Altria Group (MO)

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Altria Group (NYSE: MO) is the parent company of Philip Morris USA, the largest U.S. tobacco company, and smokeless tobacco and wine manufacturer UST. The company formerly owned Kraft Foods (KFT) and Philip Morris International (PM), which housed its international tobacco business. From an investment standpoint, the company is known for its high dividend yield.

In the past, Altria has focused primarily on maintaining market share in the U.S. Altria is reliant on continued consumption of its products. Decreasing social acceptability of smoking, public awareness of smoking's health risks, and rising costs due to excise taxes and litigation expenses could all lower demand for Altria's products. Litigation also poses a risk to Altria on several fronts: negative press can negatively affect demand, and the costs of with legal battles and settlements are substantial. Despite declines in the total number of smokers, the company can compensate through price increases, so many investors still count the company as a reliable dividend stock. ^[1]

Business Overview

Originally founded in 1847, Altria Group began manufacturing and selling ready-made cigarettes in response to a marked increase in smoking's popularity. Altria entered the U.S. cigarette market in 1902 and has been a dominating force in both the domestic and international tobacco industries ever since. Its flagship brand Marlboro has become the world's most popular cigarette by volume, accounting for an impressive 8.4% of all cigarettes sold around the world. In an effort to concentrate on its tobacco business, Altria has spun off both of former food/beverage companies, Miller Brewing Company (2002), Kraft Foods (2007), and its international tobacco business (Philip Morris International, 2008); however, Altria retains a 28.6% voting interest in SABMiller, the world's second-largest brewer, formed when Altria sold Miller Brewing Company to South African Breweries in 2002.

Business Segments

• Cigarettes (88.8% of 2009 revenue, 92.5% of 2009 operating income^[2]): Philip Morris USA (PM USA) is Altria's domestic cigarette manufacturing company. Philip Morris remains the largest tobacco company in the United States by both revenue and volume. It manages the production and distribution to wholesalers of Altria's U.S.-sold cigarette brands sold, including:
  • Marlboro, which accounts for 41.6% of all cigarettes sold domestically ^[3]
  • Basic, PM USA's only "discount" brand, which accounts for 8% of the company's total revenues
  • Virginia Slims, targeted towards women and accounting for 5% of the company's revenues
  • Parliament, which accounts for 3% of the company's revenues

• Smokeless Products (5.8% of 2009 revenue, 7.0% of 2009 operating income^[2]): Altria owns UST, the world's largest moist smokeless tobacco manufacturer by sales.^[4] UST provides Altria with the leading smokeless tobacco brands, Skoal and Copenhagen.^[4] The company's diversification into smokeless tobacco is crucial to promoting its growth due to the declining market for smokers in the United States.

• Cigars (2.2% of 2009 revenue, 3.2% of 2009 operating income^[2]) Middleton produces a variety of cigar products, including the Black and Mild brand, which accounts for 28.3% of 2008 US market share.^[5]

• Wine (1.7% of 2009 revenue, 0.8% of 2009 operating income^[2]): When Altria purchased UST in early 2009, it acquired Washington-based Ste Michelle Wine Estates, the seventh-largest wine company in the United States. Ste. Michelle generated more than $400 million in revenue in 2009 for Altria. One of Ste. Michelle's wines was named best in the world by Wine Spectator magazine last year.^[6]

• Financial Services (1.5% of 2009 revenue, 4.9% of 2009 operating income ^[2]): Philip Morris Capital Corporation (abbreviated as PMCC) is a subsidiary of Altria Group that manages a portfolio of assets, such as aircraft, manufacturing facilities, and real estate, which are leased as a form of investment. The revenues from PMCC, which totaled $220 million in 2007, are used to generate cash flow and operating income for Altria.

Trends and Forces

Smokeless Tobacco Diversifies Altria's Revenue Sources

Following the 2007 spin-off of Kraft Foods, Altria now manufactures only tobacco products. Cigarette brands in the United States fall into one of two categories: premium brands and value brands. 92% of PM USA's revenues come from its premium cigarettes, with Basic, the only value brand, accounting for the other 8%. Marlboro is by and large Altria's largest brand, constituting 40.5% of all cigarette sales in the U.S. and 8.5% of all international sales. Altria's products enjoy significant brand loyalty and very high name recognition. As such, the product line has remained relatively unchanged. In December 2007, Altria completed the acquisition of John Middleton, Inc., a leading manufacturer of machine-made large cigars.

In September 2008, Altria completed the acquisition of UST, the world's largest moist smokeless tobacco manufacturer by sales.^[4] UST provides Altria with the leading smokeless tobacco brands, Skoal and Copenhagen.^[4] The company's diversification into smokeless tobacco is crucial to promoting its growth- only 21% of U.S. adults smoked cigarettes regularly in 2007, which has declined steadily from its peak of 43% in the 1940s.^[7] Conversely, the use of smokeless tobacco is on the rise, with usage increasing by 5%-6% annually compared to an average 3%-4% decrease in annual cigarette use.^[8]

Economic Downturns

The tobacco industry has proven to be somewhat more resistant to the effects of economic downturns than other industries, perhaps due to the nature of their products or the brand loyalties. Cost-conscious consumers may stop smoking or downgrade to a value-priced brand during economic slumps, but most consume the same brands at the same, or slightly lower, level. As a result, Altria and other similar companies generally experience less of a decrease in revenues during recessions than the economy as a whole.

