Altria: When you slip on the tightrope, you fall

Shareholders beware, Altria is walking a tightrope.

The secular decline in consumption of tobacco products leads to decline in volumes, but the concomitant decline in revenue can be offset by price increases and cost reduction resulting in expanding operating margins and thus increasing profits.
Altria can continue walking the tightrope if it can continue offsetting the decline in volume by price hikes and cost savings.

What could make Altria slip? A decline in volume it couldn’t offset by price hikes and cost control.

But so far it has been steadily walking the tightrope, year after year.

When you make the extraordinarily difficult appear ordinary because you ordinarily do it, what you really are doing is working magic. That’s the magic of Altria.

1. How the magic works

– a capital-light business
– an addictive product
– strong legacy brands (Marlboro, Black & Mild, Copenhagen)
– being part of an oligopoly with a wide regulatory moat

In more detail:

Altria presents a massive amount of operating income coupled with a minimum amount of capital expenditure. Its work on cost reduction is no small game – for example, Altria has reduced head-count by 40% since 2009.

As to the regulatory moat surrounding Altria, the heavy taxes on tobacco are part of it. Excise taxes for tobacco companies in the U.S. are both based on quantity of items sold and price of items sold, and with decreasing volumes the quantity part of excise tax payments declines. With less volume less tax is paid. The profit margin expands because Altria, dominating the premium segment, hikes the price while the volume declines.

Despite those hikes, Altria’s legacy brands show resilience in keeping relative market share thanks to costumer loyalty. Marlboro, of course, stands out and it is safe to say that without Marlboro Altria would be nothing, but this is an argument for an investment, not against it. Likewise it could be said that without the Coca Cola drink the Coca Cola company would be nothing, which doesn’t make the company a bad investment either.

The regulatory moat and brand power allow for pricing power which Altria takes full advantage of to offset the steady decline in volume in the legacy business. This way Altria keeps up revenue and cash flow and is able to engage in promotional price cutting in new products it tries to build a loyal costumer base for.

What does Altria do with the cash flow it generates? Either good investment (John Middleton, UST) or malinvestment (JUUL, Cronos). But first and foremost it returns capital to those who put capital into it.
In FY 2022, dividends and buybacks combined, Altria rewarded shareholders with $8.4 billion, the tenth part of its current market cap. This also is magic.

2. What would make the magic continue?

Hope A: The acquisition of NJOY, enabling NJOY to tap into the sales and distribution network of Altria (1600 salespeople, 200.000 stores nationwide). The quality of NJOY’s product-line seems to be okay-ish, but Altria clearly banked on the legal clarity provided after the JUUL debacle, because NJOY already enjoys 6 of the 23 total Market Granted Orders (MGO) for e-vapor products in the U.S. and has the only MGO for a pod-based system. MGOs allow tobacco companies to market their products in the U.S.

Hope B: Altria-owned Helix Innovations chugging along with its core product, the oral nicotine pouch on! which has rapidly gained traction among consumers thanks to Altria’s stellar distribution network, but also thanks to steep promotional pricing cutting into margins and making on! a loss-making product. However, Altria expects on! to turn the profitability corner in 2025.
On! volume increased by 70% in FY 2022, growing into a 6% share of the oral tobacco market.
In addition, on! Plus is in the pipeline, a bigger, moist pouch. The moisture makes for faster release and better absorption of nicotine, thus being more attractive to consumers.

Hope C: The joint venture with Japan Tobacco (JT), the goal being to bring JT’s Ploom, a heated tobacco product, to the U.S. (The CEO of JT on its Q42022 Call: “Ploom X provided a steep change in our performance in HTS [heated tobacco segment]. Ploom X is our first truly global product”).

3. What could make the magic stop?

It will stop when Altria won’t manage to walk the tightrope any more: revenue decline is impossible to offset with price hikes while new products don’t gain sufficient traction to make up for the revenue loss on legacy products. When that happens, ultimately the impact on net price realisation will be felt, and from this, on EPS. And then Altria falls off the tightrope, goes into free-fall, and all sorts of bad things can happen (…the dividend…).

