Between 1964 and 1987, almost eight hundred cases made it to various Courts of Appeals throughout the United States that sought to hold tobacco companies liable for damages resulting from smoking. The tobacco lawyers protected the interests of Philip Morris USA, Brown & Williamson, R.J. Reynolds, and Lorillard by raising Rule 8 affirmative defenses of contributory negligence and assumption of the risk–arguing that tobacco consumers had a duty not to smoke if they wanted to protect their health, and they abandoned this responsibility by willingly smoking despite knowledge of the health hazards.
The tobacco industry had some merit to its claim that the American public was on notice about the risks of tobacco smoking. In 1964, the Smoking and Health: Report of the Advisory Committee to the Surgeon Rule released a study noting that cigarette smokers had a 70% increased chance of premature mortality compared to non-smokers. And heavy smokers, defined as those that smoked two packs per day or more, had a twenty-fold probability of contracting lung cancer compared to those that did not smoke. The effects of this report manifested itself in two primary commercial ways–all tobacco packs sold after 1965 contained warnings about the health risks associated with smoking, and the industry has been prevented from advertising on radio or TV since September 1970.
After seeing that individuals were struggling in their efforts to hold tobacco companies liable for the health damages of using the core product as intended, the states decided to change their lawsuit theories in the early 1990s. You may not have guessed this, but the State of Mississippi was on the legal frontier of raising the arguments that tobacco companies violated statewide consumer protection and antitrust laws and demanded reimbursement for Medicaid and other expenses that resulted from treating smokers. Mississippi raised this claim in 1994, and soon Minnesota, Texas, and Florida sued tobacco companies under the same theory. Although the antitrust argument was rejected, these four states reached an agreement with the tobacco giants in 1997 to pay for Medicaid and other expenses that were the result of smoking.
A year later, the other forty-six states of America plus Puerto Rico, the District of Columbia, and all U.S. territories agreed to the Master Settlement Agreement. The Original Participating Manufacturers–the legal term used to describe Philip Morris USA, Lorillard, R.J. Reynolds, and Brown & Williamson–agreed to pay $12.75 billion between 2000 and 2005, then $6.5 billion annually until 2008, then $8 billion annually from 2008 through 2017, and then $9 billion annually thereafter. Reynolds eventually absorbed Brown & Williamson, as well as Lorillard.
In exchange for these payments, the states agreed that it would not sue the tobacco companies anymore for the harmful effects of smoking, although individuals, labor unions, and private healthcare insurers retained the right to sue tobacco companies. The difficulty is that, especially by this point in time, the affirmative defense of contributory negligence and assumption of risk usually leads to the tobacco companies prevailing against individuals. In the 1960s, you could plausibly argue that you didn’t know what you were getting into when you started smoking. Nowadays, it’s not persuasive to judges or juries when you try to argue that you didn’t know what you were doing when you started smoking. The real losers are the states of Mississippi, Minnesota, Florida, and Texas for agreeing to a final settlement in 1997, a year before the much more lucrative Master Settlement Agreement was reached. Mississippi was the first mover in securing these payments, but it did not earn the full potential fruits of its ingenuous tactics by agreeing to a final settlement early.
I mention all of this background so you can get a feel for the political climate surrounding tobacco stock sentiment in the 1990s and early 2000s. Nowadays, people freak out when their McDonald’s investment struggles to grow profits for a few quarters. The tobacco shareholders had to see settlements of tens of billions of dollars and even have a legitimate fear of bankruptcy as the moral indignation of the time made the ceiling of the eventual tobacco payments unpredictable.
But yet, an interesting thing was happening to the core Philip Morris business while all of this was going on. The dividend yield was north of 7%, and the earnings growth was around 11% per year. Kraft cheeses and oreos were flying off the shelf, and expanding throughout North America. Philip Morris was successfully raising the prices of its Marlboro brands in the United States, growing profits by 7% despite the modest volume losses. And the international arm of the tobacco giant, now known as Philip Morris International, was expanding into countries like the Philippines and delivering robust 13% earnings growth.
This created an extreme example of earnings reality not corresponding in any way to the valuation of the stock. Philip Morris–the domestic tobacco, international tobacco, and food divisions–was being given away for almost 7x earnings. It was this combination of high growth, low valuation, and crazy high dividend yield that explained why tobacco investors in the 1990s and early 2000s reaped returns of almost 20% annually. I mention all of this history to stress the important point that there is no magical reason why Altria has historically been a great investment—instead, it has been the presence of these three factors: low valuation, high dividends, high growth.
