Altria Post-2011 Annual Report Investment and DFCF Analysis Update Extravaganza
My Conclusions:
- Valuation: Altria is overvalued, or at best is pretty darn fairly-valued. My best guess is that it is worth in the neighborhood of $30.08/share. Currently it is trading at $31.61/share, so is is mildly overvalued. I set a tentative “buy” price at the 20% downside, or $24.50ish/share, and a tentative “sell” price at the 20%-above-valuation upside, or $36.70ish/share. Note that I’m uncomfortable using the 8% estimated WACC for my discount rate, instead of a 10% rate. If I am wrong about that, then I am undervaluing the firm (and the entire industry) by quite a bit.
- Caution: The letter of the retiring Chairman & CEO is disingenuous about adjusted earnings, in my opinion. I get it, he’s retiring and wants to make a so-so year look good, but come-on.
- Currency Issues: Ironically, because of the extent to which Altria is properly valued based on its SAB Miller stake, and because of the hedging that Philip Morris International (“PMI”) does, Altria is much more of a currency arbitrage play than PMI is.
- Idea: I should strongly consider selling this stock, particularly given my already large investment in PMI. At the very least, it is a good candidate for cash-raising, should I identify another opportunity that I am otherwise unable to fund the purchase of. However, the opportunity in SAB Miller remains great, as does the potential for the market to undervalue it. And it’s definitely the best U.S. tobacco stock to own, if you’re going to own one.
Introduction: I first purchased Altria’s stock (“MO”) in 1998, before it was called Altria, as detailed in my recent PMI analysis, here. I have held my spun-off PMI stock since that time, or more accurately since its spin-off from Altria. However I’ve gotta admit I did not hold my MO/Altria stock during this entire time. I sold it shortly after the split. (As I sold my KFT stock.) I wanted to keep PMI and focus on that. I then re-bought a small amount of Altria stock during the financial crisis in 2009, primarily at $15.49/share. That is the source of my present holding. It is not a particularly large position for me. Since then I have been reinvesting dividends, and watching the company nearly double in its appraised value (i.e, stock price). Now that I have got my most recent 2011 annual report, it’s time to take another look at Altria, and see if it justifies my loyalty. I tend to hold stocks a long time, and one of my many flaws is holding onto companies after they no longer justify it. I hate selling because I hate paying taxes and I hate paying commissions and I hate the thought that I’ll likely be risking money by buying stock in a company I know less about — even after pretty thorough due-diligence, that the one I have just sold. I tend to get away with this, too, because for the most part when I am buying stocks it is with new money I have newly-saved from new income. But it’s important to remind oneself that there are other attractive zombies at the ball.
Discounted Free Cash Flow Valuation Analysis (basic valuation):
I am attaching my primary discounted free cash flow analysis for Altria, here. You can read it but you cannot edit it. For reasons that should be clear and will become moreso, I am also attaching a basic discounted free cash flow analysis for SAB Miller, here.
- Prior Cash Flows: Recently FCF has grown at a 5.2% annualized rate. I have assumed 5% growth going forward.
- Discount Rate Choice: I have chosen 10%. I recognize that some people would say the tobacco industry and Altria have a WACC as low as 8% and thereofore the discount rate should be that low. (If that is the case, I am grossly undervaluing PMI and Altria, and Altria is in fact 20% undervalued even at its current price.) As detailed in prior posts, the discount rate is the part of DFCF analysis that I most struggle with. On the one hand, I am deeply uncomfortable with giving companies divergent discount rates: intuitively I would like to evaluate them all on the same playing field. On the other hand, I recognize the relevance of divergent WACCs in setting potentially appropriate discount rates. I struggle. This reflects the fact maybe that I am The Dumb Money; that is not just a falsely-humble name, it reflects the fact that I am not a professional and I am trying to learn and do my best as I proceed with doing something that I very much enjoy doing. I prefer to err on the conservative side, so I have chosen 10%.
