3 Ways a Massive Moat Helps Altria Thrive
From 1926 to 2016, Altria (NYSE: MO) the stock averaged 17.7% per year. But time and time again investors have ignored Altria – and missed the three reasons why the tobacco giant, formerly known as Phillip Morris, has become one of the best performing stocks of all time.
an addictive product
Tobacco is addictive. This one probably comes as a no-brainer, but tobacco has been chewed or smoked in one form or another for over 1,000 years, and Altria has infamously produced and sold cigarettes and tobacco products for over 150 years. Tobacco contains nicotine, which stimulates an addictive chemical release in the brain.
You can see this dependency in Altria’s pricing power. Eight years ago, Altria generated $5.6 billion in revenue from smoking products per quarter, while selling about 34 million units. Today, Altria generates $6.3 billion in revenue while selling 17% fewer units. Although smoking has clearly slowed this decade, Altria’s revenue has grown every year since 2011, showing repeat customers are willing to pay significantly more for the same product.
Altria enjoyed great success in the early to mid-1900s as smoking grew in popularity. However, as smoking peaked in the 1960s, studies began linking the habit to several deadly lung diseases. To counter the consequences of smoking, the government has tried to coerce the tobacco industry with various laws. Tobacco production began to face legal pressures in the 1950s; whether in the form of customer or state lawsuits, advertising bans, warning labels, excise taxes or the introduction of smoke-free zones, new laws have led tobacco growers to spend a lot of time and money fighting these restrictions in court.
However, while this may seem like a difficult environment for large tobacco companies, it was much more so for small producers. From 1967 to the present, tobacco production has essentially been strained, and the wealthiest companies have survived and prospered. The largest of these companies is Altria.
Beginning in 1971, the federal government introduced several advertising bans, which ultimately prevented companies like Altria from marketing tobacco products to the public. The bans were intended to limit potential customers’ awareness of these harmful products, but the government’s measures have also created significant barriers to entry for industry start-ups. In the consumer goods industry, promotion and marketing are key to getting your name out there. To successfully sell to customers, a brand must first increase its awareness. Since new start-ups do not have the capacity to bring their products to market, the threat of new entrants in the cigarette business is quite low. That’s why Altria only has three or four major competitors in the world, and each of them has been around for over 40 years.
These bans not only discouraged competitors, but also helped Altria – which could rely on its long-established stable of well-known brands – reduce its marketing expenses. In fiscal 1991, the company spent $13.3 billion on marketing, administrative, and research expenses, which accounted for nearly 24% of its operating revenue for the year. By 2019, those costs had dropped to $2.2 billion, or about 9% of operating revenue.
As the consequences of smoking became more widely known, Altria began to see lawsuits. The first lawsuits came from people who lost loved ones or had to pay expensive medical bills, but later state governments brought their own lawsuits. Mississippi led the legal charge in 1994 with an attempt to recover losses from having to pay Medicaid to individuals. In 1998, 46 states came together in a $206 billion settlement with the four major tobacco companies.
The $206 billion would be paid over the next 25 years, but payments to states will continue indefinitely, as long as state citizens continue to receive Medicaid. In the first nine months of 2020 alone, Altria spent $76 million on tobacco and health litigation costs. For Altria, this sum represents less than 1% of its adjusted annual profit, but for smaller companies that could also be exposed to large lawsuits, fines of this size could harm their entire business.
Again, while this may not seem like a great result at first glance for large tobacco growers, it certainly discourages newcomers. Long, arduous and capital-intensive legal battles demonstrate just how much time, effort and money is spent in the courtroom – an expense that only a few companies can afford.
Besides the contentious difficulties of running a tobacco business on an ongoing basis, starting one could be even more difficult. The FDA and individual states have their own regulations and rules regarding the sale or manufacture of cigarettes or tobacco products. Many states have a limited number of permits and conduct extensive background checks during the application process, ultimately adding another hurdle for new entrants to overcome.
Hearty capital to spend
Ultimately, all this regulation has really done is isolate existing industry leaders. In the first nine months of this fiscal year, Altria generated operating profit of $8.3 billion, approximately 80% of which was distributed to shareholders in the form of a dividend. Altria can afford this payment because they simply don’t need the extra money to operate. With so few competitors, it hardly needs to spend money on marketing or other competitive costs. In the past nine months, less than 7% of revenue was spent on combined marketing, administrative and research costs.
Any excess profits created by Altria are generally spent to gobble up other actions of sin and diversify your existing business. For example, e-cigarettes and vaping have recently gained popularity in the tobacco industry, and privately owned Juul has become one of the leaders in the industry. Many consumers and investors saw this potentially disrupting Altria’s traditional tobacco business. To combat this, in 2018 Altria acquired a 35% stake in Juul for a whopping $12.8 billion.
However, shortly after Altria’s investment, users of other vaping products began to report serious lung conditions which were later attributed to dangerous additives, and Juul itself was hit with multiple lawsuits alleging that it targeted its products at teenagers. The federal government tightened regulations on the sale of e-cigarettes and Altria’s stake received an 88% discount to its initial valuation.
While most investors would view this investment as an obvious mistake, Altria viewed it as life insurance. Sure, that seems like a waste in hindsight, but without government intervention, it’s unclear what Juul might have done to Altria’s traditional smoking business.
“Sinful” but lucrative
While the ethics around Altria’s business model are still hotly debated, its ability to generate profits is hard to argue. Over the past eight years, the stock has risen only about 25%, compared to the roughly 150%-plus growth of the S&P 500. But over the same period, adjusted diluted earnings per share increased by more than 100% and free cash flow over the last 12 months increased by more than 150%. Meanwhile, annual dividends per share nearly doubled; when you add those payouts to the performance of Altria’s stock, its total return for the period comes to around 90%.
Naturally, this relatively subdued stock market performance could discourage many investors. But over the long term, stocks tend to follow earnings, and I don’t see how Altria would be an exception.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end consulting service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.