Altria Group, Inc. (MO)

PMI / Altria: Poised to Smoke the Market

Company: Altria Group Inc. (MO)
Price: $70.50 (10/19/2007)
Shares Outstanding: 2.11 Billion

Shareholders are Poised to Benefit from the PMI Spin-Off

In August 2007, Altria (MO) announced that it was considering spinning off its international operations. It made its decision to proceed with the spin-off official on September 27th when it filed a preliminary registration statement with the SEC. The company expects to announce additional details of the transaction, including its exact timing at a meeting on January 30, 2008. By purchasing MO now, you guarantee that you will receive shares in PMI when it hits the market.

Why would you want to buy shares in Altria before the spin-off? Because spin-offs consistently outperform the market. In his book “You Can be a Stock Market Genius” Joel Greenblat referenced a study that was conducted several years ago by Penn State University (go Lions!) which looked at spin-offs that occurred over a twenty-five year period ending in 1988. The study found that stocks of spun-off companies outperformed the S&P 500 by approximately 10% per year during their first three years as independently traded entities. Even the stock of the original parent companies did well, outperforming the S&P 500 by 6% annually during the same three year period.

Theoretically, if one picks stocks out of the sub-set of spin-offs that have other attractive characteristics they can do even better than outperform the S&P 500 by 10%. Spun-off companies that have insiders with a high level of ownership or stock options tend to perform even better than those that do not. If we take a look at Form 10 that PMI filed with the SEC when it announced its plan to break away from Altria, we find evidence that it will have this sort of insider ownership. In the section titled “Reasons for the Distribution” it states that the spin-off will provide “tighter alignment of compensation and rewards with the performance of each entity.” This just the sort of incentive for management that investors should look for, their interests are directly aligned with those of shareholders.

Another one of the “Reasons for the Distribution” listed in this section of the filing is “greater transparency leading to the elimination of the sum-of-the-parts discount under which Altria’s common stock has typically traded essentially as if it were solely a U.S. tobacco company.” Altria currently trades at a P/E of 14 (as of 10/19/2007). This is a discount to other companies in the sector, such as British American Tobacco (BTI) with its price to earnings ratio of 18. According to Yahoo!, the average P/E for cigarette manufacturers is over 17. By purchasing Altria now, we are getting shares in the leading domestic manufacturer of cigarettes and shares of an international powerhouse that has lots of room to grow at a discount to the rest of the industry. Many investors will be willing to pay a higher premium for PMI with its higher growth rate and with the threat of litigation in the U.S. removed.


About the Company

Altria is made up of four main parts:

- Philip Morris USA which manufactures and sells cigarettes and other tobacco products in the United States.

- Philip Morris International which manufactures and sells cigarettes and other tobacco products outside of the U.S.

- Philip Morris Capital Corporation which has a portfolio that consists of leveraged and direct finance lease investments in domestic and international assets such as power generation assets, manufacturing facilities, aircraft, and real estate.

- A 28.6% economic and voting interest in SABMiller, which manufacturers and distributes beer in the U.S. and abroad.


Company History

Although the Altria Group, Inc. was only officially formed in 1985, the companies that it owns have a history that dates back more than 150 years. The first piece was created in 1847 when Philip Morris, Esq., a tobacconist and importer of cigars, opened a shop on Bond Street in London. In 1854 he began manufacturing his own cigarettes.

After Morris’ passing, the company went public in London in 1881. In 1902, Philip Morris became incorporated in New York on Broad Street, in lower Manhattan. Its ownership was split 50-50 between its original British parent and new American partners, including Gustav Eckmeyer who had been the sole agent for Philip Morris in the U.S. since 1872.

In 1919 a new company, completely owned by American stockholders, acquired the U.S. Philip Morris company and incorporated it in Virginia under the name of Philip Morris & Co.

Philip Morris began expanding internationally in 1954 when it established its first affiliate outside of the United States in Australia. A year later, the company created a separate division for its international operations called Philip Morris Overseas. The name of the division was later changed to Philip Morris International in 1967.