- SAB Miller “Look-Through” Free Cash Flow: I can think of three ways of acccounting for Altria’s 27% ownership interest in SAB Miller. (Btw, Altria accounts for its stake using the equity method of valuation and only accounts $5 billion or so on its actual books, as of the latest annual report — see Annual Report, Note 7, page 23.) The first is literally to take 27% of Altria’s stake out of the present market capitalization of SAB Miller. That gives you about $17.24 billion, as of today’s market prices and exchange rates. NOTE THAT A LARGE NUMBER OF AMERICAN IDIOTIC FINANCIAL WEB SITES IMPROPERLY LIST SAB MILLER’S UK MARKET CAPITALIZATION NUMBER IN DOLLARS WITHOUT ACCOUNTING FOR EXCHANGE RATES, INCLUDING BOTH MORNINGSTAR AND YAHOO FINANCE USA. The actual market cap of SAB Miller is, as of 4/16/2012, GBP 40.355.09 Billion. See here. At today’s exchange rate, which is about GBP 1.58 per dollar, that translates to a U.S. dollar market capitalization of about $63.87 billion.) Here is the valuation using this method, see D36 on Altria Spreadsheet Two, here. The second method is to give Altria 27% of SAB Miller’s enterprise value, which I’m not going to get into this time. The third, which I have chosen, is to attribute 27% of SAB Miller’s total estimated lifetime free cash flow, discounted to present value, to Altria. (Note, I kid you not, that Morningstar’s cash flow sheet, which states all numbers are in U.S. dollar, is AFUP as well. If you want something more accurate, you need to go to Yahoo Finance UK website, here.) Anyway, free cash flow is the method I have chosen, as reflected in D36 on Altria Spreadsheet One, here. But no, we’re not done yet. You see, Altria has already accounted the dividends it gets yearly from SAB Miller in its own free cash flow (e.g., Annual Report, p. 15). Thus, we have to back those out. Spreadsheet one above reflects that backing-out, to prevent that money from being double-counted. Flawed though it may be, I have done this adjustment by assuming the 2011 dividend ($357 million) will grow at an equivalent rate to SAB Miller’s free cash flow, discounting it at the same rate, and backing out the sum of that discounted-to-present value number.
Any obvious problems with the cash flow: For my purposes today, I have not delved deeply into the components of SAB Miller’s and Altria’s free cash flows. (I generally trust these companies.) But in a few minutes of review, I see nothing on the cash flow sheets that is an immediate red flag. No truly strange things, and depreciation/amortization is roughly in line with investments in property. Additionally, it’s not like half of free cash flow is composed of inventory or some crazy thing like that.
A Note on The Annual Report and Chairman’s Letter: I am…less than impressed by the letter from Michael E. Szymanczyk, retiring Chairman and CEO of Altria/PM USA. After reading the financial highlights on page 1, where EPS is reported as a 12.3% drop from $1.87 to $1.64, I was somewhat surprised to see Mr. S tout the “adjusted diluted earnings per share growth of 7.9%” to “$2.05”. I was just thrilled, thrilled I tell you, to see a happy graph of that “growth”, below which in tiny, light-gray print, is the following sentence: “*Further explanations and reconciliations of adjusted measures to corresponding GAAP financial measures are provided on page 102.” Page 102! Of course. Page 102 of 104.
So, turning to the deserted, unlit alley that is page 102, there the non-GAAP “growth” is explained, and is increased among other things by a $0.30/share “PMCC leveraged lease charge.” That is more fully explained earlier, in Note 19, at pages 57-59. Basically, you need to know that Altria is in the process of closing down a finance business. It had the prescience to begin this process in 2003. The business does stupid things like lease/loan jets to American Airlines. Anyway, Altria decided it wasn’t going to prevail in getting preferred tax benefits some big old transactions that it treated as leases buy may actually have been loans for income tax purposes. It relates to an IRS audit….
This is what you call a “one-time charge,” ladies and gentlement, but you know what? It’s still a charge. Ya lost that money, Mr. S. I get the point of emphasizing what earnings would have been without this $0.30/share charge. That is because Altria’s financial services devision basically saw a $500 million earnings swing this year (also hurting it is American Airlines’ bankruptcy, since AA is, er, voiding a bunch of aircraft leases). But I object a bit to the way Mr. S’s letter is written. 2011 kind of stunk for Altria. Just admit it. Don’t tell me how much the stock price went up. I can get that on Yahoo Finance. Cigarette revenues were down 1.1%. Cigarette net income was only up 2.3%. Copenhagen and Skoal and the “tiny” wine business and the share price performance of SAB Miller, which this guy does not control, were the positive Altria stories of 2011.
Dividends: Dividends are important here. With the recent dividend increase, this puppy is now sporting a 96%+ payout ratio on earnings, though it is in the seventies for FCF. That’s the headline the simpletons will give you. NOTE THOUGH, with the above one-time earnings charge gone next year, the payout ratio on earnings will actually decrease a fair bit, likely into the very manageable seventies.
