Last week I shared my April Investing Ideas, and the post primarily focused on fallen angels — once great companies that have “fallen” from grace.
As usual, my “ideas” posts always generate a bunch of comments. Some people agree, and other people disagree, but I always like to read the feedback.
This “fallen angel” theme generated some additional questions about two more fallen angels I didn’t mention in the post — Altria and Philip Morris International.
These stocks were interesting enough I decided to do a separate post for them! Their shares have fallen in recent months, and I think everyone wants to know, “When is the right time to buy?”
But are these really angels on their way back to new highs? Or, are they devils slowly sinking into a grave?
Fallen From Grace
Generally MO focuses their business on the United States, and PM focuses on everything outside of the United States.
Yes, these are ‘sin’ stocks, that are frequently disliked by many investors. This year in particular they’ve seen a lot of negativity: MO stock is down 21% YTD, and PM is down 22% YTD.
“Them’s no small potatoes.”
The cigarette business is an industry that’s been in decline for decades now. It’s been a dying industry since the 1960’s, when usage peaked at around 43% of adults in the U.S.
Despite the long slow decline, cigarette stocks have been very good performers for investors (up until recently). In fact, last year I wrote a post that discussed why Altria is one of the best performing U.S. stocks ever.
Yup, those are average annual returns of 20.6% from a industry in decline. That really incredible when you think about it!
So shouldn’t we be super excited when top performers like this are finally cheap?
Not really. Just because Altria and Philip Morris enjoyed outstanding returns in the past does not mean they will outperform in the future.
What we really need to understand why the stock price is falling right now. Not what it did in the past!
After doing some research, I was able to come-up with several possible answers to explain the recent fall:
1. Smokeless Tobacco products might not turn-out to be as positive as was hoped. Shares were overvalued on growth hopes.
2. Interest Rates are rising, and these stocks are often considered bond proxies… so when bonds fall due to rising interest rates, so do these stocks.
3. Debt levels are high, and cash flow management problems could hurt future dividends (more on this later).
A Dead Company?
Would you ever consider investing in a company on its way to a slow death?
The question is rather silly of course — EVERY company is going to die someday. They all have a limited lifespan… But how short is the lifespan on cigarette companies?
As far as smoking goes, the CDC estimates that 15% of all U.S. adults smoke, and that number drops every year. Internationally the trend is similar — most countries are seeing a decline in smoking.
In recent years however, new smokeless products had investors convinced that growth was right around the corner. Hopes were placed on new products like e-cigarettes, vaping, and safer “heated” tobacco products.
These new products put ‘dreams of growth’ in investor’s heads, but the facts seem pretty clear to me — nicotine and tobacco products have far less social acceptance than they used to.
Alcohol and caffeine are also addictive substances, but they enjoy far more social acceptance than nicotine based products. It’s considered socially acceptable to drink coffee and alcohol in public.
Cigarettes (by comparison) are highly regulated and heavily taxed. Even ‘e-cigarettes’ cannot be used in most public buildings, and have designated locations for use. (Regulations for e-cigarettes vary by state of course.)
So should investors think of Altria and Philip Morris as “dead companies” in terminal decline?
Not in the immediate sense. The most recent 10Q’s for both MO and PM indicate the hopes for becoming “growth” stocks are probably unrealistic. Phillip Morris has seen some revenue growth from “smokeless” products, but that hasn’t translated into cash flow improvements.
That said, the new products do give Altria and Philip Morris a longer time horizon. I highly doubt these new “lower risk” products are going to draw a ton of new customers. Cigarette use will probably continue to decline into single digit percentages, and taxation/regulation around the new “lower risk” products will continue to rise.
So how do investors profit from a declining business like this? Well, mainly from dividends and share buybacks. That, and buying at the right price.
Dividend investors have been attracted to Altria and Philip Morris over the years due to a large and growing dividend payout. That (mostly) hasn’t changed.
Currently Altria sports a dividend yield of 5% and Philip Morris pays a tidy 4.27% dividend.
But what does the future hold? Will there still be decades of growing dividends to come?
Unfortunately this is where I believe the big problem lies. In the past, MO and PM were able to continuously raise dividends because they bought back shares and paid the dividend out of free cash flow.
Meanwhile, shares were cheap. In Altria’s case, shares frequently traded hands at EBIT/EV multiples of 5. That’s cheap! Every dollar invested in share buybacks resulted in very good returns on capital employed.
These days the shares aren’t so cheap. Altria sports a EBIT/EV ratio of 11, and Philip Morris has a ratio of 13.3.
That’s fairly expensive. Furthermore, the dividend situation isn’t what it used to be — dividends now exceed annual free cash flow at both companies.
Furthermore, Altria now borrows money to buy back shares. Philip Morris actually stopped buying back shares in 2016 because they couldn’t afford it.
Debt levels at both companies are growing. While it’s not a huge problem “yet” because of low interest rates, it might mean trouble for future dividend increases.
To grow dividends, both companies must (currently) grow their debt levels. At some point, this is going to be unsustainable.
Would I Invest?
Now we come to the big question — Would I invest in either company?
To give a single word answer: No. I wouldn’t, and it’s not because these are ‘sin’ stocks.
First of all, investors need to realize that earnings quality at either company is pretty rubbish. The earnings per share number that’s published has very little to do with how much cash the company actually generates. EPS is garbage here. Investors are better served by completely ignoring that number.
Second, the “magic formula” that fueled the 20.6% stock returns of the past no longer exists. Shares are expensive on a cash flow basis, and dividend payouts now exceed free cash flow. Furthermore, share buybacks are significantly less effective now that money must be borrowed to buy shares.
In my honest opinion, share prices have room to fall further… at least until they become attractive to investors looking for a corporate bond replacement.
This kind of investment might be interesting to some investors, but I would rather skip the potential 10-20% losses.
What do you think? Am I wrong? Do Altria and Philip Morris have a bright future ahead?
[Image Credit: Flickr]