The growth potential and existing cashflow returns offered by Altria (MO:NYSE) are not fully priced in by the market. The cashflow returns offered by Altria are both generous and hypothesised to be durable. Growth will be driven by the global distribution of JUUL Pod e-vapour devices and a possible merger with Phillip Morris International (PM:NYSE). The monetary value created by this growth will be protected by regulatory barriers imposed by governments, as the possible health risks of the new e-vapour category becomes a concern for the public.
The growth opportunity is thought to be second in importance to that offered by the size, and durability, of cashflow generated by the company’s traditional cigarette business. It is further thought that if financial markets continue to become ‘desperate for yield’ that the significant ESG drawbacks of Big Tobacco will be outweighed by the returns offered by their underlying cigarette businesses, with Altria offering the most value for investors at current market prices and given the above mentioned growth possibilities.
Part One: A Briefing on Regulation and The JUUL Product
The Regulatory Moat
Vaping products globally are currently being adopted by individuals under the assumption that they carry a lower health risk than traditional cigarettes. This assumption is based upon no scientific research, evidence or fact. In the case of JUUL Labs the company has been formally warned by the U.S Food and Drug Administration (FDA) “for marketing unauthorised modified risk tobacco products”. It would be reasonable to assume that the current scrutiny that the vaping market is facing will result in significantly more regulation surrounding the sector.
A key regulation that has been touted by the FDA has been the pre-approval of all JUUL pod flavours prior to their commercial release, a measure that will be mandatory for all manufactures of e-vapour products in May 2020. A measure such as this will inherently increase the burden upon vape manufacturers, resulting in an increase in testing and compliance costs.
Any severe measures put in place, such as the proposed ban on flavoured vaping products, will have a material impact on both the business operations and value of JUUL. However, the impact on small operators entering the market, or making counterfeit pods, will likely be terminal. In the long-term it is probable that with the support of Altria and its seasoned Big Tobacco executive team, that JUUL can catch and retain the majority of the global e-vapour market, as it has done in the U.S.. Capture of the global market will also be made easier through either a merger with PM, or though the licensing of JUUL to PM for global distribution, similar to the current licensing of IQOS to Altria for its North American launch.
These regulatory measures will not eliminate, nor mitigate, the competitive risks posed by other Big Tobacco companies developing reduced risked heat-not-burn and e-vapour products. The measures however eliminate what one can think of as the ‘craft’, as in craft brewery, threat.
This is in reference to the constant entrance to the beer market of micro brewers, whom continuously develop new twists on beer and beer marketing. The ultimate effect of these brewers is both the slow encroachment on the craft beer market share of Big Brewing’s craft beer brands, as well as the absorption of Big Brewery capital, as leading brewers continually acquire leading independent craft-brewers and their product lines.
The introduction of more scrutinous regulation, raising the amount of capital and technical skill required to enter the reduced risk tobacco market, will mitigate, if not eliminate, the ‘craft’ threat. Just as one doesn’t see ‘craft’ cigarettes popping up at the local tobacconist or pub, one won’t see the continued introduction of new reduced risk smoking products to the tobacco market, as the level of regulation they face becomes similar to Big Tobacco.
One can reasonably assume this will reduce the threat of JUUL losing market share to the constant onslaught of new start-ups entering the e-vapour market. This regulation will also result in the reduction of capital allocated to acquiring successful start-ups and their e-vapour brands that target market niches with a differentiated marketing approach, such as in the case of craft-beer.
Premarket Tobacco Product Applications (PMTA) and Modified Risk Tobacco Products (MRTP)
There are two regulatory hurdles that e-vapour products may face, the PMTA that is compulsory as of May 2020 and the MRTP that offers a significant competitive advantage for e-vapour producers if obtained.
The two regulations differ in the fact that the PMTA is simply an authorisation from the FDA. It allows the e-vapour producer to market the product in question. The FDA had previously set a deadline of 2022 before companies had to apply for regulatory approval, however, after a federal judge ruling companies now need to apply by May 2020.
The application process for PMTA is onerous and complex, requiring companies to prove that their products are “appropriate for the protection of the public health”. After the deadline date, a PMTA will be a requirement to sell e-vapour products in the U.S.
Whilst a PMTA is now compulsory for all e-vapour producers an MRTP is not. The two differ in the fact that a PMTA simply allows a successful applicant to sell an e-vapour product in the U.S., whereas a successful MRTP applicant may market health claims in relation to their e-vapour product.