Those are the risks I identify, which might manifest individually or combined:

Risk A: Faster than anticipated volume decline
The discount segment has been taking market share from the premium segment in 2022 because consumers traded down with the pessimistic economic outlook, but instead of also gaining share in the discount segment, Altria actually lost 18% of discount market share in 2022. This partly accounts for the overall almost 10% volume decline in cigarettes, considerably exceeding the expected secular mid-single digit decline.

On the Q42022 Call Altria’s CEO explains the notable volume decline with first, a normalisation of the revenue increased during COVID which now negatively skews the comps: “[T]here’s no change in the overall trend, if you will, the long-term trend. As we went through COVID (…) we actually saw what we believe nicotine occasions go up.”
The second reason he gives is that Altria didn’t partake in the deep discount space they say other manufacturers engaged in during 2022. “[W]e certainly don’t want to grow the discount category (…) I think being premium focused where we feel the profitability and the high loyalty is in the cigarette space”.

You can think of those explanations of the CEO what you will. Personally I assume that Altria will maintain its market share in the premium segment while the share of the premium segment in the overall cigarette market will fluctuate with economic cycles. However, if Altria’s decline in the discount segment continues at the pace of 2022, this could drive a hole into revenue that new products won’t be able to fill, especially if market share of the discount segment remains strong with costumers continuing to downgrade in a recessionary or low-growth economic environment.

Risk B: imprudent capital allocation
Since the 1980’s big tobacco has been fully conscious of the danger of declining volumes to its business and has been engaging in attempts to deal with the danger. However, those very attempts can prove to be more dangerous to the business than the decline in volume, as Altria masterly and deplorably showcased in deploying some 13 billion for a 35% stake in JUUL and then writing the investment successively down until exchanging it for an underwhelming licence agreement on JUUL intellectual property.

Risk C: cannibalisation
This is an overall theme with the introduction of new products, but can already be seen in the example of on!. Volume of legacy oral tobacco products Copenhagen and Skoal decline at the same time the company aggressively promotes the nicotine pouch on!. With legacy volume declining and on! volume expanding, cannibalisation seems likely underway. Besides, profit margins will compress in the near future for so long as on! remains loss making.

Risk (???) d: Regulation
Some risks are obvious. For instance, Altria would teeter heavily on the tightrope if excise tax were to be based entirely on price instead of on volume. Or the FDA might ban this or that or anything by tomorrow.

However, with big tobacco I’m rather inclined to believe that it is running a joint venture with regulatory bodies. If anything, the FDA appears to be Altria’s partner in crime. It’s not exactly the partner in crime you would wish for, but still a partner. The reason is that the huge regulatory hurdles maintain an effective oligopoly for big tobacco. Advertising, promotion and marketing for tobacco products is only possible within very limited parameters. Think about it: how do you want to create a costumer base for a new product if you’re running steadily into road-blocks on your way to reaching them?

For instance, a Premarket Tobacco Product Application (PMTA) for a new tobacco product is to be submitted to the FDA and approved by them before said product can be legally marketed in the U.S. The development process surrounding a PMTA is estimated to go into the millions. And for each flavour, nicotine strength and size a separate PMTA needs to be submitted. Those are costs only major producers can shoulder, effectively crowding out nascent competition. Add to those the costs of litigation tobacco companies are fighting on a regular basis.

4. Takeaway

My humble assumption:
Price increases and cost control will counteract decline in legacy product volume, a decline furthered but not exacerbated by cannibalisation through new products. For the next ten years I see Altria very much continue its walk on the tightrope with either flat or very low revenue growth, backed however by EBIT margin expansion. In 2022, which perhaps was a bad outlier year, revenue was down 2%, but Altria still could drive up adjusted EPS by 5%. If revenue remains flattish for the next ten years, Altria won’t slip and fall. If 2022, however, saw the initiation of a revenue decline trend, then from now on the days of Altria walking the tightrope are counted.