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Smokin' hot. That would be the shares of Altria Group, the leading cigarette maker in the U.S. The stock rose 20% in 2011's flat market, and it's up 50% over the past two years, nearly four times the market's gain. Less than two weeks ago, the company, which is the parent of Philip Morris USA and its iconic Marlboro brand, hit a 52-week high of $30.40.
It isn't hard to see the appeal: The stock (ticker: MO) has lived up to its reputation as a defensive investment, with stable cash flow and a dividend yield of 5.5%. That's a real head-turner at a time when money-market rates are less than 0.5% and the 10-year Treasury is yielding less than 2%.
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Yet in reaching for yield, investors have largely ignored the risks accompanying Altria and its rivals in the tobacco business. U.S. cigarette sales are in a severe long-term decline. Shipments are down by a third over the past 10 years. In 2011 alone, cigarette volumes fell an estimated 3.8%, reflecting the weak economy and an ever-growing public backlash against smoking.
"Operating conditions in the U.S. cigarette industry are more difficult than generally recognized," says David Adelman, long-time tobacco analyst at Morgan Stanley. He isn't recommending any of the stocks.
To some extent, the industry has been able to offset the volume decline with increases in wholesale prices. The companies have raised those prices by nearly 35% over the past 10 years, even as consumers shouldered huge jumps in federal and state cigarette taxes. Total retail prices, including taxes, surged by two thirds over the 10 years, to a national average of $5.95. That was more than double the rise in overall consumer prices.
But price increases can't solve everything. Smokers' demographics have changed, making the industry more reliant on those that can least afford the habit in a time of economic stress. Health concerns dog the smoking industry. The number of young people taking up smoking has plummeted to the lowest level in a decade. Smoking is prohibited in public places in 30 states, and many major cities have enacted even more severe bans. You can't even smoke in New York's Central Park anymore.
Then there's regulatory uncertainty, firmly on the rise since the Food and Drug Administration took on tobacco as part of its bailiwick in 2009. A long-awaited public comment from the agency on the public-health impact of menthol cigarettes was expected in mid-November, and could come any day.
Even the cigarette companies' all-crucial pricing power could soon take a hit. Concerns about a potential price war are swirling about the sector as No. 1-selling Marlboro loses market share to less-expensive smokes and new competitors like Newport Red, a nonmenthol cigarette introduced a year ago by Lorillard (LO).
The specter of another Marlboro Friday— in April 1993, Philip Morris slashed the price of a pack of Marlboros by 20% to reclaim market share—still haunts the industry. Not only did tobacco stocks suffer mightily from price-cutting, but the move also raised doubts about the strength of a host of established brands. Another price-slashing battle was precipitated by Philip Morris in 2003, again in a bid to reclaim share. There are no signs of another price war -- quite the opposite -- but the introduction of budget brands is cannibalizing sales of premium brands.
INVESTORS SEEM UNFAZED by any of this. Tobacco stocks are trading at multiples of enterprise value to Ebitda (earnings before interest, taxes, depreciation and amortization) between nine and 10, based on 2012 figures, more than a full point higher than their five-year averages, Adelman notes. The stocks also look rich based on their double-digit price/earnings ratios; earnings are growing only in the single digits, and most of that growth, of late, has come from cost-cutting measures. Stock buybacks, often cited as a driver of earnings per share, look to have merely offset stock awards for compensation. Altria's shares outstanding have barely budged in eight years.
Altria, by far the biggest U.S. cigarette maker in both market value ($61 billion) and revenue (roughly $16 billion a year), is unquestionably vulnerable to industry woes. Some 80% of its profit comes from its Philip Morris USA cigarette unit, which, in addition to Marlboro, includes Virginia Slims, L&M, Merit and Parliament. And the company groans under a huge debt load.
