Altria: Why Investors Should Look Past Q2 Revenue And Profit Decline
Altria saw declines in both its revenues and operating income in Q2 as macro headwinds led to an 11% drop in its cigarette volume. However, the results were made worse by some one-off items, and Altria reiterated its outlook for a 4-7% EPS growth in 2022. Underlying trends in the U.S. cigarettes business are stable, and recent FDA actions on e-vapor can benefit Altria earnings. We expect a stable U.S. cigarette market. Altria can now free itself to compete in e-vapor, and struggling Oral Tobacco segment is small. At $44, Altria has a 9x P/E and an 8.2% Dividend Yield. We expect a total return of 74% (20.0% annualized) by 2025 year-end. Buy. Introduction Altria Group, Inc. (MO) released Q2 2022 results on Thursday morning (July 28). MO stock finished the day flattish (down 0.2%). We upgraded our rating on Altria to Buy in February 2020. Shares currently have a gain of 11% since our upgrade, with dividends more than offsetting a 7% decline in the share price, having fallen 23% from their April 2022 peak: Librarian Capital Altria Rating vs. Share Price (Last 1 Year) Source: Seeking Alpha (28-Jul-22). Q2 2022 results were largely in line with our investment case. Macro headwinds are pressuring Altria volumes, and both revenues and operating income fell year-on-year. However, part of the decline was due to one-off items, and management reaffirmed their guidance for a 4-7% Adjusted EPS growth in 2022. We expect continuing stability in the U.S. cigarette market, and recent FDA action on e-vapor makes this more likely. Altria shares now trade at a 9.3x P/E and an 8.2% Dividend Yield. Our forecasts indicate a total return of 74% (20.0% annualized) by 2025 year-end. Buy. Altria Buy Case Recap Our investment case on Altria is based on the continuing ability of its cigarette business to deliver on its traditional earnings algorithm, which includes: A low-to-mid single-digit annual decline in cigarette volumes A mid-to-high single-digit annual rise in average cigarette prices Together these give a low-single-digit annual growth in revenues Revenues After Excise tend to grow even faster as excise growth lags EBIT margin expands with higher unit price and operational savings Including buybacks, EPS tends to grow at mid-to-high single-digits Altria's cigarette volume decline accelerated during 2016-19, partly attributed to an explosive growth in U.S. e-vapor. However, Altria still guided to an EPS growth of 4-7% in both 2019 and 2020 (achieving 5.8% in 2019). FDA actions against e-vapor in late 2019 pushed e-vapor volume downwards until Q1 2020, after which it resumed growing but at a modest pace. COVID-19 boosted U.S. cigarette consumption, as pandemic restrictions meant more occasions to smoke and government stimulus programs added to smokers' disposable incomes. Altria's Smokeable volume decline was just 2% in 2020, and remained below 5% during H1 2021 (but rising in H2). Altria Smokeable Volume Declines (Adjusted) (2013-21) Source: Altria company filings. NB. Figures adjusted for inventory movements. We believe declines in U.S. cigarette volume will remain stable, with e-vapor growth staying modest, and nicotine pouches and Heat Not Burn both being too small to have a meaningful impact. Q2 2022 was an atypically bad quarter for Altria, due to rises in gasoline prices and inflation. Revenues and Profits Declined in Q2 In Q2 2022, Altria’s Net Revenues After Excise fell 4.3% year-on-year, and Adjusted Operating Companies Income (“OCI”) fell 1.7%. Net Income fell 0.2%, but Adjusted EPS rose 2.4% largely because of a lower share count: Altria Group P&L (Q1& H1 2022 vs. Prior Year) Source: Altria results release (Q2 2022). Across H1, Net Revenues After Excise fell 2.9%, OCI rose 0.8%, Net Income rose 1.4% and Adjusted EPS rose 3.5%. Macro headwinds on Altria cigarette volumes was certainly a factor in Q2, but there were also one-offs. The disposal of the Wine business, for example, contributed 0.8% to the year-on-year OCI decline in both Q2 and H1: Altria OCI by Segment (Q1& H1 2022 vs. Prior Year) Source: Altria results release (Q1 2022). The Smokeable segment contributed 87% of segment OCI in Q2, and rose 0.6% year-on-year. Oral Tobacco, the other segment, saw OCI fell 8.9% as it continued to struggle with structural issues. Macro Headwinds Hitting Cigarettes Demand Cigarette volumes in the Smokeable segment fell 11.1% year-on-year. However, as is structural for tobacco, Net Revenues fell only 2.9% thanks to price increases, and Net Revenues After Excise fell only 0.7% as excise did not rise as much as price. Smokeable Adjusted OCI rose 0.6% even on lower revenues, driven by lower promotion spend: Altria Smokeable Financials (Q1& H1 2022 vs. Prior Year) Source: Altria results release (Q2 2022). The gap between volume decline (11.1%) and Net Revenue After Excise decline (0.7%) was achieved while the average retail pack price for Marlboro cigarettes rose by just 5.6% ($0.43) year-on-year, below inflation and lower than the ($0.45) increase in Q2 2021. Marlboro’s retail share actually rose 10 bps from Q1 (at 42.7%), and total discount segment market share of the industry was sequentially stable at 26.4%. Management attributed the volume decline to macro headwinds, specifically higher gasoline prices and inflation. In Altria’s estimates, "Macroeconomic & Other Factors" as a headwind to industry volume stood at 2.6% on a last-twelve-month basis as of Q2 2022, continuing its deterioration from being a positive benefit in the 12 months to Q3 2021: U.S. Cigarette Industry Volume Decline by Component (Rolling 12 Months) Source: Altria quarterly metrics (Q2 2022). However, Altria’s year-on-year decline in Q2 was also made worse by one-off items. Trade inventory movements made its volume decline about 1 ppt worse; its cigarette volume decline was an estimated 10% on an adjusted basis. There was also a one-off step-up in MSA settlement costs as higher inflation assumptions have been used. Management observed that consumers have prioritized tobacco purchases by reducing non-tobacco purchases, and that surveys indicate smokers remained brand-loyal. Volume declines may decelerate once consumers have adjusted to the new environment, and prior-year comparables will also get easier as we move into H2 2022: 1-Year Cigarette Volume Decline - Altria vs. Industry (Since 2020) 1-Year Cigarette Volume Decline - Altria vs. Industry (Since 2020) To sum up, the Smokeable segment generated positive OCI growth even with an 11% shipment volume decline, while the underlying decline was about 1 ppt less. We believe that there is a good chance that Q2 would mark the trough in year-on-year volume declines, and expect OCI growth to return to low-to-mid single-digits in future quarters. FDA Actions Limiting E-Vapor Growth FDA actions have caused U.S. e-vapor volume to reverse in Q2, and may hinder it further in future. According to estimates quoted by Altria, U.S. e-vapor volume in Q2 was down 7% from Q1, its first sequential decline since Q1 2020, largely due to a reduction in vape store volumes: U.S E-Vapor Category Volume by Quarter (Since 2019) Source: Altria company filings. The FDA has been active in issuing Marketing Denial Orders (“MDOs”) on an increasing number of e-vapor products since late 2021, including Juul (which has obtained a temporary stay from the courts) and Imperial Brands (OTCQX:IMBBY) (which tried but failed). Enforcement actions may have been stepped up after a law giving the FDA explicit authority to regulate synthetic nicotine went into effect in April. In the first two weeks of July, warning letters were sent to 107 retailers. On the Q2 earnings call, Altria management highlighted how the FDA has so far issued Marketing Granted Orders to only 23 e-vapor products representing just 1% of e-vapor industry volume, how the only decisions made on flavored e-vapor products have been rejections, and how a substantial number of e-vapor products contain synthetic nicotine and were thus required to obtain FDA authorisations by July 13. Altria expects further changes in the sector. Continuing stability in the U.S. cigarettes market will be beneficial to Altria earnings, and ongoing FDA actions on e-vapor make this more likely.