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Investment Overview for Altria Group, Inc. (NYSE:MO)

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1. Changes in trends and Altria's performance
   • Altria posted its second quarter earnings on July 26, wherein it reported a decline in revenues and a growth in earnings. While this had been anticipated, its sales fell more than expected, resulting in a miss on consensus expectations on the metric. It is not an unknown fact that the smoking rate has been falling, with the U.S. witnessing one of the steepest declines in the world. In the face of this, a majority of the company's revenue growth in the past had been a result of increasing the prices of tobacco products, as well as the growth of its smokeless and innovative products segments. However, this time, a rise in prices was not able to fully offset a fall in volume. Altria got a boost to its earnings as a result of the overhaul of the corporate tax code, which reduced the tax rate from 35% to 21%, effective January 1, 2018. Based on the strong earnings performance in the first half, the company has raised the lower end of its guidance, with the range now being $3.94 to $4.03, from $3.90 to $4.03 earlier.

2. Other factors to watch out for:
   • Altria, in partnership with Philip Morris, submitted a Modified Risk Tobacco Product Application (MRTPA) with the US FDA for iQOS, its heat-not-burn tobacco product on December 5, 2016. Philip Morris International's proposed claim that its iQOS device presents less of a health risk than traditional cigarettes by an advisory panel instituted by the FDA. Philip Morris is currently trying to gain FDA approval to start selling its heat-not-burn tobacco device called iQOS with a reduced risk claim in the US. Once iQOS gets a go ahead, Altria (NYSE:MO) will get exclusive rights to sell these products in the US. Moreover, as Philip Morris was the first company to seek US approval to market a tobacco product as being less harmful than traditional cigarettes, they would, logically, be the first company to receive approval from the FDA, implying a significant marketing advantage over other reduced risk tobacco products. However, this latest development is a tremendous setback. The first thing to consider is that the advisory panel's recommendation is exactly that - it is a recommendation; it is not binding. Moreover, this recommendation is only for the purposes of its marketing, and not for its sale. This means that if the recommendations are accepted, Altria/Philip Morris would not be able to claim its iQOS device is less risky. The actual permission to sell this device is via a different application filed with the FDA. And hence, this recommendation has no bearing on whether Altria will get a green light to sell this device in the US.
   • A development that dampened the results for the company in 2017 is the tax hike in California, which raised taxes by $2 to $2.87 per pack, starting in April. The California cigarette market is the second largest in the nation, after Texas, and constituted roughly 7% of the US cigarette market before the tax was implemented. Thereafter, the volume contribution of the state has fallen. Since Marlboro has an over 50% share in the state, it disproportionately affected the brand, contributing to its 0.2 percentage points decline in the national retail share. These dynamics are expected to negatively impact Marlboro's performance in the remainder of the year as well. Based on past experience, tax increases of this magnitude impact the most in the short term, after which the rate of volume decline slows down. For the full year, the company estimates a 1% negative impact on the industry volumes resulting from the excise tax hikes, in California in April and in Pennsylvania back in August 2016.
   • The FDA plans to limit the nicotine content in "combustible cigarettes" to non-addictive levels, in order to prevent thousands of deaths and billions of financial costs related to tobacco use. This surprising move caused stocks of tobacco companies to plummet on July 28, with Altria plunging almost 20% at one point, before recovering to a 9.5% decline. If the FDA does succeed in getting its proposal passed, it will inevitably impact the earnings of the company. Some reports suggest that if cigarettes in the future have lower levels of nicotine in them, addicts will end up smoking more to get their "nicotine fix." Hence, the cigarette volumes for Altria could actually go up. However, this is highly unlikely. A study by the New England Journal of Medicine has shown that smoking compensation does not occur when smokers are given cigarettes with nicotine levels low enough not to be addictive. If Altria was just a cigarette company, it would have faced a significant drop in its earnings. However, Altria has a diversified business, including a 10% stake in Anheuser Busch. While the company still gets close to 90% of its revenues from its smokeable segment, the company can instead focus on its smokeless segment to recover some of the losses. Furthermore, the launch of iQOS in the future would also help to mitigate this. One thing that needs to be considered is that it is not certain that such a proposal will get passed. And even if it does, it will take a long time before it happens. For the foreseeable future, it will have no impact on the company's earnings, and so, the immense drop in the share price may be an overreaction by the market.

