How FDA Concerns Have Made Altria An Undervalued Stock

by Trefis Team
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Altria Group, Inc.
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Altria‘s (NYSE:MO) stock is down almost 20% this year, and a few factors may be responsible for this. The company missed consensus estimates on revenues in the fourth quarter of 2017, which fell 3% for the year, driven by a fall in cigarette volumes. While the company managed to beat expectations in the first quarter of 2018, the stock fell post the earnings release due to a big decline in the cigarette volume, which came in at 7%, after adjusting for trade inventory movements (partly due to the tax hike in California). Besides the above, certain decisions by the FDA have also played a major role in the decline in Altria’s stock price. At the beginning of the year, news broke regarding the rejection of Philip Morris International‘s (NYSE:PM) proposed claim that its iQOS device presents less of a health risk than traditional cigarettes by an advisory panel instituted by the FDA. Two announcements by the FDA in March also rattled a few investors. First, the FDA announced it was working on a policy framework to lower the nicotine levels in cigarettes. A few days later, the administration stated it was considering policies to restrict the use of flavors, including menthol, strawberry, and chocolate, in tobacco products in a bid to prevent young people from getting addicted to nicotine. Consequently, after the negative stock reaction to these events, we feel the company’s stock is now undervalued.

We have a $78 price estimate for Altria, which is significantly higher than the current market price. The charts have been made using our new, interactive platform. You can click here for our interactive dashboard How FDA Concerns Have Made Altria An Undervalued Stock to modify the assumptions and gauge the impact on the company’s revenue, earnings, and price per share metrics.

Reasons Why These Developments Should Not Matter So Much

1. Shipment Volume Decline: 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. The growth of the smokeless segment continued in the Q1 2018, helping in improving the margins as well. Altria’s earnings were also boosted as a result of the reduced tax rate, and higher equity earnings from AB InBev. Moreover, Altria repurchased $513 million in shares in the first quarter, reducing its share count by eight million. This was another factor that helped in the solid growth of the EPS in the quarter. The company has approximately $500 million remaining in the current $1 billion repurchase program, which is expected to be completed by the end of the year. MO has also recently expanded its buyback program, and has authorized another $1 billion, which is set to be completed by the end of the second quarter of 2019.

2. Rejection of iQOS Reduced Risk Claim: 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 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. While a possibility of a rejection of the claim can be considered a significant 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.

3. Reduction Of Nicotine Content In Cigarettes: 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. Stocks of companies like Altria tanked in the aftermath of this proposal. 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. Furthermore, addiction is not the only reason that people smoke, and so the decline in volumes in the future may not be as magnified as people are estimating. Moreover, if the FDA’s purpose is to reduce the smoking of cigarettes, it may actually result in better tax treatment for Altria’s iQOS product.

4. Restriction On Flavors In Cigarettes: To prevent the youth from using tobacco, the FDA is having a closer look into flavors such as menthol in cigarettes and the fruit and candy-flavored little cigars and cigarillos. On the flip side, it is also considering the fact that the addition of such flavors to e-cigarettes may help regular smokers to switch to less harmful tobacco products. Fear that such a step could further lower Altria’s sales spooked investors. However, given Altria’s dominant position in the non-flavored cigarette market (Marlboro has an over 50% share in the cigarette market), as well as the relative price inelasticity of tobacco products, the company has been able to increase its revenue per unit, and consequently its sales, without influencing the demand significantly.

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