- Altria's business model has a good chance of delivering profit and cash flow growth over the coming years.
- Shares offer a very high dividend yield.
- There is upside potential in Altria's shares, possibly well in the double digits.
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Altria (MO) will continue to generate solid results over the coming quarters, as it did during Q1. Due to the recession-resilient business model, Altria would most likely even perform in a solid way in case there is a second wave of the coronavirus pandemic.
Altria's shares continue to trade at a very inexpensive valuation and at a discount to historic norms, while also offering an attractive dividend yielding around 8% at current prices. The huge spread between Altria's current dividend yield and the yield investors can get from treasuries means that it may be one of the best times ever to buy this Dividend Aristocrat.
Reason 1: Altria's Business Model Has Stood The Test Of Time
Altria is primarily a tobacco company, although the company has ventured into other businesses over the decades. This includes its exposure to the brewing industry via its stake in Anheuser-Busch InBev (BUD), and recent purchases of stakes in Juul and Cronos (CRON).
The tobacco business has been a great industry to be active in in the past, even though many people assume that declining smoking rates must mean that the industry is doomed. Smoking rates have fallen for several decades in a row, however, and profits continued to climb nevertheless.
During the mid-60s, more than 4 in 10 Americans smoked, but over the coming 50 years, this rate has dropped to less than 20%. What did Altria's earnings, dividends, and share price do over that time frame?
Since 1975 (the YCharts chart does not go back to 1965), Altria has delivered a total return of 2.54 million percent. Yes, million. An investment of $1 back then would have turned into $25,400 today. This equates to annual total returns of ~25% over a time frame of 45 years as long as investors reinvested all dividends and held onto shares that were spun off over the years, such as Philip Morris (PM), and Kraft Foods, which later became part of Kraft-Heinz (KHC). The smoking rate in the US has thus declined for decades, and yet Altria has been one of the best investments that one could have made over the last fifty years. How is that possible?
Altria has managed this feat thanks to a business model that is not reliant on growing sales volumes for its main product, cigarettes. Instead, the nature of the product allows Altria to increase the price per cigarette regularly, and at a meaningful pace. As price increases happen at a faster pace than the declines in the US smoking rate, revenues have gone up, not down, despite the fact that demand for Altria's main product has been waning.
At least in theory, the same principle should allow Altria to grow its revenues in the future, too. Another benefit of this approach is that Altria does not have to produce a growing amount of cigarettes. In fact, they have to produce fewer and fewer cigarettes, which allows them to close down plants and to save production costs while they still grow their revenues. This is how the company has managed to grow its already very strong operating margin of around 45% five years ago to an even better 52% during the last year.
At Cash Flow Kingdom, we put a lot of emphasis on a company's ability to generate cash. Thankfully, the above properties make Altria's main business, tobacco, a great cash cow:
Altria has managed to generate operating cash flows of $4.65 over the last four quarters, for a cash flow yield of 12% at the current price of $39. As can be seen in the above graph, cash flows have also risen considerably over the last decade. Due to the fact that Altria does not have to expand its production capacity, as sales volumes are declining anyways, the need for capital expenditures is minimal, and free cash flow per share totaled more than $4.50 over the last four quarters.
This free cash can be used for a range of purposes, including paying dividends, buying back stock, and expanding into new industries. Altria's past expansion into new businesses such as cannabis, alcohol/beer, and reduced-risk products show that management is eager to utilize the vast cash flows in a way that is beneficial for the company's owners.
To make things even better, Altria's business model is also highly resilient versus recessions and other crises. During the first quarter of the current year, Altria managed to report revenue growth of 15%, easily beating all analyst estimates. Demand for cigarettes and other tobacco products does not decline during recessions, in fact, demand actually increases: A range of studies point out that smokers are more inclined to keep smoking during recessions, and that the number of cigarettes they smoke increases during economic downturns. The business is thus quite resilient versus adverse economic conditions, and it is not a large surprise to see Altria do well during the current crisis. The recession-resilience is also a key factor for Altria's great dividend growth track record - no matter the condition of the economy, the company has managed to grow its dividend like clockwork, for more than 5 decades in a row.
Altria's balance sheet holds about $24 billion of net long-term debt, but relative to annual EBITDA of more than $11 billion this does not seem too much. With a net debt to EBITDA ratio of slightly above 2, Altria is not overleveraged at all.
