peers, is/are already set up for success. The company owns the nation's most popular cigarettes, and it can live off the meat of its current portfolio, less vaping, if it needs to while it pays down debt. In addition, a vaping ban would likely also affect the current decline of traditional smoking. It may rise once again. As a result of this, Altria would need time to revert its net debt/EBITDA, but would ultimately do so and return to dividend growth.

While being a shareholder during this time will be a negative experience because of the initial cost basis, the fact is that Altria, in such a position, would be more undervalued than ever if it fell more. Once again, the company portfolio and market penetration are too good .

And this is the worst-case scenario.

To me, there are two reasons an investor could conceivably not choose to invest in Altria at such a valuation - both perfectly acceptable and respectable reasons.

Moral/ethical guidelines that disallow investments in corporations involved in businesses such as this.A firm belief/knowledge that a vaping ban/restriction will be instituted that will devalue JUUL/vaping companies and cause Altria to fall even further.

Beyond this...not much I can see. Even trading sideways/flat for the next few years, if we assume the dividend is covered, this is an opportunity the likes of which isn't seen all that often.

Because of the subject matter/product involved, this tends to get a lot of people riled up. Add to that factual regulation and worldwide banning currently ongoing, and health reports linking vaping to illness, disease, and death, it's no wonder why there's so much emotion involved in the stock (and the products) at the moment.

I say - take a step back and look at the numbers.

Thesis

I say this because the opportunity presented here is one I consider extremely good, and with very little realistic long-term downside. This morning, I went ahead and doubled down on my already moderate position, extending Altria to a full position in my portfolio, one of the few American companies so far that have warranted a 0.9%-1.0% target allocation.

What if the worst occurs, and vaping is banned, causing Altria to fall another 50%?

Well, I'll most likely double down in steps as the share price deteriorates in the short/medium term.

However, because of the indications coming out of the medical cases we are seeing, which is that the illness is caused not by any fundamental vaping product but by harmful additions of other substances (not to mention people have now been vaping for 13+ years, which nothing like this reported until it became more commonplace/THC-oils became involved), I see this risk as extremely small compared to how the market is currently whipping this stock.

In the end, the argument here is risk/reward ratio in light of an extremely qualitative company with a market-dominating position. This is something I welcome.

That being said, the following is also part of my stance, not as an investor, but as a human being:

The consumption/smoking of tobacco and nicotine products is a risk associated with risk, illness and eventual/potential death. The reason I myself never have used a single tobacco or nicotine product, nor ever will, is the health-associated reasons here, which have been established for near-on 80-90 years. Despite my nationality/background, however, being Swedish/living in Sweden doesn't make me someone who believes the government should intervene and decide yay or nay for what we adults may or may not do. It's a choice - much like other substances which can be considered harmful.

As such, you may say that investing in Altria violates one of the rules many investors see as fundamental - don't buy a company if you don't believe/like their products.

Well, I do believe Altria's products are excellent - for their target consumers. I just happen to not be one of their target consumers. But for those who consider tobacco a positive or necessary vice, I consider Altria's products excellent.

All of these reasons/backgrounds are why I've chosen to double down in Tobacco, and Altria specifically, and rate the company a STRONG BUY .

Thank you for reading.

Recommendation

Due to undervaluation and considerable upside, I consider Altria a STRONG BUY at valuations of 10.5 times earnings. As always, my recommendation is careful position sizing.

Disclosure: I am/we are long MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.


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