ALTRIA USED TO BE LESS DEPENDENT on the U.S. market. But in 2008 it spun off Philip Morris International, which sells the Philip Morris lineup and other brands in some 180 countries around the world. Along with cash flow from packaged-foods giant Kraft Foods, which Altria spun off in 2007, the international unit helped offset declines in domestic smokes, and gave it the wherewithal to wage price wars comfortably. Now that cushion is gone.
All the same, Altria shares are pricey by almost any measure. The recent 52-week high, adjusting for the spinoffs, was also an all-time high. At a recent $30, they are trading at nearly 14 times the consensus-earnings estimate for next year, $2.19 a share. Adelman of Morgan Stanley, assigning a multiple closer to 11, sees them falling to $25, or more than 15% -- the equivalent of nearly three years' worth of dividends.
The stocks of the top cigarette makers are near 52-week highs, as investors rush for the high dividend yields. And Altria, the largest of the domestic companies, is offering the highest yield -- 5.5%.
THE COMPANY IS CLEARLY SHOWING some stresses. Most worrisome, Marlboro, which accounts for a full 87% of Altria's cigarette shipments, has been ceding ground to rivals' brands and cheaper smoking alternatives, like cigarillos and even pipe tobacco. In the third quarter of 2011, Marlboro's volume dropped 10%, and the brand lost almost a full point of market share from year-earlier levels, coming in at 41.7% of the U.S. retail market. Some of that share loss is attributed to the July price hike, as the company sought to protect margins rather than market share.
At the same time, Altria is burdened by heavy debt taken on in 2009, during the $11.7 billion acquisition of smokeless-tobacco producer UST, which makes the Copenhagen and Skoal brands of snuff. Smokeless tobacco is a fast-growing and less-regulated part of the market, but pricing is fierce, and Altria paid dearly to get in. It financed the deal by issuing $10 billion of debt at about 9.5%, the going rate in the wake of the financial crisis. That has left the company with a total of about $14 billion of debt, or 70% of its capital, above the industry average and up from 40%.
While Altria generates ample cash flow -- $3.5 billion a year -- to fund its debt, it is using more and more of its free cash to support its dividend, for which it pays out a generous 80% of earnings, and to buy back stock. The balancing act could get tougher as the industry's volume decline persists.
"Pricing needs to be healthy, Marlboro needs to stay healthy," says Bonnie Herzog, tobacco analyst at Wells Fargo Securities. Herzog would like to see more evidence that the brand is stabilizing and winning back share profitably before recommending the shares. "Altria has a lot riding on its Marlboro brand franchise," she says. "Has Marlboro peaked? That's a question mark for me."
Altria officials were unavailable to comment. But the company directed Barron's to remarks by Chief Financial Officer Howard Willard at a Barclays Capital investor conference in September. Philip Morris USA, Willard said, is "willing to accept short-term negative year-over-year retail-share comparisons for Marlboro, because it is not focused on growing the brand off of higher levels of promoted share. PM USA's objective in the cigarette category is to balance income growth with Marlboro's share growth."
Marlboro, long the best-selling U.S. brand -- in every state, in every age group -- has always commanded an above-average retail price. Nationwide, a pack of Marlboros sold for an average $5.74 in the third quarter, compared with $4.22 for the cheapest brand.
But even average-priced smokes are a tougher sell these days, because the weak economy has been hitting smokers hard. As a group, they have lower household incomes than nonsmokers and are nearly twice as likely to be unemployed, Morgan Stanley points out. For a struggling family, kicking a pack-a-day habit could free up enough money -- more than $2,000 a year -- to cover monthly payments on a car.
Little wonder, then, that many smokers have been trading down to cheaper brands or lower-priced little cigars or bulk tobacco for rolling their own cigarettes. Shipments of roll-your-own and pipe tobacco jumped 36% in the first half of 2011.
Whether because of price considerations or fashion, Marlboro has long been losing share among younger smokers, ages 21 through 29. That rugged cowboy who has long been the brand's symbol doesn't seem to resonate with the Facebook generation.