Bull Case for Altria

Altria is a Cash Generating Machine

Despite its declining customer base and the constant threat of litigation, Altria's domestic cigarette business is a cash cow. It currently pays a 4.2% dividend (as of 10/19/2007). Not only is its current dividend attractive, but the company has an outstanding record of dividend growth, raising it 40 times in the past 38 years.

Altria will use the tremendous amount of cash that it generates to continue to increase its dividends and probably to buy back a large number of shares in the near future. The company stopped buying back its shares in 2003 after it lost a $10 billion class-action lawsuit in Illinois (the verdict was subsequently overturned). This lawsuit severely limited its access to the commercial paper market, so it decided to begin building up its cash reserves. And build reserves it did. At the end of its 2007 fiscal third quarter, Altria had $7.3 billion in cash on the books, an increase of $2.6 billion from the $4.7 billion that it reported having on December 31, 2006. Furthermore, the company reduced its long-term debt to $3 billion from $6.2 billion on December 31, 2006. This reduced debt level will lead to lower interest expenses and the cash that’s on the books can be used to buy back shares and increase its dividend.

Update: Altria has decided to put some of the aforementioned stash of cash to work. On 11/1/2007, the company announced that it is purchasing the machine-made cigar manufacturer John Middleton Inc. for $2.9 billion. The total net cost of the transaction will actually amount to more like $2.2 billion after backing out a $700 million tax benefit. According to Altria, sales in this segment have grown at a 4% annual rate since 2003 and cigars are “highly profitable.” John Middleton expects to sell 1.2 billion cigars and pull in $360 million in revenue in 2007.


New products

Part Philip Morris USA’s growth strategy is to develop new products. It is working on a new line of smokeless tobacco products. The company is currently test marketing Marlboro Snus in Texas and Marlboro Moist Smokeless Tobacco in Georgia. Altria also recently opened a new state-of-the-art R&D center in Richmond, Virginia to help it improve its existing products and to develop new products including ones that have reduced health risks. The center is expected to be fully operational by Q2 2008.


Things are looking up for SABmiller

After the spin-off, Altria will retain its 28.6% interest in SABMiller. On October 9, 2007 SABMiller reached an agreement with Molson Coors Brewing Co. to form a joint venture to merge the companies’ U.S. operations (including Puerto Rico). The transaction is expected to be completed by mid-2008. The companies believe that this merger will result in substantial economies of scale and savings. In the merger announcement, they stated that in exchange for a one-time charge of $450 million they expect to realize major cost synergies “through the optimization of production over the existing brewery network, reduced shipping distances, economies of scale in brewery operations and the elimination of duplication in corporate and marketing services.” The combined Miller / Coors entity expects to realize $50 million in savings during the first full year of combined operations, another $350 million in annual savings in year two, and an additional $100 million annually in year three for a combined annual savings of half a billion dollars. This savings will help the company boost its earnings in a relatively mature industry. Over a quarter of any increase in earnings will flow directly to Altria’s bottom line.


Huge Competitive Moat

In the book "The Dhando Investor" Mohnish Pabrai continuously stresses the importance of investing in businesses that have durable moats, meaning that they have a significant edge over potential competition. I think that Philip Morris USA has an outstanding moat in the form of the Tobacco Master Settlement that the major U.S. cigarette manufacturers reached with the federal government in 1998. The settlement’s restrictions on pricing have made it very difficult for small companies to compete with "Big Tobacco." So Philip Morris USA isn’t going to have any new competitors sneaking up on and undercutting them on price or stealing sales with innovative new products.


Bull Case for Philip Morris International

I believe that Mr. Market is not currently providing PMI with the multiple that it deserves because of the constant threat of litigation, increased taxes, and a declining customer base that are associated with Philip Morris USA. By spinning off PMI, Altria will unlock its true value.

In 2006, the last full year that results are available for, PMI had net income of $6.1 billion. Using a distribution ratio of one PMI share for every Altria share, the spin-off will produce 2.1 billion shares of PMI, giving it an initial EPS of around $3. If one assigns a conservative P/E ratio of 17 to this (the average multiple t