Reason 2: Altria's Huge Dividend Yield Could Allow For A Lot Of Income Down The Road
Altria has been a favorite among dividend growth investors for many years, thanks to its long dividend growth track record, the resilience of its business model, and the presumed safety of its dividend. In the past, many investors loved to load up on Altria's shares when they were trading at a yield of 3%, 4%, or 5%:
Even following the Great Recession, Altria's dividend yield was not as high as it is now. Due to a couple of steep dividend increases in the recent past, such as the 14% hike in 2018, its dividend yield is at an above-average level. Another factor for that is a rather low share price, as tobacco and other consumer good companies seem to be out of the market's favor right now. Based on quarterly dividend payments of $0.84, Altria is yielding 8.4% right here, or about 4.5 times as much as the broad market. Let's take a look at what dividend proceeds could look like over the coming years:
The above table showcases what an investment of $10,000 could look like in the future. Such an investment would equate to 251 shares bought at today's price, which would allow for dividend proceeds of ~$840 this year. I calculated with a dividend growth rate of 3% over the next ten years, no dividend growth thereafter, and all dividends being reinvested at an average yield of 8.4%.
The dividend growth assumption seems rather conservative in this scenario, as 3% dividend growth is well below the long-term EPS growth estimate by the analyst community (currently 6% a year). On top of that, the scenario laid out above assumes that Altria will not even be able to keep dividends growing in line with inflation or GDP growth from 2030 onwards, which again seems quite conservative relative to the strong historic dividend growth performance. Nevertheless, the huge impact of compounding on the share count would result in an annual dividend income of more than $11,500 in 2050 in this scenario, for a yield on cost of more than 110% for someone who buys right here.
Altria's dividend seems to be quite safe, due to the recession-resilience of the business and due to the fact that the free cash flow payout ratio is only 74%. The payout ratio relative to the net profits that Altria generates is 78% based on current forecasts for this year's EPS.
Reason 3: If Market Sentiment Changes, Altria's Shares Could Have A Lot Of Upside
Not too long ago, Altria was trading hands for close to $80, or roughly twice the current share price. In 2017, when this all-time high was hit, Altria was substantially less profitable compared to now.
Altria's underperformance since then cannot be explained by a weak operating performance, rather, the explanation is that the earnings multiple has contracted a lot.
Right now, shares are trading for 9.3 TIMES this year's expected profits, which is substantially lower than the long-term median earnings multiples Altria has historically traded at. With interest rates at record lows and not a lot of options for retirees to put their investments to work in order to receive income, it would not be a large surprise to see Altria's share price expand meaningfully going forward. Its shares may never trade at 16+ earnings multiples again, but even a multiple expansion towards 12 times its annual net profits would result in a share price upside potential of ~30%.
Drivers for upside potential include a search for yield by retirees and other income-oriented investors, but also more company-specific factors could play a role. If the recently-approved iQOS system, developed by Philip Morris and marketed by Altria, is successful in the US, this could lead to an improved outlook for the two companies. Such an improved outlook could result in more investors looking for exposure to either of these two tobacco giants.
A similar situation could occur if there is good news for JUUL or Cronos. Right now, it looks like the market prices Altria as if these two investments were total failures. If, on the other hand, JUUL can get back on the growth track, or if Cronos gets the ability to expand in the US, the stakes Altria owns in these companies would increase in value. This, in turn, would likely attract new investors and could lead to share price gains for the company.
Even if something like that does not materialize, Altria could still attract investors that may increasingly ask themselves why they should invest in a company like Coca-Cola (KO) instead of Altria:
Altria is way cheaper, trading at substantially less than half of Coca-Cola's valuation. On top of that, Altria has a better long-term growth outlook and a much higher dividend yield. The products of both companies are unhealthy, so Coca-Cola isn't really winning on that subject. Altria currently is out of favor, just as it was very much in favor a couple of years ago, when shares traded for more than 20 times earnings. A reversal of this trend could easily occur, which would allow for meaningful upside potential, even without any big positive company-specific news.
Altria is, like all other stocks, not a risk-less investment. Increased crackdowns on smoking could hurt the company, but due to the fact that the government loves the cigarette tax revenues, a big push to lower smoking rates does not seem too likely. In the meantime, Altria offers a fat dividend yield, a lot of upside potential, and protection versus recessions and economically harsh times, as the company has historically done well during times like these. There is some risk that COVID-19 will lead to increased measures against smoking, but so far, the only country where the government has cracked down on smoking is South Africa, where Altria is not operating.
It should also be noted that Altria's management has shown that it is able to deliver highly attractive returns in the past, and its very shareholder-friendly approach towards dividends and share repurchases is another plus. Management is also aligned with shareholders, as insiders own $370 million worth of stock. Insiders also have expanded their stake in the company by 10% over the last year, which shows that those that know the company very well see considerable value here. We thus believe that Altria is definitely worthy of a closer look at its current overly low valuation, with its dividend yield close to record highs.