MARLBORO'S SHARE OF the total cigarette market has fallen for three straight quarters, reaching the lowest levels since the fourth quarter of 2009. That was when the Obama administration pushed through the biggest-ever increase in the federal excise tax on cigarettes -- 62 cents, to $1.01 a pack -- to help fund the State Children's Health Insurance Program.
Altria posted a nearly 5% decline in revenue in the third quarter of 2011, significantly worse than the performance of rival tobacco makers. Reynolds American (RAI), maker of Camel and Pall Mall as well as Natural American Spirit brands and Grizzly chewing tobacco, posted a drop of 1.7%. Lorillard, maker of Newport, the top-selling menthol brand and the No. 2 -selling cigarette in the U.S., increased sales by 4%. Newport now accounts for about 10% of the U.S. market and continues to gain share.
To fight back, Altria in 2010 introduced lower-cost versions of Marlboro in "special blends." That seemed to help, but didn't prevent a renewed slide this year. Industry observers fret that the special blends, in flavors with names like Gold and Black, diminish the overall strength of the brand by confusing customers and cannibalizing the main brand.
Philip Morris USA also has instituted what it calls the "Marlboro Leadership Program," which puts a price cap on what participating retailers can charge for a pack of Marlboros in return for promotional incentives, essentially cutting into retailers' margins. So far, the program has met with mixed response from retailers. Lorillard, for its part, has started going head-to-head with Marlboro by extending the Newport brand into the nonmenthol arena with its new Newport Red brand, a much more focused effort seen as leveraging the strength of Newport without diminishing the original brand.
Marlboro's travails have led to the previously unthinkable notion that the brand could be headed the way of Reynolds American's Winston, once the best-selling cigarette in the U.S. and now ranked a distant No. 6. Restrictions on advertising and marketing tobacco products in the U.S. make it that much tougher to boost a brand -- and increases the importance of price.
Marlboro, of course, is by no means in free-fall, and Altria does have some sources of earning beyond cigarettes. It holds a nearly 30% stake in brewer SABMiller (SBMRY), worth about $15 billion, plus cigar maker John Middleton Co. and finance company Philip Morris Capital, which specializes in real estate and aircraft leases. For the moment, Altria also has some exposure to the wine industry, as a result of acquiring Chateau St. Michelle Wine Estates as part of the UST deal for snuff brands.
The fact is, though, that the huge bulk of Altria's incomestems from the sale of smokes, and given the state of the industry, that should give investors real pause.
Instead, the holders of MO continue to focus on the high dividend yield.
THERE IS SOME JUSTIFICATION for the dividend fixation. Shareholders are benefiting more than ever from the Richmond, Va.-based company's dividend policy. In August, Altria raised its quarterly nearly 8% to 41 cents a share, for an annualized rate of $1.64 a share. Altria likes to boast that it has raised its dividend 45 times in the past 42 years.
There's no question of its ability to support its dividend, but should the Marlboro brand remain under pressure and price cuts become necessary, the company could have a harder time continuing to boost the payout while at the same time servicing its debt. Under the terms of its debt covenants, it must maintain a leverage ratio of no more than two times its debt-to-Ebitda or risk a credit downgrade. The ratio is now 1.9.
Not only is Altria using its $3.5 billion in free cash flow to support the dividend, it is also funding massive buybacks of its stock. Immediately on completing a $1 billion repurchase program in the third quarter, the company authorized a $1 billion buyback that it expects to complete by the end of 2012.
Cost-cutting absolutely has aided the shares, with $1.5 billion in expense reductions occurring between 2007 and the end of this year. Another $400 million of annual expenses is on the chopping block through the end of the 2013. But cost-cutting can go only so far in supporting profit growth, and it's unclear what can take its place. For now, investors would do well to steer clear of the stock.
Put that in your pipe and smoke it.
E-mail: editors@barrons.com
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