Co-produced with PendragonY
Each business goes through several stages. First, there’s the introduction stage. When the business picks up, it becomes the growth stage. Following that, it reaches cash cow stage whereby the growth is lower, but the company is generating high enough cash to be able to reward shareholders. This is where Altria (MO) is today. In this case, MO is able to reward shareholders with very high dividends.
Altria is a tobacco company owning the U.S. rights to many of the most popular brands like Marlboro, Benson & Hedges, Parliament, and Virginia Slims. The revenues from these brands make it one of the largest tobacco companies in the U.S. with its headquarters in Richmond, Virginia. While it has investments outside of tobacco, most notably Anheuser-Busch-Inbev (BUD), Cronus Group (CRON), and JUUL, it still gets approximately 85% of its revenue from cigarettes. “I Quit Original Smoking” (or IQOS) is a new heat-not-burn tobacco product that’s also seeing significant investment from Altria.
In past articles on Altria, we have pointed out that tobacco companies have typically had improving stock prices when the economy struggled. This year has proven to be the exception to that rule. And while MO share prices declined along with the rest of the market in late February and March, it also has been slower than the rest of the market to recover from those declines. If the company’s operations have recovered, this lack of share price recovery is an opportunity.
So how has the share price done?
Here’s how the share price of MO compared to the S&P 500 during the initial market reaction to the COVID-19 crisis from Feb. 17 to April 30:
So MO crashed pretty much in line with the market as a whole and then recovered in line with the market as well until the end of April. But that didn’t last.
The first big drop in share price not matched by the market came just after Altria released its Q1 earnings report on April 30. A slightly smaller drop occurred when Q2 earnings were released – July 28. And the most recent drop happened after Sept. 9 when Altria re-affirmed its FY 2020 guidance.
With a drop in the share price of 19% from the start of the year, particularly given that SPY is up just under 7%, is there an opportunity here? We need to look at the company’s operations to determine that.
Let’s take a look at the performance in Q2 and YTD.
Source: Q2 Earnings report *OCI = Other Comprehensive Income
Here’s a slide comparing earnings and income between the first half of last year and the first half of this year. And it very much shows why investing in tobacco companies was seen as a good idea during bad economic times. The first half of 2019 had a strong economy, while that same period in 2020 had the impact of the COVID-19 shutdowns. And yet, Altria earned more in 2020. Earnings were up 8.5%.
It’s no secret that the number of people smoking is declining. And even smokers are smoking fewer cigarettes. So how has volume held up this year?
Source: Q2 Earnings report
This slide shows adjusted volumes (they are adjusted to take out the impact of when people buy them to get a better idea of how many people are actually smoking). So this year the volume decline is less than it was last year. And much of the change in the volume projections were due to changes in the estimates of how many cigarettes were purchased for pantry building (an estimate of how many cigarettes were bought now to be smoked later). As CEO Billy Gifford said in the Q2 conference call:
As we discussed in our first quarter earnings results, first quarter industry volumes benefited from pantry loading in March and we expected to see this payback in the second quarter. Due to the macroeconomic factors, we described earlier that impacted adult tobacco consumer’s behavior, we saw only minimal volume payback in the second quarter as underlying demand remained consistent across the quarter.
BUD and the Ste. Michelle wineries continue to see negative impacts from COVID-19, but that should likely diminish over the months. IQOS has launched and so Altria is working its plan to move current smokers to products that don’t burn tobacco.
The spread between the dividend yield for MO and the 10-year Treasury rate continues near record highs and is now at 7.6%. Given the Federal Reserve’s recent commitment to keep rates low for some time, this yield is very attractive. Earlier in the year, when Altria pulled its guidance for 2020, we had some reservations about the level of dividend safety. However, the dividend is looking much safer given that management recently re-affirmed its guidance for 2020.
Back at the end of July, Altria announced a dividend increase of 2 cents a share. This was only half the increase implemented in 2019, but given the economic times, it’s still pretty good. Management does not increase the dividend unless they expect to be able to pay it going forward. So while it’s a bit optimistic to say that the safest dividend is the one just raised, a raise is a great sign that MO is still doing very well as a company. Their financial results were very solid and they speak for themselves.
What Comes Next?
The biggest risk to Altria is that cash strapped states will impose higher taxes on cigarette sales. Given that the way most of the taxes are calculated produces a bigger impact on the end price of premium products (the most profitable ones), this could hurt profits even if it doesn’t reduce volumes. Also, in the past, the fact that due to the settlement in the tobacco litigation taxes, states shared in tobacco company profits which tended to temper raising direct taxes. The need for immediate cash may preclude legislators from making such longer-term calculations.
As everyone knows, more people are quitting smoking and fewer people are starting to smoke. IQOS and nicotine pouches are key products in Altria’s efforts to find a replacement for cigarettes. Investors will need to keep an eye on how these two products are doing. Altria’s management hopes that increased IQOS sales will maintain profits and its cash flows going strong. The latest figures coming from the year 2020 are very encouraging.
Altria has a solid and consistent performance as a company. In fact, it has proven to be one of the most recession-resilient companies this year with its results barely impacted by the pandemic. Thus when the price is low, it’s a great time to buy this great cash cow yielding over 8%. The share price is lower despite a good performance in the year 2020, including a dividend hike at the time when many companies were reducing dividends to preserve cash. We are long-term investors in Altria. As long as the company keeps performing well, we will continue to see lower prices as an opportunity. Today is one such a great opportunity!
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Disclosure: I am/we are long MO AND IMBBY. 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.
Additional disclosure: Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.