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Revenue per Smokeable Product: We currently estimate revenue per smokeable product unit to increase by ~18% over the course of the Trefis forecast period, which would suffice to offset the current cigarettes industry volume decline. However, it is also possible that the annual increase in revenue per cigarette is lower than expected due to a lower room for higher pricing. A 1% annual rate of increase would imply a 6% downside to the Trefis price estimate.

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Altria Group, Inc. (previously named Philip Morris Companies Inc.) is one the largest tobacco corporations in the world and the parent company of Philip Morris USA, John Middleton Inc., United States Smokeless Tobacco Inc., Philip Morris Capital Corporation, and Chateau Ste. Michelle Wine Estates. The company formerly owned Kraft Foods (KFT) and Philip Morris International (PM), which housed its international tobacco business. In January 2009, Altria Group completed the acquisition of UST Inc., a moist smokeless tobacco manufacturer, and owner of the Chateau Ste. Michelle Wine Estates. In addition, proceeding the combination of Anheuser-Busch InBev and SABMiller, Altria attained a 10.2% ownership in the entity.

The brand portfolios of Altria’s tobacco operating companies include well-known names such as Marlboro, Copenhagen, Skoal, and Black & Mild. Ste. Michelle produces and markets premium wines sold under various labels, including Chateau Ste. Michelle and Columbia Crest. It exclusively distributes and markets Antinori, Champagne Nicolas Feuillatte, and Villa Maria Estate products in the United States.

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Cigarettes and cigars are the most valuable division with about 70% contribution to Altria's value

Cigarettes and cigars are the most valuable division of Altria Group with about 70% contribution to its stock value. Philip Morris USA occupies more than 50% retail share in the US cigarettes market. It sold 116.6 billion cigarettes in 2017, with Marlboro being the most popular cigarette brand occupying a giant retail share of 43% by itself.

Growth in smokeless tobacco products

Smokeless products is a high growth niche segment of tobacco products in the US and is projected to grow at an annual rate of around 6% to 10% over the next few years. Altria currently occupies more than 53% of the market share in the US in terms of volume of sales with its leading smokeless tobacco brands which include Copenhagen, and Skoal.

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Declining tobacco consumption

The volume of tobacco products sales has been declining as a result of growing health consciousness among people about the extreme health risks of smoking. Federal and state governments in the U.S. have also been discouraging tobacco consumption through high excise duties and legislative controls like bans on public smoking and strict restrictions on advertising and marketing of tobacco products as well as compulsory health warnings. The volume of cigarette sales is expected to decline by roughly 4% each year over the next five years.

High excise duties on tobacco products and anti-tobacco legislation

US federal, state, and local governments, tax tobacco products for both revenue and public health purposes. High excise duties lead to increases in cigarette prices which also discourage cigarette smoking.

A development that dampened the results for the company in 2017 was the tax hike in California, which will raise taxes by $2 to $2.87 per pack, starting in April. Since California is a high volume state, it will negatively impact the revenues for the company. Furthermore, there are also proposals in several other states to raise the excise taxes further. For the full year, the company estimates a 1% negative impact on the industry volumes resulting from the excise tax hikes, in California in April and in Pennsylvania back in August 2016.

Governments also resort to anti-tobacco legislation and anti-smoking laws to discourage tobacco and cigarette consumption. Legislation such as those banning smoking in public places leads to a reduction in cigarette sales. Family Smoking Prevention and Tobacco Control Act, 2009 also gave the US Food & Drug Administration (FDA) the authority to regulate the tobacco industry, which may lead to greater restrictions on tobacco products. The FDA can limit what goes into tobacco products. For instance, in 2010 the organization enforced a ban on the use of strawberry, vanilla, chocolate, clove, and other such flavors in cigarettes and required the ingredients to be publicized as well as limited marketing, especially to young people. There is also a risk of ban or restrictions on menthol cigarettes that currently comprise almost 30% of cigarette sales.

Strong pricing

Most tobacco and cigarette businesses today follow a Price-Profit First Strategy and enjoy a significant room for strong net pricing and margin expansion. Despite declining cigarette sales, revenues and profit margins are maintained through higher pricing.

Risks from litigation

The tobacco industry is highly susceptible to adverse litigation. Apart from the likely enormous damage payments, the negative publicity generated by such large and high profile court cases also hurt tobacco products' demand. Due to its large size and market share, Altria is more susceptible to such litigation risks.

How Does Trefis Modelling Work?

How do we get the historical numbers for this chart?

Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.

Who came up with the Trefis forecast for future years?

The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.

How does my dragging the trendline on the chart impact the stock price?

1. We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
2. We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.

See more on: DCF Methodology

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