Altria (NYSE:MO) is the manufacturer and marketer of the iconic Marlboro brand in the U.S. and owner of the leading smokeless tobacco brands Skoal and Copenhagen. Despite declining cigarette volume sales in the U.S. and rising consumer awareness of the health risks associated with tobacco use, strong brand loyalty gives Altria pricing power in cigarettes and its strong brands in smokeless tobacco are benefiting from continued growth in this segment.
Here, we take a look at some of the key trends driving our valuation, which is based on a discounted free cash flow to the firm.
Cigarettes And Cigars Division Under Pressure
Altria generated $24.6 billion in revenues with an adjusted diluted EPS of $2.21 during 2012. The retail market share of its flagship brand, Marlboro, rose to 42.6% while its total cigarettes market share stood at 49.8% during the same period. The company distributed $1.76 annualized dividends during 2012, growing 7.3% y-o-y.
Altria’s smokable products division that sells cigarettes and cigars makes up for almost 70% of our price estimate. This particular division has been a source of spectacular cash flows for the company in the past. Even while operating in a very challenging environment, the division’s cash profits increased from $1.46 billion in 2009 to $4.5 billion last year. However, due to regulatory uncertainties associated with the operating environment of this particular division, marked by highly restrictive marketing rules, ever-increasing indirect taxes and declining total volumes, the outlook is not very healthy. (See Where Is The U.S. Cigarette Industry Headed)
We estimate that the total U.S. cigarette volume will decline at a 3% CAGR over our forecast period. This fall is due to a number of reasons – rising prices due to increasing indirect taxes cause a decline in demand, increasing popularity of smokeless tobacco products and e-cigarettes among the adults as alternatives to traditional cigarettes is further driving the volumes down, marketing restrictions imposed by the FDA in 2009 have significantly reduced the market reach of these companies and increasing health consciousness among consumers in general, has also led to the decline of the number of cigarettes sold in the U.S. On the other hand, improving macroeconomic fundamentals like employment rate and disposable income are expected to reduce the downward pressure on volumes as the economy recovers from the 2009 recession.
The Rise Of Smokeless Tobacco Category
Smokeless products division makes up for more than 20% of our price estimate for Altria. The company diversified into the smokeless tobacco category in a big way with the acquisition of UST Inc. in 2009. Its flagship brands Copenhagen and Skoal together hold more than 55% of the market in this segment. Cash profits from the segment have grown significantly from around $100 million to $700 million since 2009. We estimate the positive trend to continue and take cash profits from the division to be around $1 billion over the forecast period. We back our estimate on growing volume of these products and the strong hold of Altria’s core brands in this category.
Total U.S. smokeless product volume is expected to increase at a 5% CAGR over the forecast period. This is primarily due to the increasing popularity of these products among adults and relatively lower regulatory concerns. Volume growth in the segment has been largely fueled by rising cigarette prices, as these products have grown as alternatives to cigarettes. Smokeless products are perceived to pose lower health risk and are taxed lower than the traditional cigarettes. Many consumers have adopted smokeless products to help them quit smoking. 
Brands Are The Key
However, we believe that Altria’s true competitive advantage lies in its iconic brands which are expected to drive a significant portion of the future cash flows for the company. Marlboro and Copenhagen, two of the company’s largest brands are in great shape and have been increasing their market share lead in their respective segments. (See: Altria Bets On Its Brand Strength To Drive Long-Term Value) As marketing environment gets tougher for the tobacco companies, existing popular brands are further expected to increase their hold on the market due to lesser competition from emerging brands. This is expected to enhance pricing power and hence profitability prospects of the company.Notes: