Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Altria

By Brian Nelson, CFA

About 15 years ago, I picked up a text from Professor Jeremy Siegel out of the University of Pennsylvania’s Wharton School of Business, The Future for Investors (1). I must have been at one of his talks. I ended up getting a signed copy from him; it was a neat experience. In any case, perhaps one of the more striking takeaways from his 2005 book was the following excerpt:

Some readers may be surprised that (Altria) is a top performer for investors in the face of the onslaught of government restrictions and legal actions that have cost the firm tens of billions of dollars and threaten the cigarette manufacturer with bankruptcy.

But in the capital markets, bad news for the firm often is transformed into good news for investors. Many shun the stock in the company and fear that its legal liability for producing a dangerous product--cigarettes--will eventually crush the firm. This aversion to the firm pushes down the price of (Altria's) shares and raises the return to investors who stick with the stock.

As long as the firm survives and continues to be very profitable, paying out a good fraction of its earnings in the form of dividends, investors will continue to do extraordinarily well.

-- "The Future For Investors," Jeremy J. Siegel explaining why Altria (MO) "has been the golden company that beat the market by 9 percent per year over the last half century and left every other firm far behind in the race to be number one (through 2003)."

For many, many years, Professor Siegel has been right, but how things have changed since the publishing of his text. On a price-only basis year-to-date in 2020, Altria’s share price has fallen more than 20%, while the S&P 500 has increased ~10%. The comparison gets even worse over a 5-year stretch. Shares of Altria have fallen more than 30%, while the S&P 500 has increased by nearly 70%. That’s a 100 percentage-point difference; for Altria to close that gap on a price-only basis, its share price would have to advance nearly 170%.

That’s why Warren Buffett’s first rule of investing is to never lose money because it takes substantially higher returns to make up the losses from the much smaller, depleted base. In some respects, the compelling math of gains and losses (a 50% loss takes a 100% gain to breakeven) plays into how we view price/momentum considerations at Valuentum. We don’t want to stick with losers, or stocks with substantially deteriorating technical/momentum indicators.

We’re much more comfortable adding to positions or initiating positions in the newsletter portfolios with the market at our backs—i.e. when cash-rich underpriced and attractive stocks have strong technical and momentum indicators. When it comes to our best ideas, for example, we want the market to be in agreement with us (i.e. strong technical and momentum indicators) because, after all, the market simply has to converge to our thoughts for any idea to work out. No matter how much you like a stock, if the market never agrees, you’re going to have a loser on your hands.

The Valuentum process doesn’t quite fit the definition of momentum (following the crowd/trend) because it is grounded in robust discounted cash-flow analysis and cash-based sources of intrinsic value, and it also doesn’t suffer from overconfidence bias that some value investors fall into when buying stocks that collapse, believing that they are somehow cheaper just because their price has fallen. The value of the stock could have fallen even more, and the stock could be more expensive, despite the share-price slide. In some ways, the Valuentum approach, is counter-contrarianism (this might be a new word we just created).

Quite simply, we’re not pure value investors, per se; we’re Valuentum investors. Unlike some of the value investor greats like Oaktree’s Howard Marks, we don’t like buying “falling knives,” as they can get even the smartest investors into trouble. Here’s how Marks thinks about “falling knives” in his book The Most Important Thing Illuminated (2):

The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something comfortable again, its price will no longer be so low that it’s a great bargain…It’s our job as contrarians to catch falling knives, hopefully with care and skill (page 121).

That’s just not how we view things. There are far too many examples from Kinder Morgan (KMI) and General Electric (GE) and beyond, where too many investors thought shares were cheaper just because the market punished them severely (and they just kept falling). The value of the enterprise on the basis of its cash-based sources of intrinsic value is going to act as the anchor to the share price over time, and that means that falling prices of even good companies can sometimes become value traps. We think waiting for technical/momentum indicators to turn higher is a much more prudent approach.

Now back to Altria. The company took a big gamble on JUUL Labs a couple years ago, taking a 35% stake in the e-cigarette maker at an estimated valuation of about $38 billion at the time. In late October 2020, Juul reduced its valuation to about $10 billion, and more recently has had to cut a large chunk of its workforce. Altria’s intrinsic value has taken a big hit as a result, too. The uncertainty of the legal issues surrounding the sale of youth-friendly flavored cigarettes, the outbreak of vaping-related lung illnesses, among other litigious considerations have been a thorn in the side of JUUL. Frankly, we didn’t like the purchase of JUUL from the beginning. Here’s what we wrote in December 2018, almost two years ago now, “Parting with Altria on News of Stake in JUUL:”

We’re parting ways in both the simulated Best Ideas Newsletter portfolio and simulated Dividend Growth Newsletter portfolio with one of the best-performing companies in history, Altria. We’re not unhappy with the performance of the company, but as soon as we said we were okay with some of its share-price weakness, it seemingly rushed out and deployed capital that would have been better used to support the dividend. We think Altria’s operating assets are starting to make for a convoluted company with ownership stakes in entities that may now only cloud the view of other analysts measuring value. GE fell into the same trap a few years ago. We’re out and not looking back.

Cigarette smoking continues to face social and legal pressures, and estimates from Altria put 2020 full-year domestic cigarette industry volumes to be in a “range of unchanged versus the prior year to down 1.5% based on better year-to-date industry performance.” Though the company is holding the line and showing some resilience, Altria will be facing an uphill battle in the decades to come, and cigarettes are already too pricey, to keep pushing through price increases. According to some stats, the average price of a pack of cigarettes is $13 in Chicago, and New York may even have higher price points. Just how many more price hikes can smokers take?

That said, Altria is holding up in the face of all kinds of obstacles. The company is targeting adjusted diluted EPS for 2020 in a range of $4.30-$4.38, implying a growth rate of 2%-4% from last year’s adjusted numbers. Altria has substantial free cash flow generation, too, with the measure coming in at $7.6 billion during the last fiscal year, covering cash dividends paid during the same period by about 1.25x. Its net debt load is not that great, however, standing at $25.1 billion at the end of the third quarter of 2020. That’s why the Altria gets poor dividend marks on our scale. Net debt is very punitive in the calculation.

As of this writing, Altria’s current annualized dividend rate is $3.44 per share, which implies a dividend yield of ~8.7%. On a dividend payout ratio, things don’t look too bad and are roughly in line with its target payout of ~80% of adjusted diluted EPS. The company’s free cash flow generation through the first nine months of 2020 isn’t bad either, coming in at $5.7 billion, up 11% on a year-over-year basis, covering cash dividends paid with free cash flow by ~1.2x. Altria’s 10% stake in AB-InBev (BUD)—worth about $13.2 billion--gives it some breathing room with respect to liquidity for the dividend, but things are looking at little dicey at Altria, particularly as the size of its dividend yield starts to reflect more and more risk of a cut.

Concluding Thoughts

Altria’s core business is under attack from almost every front, and the trend toward investing in ESG-friendly (Environment, Social and Corporate Governance) names has the company’s investor base shrinking by the day. Aside from cigarettes, Altria has exposure to cigars, smokeless tobacco (UST), wine (Ste. Michelle), oral nicotine pouches, AB-InBev, JUUL, cannabinoid company Cronos (CRON), among other interests, but it’s clear the company’s back is against the wall as it struggles to diversify.

A huge misstep with JUUL that cost it billions, very tight dividend coverage with earnings and free cash flow, a huge net debt position that will be tough to pay down given dividend obligations, and a lofty dividend yield that speaks more to risk than anything else should give investors pause. We don’t expect trouble at Altria anytime soon, but we think the red flag will go up if it ever starts to look to unload its stake in AB-InBev. If that happens, investors should run for the hills, in our view. Altria may never make a comeback, and we’ve been out of the name since it announced the deal with JUUL back in December 2018. Our fair value estimate stands at $42 per share.

View Altria’s stock page >>

(1) https://www.amazon.com/Future-Investors-Tried-True-Triumph/dp/140008198X

(2) https://www.amazon.com/Most-Important-Thing-Illuminated-Thoughtful/dp/0231162847/ref=tmm_hrd_swatch_0?_encoding=UTF8&qid=&sr=

Brian Nelson owns shares in SPY, SCHG, DIA, VOT, and QQQ. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.