The bottom of the Altria group is there: strong technical and fundamental (MO) signals

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The investment thesis

If you are reading this, you should know that Altria Group (MO) has been lagging the overall market for years. However, the trend has reversed recently. MO has been showing a strong upward trend since the end of 2021. It shows a clear and strong technical signal of a reversal in sentiment. The S&P 500 has lost more than 6% since peaking on December 27, 2021, while Altria Group’s share price has gained 7% since then.

At the same time, the stock is showing equally strong trading fundamentals. Its activity remains very profitable with an extremely high return on capital employed (“ROCE”). In fact, its ROCE has averaged over 130% in recent years, rivaling even the outperformers of FAANG Group.

Yet its valuation is too cheap, selling at only 8.2x of its 2021 pre-tax earnings and around 7.9x of its FW pre-tax earnings. In the short term, an investment here is well positioned for significant short-term gains. And in the long-term yields, you’ll see that’s like owning a capital bond with a yield of 12% and at the same time with a coupon payment that’s increasing by 4-6% per year.

Strong technical signs

After lagging the overall market for years, sentiment towards MO has recently reversed. As you can see from the following chart, its stock price bottomed out in early December 2021 at nearly $43 per share. Since then, its stock has rallied to the current level of around $50 per share, an appreciation of 17%. In contrast, the S&P 500 hasn’t gone anywhere over that same period – it’s actually lost 1%.

What has happened over the past few weeks since the global market peaked on December 27, 2021 is even more telling. As indicated by the orange arrows in the following chart, the price of MO remained bullish and rose 7%, while the S&P 500 lost more than 6%. The stock held its gain for days even as the overall market suffered some of its worst daily bruises.

And then we’ll see that the stock’s valuation is still attractive even after such a big rally and the company’s fundamentals are just as strong.

Altria MO outperforms on deadly market day

Author and Yahoo Finance

Buffett’s 10x pre-tax valuation and rule

The stock’s valuation remains attractive even after the strong price increases above. The following chart shows its historical prices compared to 10x of its pre-tax earnings (Buffett’s so-called 10x pre-tax rule). Earnings before taxes are also referred to as “EBT”, Earnings Before Taxes, in this article.

As seen, whenever the price is well above 10x EBT, it is a good time to sell. And whenever the price is near or below 10x EBT, it has been a good time to buy. You can see that right now the stock price is still below 10x EBT with a good margin, signaling a very attractive valuation and a very attractive entry opportunity.

Altria MO valuation and Buffett's 10x pre-tax rule

Author based on Seeking Alpha data

In case you were wondering why, of all the valuation metrics, I chose profit before tax? The reasons are detailed in my earlier writings on Buffett’s 10x pre-tax rule. And a very brief summary is provided below to facilitate the rest of this discussion.

First, Buffett himself paid about 10 times his pre-tax profits for so many of his biggest and best deals, so that can’t be a coincidence.

Second, after-tax profits do not reflect company fundamentals. Taxes may change from time to time due to factors unrelated to business fundamentals, such as changes in tax laws and changes in capital structure. Additionally, there are many ways to reduce a company’s actual tax burden.

Third, pre-tax profits are easier to compare, for example, to bond profits. The best equity investments are in bonds, and when we talk about bond yield, that yield is pre-tax. Thus, an EBT of 10x would provide a 10% pre-tax earnings return, directly comparable to a 10% yielding bond.

As a result, if I buy a business with stamina at 10x EBT and even if the business stagnates forever, I’m already perfectly happy to make a 10% pre-tax return. Any growth is a bonus.

Then we will see that MO not only has a stable stamina, but also a very healthy growth prospect.

MO: what are its growth prospects?

As can be seen, MO earnings are expected to grow by around 5-6% per year for the next several years, according to Wall Street consensus estimates. In the rest of this section, I will argue that:

A) such a growth rate is indeed very reasonable and can be achieved organically with great certainty.

B) and such a mid-single-digit growth rate need not be overlooked. In the case of MO, such growth is more than enough to already offer a very nice total return to shareholders.