This history is important to keep in mind because long-term shareholders of Altria are starting to say a lot of stupid things on investment message boards. With the price hitting an all-time high of $60, the three elements that explained the outsized success of Altria in the past are no longer true at the present moment.
Those 7% dividends that made it such a lucrative investment in the past? That’s gone. If you buy today, you get a 3.8% dividend yield. That’s the lowest starting yield on the stock in the past quarter of a century. Those high dividends were an important part of outsized returns, and nowadays you could get the same dividend yield by purchasing a gold-plated AAA firm like ExxonMobil (XOM). So we can scratch that element off of the historical basis for Altria’s outsized success.
The next element is valuation, which is partially tethered to dividend yield (e.g. low valuations tend to correspond to unusually high dividend yields, and vice versa.) With the stock near $60, the current P/E ratio of the stock is 23. That is over 3x as expensive as the stock traded in the 1990s and early 2000s when you could buy the old Philip Morris for 7x earnings. Even from 2003 through 2014, the valuation of the stock traded within the band of 11x earnings and 16x earnings. This 23x earnings valuation is uncharted territory. I don’t know how else to put it: Today, October 21st, 2015, is the lowest initial earnings yield that Altria investors will receive in my entire lifetime. In the entire quarter century that preceded this, you couldn’t find a more expensive time to buy based on P/E metrics.
And lastly, there is the element of growth. If the growth at Altria was unusually high, it could be justifiable to accept a lower valuation/lower initial dividend yield if there was a plausible reason to believe that future growth was better than past growth. That’s not happening right now. Don’t let the recent 9% dividend hike fool you–profits are only growing at 5% annually. And Altria makes all of its money in the U.S., so there is no currency exchange rate distorting the returns. The dividend is going to eat up 80% of Altria’s profits, up from 70% at the time of the Kraft and Philip Morris International spinoffs.
That 5% growth is covering up volume declines, as half of the earnings growth is the result of stock buybacks that are expected to total 60 million by the end of this year. A couple summers ago, I looked at the Emerson Electric buybacks at $70 per share, and thought it was foolish based on valuation. Now, all those shares look suboptimal in hindsight as the stock has spent most of the third quarter this year trading in the $40s.
I’m reaching the same conclusion when I see Altria buybacks near $60 per share. Management is not making a value-added decision repurchasing stock at 23x earnings. It doesn’t impress me when management teams get aggressive about stock buybacks during the loftiest valuation point in the past quarter century. When the stock comes down to 12x earnings or 15x earnings, people will wonder what they were thinking in the third quarter of 2015. It’s the great paradox of buybacks that threatens the discipline of even intelligent people–surplus cash becomes available in good times, and good times are usually when the stock is valued most highly.
All that said, there is one item of special interest on Altria’s balance sheet right now: The 27% stake in SABMiller that is now worth $28 billion after the 50% premium that has fallen into Altria’s lap since Anheuser-Busch Inbev came knocking. It will be interesting to see how Altria will handle this. The Anheuser-Busch proposal actual comes with two separate offers. The first is the all-cash offer that loosely translates into $68 per share in U.S. dollars, and there is also the partial share option that comes with an 11% discount. It has been reported that Altria executives pushed heavily for this second option, as it avoids huge one-time capital gains tax, and suggests a high probability that Altria may enjoy a meaningful minority interest in the SABMiller Anheuser-Busch Inbev Frankenstein that is about to be unleashed to the world.
This is why I see a distinction between holding a stock and buying a stock. Some people say, “Why own anything if you wouldn’t buy it right now?” My answer is that interesting things do happen to overvalued stocks. This megabrew interest may deliver escalating earnings per share growth in the next five years, and fat dividend payments to Altria to boot. This money could pass through directly to shareholders in the form of Altria’s dividend policy, or it could be used to expand into the e-cigarette and vape markets. But even with this item of interest, I can’t recommend paying 23x earnings for a stock that ought to be valued around 15x earnings. You don’t want to go through life picking up large caps when they are trading at the highest P/E valuation in the past 25 years while delivering lower than usual earnings per share growth. The three elements that have historically made Altria shareholders exceptionally rich do not exist right now.
Originally posted 2015-10-21 02:11:27.