Why I am holding my Altria shares for now, but would not buy at current price.

When I first started reading about Altria (MO) its dividend is what initially got me very intrigued.  Altria was the first company that I bought where I actually read an annual report so it was my starting point for the research I am doing now.  However, I was not doing any type of valuation or near the amount of research I am doing now so I got a bit lucky that my position is now up around 30%.  I started doing this write-up and research of Altria mainly to see how far I have come since I originally bought.

However, now that I have just read its most recent 10K and 10Q I have found many things that bother me about the company.

First I will give the reasons why I originally bought more than a year ago:

• Big dividend in a low yield environment, the dividend has been growing as well.
• Huge competitive advantages that I noticed even then: Addicted customers who were willing to keep paying higher and higher prices.  A government sponsored mini-monopoly since there aren’t likely to be any new entrants due to litigation and taxes.  Massive brand recognition and market share.
• They were producing about $3 billion in FCF per year, which I thought was enough to cover the dividend.

Risks I saw then:

• Massive debt load over $12 billion.
• Litigation expenses.

Those were literally the only two concerns I had, and the only major concern of the two was the debt.  Altria seems to win a lot of its lawsuits or if they do lose, they end up having the amount to be paid out cut substantially, so that did not worry me too much.

The above are literally the only things I looked at before deciding to buy MO last year.  Not very in-depth thinking, and definitely not enough to get me even close to a buy or sell decision today.

Analysis now

Altria comprises Philip Morris USA, U.S. Smokeless Tobacco Company, John Middleton, Ste. Michelle Wine Estates, and Philip Morris Capital Corporation. It also owns a 27.1% interest in SABMiller, the world’s second-largest brewer. Through its tobacco subsidiaries, Altria holds the leading position in cigarettes and smokeless tobacco in the United States and the number-two spot in cigars. The company’s Marlboro brand is the leading cigarette brand in the U.S.

Having sold its international segments and the bulk of its nontobacco assets, Altria now operates primarily in the challenging U.S. tobacco industry. U.S. cigarette volume is in secular decline, and the Food and Drug Administration, having assumed regulatory control, has been quick to assert its authority. The threats of regulation and taxation have now overtaken litigation as the most significant risks to an investment in tobacco, in our view. Despite these headwinds, tobacco manufacturing is still a lucrative business, and we think Altria is poised to generate steady medium-term earnings growth. The addictive nature of cigarettes and Altria’s dominance of the U.S. market is the key reasons behind our wide economic moat rating.

The two descriptions above are taken from Morningstar.com.  You can view Altria’s SEC filings here.

Valuations:

These valuations are done by me, using my estimates, and are not a recommendation to buy any stock in any of the companies mentioned.  Do your own homework.

Valuations were done using 2011 10K and second quarter 10Q.  All numbers are in millions of US dollars, except per share information, unless otherwise noted. Valuations were done on July 27th 2012.

Net cash and EBIT valuation:

Altria has cash and cash equivalents of 1,528.

Its number of shares outstanding are 2,027.

Altria has total current liabilities of 6,081.

Cash and cash equivalents-total current liabilities=1528-6081=-4553.

• -4553/2027=-$2.25 of net cash per share.

Altria has a trailing twelve month EBIT of 3519+6068-1295-1539=6753.

5X, 8X, 11X, and 14X EBIT+cash and cash equivalents=

• 5X6753=33765+1528=35293
• 8X6753=54024+1528=55552
• 11X6753=74283+1528=75811
• 14X6753=94542+1528=96070

• 5X=35293/2027=$17.41 per share.
• 8X=55552/2027=$27.41 per share.
• 11X=75811/2027=$37.40 per share.
• 14X=96070/2027=$47.40 per share.

Current price is $35.63 per share.

Market cap is 72.44 billion.

Enterprise value is 84.44 billion.

• EV/EBIT=12.50

My average unit cost including dividends is currently $27.10 per share for the MO shares I currently own.

