What was once one of our favorite hidden gem holdings has turned into a ‘letting this winner run’ scenario. Newsletter portfolios holding Altria (MO) reported quality third-quarter results October 29, as it grew revenue at a solid 3.2% rate. The firm’s fundamentals remain rock-solid, as it leveraged the revenue expansion into adjusted diluted earnings per share growth of 8.7% to $0.75. Management reaffirmed its 2015 full-year guidance for adjusted diluted earnings per share of $2.76-$2.81, which represents growth of 7.5%-9.5% over 2014 levels.
The company was also pleased to report its continued cooperation and support of the AB-Inbev (BUD) and SABMiller (SBMRY) merger as SABMiller’s largest shareholder. The deal offers a compelling opportunity for Altria to strengthen its position in the global brewing business, in management’s opinion. Read more about that here.
Regardless of the developments in the brewing business, Altria continues to strengthen its position in the tobacco industry. The firm’s premier brands, Marlboro and Copenhagen, gained market share in the quarter, and are now up to ~44% and just under 32%, respectively; the combination of the Copenhagen and Skoal brands dominate the smokeless tobacco market with their sales accounting for more than 51% of the entire retail market.
Despite smoking in the US on the decline for years (total industry volumes declined ~1% in the third quarter, according to Altria), shipment volume remained flat-to-up modestly in Altria’s smokeable segment during the same period, depending how trade inventory movements and other factors are accounted for. Revenue in the segment grew by 3.1% from the year-ago period, driven primarily by higher pricing, which accounted for a large part of the 2.7 percentage-point increase in adjusted segment operating income margin. Smokeable segment adjusted operating income jumped more than 11% in the quarter.
Cigarette shipment volume was buoyed by the firm’s discount brands, where shipment volume grew more than 10% on a year-over-year basis. Though Marlboro shipment volume fell by less than 1% in the third quarter, the brand has grown its number of sticks sold by ~1% in the year-to-date period. This volume figure becomes more impressive when considering industry-wide cigarette volumes fell in the quarter. Black & Mild brand cigar shipment volume was relatively flat in the third quarter, and total cigar shipment volume grew by more than 1% from the year-ago period.
Altria’s smokeless segment delivered a similarly strong performance in the third quarter. Smokeless revenue advanced 3.4% due to higher pricing and nearly a 4% shipment volume increase for the Copenhagen brand. Promotional spending continued to cut into the segment’s operating margin, which fell by more than 1 percentage point in the period, but it was not enough to fully mitigate the segment profit improvement in the quarter, as adjusted segment operating income increased 2.5%.
Not to be forgotten is the solid performance of Altria’s wine segment, where revenue grew nearly 9% in the third quarter on a year-over-year basis. Adjusted segment operating income advanced nearly 13% based on increased shipments and improved product mix. Management was also encouraged by the expanded distribution of the company’s Nu Mark e-vapor products as it continues to work with Philip Morris (PM) in a joint project in the research, development, and technology sharing for e-vapor products.
Though Philip Morris also reported solid results, released October 15, on an operational basis in the third quarter of 2015, the firm’s growth was offset by massive currency headwinds. Reported revenue fell nearly 12% excluding excise taxes in the period, compared to growth of almost 6% excluding excise taxes and changing foreign exchange rates on a year-over-year basis. The constant-currency growth was driven by favorable pricing, as cigarette shipment volume fell by 1.5% from the year-ago period, excluding acquisitions.
Philip Morris’ strongest-performing segments in constant currency in the third quarter of 2015 were the following two divisions: ‘Latin America and Canada’ and ‘Eastern Europe, Middle East, and Africa (EEMA)’. The EEMA region was the company’s only region to grow shipment volume in the quarter, with a 2.6% rate of expansion compared to the year-ago period. The ‘Latin America and Canada’ region was the only geographic segment to report positive operating income growth on a reported basis–operating income in the region grew by more than 10%. The region also had the highest growth rate on a constant currency basis, as it grew operating income nearly 30% excluding the impact of foreign exchange rates in the period.
Philip Morris’ company-wide adjusted operating income growth was strong in constant-currency in the third quarter, advancing by more than 9% from the year-ago period. The strong performance helped adjusted diluted earnings per share grow nearly 16%, excluding the negative impact of foreign exchange rates. Management expects adjusted diluted earnings per share to grow between 11%-12% in constant currency for the full-year period. The company recently increased the regular quarterly dividend by 2% to an annualized rate of $4.08 per common share.
While some tobacco companies, like Philip Morris, struggle with organic volume growth, Reynolds American (RAI) has augmented its growth potential via the acquisition of Lorillard. On October 27, the firm reported significant revenue growth of over 41% in the third quarter thanks to significant pricing and volume boosts primarily from the addition of Newport brand cigarettes; the combination of the former Lorillard entity helped raise cigarette volume nearly 30% in the quarter, and in our view, has given Reynolds American improved pricing power. Increased pricing and volume of the firm’s snuff products added to the resilient revenue performance in the quarter.
Despite the elevated, mostly acquisition-driven top-line growth, perhaps the most impressive advancement in the quarter was the 6.4 percentage-point expansion of the company’s adjusted operating margin in the period, to 44.4%. Adjusted operating income grew nearly 65% as a result, revealing a significant leveraging of the top-line expansion and integration benefits. Management tightened its guidance range for full-year adjusted diluted earnings per share to $1.94-$2.00 from $1.90-$2.00, representing 13%-17% growth from 2014 adjusted diluted earnings per share. Reynolds American’s diluted weighted average share count increased by nearly 400 million shares from the year-ago period.
Reynolds American’s management has stated the deleveraging of its balance sheet will be a priority moving forward, an initiative we like, and one that will be supported by the sale of the international segment of the Natural American Spirit brand for $5 billion to Japan Tobacco. Reynolds thinks it has made a shrewd move, as the price of the agreement is reportedly 250 times the brand’s EBIT. The deal is expected to close by early 2016 and is subject to regulatory approval.
All things considered, we like the tobacco industry a lot, and Altria is currently the largest holding in both newsletter portfolios. The position in Altria has performed as well as we could have hoped, and while we are going to let this winner run for the time being, we won’t hesitate to take some off the table in the event other, better ideas surface. The firm’s formerly hidden asset in SABMiller is no longer a secret, and shares have advanced far past our fair value estimate of $55. Some profit taking can be expected in the near future.