The higher standard of proof applied to the MRTP is due to the fact that the ability to publicly claim and market that an e-vapour product is not as harmful as a combustible cigarette increases the potential market for the product. For example, individuals such marketing may appeal to may include people who have quit smoking due to health fears, individuals transitioning to e-vapour from combustible cigarettes for health reasons, or even individuals who have always avoided the product due to health fears. Hence, and MRTP for an e-vapour product provides a competitive advantage over its e-vapour competitors who cannot make equivalent health claims.
Nicotine Salts & JUUL E-liquid
JUUL pods contain: glycerol (non-toxic sweetener), propylene glycol (organic non-toxic sweetener), flavour and nicotine salt. The term ‘nicotine salt’ is at first confusing, however, nicotine salt simply refers to the scientific definition of the substance. As defined by the encyclopedia Britannica a salt in chemistry is a “substance produced by the reaction of an acid with a base. A salt consists of the positive ion an acid and the negative ion of a base. The reaction between an acid and a base is called a neutralization reaction”.
The creation of nicotine salts is achieved through the combination of specific acids (low pH) with freebase nicotine (high pH), which is pure chemical nicotine extracted from tobacco plants. In the case of JUUL the acid used in their nicotine salt is Benzoic Acid.
Benzoic acid is a widely used substance as it is used for “for foods, fruit juices, and soft drinks that are naturally in an acidic pH range”. It Is a widely produced substance as it used in a range of instances from processed foods to cosmetic and hygiene products.
JUUL Supply Chain
The aim, of understanding what the key ingredients are in the production of JUUL’s nicotine salt formula is not to determine the associated health risk of the product, but the power of the company’s suppliers in pricing the key inputs. In relation to base nicotine, extracted from tobacco plants, the relationship of Altria with tobacco growers will be used to determine relative bargaining strength for JUUL.
In the United States, Altria enters into supplier contracts where it purchases “the majority of its burley and flue-cured leaf tobaccos directly from tobacco growers. Under the terms of this program, PM USA [Altria] agrees to purchase the amount of tobacco specified in the grower contracts”. This direct arrangement between Big Tobacco companies and tobacco growers has only evolved during the last two decades, and now is accepted as the status quo arrangement in North America.
Previously, Big Tobacco companies would purchase tobacco leaf through the U.S. government’s tobacco program that guaranteed minimum prices for tobacco leaf sold within the U.S.. The move away from a regulated relationship between Big Tobacco and U.S. growers was seen as being advantageous to Big Tobacco, as it reduced the pricing power of tobacco growers and allowed for increased volumes of tobacco leaf growing, making smaller sized growers unable to compete with large scale, low cost, tobacco growers.
Given that base nicotine (pure nicotine) is extracted directly from tobacco leaves, one could reasonably make the assumption that the purchasing power of Altria in regard to base nicotine is equivalent to that of tobacco leaves.
A Potential Merger
To properly understand the merger talks that have recently been disclosed between Phillip Morris International (PM:NYSE) and Altria (MO:NYSE), it is best to first recall the two companies backgrounds and previous relationship.
PM and MO are the spin-offs of the prior demerger of Phillip Morris. The Phillip Morris company split its North American business, with declining unit sales and high regulatory scrutiny, off into Altria, and its growing international business off into Phillip Morris International, in effect shielding its international operations from U.S. Government regulators.
Since the break-up the companies have shared a considerably close relationship. This is evident in the following co-ordination:
Altria currently has the distribution rights to PM’s ‘heat-not-burn’ IQOS device within North America.
The two companies also distribute the same brands, primarily Marlboro, in separate geographic locations.
Considering the majority of the two companies’ products are identical, in terms of branding and production, it is hard to see how the two companies will not enjoy a significantly smoother merger than what is typical of other mergers of similar sized companies.
The since ceased merger talks disclosed what was effectively an acquisition of Altria by Phillip Morris International, through an all share combination. The combination would leave PM shareholders owning between “57 and 59 per cent of the combined group”.
On the 25th of September the companies announced that merger talks had ceased. The breakdown came directly as the result of increased scrutiny on the e-vapour market in the U.S., impacting one of Altria’s key assets, JUUL, that one would assume PM was seeking exposure to.
Reported Health Effects of E-Vapour Products
Recently in the U.S. there has been an outbreak of respiratory lung diseases linked to pod vapes. As of writing there has been 1,604 probable cases of severe lung illnesses related to vaping in the U.S., according to the Centres for Disease Control and Prevention. There have also been 34 deaths resulting from the vaping related illnesses so far.
Research performed by the Centre for Disease Control and Prevention (CDC) in the US indicates that the majority of victims had been vaping counterfeit versions of e-vapour pods containing THC (tetrahydrocannabinol) oil with traces of Vitamin E acetate present in all patient samples. Vitamin E Acetate is an oily agent recently found in black market THC products.
