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2019-11-08 16:01:05

Altria’s (MO) investment thesis is on the back of its consistent ability to deliver stable EPS growth with a highly attractive dividend yield. However, the company’s core cigarette business is being disrupted by newer technologies in the market, and newer regulations could fundamentally reshape its business. JUUL, the company’s largest bet on the technology play, is also facing regulatory overhand with Altria marking down $4.5 bn in JUUL amid vaping backlash. While EPS & DPS growth may remain stable going forward, uncertainty amid the regulatory changing scenario will continue to remain an overhang on the stock.

The company’s shares trade at a multiple of ~11x 1Y Fwd earnings, a significant discount compared to its peers coupled with an attractive dividend yield of ~7%. Furthermore, we think the new strategy to focus on IQOS makes the business more sustainable. However, although the company doesn’t remain immune to short term growth pangs with 2020 earnings expected to probably be below consensus along with the lingering regulatory overhang, We have lifted our price target despite the EPS cut, as we think (MO) is on a more sustainable path with the right growth avenues.

Data by YCharts

3Q Review

The central message of the 3Q conference call was that (MO) is moving from a highly predictable business to one with more volatile earnings – In the past, MO used to produce around 8% EPS growth annually, reflecting highly predictable volume trends in cigarettes and moist smokeless tobacco. In today’s call, however, MO acknowledged that its nicotine business has become much more complex and as a result, the same would be reflected in their annual results. Management also said it needs to invest materially behind iQos and On! in the short term.

Consistent with our expectations, (MO) announced a $4.5 bn impairment charge on its investment in JUUL due to the increased likelihood of FDA action to remove flavored products from the market and various e-vapor products. (MO)'s impairment implies a $23.7 bn total value for the business vs. $38 bn at the time of MO's investment in December 2018. While softer JUUL growth could have a cross-category movement benefit to aid its cigarette volumes, MO reiterated its mid-term outlook for US cigarette volumes to decline by 5-6% in 2019 and by 4-6% through 2023.

4Q Guidance

The new guidance implies the 2020 EPS guidance could be 5% or below – MO said it is now targeting an EPS CAGR of 5% to 8% between 2020 and 2022. In the call, management clarified it is NOT guiding to an annual range with 5% as a floor. MO didn’t give specific 2020 guidance which they mentioned should be out along with their latest annual results. However, it would be sensible to prepare investors now if management has come to plan for 2020 with EPS growth of only 5% (or below).

MO’s outlook for a 5-8% EPS CAGR from 2020-2022 gives the company more flexibility in a less predictable operating environment characterized by changing consumer preferences and a wider range of product choices. We believe MO has positioned its new growth target avenues in a way that the company could surprise themselves, but we continue to believe that mid-to-high EPS growth is optimistic given ongoing top-line pressures, declining opportunity for cost savings, and increasing investment needs behind IQOS commercialization, which is now expanding to a second test market in Virginia.

Positives & Negatives

Positives:

1) The All Other segment delivered a profit (at 8mn USD) vs recent historical losses (loss of 38mn USD last year). We would not expect this to continue, however, as this reflects no further investment behind vapor which is set to be replaced by IQOS investment

2) Smokeable price/mix remains very robust at 9.6% (2Q 7.0%, 1Q 8.2%). With the current cigarette industry pressures, strong pricing is important

3) Group margin gains of 550bps reflecting the support of the $575mn cost save program

4) Deep discount segment growth appears to have stalled with a 10bps gain sequentially vs 20bps in Q1.

Negatives:

1) The market will not like the fact there has not been an upgrade to cigarette industry volume guidance for the year on the back of the recent vapor slowdown. We have argued for some time the cigarette pressures are largely more driven by factors other than vapor (price increases, gas prices, regulatory move to a minimum age of 21 for buying cigarette products)

2) Marlboro returned to sequential share loss, down 0.2% on 2Q after a 0.2% gain in 2Q and a 0.1% gain in 1Q. We do note however that Marlboro is historically stronger in 1H19

3) Share of other premium cigarettes was down 10bps sequentially which does not read well around the success of Nat Sherman and its national expansion

4) The write-down in the Juul investment and likely overhang due to regulatory uncertainty

Valuation

Our target price is DCF-based and assumes -1% normalized top-line growth and 0% normalized EBIT growth. We assume a WACC of 7.5% (derived from CAPM, assuming 0.6x beta and 77% equity) and a -1% terminal growth rate (projected long-term growth of the category). Our target also includes ~$9-$10 per share attributed to the current market value of MO's equity stake in ABI, ~$1 per share for the fully diluted value of MO's stake in CRON (at a 50% haircut to CRON's current market value due to uncertainties related to cannabis), and ~$2-$3 per share for MO's stake in JUUL (a two-thirds discount to MO's investment).

Terminal Value Growth Rate

-1.0%

WACC

7.5%

Period

3Q19 TTM

3QE20 TTM

3QE21 TTM

3QE22 TTM

3QE23 TTM

3QE24 TTM

3QE25 TTM

Revenue

$19,780

$19,767

$19,699

$18,562

$18,224

$18,243

$18,344

Revenue Growth

-0.1%

-0.3%

-5.8%

-1.8%

0.1%

0.5%

Operating Margin

52.2%

54.6%

55.6%

56.6%

57.1%

57.5%

59.5%

EBIT

10,328

10,795

10,955

10,503

10,414

10,496

10,914

Tax Rate

23.7%

23.6%

23.5%

23.5%

23.5%

23.5%

23.5%

After-tax EBIT

7,883

8,245

8,381

8,035

7,967

8,029

8,349

+: D&A

222

230

229

217

212

212

201

+: Capital Expenditures

-266

-250

-239

-234

-227

-227

-228

+/- : Changes in Working Capital

-270

913

47

-162

-26

38

37

Unlevered Free Cash Flow

7,569

9,139

8,417

7,856

7,927

8,053

8,359

Terminal Value

97,358

Discounted Cash Flow

9,139

7,830

6,798

6,381

6,030

63,084

Discounted Cash Flow

99,262

+: Equity Holdings

21,391

-: Net Debt

27,493

Implied Equity Value

93,160

Shares Outstanding

1,842

Implied 12-month Target Price

$51

While the near term story is affected by regulatory concerns and lack of growth engines, the long term outlook of the company remains strong. (MO) is still a very attractive play with a decent EPS growth and fairly attractive dividend yield which should be enough to hook the investors. Initiate at Buy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.


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