Altria: Successfully Navigating Secular Shifts

Summary:

• Altria’s stock delivered a total 7.5% total return since November 2023 when my initial bullish thesis was published.
• The company’s profitability and cash flow are rock-solid which helps in improving Altria’s balance sheet.
• Altria’s shift from traditional cigarettes to new products is developing successfully as the footprint of its e-vapor and nicotine pouch products is expanding rapidly.
• My valuation analysis suggests that the stock is massively undervalued.

Investment thesis

My previous bullish thesis about Altria (NYSE:MO) aged decently since the stock delivered a total 7.5% return since November 2023. Today I want to refresh my thesis as lots of development occurred and I must share my insights about them. The company’s performance is moving in line with the management’s strategic initiatives and the valuation is still very attractive. All in all, I reiterate my “Strong Buy” rating for MO.

Recent developments

The latest quarterly earnings were released on April 25, when there was a slight miss in revenue and positive surprise in terms of the EPS. Revenue decreased by 1% YoY, and there was a slight shrink in the adjusted EPS, from $1.18 to $1.15.

The company generated around $2.8 billion in levered free cash flow [FCF] in Q1 and improved its net debt position by $1.1 billion. Positive trends in balance sheet and stability in cash flows are crucial bullish signs for MO because its forward 8.95% dividend yield is the stock’s major competitive advantage. Therefore, I think that from the dividend safety perspective, the picture became better for MO investors as a result of Q1 operations.

Altria’s diversification away from traditional smokeable products is crucial in the company’s long-term success because traditional tobacco consumption is declining, which is a secular trend. The company bets big on following emerging industries: e-vapors [vapes], nicotine pouches, and heated tobacco. All these industries are growing and below I have summarized the expected growth rates for these industries.

As we see above, all three industries are experiencing robust momentum, which is a big advantage for Altria as the company aggressively expands into these new markets. For example, the footprint of Altria’s e-vapor product, NJOY, is expanding rapidly as cumulative stores with distribution almost doubled within the last two quarters. The fact that, according to the latest 10-Q report, NJOY is “currently the only pod-based e-vapor product with market authorizations from the U.S. Food and Drug Administration [FDA]” is a big strategic advantage for Altria.

Altria’s oral tobacco [nicotine pouches] flagman, “on!” brand also demonstrates strong growth momentum. The product’s shipment volume skyrocketed in Q1 with a 32% YoY increase to more than 33 million cans shipped. This growth is notably beyond the market’s growth in recent quarters, meaning that on! is conquering market share at a rapid pace. According to tobaccoreporter.com, on! is the second largest nicotine pouches brand by sales volume which is a strong position. Altria’s vast experience and strong distribution network give me optimism that the company’s nicotine pouches business will be able to grow at least in line with the overall oral tobacco market, which is projected to compound with a 35.7% CAGR by 2030.

In another emerging industry, heated tobacco, Altria is at the early stages of development. However, the creation of a “Horizon” Joint Venture with Japan Tobacco International (OTCPK:JAPAY) , which will be responsible for the U.S. marketing and commercialization of heated tobacco stick products owned by either party. Since it is a relatively new venture, there is still substantial uncertainty about its future prospects. However, Barclays forecasts U.S. cigarette and heated tobacco annual sales at around 122.79 billion sticks in 2030. Therefore, the heated tobacco market is likely to become comparable to the traditional cigarettes market. Since both Altria and JAPAY have vibrant histories and traditions of building successful distribution networks, I have a high conviction that their JV will be able to absorb positive industry trends in heated tobacco.

Given all these Altria’s promising prospects within industries, which are projected to compound rapidly over the next decade, I am not surprised that the management has a positive FY 2024 outlook with an expansion between 2% to 4.5% in the adjusted EPS. That said, I believe that Altria’s stellar 8.95% forward dividend yield is safe.

Valuation update

The share price declined by around 7% over the last 12 months, significantly lagging the broader U.S. market. On the other hand, 2024 has been robust so far with a 9% YTD rally. MO has a high “A” valuation grade from Seeking Alpha Quant, which means that the stock is very attractively valued from the ratios perspective. Indeed, most of the valuation ratios are notably lower than the sector median and MO’s historical averages.

Since MO is a dividend aristocrat, I am confident that the dividend discount model [DDM] approach is the most suitable to continue with. I calculate the cost of equity using CAPM. The current 10-year Treasuries yield is 4.57%, which is the risk-free rate. According to Seeking Alpha, MO’s 24-months beta is 0.49. I use 2023’s U.S. equity risk premium which was at 5.7%.

As we see above, MO’s cost of equity is 7.36%. This level will be used as a required rate of return for my DDM valuation. I take a 2% expected long-term dividend growth rate to be in line with historical inflation levels. Since I am calculating target price for the next 12 months, I am using FY 2025 consensus dividend estimate, which is $4.15.

According to my DDM simulation, MO’s fair share price is $77.4. This indicates that there is a 76% upside potential from the stock’s last close. That said, the valuation is very attractive.

Risks update

The target price, which I have calculated based solely on quantitative factors, disregards qualitative considerations. The discount is also influenced by the industry in which MO operates. As there is a secular trend of reduced consumption of traditional cigarettes compared to previous decades, the company’s traditional tobacco business is expected to decline over time. Consequently, the assumption that the company’s legacy business will gradually lose its scale will continue to exert downward pressure on the stock price. While recent developments demonstrate the company’s success in aligning with changing customer preferences by expanding the footprint of new products, these ventures are relatively new, leading to significant uncertainty. Therefore, it might take several quarters of robust growth in new products before the stock starts moving closer to its fair value.

Investors should also be aware about certain details related to the U.S. e-vapor market. It is still young and there are loads of illegal products. Therefore, Altria’s success in this domain will significantly depend on legal actions from the U.S. authorities to ban illegal competitors from the U.S. market. Since there are thousands of illegal vapes flooding the market there is a substantial risk that some of them might stay in the market for longer and put pressure on Altria’s market share.

Bottom line

To conclude, I like the trends MO demonstrates in its transition from legacy tobacco business to new ventures like e-vapors, heated tobacco and nicotine pouches. Altria’s profitability is still stellar and cash flow is stable. The stock is certainly attractively valued, and an 8.95% forward dividend yield looks like a gift for dividend investors. I think that MO deserves to remain a “Strong Buy”.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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