Eleven years ago, tobacco giant Altria (NYSE:MO) finished spinning off its international business as Philip Morris International (NYSE:PM). The split let Altria focus on tackling litigation and declining sales in America, and allowed PMI to expand more aggressively in overseas markets with higher smoking rates.
But smoking rates fell worldwide over the past decade, forcing both companies to repeatedly raise prices and cut costs to stay profitable. Regulators exacerbated the pain by tightening regulations on tobacco and e-cigarettes.
To make matters worse, British American Tobacco (NYSE:BTI) overtook PMI as the world's largest publicly traded tobacco company in 2017 by acquiring Altria's rival Reynolds American. In response, many analysts suggested that Altria and PMI, which were already partnered in the development of alternative smoking products, should reunite to stay competitive.
Altria and PMI apparently listened to those suggestions, and the companies recently confirmed that they were mulling an all-stock "merger of equals," in which investors in both companies trade their shares for shares of a new company. That might sound like a reasonable proposition, but it's a terrible idea, for four simple reasons.
1. PMI has better growth than Altria
PMI sells its products across six geographical regions: the European Union, Eastern Europe, Middle East & Africa, South & Southeast Asia, East Asia & Australia, and Latin America & Canada.
Last quarter PMI's sales across all of those regions except Latin America & Canada rose on a constant currency basis as it offset its lower shipments with price hikes and sales of iQOS heated tobacco products. PMI's total cigarette shipments fell 3.6% annually, but shipments of its heated tobacco products surged 37%, causing its total (cigarette and heated tobacco) shipments to dip just 0.1% on a like-for-like basis. As a result, PMI's revenue rose 9% on a constant currency like-for-like basis during the quarter.
Altria's cigarette shipments, excluding trade inventory movements, fell 7% annually last quarter. Its shipments of smokeless (mainly snuff and snus) products also fell 3% on the same basis. Altria's revenue still rose 6% annually thanks to price hikes, but it's growing at a slower pace than PMI.
Merging Altria's U.S. operations back into PMI would increase the latter's annual revenue net of excise taxes by roughly two-thirds -- but the addition of that slower-growth revenue would offset the stronger growth of PMI's other regions.
2. PMI has higher gross margins than Altria
PMI has also consistently generated higher gross margins than Altria since the split:
PMI has higher margins because it has lower manufacturing costs and better pricing power than Altria in many markets. Blending Altria's lower-margin revenue with PMI's isn't in the best interest of the latter's shareholders.
Altria might argue that the combination would generate synergies by merging sales and R&D teams for heated tobacco products -- but Altria and PMI already pooled those resources several years ago.
3. Altria has rising debt, PMI has declining debt
Altria's long-term debt surged from $11.9 billion at the end of 2018 to $27.1 billion at the end of the second quarter. That increase can be attributed to two recent investments: a $12.8 billion stake in e-cigarette maker Juul, and a $1.8 billion stake in Canadian cannabinoid company Cronos.
Neither of those businesses is an established growth engine like iQOS. Altria's massive investment in Juul is questionable, since the company only generates about $1.5 billion in annual revenue and is being pilloried by the FDA. Its investment in Cronos is also highly speculative, since it only generated $15.7 million in revenue last year.
Meanwhile, PMI reduced its long-term debt from $27 billion to $24.9 billion during the same period. Unlike Altria, which constantly uses its free cash flow to repurchase shares and boost its EPS, PMI hasn't repurchased any shares in recent quarters due to currency headwinds. Instead, it allocates more of its cash toward extinguishing its debt. Therefore, merging the two companies punishes PMI shareholders for Altria's speculative bets.
4. A divided board and management
PMI and Altria will have to figure out how to bring together their respective boards of directors and management teams to lead the combined company. At present, the way the two companies have handled key issues in the past could cause friction and affect decisions about buybacks, dividends, and new products like e-cigarettes, heated tobacco products, and marijuana.
In fact, PMI CEO Andre Calantzopoulos previously criticized Juul for causing a teen vaping "epidemic" in the U.S., and stated that he wasn't interested in investing in cannabis products -- which casts a cloud over Altria's recent investments.
PMI and Altria both have a lot of moving parts, and merging them together again would likely throttle the efficiency of both sides instead of generating meaningful synergies.
PMI investors should reject this idea
Altria seems to want PMI to bail out its ailing domestic business with a merger. That might benefit Altria's investors, but it would hurt PMI investors. PMI still has potential catalysts on the horizon -- including a weaker dollar and the growth of iQOS -- but those tailwinds will fade away if it merges with Altria.