Tuesday, October 1, 2019

Opportunity in the Big Tobacco Duopoly?

Over the past couple of years (since short-term interest rates have been non-zero) we have watched for opportunities to buy short-term corporate bonds at yields meaningfully higher than treasuries of the same maturity.

"Yields meaningfully higher" has meant a spread of a fraction of a percent - say 0.25% higher. Enough to be worth the bother, while still being a loan on which it is hard to imagine losing the capital invested.

This has typically meant a bond from a disfavored company (maybe with a low "rating"), yet a low multiple of net debt to free cash flow, and a high multiple of equity market capitalization to net debt. Some examples of issuers:

  • Anheuser-Busch InBev (BUD) has a market capitalization of $190 billion, $130 billion of total liabilities less current assets (for a total EV of ~$300 billion), and operating income of $18 billion. Their EBITDA is $23 billion.
  • Becton Dickinson (BDX) has a market capitalization of $68 billion, debt of $20 billion (enterprise value of $88 billion), and operating income of $2.7 billion. Their EBITDA is $5 billion.
  • Fiserv (FISV) has a market capitalization of $70 billion, net debt of about $5 billion, and operating income of $1.5 billion. Their EBITDA is $2 billion.
  • Juniper Networks (JNPR) has a market capitalization of $8 billion, no net debt, operating income of ~$500 million, and EBITDA of ~$700 million.
  • Kraft Heinz (KHC) has a market capitalization of $33 billion, total liabilities less current assets of $42 billion, operating income of $6 billion, and EBITDA of $6.4 billion.
  • Altria (MO) has a market capitalization of $82 billion, total liabilities less current assets of $38 billion (enterprise value of $110 billion), operating income of $10 billion, and EBITDA of $10 billion.
  • Molson Coors (TAP) has a market capitalization of $12 billion, debt of $10 billion (enterprise value of $22 billion), and EBITDA of $2 billion. Net income is a bit under a billion. (The story here is that Molson Coors' core brands, which include Coors Light, Miller High Life and Blue Moon, have been losing market share.)
Some of these enterprise values seem very high relative to the cash flows, but that is coming from the equity market capitalization component of the enterprise value and not from the debt load. (Kraft Heinz used to be like this, but the air came out of that bubble and the stock is down 70% since February 2017.) You can see in this table how this shakes out:

BUD 25 13.3
BDX 91 17.8
FISV 44 24.1
JNPR 17 10.2
KHC n/m 10.1
MO 13 10.6
TAP 14 9.8

The companies with higher EV/EBITDA valuations have higher P/Es - the overvaluation of the enterprise is coming from the equity side. Essentially, the investors in BUD, BDX, and FISV perceive these as ultra high "Quality" businesses and are willing to value their equity investment in them more like a bond.

Meanwhile, the TAP, MO, KHC, and JNPR lack the bond-like "Quality" halo and the enterprises are priced accordingly. Both Kraft Heinz and Molson Coors have tired, overpriced brands in very competitive spaces (the grocery shelf and the beer aisle). Juniper is the odd company out of this list because it is so much smaller than the others - not a mega cap - but its sales are shrinking as it loses market share to Arista and Cisco.

What about Altria (MO)? People are smoking less, but this is an addictive product in an almost duopoly industry. Almost any cigarette you would care to smoke in the U.S. is sold by either Altria or British American Tobacco (which bought R.J. Reynolds). (Note that Philip Morris, ticker symbol PM, sells the same Marlboro & co brands that Altria does, but internationally. It's one company for U.S. sales and one for international.)

Altria spent $5.4 billion on dividends last year, 6.6% of the current market capitalization, and repurchased an additional $1.7 billion of stock. They returned an average of $6.8 billion a year to shareholders from 2016-2018, which is about an 8% shareholder yield. The stock is at a five year low, with the result that the dividend yield and P/E are very cheap relative to the levels of the past decade:

In addition to the cigarette business, Altria owns 35% of the currently leading vaping company Juul, 10% of AB InBev, and the Chateau Ste Michelle wine company in Washington state.