On the other hand, however, the weaker economy has caused many consumers to trade down to lower-priced brands of cigarettes. ^[9]

Premium vs. Value Brands

As cigarette prices have continued to rise, some consumers have switched from premium brands to value or deep-discount brands. Most of Altria's cigarette brands are classified as premium, making it more sensitive to these shifts in consumption than some other tobacco companies with more equally-distributed product lines. As such, Altria tries to manage the price gap between value and premium cigarettes by keeping their wholesale prices at a level high enough to be profitable but not so high that consumers start switching to value brands.

Adverse Litigation and Legal Landscape

The tobacco industry is highly susceptible to litigation. Large, high-profile court cases generate negative publicity and can be very costly for tobacco companies, even before including any damages awarded. Due to its size and significance in the domestic market, Altria is somewhat more likely than other tobacco firms to be targeted in a large lawsuit, increasing its exposure to litigation headline risk relative to that of competitors. There is significant regulatory risk in Altria's business.

Decrease in Consumer Demand

The demand for Altria's products is subject to many health and wellness factors, including:

• Public awareness of health risks associated with smoking
  • The increase of public awareness about the dangers of smoking cigarettes has led to a decrease in the number of smokers (from roughly 40% of the population in the 1950s to around 20% in the early 2000s).^[7] While this factor could still affect future demand for Altria's cigarettes, the likelihood of a significant decrease in consumption due to health concerns is small, since the health risks have been widely known for some time.
• Social acceptability of smoking
  • A decrease in the social acceptability of smoking could lead to reduced rates of cigarette consumption. Conversely, a glamorization of smoking could stimulate growth in demand for cigarettes. On the whole, smoking has become somewhat less socially acceptable in the U.S., due to both shifts in cultural attitudes and government regulations on smoking. For some, though, there is still a certain glamorous quality associated with smoking. Cigarettes' social acceptability varies depending on region, however, and many of Altria's other, non-U.S. markets are not as affected by a negative public perception of smoking.

Government Regulation

Governmental regulations can have a large impact on tobacco companies' revenues and, indirectly, consumer demand. There are two main ways in which governments attempt to regulate the consumption of cigarettes, excise taxes and regulations on smoking in public places.

• Cigarette excise taxes are per-pack taxes placed on cigarettes by governments. They serve two purposes: reducing public cigarette consumption and providing a large source of revenue for treasuries.
  • These two reasons put governments, especially state governments in the U.S., in a somewhat difficult position. While many policymakers want to reduce per-capita smoking rates, the excise taxes collected from tobacco companies number in the billions of dollars annually. As a result, governments have a vested interested in the continued viability of Altria and other tobacco companies, making them unwilling allies of the tobacco industry.
  • Excise taxes have risen dramatically in the past three decades and are expected to continue upward. Elected officials have realized that the large profitability of the tobacco industry allows individual companies to absorb a significant percentage of an increase in excise taxes without passing the full cost on to consumers. As such, governments can increase revenues from tobacco companies without severely harming demand for the companies' cigarettes. In Q3 2009, a 62-cent-per-pack federal tax increase took effect. In response, Altria boosted prices even further to increase margins even as it anticipated volume sales to fall. At the end of the quarter, the company reported a 12% fall in volume sales, compared to an industry decline at around 10%, though better-than-expected earnings.^[10]
• Restrictions on cigarette consumption include bans on smoking in public places such as restaurants, workplaces, etc. In the U.S., there has been a recent increase in the number of cities with smoking bans in effect. While having no impact on private consumption of cigarettes, these bans prohibit smoking in many public places, limiting the ability of consumers to choose when and where to smoke.

Competitors

Altria's Philip Morris USA holds a 50% share of the U.S. tobacco market with a 60% share in the premium brand segment ^[11]. The only two other major competitors in the domestic market are Reynolds American (NYSE:RAI), which has a 29% market share, and Carolina Group's (NYSE:CG) Lorillard, which holds 10% of the market share. The remaining 11% of the domestic tobacco industry is composed mainly of deep-discount manufacturers and other small, specialty cigarette makers. Each of Altria's two main domestic competitors has advantages and disadvantages. RAI produces more savings brands, making it likely to benefit from consumers' switching from premium to value brands. Lorillard's flagship cigarette Newport is by far the most popular brand of mentholated cigarettes. However, Altria's size and revenues put both of them at a relative disadvantage in terms of sheer heft in the industry. Both competitors are subject to the same external events, i.e. taxation, litigation, and changes in popular attitudes about smoking.

References

1. ↑ The Motley Fool, "4-Star Stocks Poised to Pop: Altria"
2. ↑ ^{2.0 2.1 2.2 2.3 2.4} Altria 2009 Annual Report, "Financial Highlights"
3. ↑ Altria 2009 Annual Report, page 97
4. ↑ ^{4.0 4.1 4.2 4.3}
5. ↑ Altria 2009 Annual Report, page 98
6. ↑ Richmond Times Dispatch "Altria Group Inc. gets taste of wine business"
7. ↑ ^{7.0 7.1} "U.S" Smoking Rate Still Coming Down" 7/24/2008
8. ↑ TradingMarkets.com 1/25/2009
9. ↑ The Street, "Cigarette Maker Lorillard's 2Q Profit Falls"
10. ↑ Forbes "Cigarette demand falling, but profits solid"
11. ↑ Virginia Places