This confirmed what has been believed and expressed by many health experts for some time, that the use of e-vapour products can pose a significant risk to the health of those individuals whom choose to use the products. The current summary advice provided by the New York Health Department is that “anyone using vape products should never use unregulated products purchased “off the street.”
The key word in the above paragraph is “regulated”, it would be reasonable for one to assume that the higher the level of harm caused by counterfeit e-vapour products, containing either nicotine or THC, the higher the chance of increased regulation and associated penalties being applied to the e-vapour market.
Although merger talks have ceased, there still remains a strong business case for the merger to proceed once scrutiny of the U.S. e-vapour market has subsided. This may take months or years, however, once more stringent regulation has been put in place around vaping products it will make existing market participants more valuable to a prospective acquirer seeking to enter the market.
Why MO:NYSE Offers More Value Than PM:NYSE
As announced by both companies, merger talks have been discontinued, however, with the growth of alternative tobacco products in both the heat-not-burn and e-vapour markets, there remains a strong business case for the merger to proceed at some point in the near future.
As already stated, the business activities of both companies are concerned with the manufacture and sale of the Marlboro brands of cigarettes. In the case of a merger Altria would benefit from exposure to PM’s growing combustible cigarette business within emerging markets, predominately within South-East Asia. Secondly, in the case of no merger, Altria is also still in the position to influence the decision of JUUL to licence its product to PM for its international distribution.
Finally, Altria currently is valued significantly more conservatively than PM, with earnings yields of 7.14% and 5.85% respectively. This conservative valuation is due to the higher rate of unit sale declines in Altria’s North American markets than compared to PM. The economic effect of a decline in unit sales will be covered later in the report, however, the point here is that any merger between the two companies will result in a higher growth rate being applied to FCFE earned by Altria’s current businesses.
Conversely any merger will result in a reduction of the growth rate currently applied to PM’s FCFE. Hence, post-merger Altria FCFE will be priced at a higher premium than at present, due to the effects of the business combination described above. The combined effect of the above factors reduces the downside risk of Altria stock in the case of either a merger or no merger, hence why one can assume Altria offers more value than PM.
Part Two: Market Structure, Nicotine Content Unit Economics & Management Team
1. Competition in the Industry
The Big Tobacco industry is a pure oligopoly, with the five largest companies enjoying 86 % of sales, when sales are measured in $USD. These figures exclude the Chinese tobacco market, which is the world’s largest, as the market is solely controlled by the state-owned China National Tobacco Corporation (CNTC).
2. Potential of New Entrants into the Industry
For traditional tobacco products, immaterial.
For substitute products it seems to become only less likely as entry becomes significantly harder due to regulation. The current outbreak of vaping related illnesses has seen significantly more regulatory scrutiny on the sector. The Trump Administration has proposed an outright ban on flavoured vaping products, a ban which many within the industry believe will go ahead. This will result in a regulatory fence being placed around the e-vapour market with entry only via the locked gate of the regulatory body. The FDA is the only regulatory body with the key to allow entry.
Given the regulatory experience of Altria, it would be reasonable for one to expect that their ability to introduce new products, and product improvements, under the JUUL brand in the face of regulatory scrutiny from the FDA, would be significantly higher than any new entrants wishing to enter the market. i.e. they don’t have the key to the gate, but they are old friends with the regulator who does.
3. Power of Suppliers
As discussed above, Altria sources the majority of its Tobacco leaf from the United States where it is the market’s largest purchaser. The market was deregulated in 2001–2003, with the removal of a price floor. This led to significantly lower prices that eliminated smaller growers from the market, with major growers contracting directly with Altria at prices well below that previously set by the US government.
According to reports written on the tobacco growing industry, this resulted in Big Tobacco manufacturers enjoying considerably more power in the relationship. This is due to the disproportion in the size of the tobacco manufactures (bigger) in relation to that of tobacco growers (smaller).
4. Power of Customers
The price elasticity of any product is dependent on the ability of customers to substitute the given product with another when a price increase occurs. When we think of close substitutes to cigarettes not many come to mind, however, the few that do are heat-not-burn and e-vapour products. The most popular of both these substitutes are IQOS and JUUL respectively, both of which are leaders in their respective markets.
5. Threat of Substitute Products
E-vape’s and heat-not-burn products. Both leading brands controlled by Altria and Phillip Morris International respectively.
With PM having full ownership of IQOS and Altria having a 35% stake, two board members and appointing JUUL’s current CEO, it’s evident that PM and Altria exert control over and enjoy the economic benefits of both products.
