Wednesday, December 26, 2018

Analysis of Altria's Recent Deal Activity

Last week, we had Altria Group (MO) announce a major investment in JUUL, which makes e-cigarettes. You can read the press release here:

As part of the agreement, Altria will participate in the e-cigarette category only through JUUL. The investment complements Altria’s non-combustible offerings in smokeless and heat-not-burn, upon FDA authorization of IQOS. JUUL has a large market share in e-vapor market in the US, and has global operations.

Earlier this month, Altria announced an investment in cannabis company Cronos.

As a shareholder, I am not overly excited about these moves. There are several risks I am seeing behind this investment.

The first risk is that they are investing in a business at a high valuation. This is a business that has only been around for a few years, and has an exciting product that can offer a lot of growth for the future. t has had some rapid growth, although we do not know if we can easily project it onto the future.  At a high enough price however at a high sales multiple a lot of the future profits are already baked in. We live in an era where we have a lot of cash chasing private equity deals, which increases their valuation. The implied value of Juul is $38 billion, versus $16 billion during the summer, when the company closed a round of funding from venture capitalists.

Altria has had success in the past with other investments and acquisitions, including those of UST, General Foods etc. So I am going to give them the benefit’s of the doubt of course. But it does seem like JUUL is getting Altria’s shelf space, distribution, relationships with retailers and customers, and Altria is seemingly trying to disrupt its own business. Too much deal activity in such a short period of time, at such inflated valuations seem a little concerning. I am hopeful to be wrong on this one.
Second, I am always concerned when mature and successful companies buy their way to future growth. There is always the risk that you are overpaying, and that the investment banker projections do not turn out as expected. The deals for a marijuana company and Juul make it seem like Altria does not believe in the future of cigarettes. However, we do not know whether there will be the same level of brand awareness that Altria’s products generate. So if you pay too much, and turns out that the product doesn’t have the same lasting value and brand awareness that traditional tobacco products have, you may have to deal with impairments. If a $12 billion investment goes sour, the debt still stays on the balance sheet.

Third, there is a risk that Altria is going to cannibalize existing sales, because it will help Jul distribute products and give up its shelf space. This is for a company that Altria only has 35% interest in and overpaid for. This move looks like a desperate one or it shows that executives want to leverage the stable cash flows of Altria on a gamble for a hot new product.

The other risk is of increased regulatory oversight of alternative tobacco products. If those are viewed as gateway drugs into nicotine addiction, we may get more regulation. We do not have the same level of visibility that we have with the Master Settlement Agreement of 1998.

I read some articles that stated how JUUL employees will be receiving massive bonuses after the deal closes. I am really hoping that these employees do not leave their work after this – there is a real risk that their productivity will be lower and they won’t be as hungry as before.

The real risk as a dividend investor is that the added debt will result in less flexibility with future dividend growth. The company did announce some cost savings, but the amount of new debt is going to be pretty high. I would state that the risk of a dividend cut is higher today than a few months ago. In my reviews of dividend paying companies and why they cut dividends, I have learned that large investments made with debt increase the risk of dividend cuts down the road. I am hopeful that Altria’s management will not make any drastic changes, and I am certainly not forecasting a dividend cut. However, I will monitor the situation closely. I do hope they manage to join the dividend kings list in 2020.

While I will hold on to my shares for the foreseeable future, I may think before from buying more shares. It is possible that earnings per share will continue growing over time driven by the core tobacco business. The valuation is attractive at 12 times forward earnings. However, the situation is different today, and I am a little concerned about the size and premium paid for recent acquisitions in new and untested markets. The concern is that with the added emphasis on growth, Altria of 2019 will be different than the Altria I invested in the first place. It is possible that dividend growth will be curtailed. I believe that the dividend will likely become less of a priority, and the risk of a dividend cut, although very remote, is increased. I also have a high position in Altria in my personal portfolio, which is another reason why I may not buy more, due to risk management.

Relevant Articles:

- How to avoid dividend cuts
The importance of pricing and valuation in dividend investing
- Altria Rewards Shareholders With a Smoking Hot Dividend Increase
September 2018 Dividend Champions List

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