PMI / Altria: Poised to Smoke the Market
For my first blog post ever, I would like to share an investment case that I've been working on for Philip Morris International and Altria with everyone. Enjoy and let me know what you think.
PMI / Altria: Poised to Smoke the Market
Company: Altria Group Inc. (MO)
Price: $70.50 (10/19/2007)
Shares Outstanding: 2.11 Billion
Shareholders are Poised to Benefit from the PMI Spin-Off In August 2007, Altria (MO) announced that it was considering spinning off its international operations. It made its decision to proceed with the spin-off official on September 27th when it filed a preliminary registration statement with the SEC. The company expects to announce additional details of the transaction, including its exact timing at a meeting on January 30, 2008. By purchasing MO now, you guarantee that you will receive shares in PMI when it hits the market.
Why would you want to buy shares in Altria before the spin-off? Because spin-offs consistently outperform the market. In his book “You Can be a Stock Market Genius” Joel Greenblat referenced a study that was conducted several years ago by Penn State University (go Lions!) which looked at spin-offs that occurred over a twenty-five year period ending in 1988. The study found that stocks of spun-off companies outperformed the S&P 500 by approximately 10% per year during their first three years as independently traded entities. Even the stock of the original parent companies did well, outperforming the S&P 500 by 6% annually during the same three year period.
Theoretically, if one picks stocks out of the sub-set of spin-offs that have other attractive characteristics they can do even better than outperform the S&P 500 by 10%. Spun-off companies that have insiders with a high level of ownership or stock options tend to perform even better than those that do not. If we take a look at Form 10 that PMI filed with the SEC when it announced its plan to break away from Altria, we find evidence that it will have this sort of insider ownership. In the section titled “Reasons for the Distribution” it states that the spin-off will provide “tighter alignment of compensation and rewards with the performance of each entity.” This just the sort of incentive for management that investors should look for, their interests are directly aligned with those of shareholders.
Another one of the “Reasons for the Distribution” listed in this section of the filing is “greater transparency leading to the elimination of the sum-of-the-parts discount under which Altria’s common stock has typically traded essentially as if it were solely a U.S. tobacco company.” Altria currently trades at a P/E of 14 (as of 10/19/2007). This is a discount to other companies in the sector, such as British American Tobacco (BTI) with its price to earnings ratio of 18. According to Yahoo!, the average P/E for cigarette manufacturers is over 17. By purchasing Altria now, we are getting shares in the leading domestic manufacturer of cigarettes and shares of an international powerhouse that has lots of room to grow at a discount to the rest of the industry. Many investors will be willing to pay a higher premium for PMI with its higher growth rate and with the threat of litigation in the U.S. removed.
About the Company
Altria is made up of four main parts:
- Philip Morris USA which manufactures and sells cigarettes and other tobacco products in the United States.
- Philip Morris International which manufactures and sells cigarettes and other tobacco products outside of the U.S.
- Philip Morris Capital Corporation which has a portfolio that consists of leveraged and direct finance lease investments in domestic and international assets such as power generation assets, manufacturing facilities, aircraft, and real estate.
- A 28.6% economic and voting interest in SABMiller, which manufacturers and distributes beer in the U.S. and abroad.
Although the Altria Group, Inc. was only officially formed in 1985, the companies that it owns have a history that dates back more than 150 years. The first piece was created in 1847 when Philip Morris, Esq., a tobacconist and importer of cigars, opened a shop on Bond Street in London. In 1854 he began manufacturing his own cigarettes.
After Morris’ passing, the company went public in London in 1881. In 1902, Philip Morris became incorporated in New York on Broad Street, in lower Manhattan. Its ownership was split 50-50 between its original British parent and new American partners, including Gustav Eckmeyer who had been the sole agent for Philip Morris in the U.S. since 1872.
In 1919 a new company, completely owned by American stockholders, acquired the U.S. Philip Morris company and incorporated it in Virginia under the name of Philip Morris & Co.
Philip Morris began expanding internationally in 1954 when it established its first affiliate outside of the United States in Australia. A year later, the company created a separate division for its international operations called Philip Morris Overseas. The name of the division was later changed to Philip Morris International in 1967.