Only the 14X EBIT valuation would get me a reasonable margin of safety if I were to buy now.  If I were to buy MO shares now I would be using either the 11X or 14X EBIT valuations as my base case.

A couple things of note:  Altria has a negative net cash number which I generally do not like.  Altria’s EV/EBIT is higher than the companies I usually evaluate, which is another sign that it might be fairly or overvalued currently.

Revenue and EBIT valuation:

Using Trailing twelve month numbers:

Revenue: 16,670

Multiplied By:

Average 4 year EBIT percentage: 34.13%

Equals:

Estimated EBIT of: 5,689.47

Multiplied by:

Assumed fair value multiple of EBIT: 10X

Equals:

Estimated fair value Enterprise value of MO: 56,894.7

Plus:

Cash and Cash equivalents: 1,528

Minus:

Total Debt: 13,089

Equals:

Estimated fair value of common equity: 45,333.7

Divided by:

Number of shares: 2,027

Equals:

$22.36 per share.

Low estimate

My high estimate of value, which I would use as my base estimate of value in this case, was a 15X estimated EBIT multiple which came out to $36.40 per share, about evenly valued.

Free cash flow valuation:

Again using Trailing twelve month numbers.

Operating cash flow: 3,388

Minus:

Capital expenditures: 108

Equals:

Free cash flow (FCF): 3,280

Divided by:

Industry median FCF yield: 6%

Equals:

Industry FCF yield implied fair value: 54,666.67 ($26.97 per share.)

Multiplied by:

Assumed required FCF yield as a percentage of industry FCF yield: 95%

Equals:

Estimated fair value of common equity of MO: 51,933.34

Divided by:

Number of shares: 2,027

Equals:

$25.62 per share.

Low estimate

My high estimate, where I changed the assumed yield from 95% to 125% came out to $33.71 per share.

I would estimate its intrinsic value to be the 11X EBIT multiple from the net cash and EBIT valuation, $37.40 per share.

Through these valuations I have found Altria to be either overvalued or about fairly valued at current prices.  Looks like I got a bit lucky when I was doing no valuations, or the amount of research I am doing now, when I bought MO around $27 per share.

I was mainly doing this exercise to see how far I have come since I originally bought MO, doing no valuations and minimal research.  My intention when I started this was not to do a complete analysis, but I found a few things that gave me some pause while reading its SEC filings that I wanted to highlight.

Concerns:

• All the litigation, which I will not detail here since it takes up at least 50 pages of the 10K.  If you would like further information please read Altria’s annual reports.
• Altria has been issuing debt and drawing on its short-term credit line to in part sustain its stock repurchasing and dividend.
• Debt of around $13 billion, around $11 billion of which came from its acquisition of US Tobacco in 2009.  Altria almost immediately charged about $5 billion of the transaction price to goodwill, meaning that that they paid almost double the price of the assets.  Quoting from the 10K “The excess of the purchase price paid by Altria Group, Inc. over the fair value of identifiable net assets acquired in the acquisition of UST primarily reflects the value of adding USSTC and its subsidiaries to Altria Group, Inc.’s family of tobacco operating companies (PM USA and Middleton), with leading brands in cigarettes, smokeless products and machine-made large cigars, and anticipated annual synergies of approximately $300 million resulting primarily
  from reduced selling, general and administrative, and corporate expenses. None of the goodwill or other intangible assets will be deductible for tax purposes.” To me paying almost double the price of the assets for supposed synergies does not make much sense and will also make it take longer for Altria to earn back its investment.
• Altria has projected pension and health obligations of around $6.5 billion.  The projected amount has been rising by around $500 million a year for the last few years as well.
• Altria has total off-balance sheet arrangements and aggregate contractual obligations of $33.7 billion, most of which are coming due after 2017, with around $4 billion a year needing to be paid over the next few years.  The total obligations include: Debt, Interest on borrowings, Operating leases, Purchase obligations, and other long-term liabilities.
• Altria’s fair value of total debt as of the most recent 10K is $17.7 billion.  A 1% increase in market interest rates would decrease the fair value of Altria Group, Inc’s total debt by approximately $1.1 billion.  A 1% decrease in market interest rates would increase the fair value of Altria Group Inc’s total debt by approximately $1.2 billion.  This risk is taken directly from its 10K on page 95 of the final section of the 10K.  Since interest rates cannot go any lower, and will not stay low forever, rising rates are going to crush the debt of Altria, unless it can refinance portions of the debt, which could also make it harder for them to issue debt in the future.
• The above are not even including the dropping rate of smoking in the US, and state and federal governments around the country regulating the tobacco industry so strictly that it has turned into a prohibition like industry.
• People have been piling into the stock recently for the high yield, which could be turning into a mini bubble around the stock and other high yield companies.
• Will not grow outside of the US.  That was the whole reason for the spin-off of Philip Morris (PM) so that Altria would have the US market, and PM would have the international markets.
• Insiders only own 0.08% of company stock.
• Since Altria does have a high debt load, it could preclude them from acquiring companies until it pays down some of the debt.

