One of the reasons why tobacco stocks had historically been successful long-term investments is because tobacco stocks were cheap, the dividend was high, the dividend increased over time, and these three factors interacted quite well for that that chose to reinvest in companies like the old Philip Morris. But when you look at where Altria is at right now, in terms of valuation, it is as if investors have discounted the incredible risks that come with the territory of investing in a highly regulated, declining industry.
At the time of this writing, Altria is trading at $54.19 per share. Some stock screeners show that the profits are $2.17, but if you read the balance sheet and exclude one-time accounting adjustments, it is more like $2.50 per share. That is the number I prefer to use because I am interested in long-term earnings power that will affect the valuation going forward. Still, that works out to a P/E ratio of 21.7x earnings even when you’re using my more favorable earnings number.
Between 1999 and 2010, Altria traded at between 9x profits and 13x profits. It came up to 15-16x profits in 2011, 2012, and 2013, and the price of the stock has really gotten ahead of earnings in the past twelve as the company has entered the 21-22x earnings range. If Colgate-Palmolive or Hershey or Nike traded at that valuation, I’d be interested. Those companies can perpetually expand.
In the case of tobacco, however, I hold that the valuation range of 10-15x earnings over the long haul is much more appropriate when you take into account the different risks facing the company. I understand that risk is one of those nebulous terms that can prove elusive when trying to define, but here’s my take: Risk is an obstacle that can either slow down profit growth or demolish a company’s existing profit base. The price of a stock, meanwhile, is an auction-like exchange of ownership positions based on how people and some computer algorithms react to information about a company (including the risks facing it).
The risks facing tobacco are: (1) Social acceptance of smoking has declined considerably. If you have a job, and smoke regularly, there are very few places that you will be able to smoke outside the home. This likely decreases the quantity of cigarettes consumed by each smoker. (2) The greater the taxes on cigarettes, the lower the demand. Marlboro has increased its costs by 65% since 2007, plus added government taxes that vary by state. Although these increases and stock buybacks have been able to compensate for 3.5% annual volume losses, it is not a given that cigarette prices can continue to rise to the sky. Frankly, I can’t see people willing to pay $20 for a pack of cigarettes in a few years, but then again, the current high prices surprise me. (3) The future of e-cigarettes have been greatly spoken of as a potential diversification stream, but it has yet to take hold as a significant revenue stream. The degree of “hope” required here should be discounted into the stock price. (4) This closely relates to number three, but the spinoff of the food companies has greatly reduced the diversification of the company. It holds a stake in SABMiller, which pays significant dividends, but tobacco makes up over three-fourths of the current profits.
Those are the reasons why I would consider Altria a value buy at 10x earnings or below, in the sweet spot of fair value around 13x earnings, and at the upper end of fair value around 15x earnings. The risk can be justified at these prices because you are receiving a 5%, 6%, or 7% yield that you can take and reinvest elsewhere until the moment comes when raising the price of cigarettes no longer offsets the 3.5% volume loss. Making an investment in a declining industry should come with a discount; and yet, Altria is priced like it has the general business tailwinds like Colgate-Palmolive or Nike. This 3.8% current dividend yield is the lowest since the 1990s before the Master Tobacco Settlement days and during a time when food profits from the Kraft brands provided substantial diversification to shareholder profits.
Part of the reason why Altria has been able to get so far ahead of itself is due to the fact that we are six years into a constantly advancing stock market, and Altria has historically been a high yielder with a high dividend growth rate. That holds a lot of appeal to people when interest rates low. The problem is that it has taken away many of the reasons tobacco investing has been so lucrative if you are looking to buy the stock right now.