Nicotine Content Unit Economics of JUUL
The product consists of a JUUL device which comes in a USB style form factor as well as a pod, which contains the JUUL nicotine salt and flavouring. The JUUL device with a pod attached measures at just under 9cm in length.
The device alone retails at $34.99 and pods come in packs of 4 retailing at $16.99, also a starter kit can be purchased containing a device and 4 different pod flavours for $50.
Each pod contains approximately 0.7ml of e-liquid, which equates to roughly 200 puffs. The nicotine levels available are both 3% and 5% nicotine by weight strengths. This is also represented as approximately 35mg/ml and 59mg/ml, or, 24mg and 41mg per pod respectively.
Measuring in nicotine mg/ml is helpful as it allows a more accurate comparison with cigarettes. I’ll take two example, Marlboro Red (full strength/heavy) and Marlboro gold (mid strength/mild). Marlboro Red’s contain 1.07mg of nicotine per cigarette or 21.4mg per pack of 20, whilst Marlboro Gold’s contain 0.72mg of nicotine per cigarette or 14.4mg per pack of 20. How this compares to the nicotine contained in a JUUL pod is broken down in the below tables:
Selling a Nicotine Addiction
To understand what Altria, and other Big Tobacco companies do, we simply need to break their value proposition down to its most fundamental level, which is satisfying their customers nicotine addiction.
Based on the above nicotine milligram contents between JUUL and Marlboro cigarettes it is evident that JUUL pods are a more potent and efficient nicotine delivery method.
Selling a nicotine addiction is a particularly price inelastic business activity. It is evident in the past five years of Altria’s unit sale and revenue.
If we focus on the average change in total cigarette shipment volumes in conjunction with the change in revenue and operating income from Altria’s Smokable Products segment, the extent of the price inelasticity becomes evident. We can see quite clearly that shipment volumes have fallen at an average of over 3% for the past 5 years, whilst simultaneously revenue and operating income have increased on average at approximately 0.43% and 5% respectively.
The inelasticity of Altria’s Smokable Products segment can almost solely be put down to the company’s ability to raise prices at a greater rate than unit declines. What gives the company this power is quite simply the addictive nature of nicotine, and the need by smokers to service their inherent addiction. Given that JUUL is a more efficient nicotine delivery mechanism, as determined above, it would be reasonable to assume that the product benefits from equivalent, if not higher levels, of price inelasticity.
The above point has been made to both illustrate the ability of Altria, and other Big Tobacco companies for that matter, to weather declining cigarette volumes. It has also been made to illustrate the pricing power potential currently inherent in the JUUL product.
Juul Market Share
Over the past 2 years JUUL has enjoyed impressive growth reaching a peak market share of around 75% of the e-vapour market in mid-2019. However, being the market leader has resulted in JUUL bearing the brunt of the public backlash, as well as regulator contempt, throughout the current e-vapour health concerns. The most recent Nielsen survey indicates that JUUL has roughly 67% of the U.S. e-vapour market.
Competitors have taken advantage of the current scrutiny primarily focused on JUUL, with significant promotions being run by competitors. For example, competitor NJOY is selling its Ace e-vape for 99 cents in stores, compared to the usual $7.99 it charges for the device on-line. This strategy has also been adopted by British America Tobacco’s Vuse e-vape brand and Blu, both selling their devices for $1 when a customer buys a packet of pods.
The above competitors are also still offering fruity flavours, whereas JUUL has ceased selling such flavours until such case where it obtains a PMTA from the FDA. So, whilst the above competition has had a material effect on JUUL’s market share, it is questionable how sustainable such drastic discount strategies are on what are essentially nicotine lollipops in the face of increased regulatory and public scrutiny of the e-vape sector.
Kevin Carlyle (KC) Crosthwaite
In wake of the of the reported ‘e-vapour epidemic’ JUUL’s CEO, Kevin Burns, stood down voluntarily to be replaced by KC Crosthwaite. Mr Crosthwaite is a seasoned Big Tobacco executive, having over 20 years’ experience in the tobacco industry. Most recently he served as Altria’s Chief Growth Officer, a role he fulfilled from May 2018.
As described by JUUL, whilst Chief Growth Officer of Altria, KC Crosthwaite “oversaw the company’s expansion into alternatives to combustible cigarettes and played a key role in the commercial and regulatory efforts related to the U.S. launch of IQOS”. This is in reference to Mr Crosthwaite successfully leading the application of Altria’s PMTA application for PM’s IQOS, the first product to be successful in obtaining a PMTA.
