Altria (NYSE:MO)

Blowing Smoke Rings around the Competition

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Few industries are more widely disliked than tobacco. While the industry has remedied many of its bad business practices in recent decades - in part because of civil and government lawsuits - it continues to have a sour reputation.

A H A T E D I N D U S T R Y

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It’s a plain truth that many investors shun tobacco investments on moral grounds. They simply refuse to invest in tobacco companies because of their negative feelings toward the industry.

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And that’s fine if morality is a factor in the investment decision process. However, for those interested in turning this hated industry into an opportunity for safe and steady income, I encourage you to read on.

SAFE & STEADY INCOME

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large companies with huge economic “moats,” brands that are dominant around the world, healthy balance sheets, recession-proof products, and safe and steady dividends are where you want to be invested. These types of companies can weather a storm better than the competition, and can provide a decent return in a low-yield world.

In today’s volatile stock market,

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The world’s premier tobacco company is Altria (NYSE:MO). You know Altria best for its Marlboro cigarette brand, one of the most widely recognized and valuable brand names in the world. In fact, Millward Brown, a global market research agency, estimates the world market value of the Marlboro brand at $69.4 billion, putting it in the top 10.

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Because of market penetration and pricing power. Philip Morris USA, Altria's cigarette segment, commands 50% of the U.S. market. Total market penetration for Marlboro alone is 42%, while Altria's lesser-known brands - Merit, Virginia Slims, Parliament, and Benson & Hedges – comprise the remainder.

Why is Marlboro so highly prized?

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Prior to 2007, Altria was a massive conglomerate. In addition to its

cigarette business, Altria owned Kraft Foods, the second largest packaged food company in the world, as well as Miller Brewing. Altria sold a majority interest in Miller to South African Brewers in 2002 (Altria still retains a 27% stake). Kraft was spun off to Altria shareholders, who in 2007 received 0.68 shares of Kraft stock for every Altria share.

A MASSIVE CONGOLMERATE

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Altria is particularity adept at focusing on the domestic tobacco business. In March 2008, it spun off its international cigarette operations as Philip Morris International. In the deal Altria stockholders received one share of Philip Morris for each Altria share.

While these sales and spin-offs shrank Altria's size by more than half, they cleared the way for management to focus on the still-lucrative domestic tobacco market. And for shareholders, these moves have helped to unlock value.

ADRESSING THE DOMESTIC FRONT

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The real economic value of a powerful cigarette brand like Marlboro is its price inelasticity - a consumer's perceived value of the product doesn't significantly decline as the price rises. This allows Altria to more easily pass ever-rising sales and excise taxes on to consumers.

THE KEY TO SUCCESS

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It's no secret that overall cigarette consumption is on the decline. Rising prices obviously play a part, but the decline has just as much, if not more, to do with the growing consciousness surrounding smoking's health risks. Governments have also aggressively discouraged tobacco consumption through high excise duties and legislative controls.

AND OF COURSE THERE ARE HEALTH RISKS...

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A $1 billion e-cigarette industry has emerged to help offset the decline in use, giving Altria an alternate market to capture. E-cigs, as they are called, are battery-operated and marketed as tobacco free products and a “healthier” smoking option. Altria estimates that 90% of adult smokers are aware of them and about two-thirds have tried them.

However,

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Although Altria’s Nu Mark subsidiary was the last of the big tobacco companies to enter the market, it first tested its MarkTen brand of e-cigs in late 2013 and plan to expand the brand in late 2014. Altria depends primarily on pricing power to counter the consumption slide - profit margins are maintained through price increases.

BRAND EXPANSION

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This isn't to say that there aren't pockets of growth in the tobacco industry.

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In late 2007, Altria acquired John Middleton Inc., a leading

manufacturer of machine-made large cigars for $2.9 billion. Middleton's principal brand - Black & Mild - is the second largest selling machine-made large cigar in the U.S.

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Altria's greatest growth potential now likely resides in smokeless tobacco, a niche market posting 7% annual revenue increases over the past few years. To compete in the growing smokeless tobacco market, Altria acquired UST Corp., the world's largest smokeless tobacco company, and its formidable brands - Copenhagen, Skoal, and Red Seal.

Now called U.S. Smokeless Tobacco Co., the company recently announced plans to build a $118 million, 230,000-square-foot facility in Kentucky to expand production. The facility is expected to be operational by 2016.

THE FUTURE OF SMOKING

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From early 2000 to the present, Altria's stock price has appreciated at around a 15% average compounded annual growth rate. Tack on an average dividend yield of 5% or so (the current yield is 5.3%), and you’re looking at a more-than-impressive 20% average annual return.

Despite being near the top of many investments to avoid, despite experiencing a continued drop in domestic consumption, and despite higher “sin” taxes, Altria’s stock price has managed to increase six-fold since early 2000.

20% AVERAGE RETURN

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By spinning off or selling various business units and acquiring others in key niche markets, Altria’s management has successfully overcome onerous regulation and bad publicity. And it’s returned a healthy dividend to boot.

A H A T E D I N D U S T R Y

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That kind of long-term success doesn’t happen by accident. If you don’t mind the business model, holding Altria for the long term should be a winning strategy. Where there’s smoke, there’s profit … at least with Altria.

WHERE THERE’S SMOKE, THERE’S PROFIT

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Ready for more?

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