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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 FY2018 earnings on January 31, wherein a 0.7% increase in revenues and a 17.6% growth in earnings was reported, with both metrics marginally missing consensus expectations. 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 has been a result of increasing the prices of tobacco products, as well as the growth of its smokeless and innovative products segments. These trends continued in 2018 as well. Going ahead the contribution of smokeless products in the company's growth is expected to rise.

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.
   • 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 85% 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.
   • Recently, the FDA ordered five brands – Juul, British American Tobacco's Vuse, Altria's MarkTen, Imperial Brands' Blu E-cigs, and Japan Tobacco's Logic – to submit their plans of discouraging use of their products by teens within 60 days. In response to this, Altria is removing its MarkTen Elite and Apex by MarkTen pod-based products until these products receive a market order from the FDA, and has stopped the sale of all flavors besides tobacco, menthol, and mint. On the face of it, an FDA crackdown on e-cigarettes – one of Altria's fastest growing segments – should worry investors. However, when the crackdown also targets one of its biggest competitors in the space, which controls close to three-fourths of the market, it may actually be a good thing. Just three years after its formation, Juul Labs has already reached a valuation of $15 billion, as it continues its tremendous growth in this fast increasing market. Its market share has spiked from 32% in November 2017, to 60% in April, and further to almost 73% by September. On the other hand, in the year ended January 27, 2018, MarkTen garnered close to $200 million in sales. This forms a tiny fraction of the $25.6 billion total revenues Altria achieved in FY 2017. As a consequence of the increased regulatory environment, the company announced the discontinuation of production and distribution of all MarkTen and Green Smoke e-vapor products, and VERVE oral nicotine-containing products.
   • Altria recently announced the acquisition of a 45% equity stake in Cronos Group, at a price of CAD $16.25 per share, for an aggregate investment of approximately USD $1.8 billion. This comes at a time when interest in marijuana is soaring, amid legalization of recreational marijuana in multiple U.S. states and in Canada, as well as an increasing use of cannabis for medicinal purposes. Accounting for both legal and black market sales, the total demand for marijuana in the United States is estimated at $52.5 billion, per the Marijuana Business Daily. On the other hand, cigarette sales have been on the decline, as fewer young people have taken to smoking. Per the U.S. Centers for Disease Control and Prevention, last year cigarette smoking fell to its lowest level on record. This is likely causing tobacco companies to hedge their bets by looking at marijuana, which potentially has lower risks of causing diseases such as cancer, while also appealing to younger users.
   • In December 2018, Altria announced that it had signed a $12.8 billion investment deal to acquire a 35% stake in JUUL Labs Inc. Investing in the US leader in e-vapor will help Altria in preparing for a future where adult smokers overwhelmingly choose non-combustible products over cigarettes. JUUL has a deep innovation pipeline and currently operates in 8 countries with rapid international expansion plans. As today's younger generation is not taking to cigarettes in such a large number, a 35% stake in a company that represents ~30% of the total US e-vapor category, will help Altria in complementing its non-combustible offerings in the smokeless category. Along with its investment in Cronos group, Altria's investment in JUUL is expected to strengthen its financial profile and enhance future growth prospects. The $12.8 billion investment is financed through a $14.6 billion term loan facility of which $1.8 billion remains undrawn.
   • Altria also announced a cost reduction program which would save costs of around $500 million to $600 million annually by the end of 2019. This program will include reducing third-party spending across the business and workforce reductions. The cost saving would offset most of the additional interest expense associated with debt raised to finance Cronos and JUUL investments.

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Revenue per Smokeable Product: We currently estimate revenue per smokeable product unit to increase by ~20% 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 9% 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 109.8 billion cigarettes in 2018, with Marlboro being the most popular cigarette brand occupying a giant retail share of 43.1% 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 50.6% 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 close to 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 and 2018 was the tax hike in California. 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.

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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