Quite simply, if there was an experienced executive that one would like to be steering the ship at JUUL, it would probably be Mr Crosthwaite, given his resume at least.
Since his appointment Mr Crosthwaite has already moved to pre-eminently appease to the FDA by voluntarily suspending JUUL’s sale of all non-tobacco and non-menthol based JUUL flavoured pods.
Part 3: Valuation
“Ultimately, the survival of the capital asset pricing model as the default model for risk in real-world application is a testament to both its intuitive appeal and the failure of more complex models to deliver significant improvement in terms of estimating expected returns…this expected return can be considered the cost of equity for a company We would argue that a judicious use of the capital asset pricing model, without an over reliance on historical data, is still the most effective way of dealing with risk in valuation in most cases”. — Aswath Damodaran, Professor of Finance, New York University Stern School of Business
Due to the above observations made by Mr Damodaran, an individual significantly more skilled at security valuation than me, I have determined that maintaining a simplistic valuation model that, relies primarily on his methods and Free Cash Flow to Equity (FCFE), will grant the highest probability of coming to an accurate ballpark figure for Altria’s valuation.
Three possible methods of conducting a DCF valuation utilising a CAPM discount rate have been determined. They are:
5-year Average FCFE (Excluding AB InBev Dividend, Inclusive of AB InBev Earnings)
Addition of the Equity Interest in AB InBev
5-year Average FCFE (Excluding AB InBev Dividend, Excluding AB InBev Earnings)
Beta adjusted for the large ownership of AB InBev and its material impact on the companies reported earnings. (o The adjustment is made as the AB InBev business is independent from the tobacco business in real world operations and management decision making.)
Addition of the equity interest in AB InBev
5-year Average FCFE Consolidated (Inclusive of AB InBev Dividend, Inclusive of AB InBev Earnings)
No addition of the equity interest in AB InBev
All three methods do not account for the equity interests in either JUUL or Cronos (CRON:TSE). The merits and drawbacks of each valuation approach have been debated extensivley. Whilst, adjusting for the Beta of AB InBev makes theoretical sense, the outcome it produces of a discount rate of 3.04% jolts the mind as significantly low.
Whilst concerningly low, the discount rate in ‘Method 2’ does seem to support the hypothesis that this report begun with: “that if financial markets continue to become ‘desperate for yield’ that the significant ESG drawbacks of Big Tobacco will be outweighed by the returns offered by their underlying cigarette businesses”. If it were any other business in question one would reject a discount rate of 3.04% immediately, however, the business in question is a mature tobacco business, where little expenditure is required on capex or marketing and where customers are physically addicted to the product.
It is ultimately up to oneself to decide which valuation method one is most confident in. After extensive deliberation I have personally been unable to come to a conclusion and simply elected to take the average of all three methods, essentially creating a Method 4.
The result of this approach is the intrinsic value of Altria’s tobacco business and interest in AB InBev being $USD 117.3 billion. This figure still does not account for Altria’s interests in JUUL, a rapidly growing company which this research report has outlined has significant growth potential.
I have also determined that the ability to accurately value JUUL is simply too hard at present.
The combustible cigarette business of Altria group has remarkable price inelasticity, so as unit volumes decline, revenues are able to maintain their levels, whilst cost efficiencies improve operating income. Due to this one can reasonably conclude that cashflows are durable and will be of a similar size to their trailing five-year average. This satisfies Benjamin Graham’s famous definition of an investment operation being “one which, upon thorough analysis, promises safety of principal and an adequate return”.
Secondly, Altria’s investment in JUUL makes sense for the company based upon the analysis conducted. This is due to the fact that as customers move towards e-vapour products the company will be in a position to capture a material part of this new market. Based on the above valuation which doesn’t include Altria’s stake in JUUL, or modelled cash flows and growth, an investment based solely on Altria’s tobacco business and AB InBev stake is currently undervalued. This effectively offers investors a free call option on any growth from the JUUL business.
One can never determine with certainty what the future may bring in terms of upside and downside risk, though we can try with some accuracy to gauge the range of permutations a business may face in the future. Given the fact that the above opportunities can be further enhanced by a merger with Phillip Morris International, for which there remains a strong business case, it is evident that there exists significantly more chance for growth and economic upside than there exists for economic downsides.
Disclaimer: The Author has a long position in Altria (MO:NYSE)
If the reader would like to do further reading, please find a list of articles and papers I found of use here:
 Investment Valuation, Aswath Damodaran
 Emerging Challenges for U.S. Tobacco Farmers, United states Department of Agriculture-Farm Service Agency (2001)