The other two tobacco companies to look at for comparison are Philip Morris (PM) and British American Tobacco. The combustible revenues of PM are holding up better than MO's - their biggest markets are Europe followed by east Asia, and smoking is still cool in those regions. Their dividend yield is 6.2% and they don't buy back stock. Over the past three years they have paid of 95% of earnings as dividend and the average amount paid would represent 5.9% on the current share price.

What is fascinating to me is that these tobacco stocks seem cheap at the same time that nicotine is making a huge comeback:

Nicotine is a drug that, like ethanol and caffeine, has stood the test of time. Does society crave it now after having cut back so sharply? Maybe people will resume consuming nicotine at very high rates, but in a different form See this astute comment about how big tobacco plans to control nicotine vaping:
Lots of people commenting who don't really understand the industry or its future. Forget cigarettes. Conventional cigarettes generate free cash flow (for now) but the volume decline is already built-in to both companies' strategies.

Both PM and MO are trying to shape the future regulatory environment around [Electronic Nicotine Delivery Systems]. This battle will be fought first and foremost in the U.S., which will influence the regulatory environment worldwide. The strategy is already taking shape:

1) Raise cigarette buying age to 21--this is window dressing to placate Congress and buy other concessions, like those below. This is exactly what both companies are lobbying on now.

2) Build a regulatory moat around [Electronic Nicotine Delivery Systems]:
- Push legislation which will require FDA submission and ingredient disclosure for e-liquid based [Electronic Nicotine Delivery Systems](consumer safety regulations, labeling, etc.).
- Regulate nicotine levels.
- Keep chasing MRTP for IQOS.
- The U.S. regulatory environment would then be the model for the rest of the world.

This would effectively cede the ENTIRE electronic cigarette space to the big players. Only the big players can afford to comply with a complex approvals/disclosure process--it would put all the small importers of various Chinese-made products out of business in the U.S. because they will not be able to afford this kind of testing/QC. The more burdensome/labyrinthine the regulatory process becomes, the better it is for PM/MO with their armies of lawyers and quality engineers.

This will be the same play in the cannabis space if and when the big players are ready: bury the small competition in regulatory bureaucracy. This is what worked in the cigarette space for decades. This is why there are now only a handful of giant companies selling a commodity product with in developed markets. No one else can afford to.

PM and MO, or future NewCo, are selling razor blades, not razor handles. The strategy is to have good enough technology, best-in-class distribution, but most importantly: giant regulatory barriers to prevent new entrants.
It is a concern that MO paid such a high valuation for its stake in Juul. On the other hand Facebook paid what seemed like high prices for two investments to defend its monopoly - and it worked.

A big proportion of MO consists of its investment in BUD (10% ownership) - $19 billion of the total enterprise value of $100 billion. BUD is not that exciting so it would be tempting to see it spun off. Or, you could spin it off yourself - isolate the bet on nicotine - by shorting it out proportionally.


Anonymous said...

The majority of people I know, both parents have to work a million hours to pay for their crotch fruit, or are divorced part time parents, have chitty brat kids, are stuck with fat ugly disinterested wives, or are otherwise miserable. I can count on one hand the number of families I know with happy marriages and well adjusted kids (as far as I can tell).

CP said...

Just over a year since this post.

MO is up about 8%.
PM up about 8% as well.

(Plus dividends.)

CP said...

Two years since this post.

Philip Morris - up 36%
Altria - up 28%
BTI - up 15%

Not including dividends.

CP said...

It is seeming possible that re-nicotinization is happening, but that the nicotine as a service business is going to remain fragmented enough such that the profit pool that used to exist in cigarettes is substantially diminished.

[...W]hat assurance do we have that the authorized reduced risk nicotine market is going to be a profitable duopoly the way that cigarettes were?