Bull Case for Altria
Altria is a Cash Generating Machine
Despite its declining customer base and the constant threat of litigation, Altria's domestic cigarette business is a cash cow. It currently pays a 4.2% dividend (as of 10/19/2007). Not only is its current dividend attractive, but the company has an outstanding record of dividend growth, raising it 40 times in the past 38 years.
Altria will use the tremendous amount of cash that it generates to continue to increase its dividends and probably to buy back a large number of shares in the near future. The company stopped buying back its shares in 2003 after it lost a $10 billion class-action lawsuit in Illinois (the verdict was subsequently overturned). This lawsuit severely limited its access to the commercial paper market, so it decided to begin building up its cash reserves. And build reserves it did. At the end of its 2007 fiscal third quarter, Altria had $7.3 billion in cash on the books, an increase of $2.6 billion from the $4.7 billion that it reported having on December 31, 2006. Furthermore, the company reduced its long-term debt to $3 billion from $6.2 billion on December 31, 2006. This reduced debt level will lead to lower interest expenses and the cash that’s on the books can be used to buy back shares and increase its dividend.
Altria has decided to put some of the aforementioned stash of cash to work. On 11/1/2007, the company announced that it is purchasing the machine-made cigar manufacturer John Middleton Inc. for $2.9 billion. The total net cost of the transaction will actually amount to more like $2.2 billion after backing out a $700 million tax benefit. According to Altria, sales in this segment have grown at a 4% annual rate since 2003 and cigars are “highly profitable.” John Middleton expects to sell 1.2 billion cigars and pull in $360 million in revenue in 2007.
Part Philip Morris USA’s growth strategy is to develop new products. It is working on a new line of smokeless tobacco products. The company is currently test marketing Marlboro Snus in Texas and Marlboro Moist Smokeless Tobacco in Georgia. Altria also recently opened a new state-of-the-art R&D center in Richmond, Virginia to help it improve its existing products and to develop new products including ones that have reduced health risks. The center is expected to be fully operational by Q2 2008.
Things are looking up for SABmiller
After the spin-off, Altria will retain its 28.6% interest in SABMiller. On October 9, 2007 SABMiller reached an agreement with Molson Coors Brewing Co. to form a joint venture to merge the companies’ U.S. operations (including Puerto Rico). The transaction is expected to be completed by mid-2008. The companies believe that this merger will result in substantial economies of scale and savings. In the merger announcement, they stated that in exchange for a one-time charge of $450 million they expect to realize major cost synergies “through the optimization of production over the existing brewery network, reduced shipping distances, economies of scale in brewery operations and the elimination of duplication in corporate and marketing services.” The combined Miller / Coors entity expects to realize $50 million in savings during the first full year of combined operations, another $350 million in annual savings in year two, and an additional $100 million annually in year three for a combined annual savings of half a billion dollars. This savings will help the company boost its earnings in a relatively mature industry. Over a quarter of any increase in earnings will flow directly to Altria’s bottom line.
Huge Competitive Moat
In the book "The Dhando Investor" Mohnish Pabrai continuously stresses the importance of investing in businesses that have durable moats, meaning that they have a significant edge over potential competition. I think that Philip Morris USA has an outstanding moat in the form of the Tobacco Master Settlement that the major U.S. cigarette manufacturers reached with the federal government in 1998. The settlement’s restrictions on pricing have made it very difficult for small companies to compete with "Big Tobacco." So Philip Morris USA isn’t going to have any new competitors sneaking up on and undercutting them on price or stealing sales with innovative new products.
Bull Case for Philip Morris International
I believe that Mr. Market is not currently providing PMI with the multiple that it deserves because of the constant threat of litigation, increased taxes, and a declining customer base that are associated with Philip Morris USA. By spinning off PMI, Altria will unlock its true value.
In 2006, the last full year that results are available for, PMI had net income of $6.1 billion. Using a distribution ratio of one PMI share for every Altria share, the spin-off will produce 2.1 billion shares of PMI, giving it an initial EPS of around $3. If one assigns a conservative P/E ratio of 17 to this (the average multiple that other publicly traded cigarette manufacturers are currently being awarded) it results in a share price of around $49.38. This increases all the way to $58.09 if the market awards PMI with a P/E ratio of 20, which is not unrealistic for an international company with a ton of cash on the books and huge growth potential.