Wall Street Consensus Estimate of Altria Group Earnings Growth

Looking for Alpha

Also, as detailed in my previous writings on Buffett’s 10x pre-tax rule, over the long term, the growth rate of an established business is simply given by:

Long-term growth rate = ROCE * Reinvestment rate

As mentioned above, ROCE represents return on capital employed. ROCE considers the return on the capital ACTUALLY employed and therefore provides insight into the additional capital a company must invest to earn a given additional income.

MO has been able to maintain a respectably high ROCE over the last decade: an average of 137% for the last decade and its ROCE has been significantly above this average in recent years (around 160%). Details can be found in my previous MO ROCE article. To help put things into perspective, this level of ROCE is extremely competitive even against the FAAMG pack. Indeed, the average ROCE of the FAAMG group is “only” around 80%. And MO’s ROCE is only second to Apple Inc (AAPL) in this group.

Now let’s move on to the reinvestment rate. MO is just the quintessential example of a cash cow. It generates a ton of cash and at the same time requires very little maintenance CAPEX. MO has used an average of ~4% of operating profit as maintenance CAPEX in recent years. It can thus sustainably pay nearly 90% of its income in the form of dividends.

As a result, it can sustainably and organically reinvest around 6% to fuel its future growth. Now with a ROCE of around 130% and a reinvestment rate of around 6%, its long-term organic growth rate would be around 7.8% (130% ROCE multiplied by 6% reinvestment rate ).

So, as mentioned above, in this case my analysis is largely in line with the Wall Street consensus. A mid-to-high single-digit growth rate is indeed very reasonable and can be achieved organically with high certainty.

Finally, such a growth rate should not be overlooked. In the case of MO, such growth is more than enough to already offer a very nice total return to shareholders. To consider:

  • Paying 10 times EBT for a company that will stagnate forever is like owning a bond with a 10% yield.
  • In the case of MO here, the current valuation is significantly below 10x EBT. That’s about 8x EBT, which is equivalent to buying a bond yielding 12.5%.
  • At the same time, there is a good prospect of long-term growth of 6% to 8% – a growth rate that can be financed organically and supported by the company itself.
  • Thus, an investment here is similar to owning a bond with a yield of 12.5% ​​and at the same time increasing the coupon payment by 4-6% per year. Such a composition can create wonders if you hold it long enough (like Buffett).

Risks

First, the pace and degree of post-COVID economic recovery is an uncertainty. There has been a long debate regarding the elasticity of demand for OM products (whether people spend less on tobacco products or not during economic downturns). But regardless, the pace and degree of post-COVID economic recovery, particularly the ongoing delta and omicron variant, is a big near-term uncertainty for MO.

The most fundamental risk is the secular decline of its smoking products. Altria has constantly faced regulatory pressures in the form of product taxes and advertising restrictions. And such pressure constantly poses risks. MO has taken proactive steps to diversify its product offerings. It invests aggressively in new, non-combustible and healthier products. I have no doubt that a top player like MO will definitely play a part in these future new products. However, the path can be tortuous (and JUUL’s failed investment is a good example of this) and the degree of success remains uncertain at this stage.

Conclusion and final reflection

The thesis is that Altria Group’s bottom is in place, as evidenced by both strong technical and fundamental signals. As such, an investment here is well positioned for both short-term gains and long-term returns. Specifically,

  • The technical trend for Altria Group has recently reversed. The S&P 500 has lost more than 6% since its peak in December 2021, while Altria’s stock price has gained 7% since then (and more than 17% since its low in early December 2021).
  • The stock’s valuation remains attractive even after the strong price increases above. It is currently for sale around 8.2x EBT or 7.9x FW EBT.
  • Such a valuation is equivalent to holding a stock bond with a yield of 12.5% ​​even if it stagnates indefinitely.
  • Still, MO earnings are expected to grow by around 5-6% per year according to the Wall Street consensus. And I will argue that such a consensus is indeed very reasonable and can be reached organically with great certainty.

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