MO: What the spin-off means to Altria

I recently wrote an analysis for Altria for my university's business journal. I have put it in for your review. Thanks. On March 28, 2008 Altria Group Inc. (MO), maker of the Marlboro cigarette brand, completed its spin-off of its subsidiary Philips Morris International Inc. (PM). This move effectively splits the company's international and domestic tobacco businesses. This move was motivated by a desire to free the international segment of the company from the constant legal battles and governmental legislation that contribute to a declining domestic tobacco business. Why the spin-off makes sense With the U.S. cigarette market in decline, (the company's 10-K predicts annual declines of 2.5-3% in industry volume in the future years) Altria will focus on continuing to diversify its tobacco product line. In addition to its main cigarette brands Marlboro, Parliament, Virginia Slims and Basic, Altria also currently owns Philip Morris Capital Corporation, 28.6% of beer-maker SABMiller, and owns John Middleton, Inc. (a leading maker of mass-production cigars) outright. Altria is also exploring the possibility of entering the chewing tobacco market. The spin-off will allow Altria to focus on expanding its market share in the U.S. cigarette market, cut costs (it plans to close one of its main production facilities in Cabarrus, North Carolina by 2010 and sold its New York City headquarters in November of 2007), and aggressively pursue new revenue streams from additional products and acquisitions. Philip Morris International will be freed from the unfavorable domestic growth conditions for cigarettes, allowing it to expand its control of the international market. The company has focused on increasing productive efficiency and will move all its production to Europe by October of 2008. The division has aggressively purchased stakes in foreign tobacco companies recently. It currently holds 80% of Mexican tobacco company Grupo Carso (with an option to purchase the remaining 20%), all of Dominican Republic's Industria de Tabaco León Jimenes, and nearly all of Pakistan's Lakson Tobacco Company Limited. All these deals were completed in the last 16 months. Evidencing its global diversity and the scope of its operations, Philip Morris International holds over 15% of the cigarette market share in over 90 countries. Management will aggressively pursue similar transactions around the world to bolster market share. Challenges to the business However, both companies face significant obstacles. Altria attracts heavy litigation continually because it is the leader among cigarette manufacturers. Smaller competitors do not face equally heavy legal battles. However, in its 10-K the company states, "Although litigation is subject to uncertainty, management believes the litigation environment has substantially improved." Evidence supports Altria's claims, as pending suits brought against the company nearly halved recently, dropping from 196 in December 2006 to 111 in February 2008. Big Tobacco is notorious for their cutthroat legal teams, and Altria's certainly lives up to the reputation. The company has won 28 out of the only 45 verdicts reached since January of 1999. Only eight of the cases Altria lost have reached been finalized, as the others continue to drag on in court. All in all, the company has paid out roughly $73 million in judgments and $35 million in interest over that span. The company also tends to battle out suits in court and exhaust all appeals, to discourage those seeking quick settlements. Unless an unprecedented verdict is reached that would open up a huge amount of new cases, Altria's ability to navigate the legal system successfully should prevent major losses that would impact the company heavily. There are several other issues that can impact Altria in the future. Restructuring costs from the spin-off could negatively impact the company in the short term. On April 24, Wall Street Journal writer Andrew Edwards reported that Altria's first-quarter net income fell 12% due to restructuring. However, many of these costs are being absorbed now, and the move to switch its headquarters from New York City to Richmond, Virginia will save the company roughly $250 million a year beginning next year. Importantly, the company did not change their 2008 earnings outlook. Other obstacles include increasing censorship of tobacco products in advertisements, heightened competition from bargain cigarette companies who do not face the level of litigation Altria does, and a potential increase of the federal excise tax on cigarettes. Philip Morris International's issues are simpler yet perhaps more threatening to the company. International competition is heavy, but the company has wisely pursued the strategy of purchasing stakes in local brands instead of singularly imposing the Marlboro brand in all markets abroad. The presence of counterfeit cigarettes is also an issue in some areas, which undermine sales. A rising dollar would also negatively impact earnings, as all business is conducted abroad for the company. The move to shift production to Europe will help offset some of the losses the company would suffer if the dollar appreciated, as manufacturing and labor would be conducted in foreign currency. Attractive aspects of each investment One of the most attractive aspects of the tobacco business is its relative freedom from the health of the macro-economy, as cigarettes need to be bought in all business conditions. With the current instability in the financial markets, tobacco represents a relatively safe bet from many of the issues that surround other consumer companies. Altria has also historically paid strong dividends. Its dividends will begin at $1.16 a share, representing a 5.6% yield based on a $20.70 stock price. Philip Morris International will begin its dividend at $1.84 a share, a 3.6% yield at a $51 price. Altria has raised its dividends every year since 1989, with the exception of 2007 due to the spin-off of Kraft (which took part of the company's dividend with it). It has also roughly halved its debt due from the end of 2005 to the end of 2007. Based on Altria's estimations that it will earn between $1.63 and $1.67 this year, putting its P/E at 12.4 (based on a $20.70 price), which would be a discount to the industry's 13.6 average. Additionally, Altria's cost-cutting initiatives, focus on expanding its domestic tobacco market share, and its pursuit of new tobacco products should begin to reap rewards in the near future. Summary Altria's moves have shown exceptional management foresight, beginning with its spin-off of Kraft in 2007 and now with the spin-off of Philip Morris International in 2008. The company has gone from a global conglomerate to three focused companies in thirteen months. At first glance, it may appear that Altria received the short-end of the deal. The domestic cigarette business provides little room for growth, while Philip Morris International has been freed to pursue market share in a huge international market without the legal headaches in the United States. However, Altria's strong dividend, stellar management, and its clear understanding of its identity after the spin-off provide strong long-term appreciation potential in a tumultuous market. Putting its money where its mouth is, Altria's board authorized a $7.5 billion two-year share repurchase program for Altria and a $13 billion two-year repurchase for Philip Morris International that commenced at the beginning of the spin-off. Altria is unquestionably not a "sexy" stock, but value investors may be intrigued by its long-term prospects as its current $20.78 price may be overly depressed. According to its Lehman Live program, Lehman Brothers has placed their price target at $26. Even JP Morgan analyst Erik Bloomquist who downgraded Altria on April 16 when the stock was around the $21.75 level put his price target at $25. The company faces significant challenges and legal dangers, but an exceptional spin-off move should greatly benefit Altria and makes for a promising long-term outlook. Altria Group, Inc. United States Securities and Exchange Commission Form 10-K. Altria Group. http://yahoo.brand.edgar-online.com/DisplayFiling.aspx?dcn=0001193125-08-041586 Associated Press. Ahead of the Bell: Altria downgraded due to 2009 Risks. Associated Press. http://money.cnn.com/news/newsfeeds/articles/apwire/7bb9b88fc30cdae1332d35865303b674.htm Yahoo! Finance for price quotes. www.finance.yahoo.com Lehman Live Andrew Edwards. Altria Earnings Fall 12%. The Wall Street Journal. http://online.wsj.com/article/SB120902084062541107.html?mod=googlenews_wsj Altria. Dividend Schedule and History. http://altria.com/investors/2_3_5_divhistory.asp#1992 Value Line Investment Survey. Altria. (Premium Service) http://www.valueline.com/secure/vlispdf/stk1700/vlispdf/f7058.pdf