Currency Issues: Ironically, because of the extent to which Altria is valued based on SAB Miller, Altria is much more of a currency arbitrage play than PMI is. As discussed in that analysis, PMI engages in a ton of hedging. Altria does not. Because of the large portion of Altria’s true valuation that is made up of its stake in SAB Miller, which reports in GBP, Altria is to some extent a play on the idea that the dollar will depreciate relative to the Pound.
Notes on Competitors: Altria’s competitors in the U.S. are Lorillard, Inc. (LO) and Reynolds American Inc. (RAI) One can also include British American Tobacco (BTI).
- Lorillard: 90% of its volume is generatted by menthol cigarettes, Newports. The FDA is much, much more likely to hammer menthol than just about anything else in existing cigarettes. Menthol is viewed as The Thing that gets young people to smoke. LO also has no equivalent to SAB Miller as a means of diversification. Here is a rough and dirty DFCF spreadsheet showing it’s is almost exactly fairly valued as of this writing, assuming the same 10% discount rate I give to Altria, and FCF growth for ten years at 7%, which is a bit less than percent less than its growth for the past four years, plus 2% perpetuity growth after that, as I assumed with Altria. I just think Altria has a much better business model, and I’m more comfortable with it. I like the SAB Miller interest that Altria has. I like the strong presence Altria has with top-shelf chew/snus, which Lorillard does not have. I don’t care that Lorillard is marginally a better “value.” It deserves to be.
- Reynolds American: Camel. Pall Mall. Winston. Salem. Doral. Kool. Misty. Camel snus (stupid name). This one is number two. Thing is, revenues and net income, this company makes Altria look like Apple. (Ok, not really.) It has compounded free cash flow at less than 1% annually the past four years. Even assuming can grow 2% from now until forever seems optimistic. Here’s my sheet. I think that unless there is some sort of turnaround of which I’m not aware, the stock is egregiously overpriced.
- British American Tobacco: I’m going to defer on this one for now, and include it in my next PMI analysis, since it is PMI’s major competitor.
Litigation and Regulation: Litigation is basically under control here. It is always going to be cost. But the fact is all the people who started smoking during the years of egregious misrepresentation about smoking are going to be dead of, at minimum, old age, before too long. Newer smokers have vastly less sympathetic cases. Regulation I am ‘meh’ about. I don’t think having a graphic picture on the box is going to do much, frankly. I also think it is about the limit of what the First Amendment possibly allows in terms of impingement upon commercial speech, at least with the current composition of the Supreme Court. I do think it will hurt somewhat however. Also note, and I find this telling, it was Lorillard and R.J.Reynolds that cared enough about this to sue, not Altria. See Annual Report, at Note 21, p. 83.
Secret Value in the Pensions?: I am horrified from a societal perspective and pleased from a shareholder perspective to see that Altria is, like so many companies, phasing out defined contribution plans. See page 33, note 17 of the annual report. Altria’s pension is underfunded to the tune of about $1.690 billion, which is a lot of cheese, but is not a disaster. Also note, per the same section, that the discount rate on obligations has had to be reduced, and Altria now sets its at 5% (probably still too high). So true pension costs, on the one hand, are even higher, since the discount rate should be lower. On the other hand, this too shall pass. And when/if the discount rate rises by two or more percent, a significant portion of the accrued pension costs will likely disappear. By my rough math, this could add as much as $0.50 to $0.70 cents per share to the value of the company, in 2012 dollars.
What’s Up With Altria’s Wine Business: I don’t get it. I think Altria’s wine business is perpelexing. It goes against the principles of focusing on core business that I thought was the point of the Kraft divestment, and the SAB Miller majority-stake sale. The business is growing, but what is the goal here? Is the goal eventually to grow it and turn Altria into a wine company once cigarettes have run their course?
Forecast for 2012: Analysts expect EPS to go up to from $2.15 to $2.35 for all of $2.12. I have no special competency or edge in determining whether this is correct or not, that is not my game, and I take the analysts largely at their word, except I always assume they are a bit too optimistic (except with Apple, with Apple they are never optimistic enough it seems, at least over the past few years). Note that as hited at above, this would bring the payout ratio down, at minimum to 73%ish of earnings. EPS is expected to grow as a combination of modest (MODEST) growth, the lack of the one time tax/lease charge, and share buyback, of which MO has been doing a bit over a billion per year in stock buybacks.