Pros:

• Altria has ownership of one of the most recognized brands in the world, Marlboro.
• Altria has 50% market share of the cigarette market in the US.
• Altria has 55% market share in the smokeless products in the US.
• Altria also has 30% market share in the cigar market in the US.
• Altria own a 27% interest in SABMiller, valued currently at about $19 billion.  Altria could sell this asset if they needed to pay down debt.
• Altria creates about $3 billion a year in FCF.
• Its margins are gigantic: Gross margin at 54%, EBIT margin at 37%, ROIC at 19%, and FCF/Sales margin at 20%.
• Addicted customers.
• Because governments regulate the tobacco industry a lot, Altria will not have to deal with any new entrants any time soon.
• Competitive advantages: Economies of scale, quasi government sanctioned monopoly.

How I think they could improve further:

Paying down the substantial debt would be a great step in the right direction.  In my opinion Altria should become a conglomerate, kind of a Berkshire Hathaway sin stock conglomerate.  Altria already owns a wine company subsidiary, and it owns part of one of the biggest beer producers in the world, and I think that MO could get further into that arena if they wanted to.  Altria could produce and sell marijuana when and if that ever becomes legalized since it would have the distribution lines already available.  Altria could also buy a company like Star Scientific (CIGX).  Here is Morningstars description of them, Star Scientific, along with its subsidiary, Star Tobacco, is a technology-oriented tobacco company seeking to develop, license, and implement technology to reduce the carcinogenic toxins in tobacco and tobacco smoke.

I remember reading a while ago that there was a rumor that either Altria or Philip Morris could buy CIGX to develop next generation cigarettes that did not have the carcinogens in them, thus alleviating the main concern with smoking.  I have not read any more rumors of that in a long time though.

One thing that is for certain, although smoking will never go away no matter how much governments regulate and tax the industry, Altria in my opinion, will eventually have to branch out at least a little bit due to declining rates of smoking in the US.

Conclusion:

Altria is one of the most dominant companies in the world.  It has a virtual monopoly in the United States in the cigarette and smokeless product segments, with at least 50% market share in both of those two industry segments.  The company has incredible competitive advantages that enable it to continue to have huge margins even with all the litigation, taxes, and regulation.

The company is not perfect as it has a myriad of issues that I outlined above.  If you were to buy Altria at the current prices, it appears that you would have no margin of safety and I would not recommend buying at this time.

However, I think the positives outweigh the negatives at the $27 price that I bought at, and I plan to hold onto my shares of Altria for hopefully decades, and hope to have my money compound well into the future.  If Altria can get its debt and pension obligations under control that should be no problem.

As always comments, concerns, and critique are welcome and would be appreciated.