Following its spin-off from Altria, Philip Morris International will be the world’s most profitable publicly traded tobacco company, with operations in over 160 countries. During the most recent quarter (Q3 2007) PMI achieved income growth in all of its reportable segments. Overall, its income rose 18.8% to $2.5 billion, as a result of higher pricing, favorable exchange rates, and cost reductions. The substantial amount of cash that it has on the books and its more attractive post-spin-off stock will provide PMI with a ton of ammunition to continue its global growth initiative by acquiring additional companies.
Realizing Savings by Moving Production Abroad
In June of 2007 Altria announced that it plans to move the production of the cigarettes that it sells abroad to Philip Morris International facilities in Europe. Altria stated that the cumulative total expenses associated with the move through 2011 are estimated at approximately $670 million, but they will all be realized by Philip Morris USA. The move is expected to generate a pre-tax cost savings beginning in 2008 with a total estimated annual cost savings of approximately $335 million by the year 2011, of which $179 million will be realized by PMI and $156 million by PM USA. So PMI is essentially receiving the benefit of half of the annual savings resulting from this move without paying a dime for it.
A Play on the Weak Dollar
While a weak dollar is probably not the best thing for the United States, it’s great for domestic companies that do business abroad. The more the dollar falls, the more PMI makes when it sells its products in foreign countries.
The Embedded Call Option: China
The possible launch of Philip Morris International’s products in China serves as an embedded call option. According to a 2002 survey by the World Health Organization approximately 57% of men and 3% women in China who are over the age of 18 smoke. China currently has approximately 350 million smokers, which is equivalent to the populations of Russia, Germany and Japan combined. It consumes nearly a third of the world’s tobacco. In 2006, China National Tobacco Corp. produced two trillion cigarettes, making it the world's largest cigarette producer. Clearly, the Chinese cigarette market is enormous.
In December of 2005, Philip Morris International reached agreement on a joint venture with China National Tobacco Import and Export Group Corporation that will allow it to produce and sell Marlboro brand cigarettes in China. At the time, the agreement was considered to be a substantial step in establishing a long-term strategic cooperative partnership between the two companies. Alas, nothing has actually been produced or sold under this agreement yet and PMI representatives declined to provide any specific guidance about when they expected to begin the production and sale of licensed products in China in the Q and A session of its most recent conference call. If PMI ever does begin to sell its products there it has the potential to make a ton of money.
In 1994 a class-action lawsuit was filed on behalf of 700,000 Florida smokers against a number of cigarette manufacturers in a Miami-Dade County, Florida state circuit court. At the time the court ruled against these companies to the tune of actual damages for three plaintiffs plus $145 billion in punitive damages. This ruling was subsequently overturned by the Florida Supreme Court. Even though these companies no longer have to pay the billions of dollars in damages, the Florida court recently ruled that the findings from the extensive jury trial that concluded cigarette makers withheld information about smoking risks and put unreasonably dangerous products on the market can be used in new cases against them. Big tobacco, including Philip Morris USA, now faces dozens of lawsuits in Florida that can use this verdict as a launching point. Smokers and their family members have until January 2007 to file individual suits. It is possible that thousands of lawsuits may be filed by this deadline.
On October 18, 2007 the U.S. House of Representatives narrowly missed having enough votes to overturn the Presidential veto of the proposed “State Children's Health Insurance Program” (SCHIP) law. This bill would have levied an additional tax of $0.61 per pack on cigarettes and used the proceeds to expand children’s healthcare. This was a big win for large tobacco companies. Analysts estimated that if the tax had passed that it would have lead to a 5% to 6% decline in cigarette sales in the U.S. Having said this, the fact that the law almost passed means that if the Democrats win control of all three branches of the government in the next presidential election there is a good chance that something like it will pass in 2008 or 2009. The threat of the increased taxation of cigarettes in the United States will continue to hang over the head of tobacco companies for the foreseeable future. Individual states have also been increasing their taxes on cigarettes and will likely continue to do so.
- Long MO