From 1926 to 2016, Altria (NYSE:MO) stock returned an average of 17.7% a year. But time and time again, investors have ignored Altria -- and missed out on 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 some form for more than 1,000 years, and Altria has infamously produced and sold cigarette and tobacco products for more than 150 years. Tobacco contains nicotine, which stimulates an addictive chemical release to the brain.
You can see this addiction in Altria's pricing power. Eight years ago, Altria was generating $5.6 billion in revenue from smokeable products a quarter, while selling roughly 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 increased every year since 2011 -- showing that recurring customers are willing to pay far more for the same product.
Altria became largely successful throughout the early to mid 1900's as cigarette smoking grew in popularity. However, as cigarette smoking peaked in the 1960's, studies began to link the habit to several lethal lung diseases. To counteract the consequences of smoking, the government has attempted to constrain the tobacco industry with various laws. Tobacco production began to face legal pressure in the 1950s; whether in the form of customer or state lawsuits, advertising bans, warning labels, excise taxes, or the introduction of non-smoking areas, new laws led tobacco producers to spend lots of time and money fighting these restrictions in court.
However, while this might sound like a difficult environment to operate in for the major tobacco companies, it was much tougher for the small producers. From 1967 to today, tobacco production has essentially been put through the gauntlet, and the companies with the deepest pockets have survived and thrived. The biggest of those companies is Altria.
Starting in 1971, the federal government introduced several advertising bans, which ultimately prevented companies like Altria from marketing tobacco products to the public. The bans aimed to limit potential customers' awareness of these harmful products, but the government's measures also built significant barriers to entry for start-ups in the industry. In the consumer goods industry, promotion and marketing are essential to getting your name out there. To successfully sell to customers, a brand must first raise awareness. Since new start-ups don't have the ability to market their products, the threat of new entrants in the cigarette business is quite low. This is why Altria only has three or four large competitors globally, and each of them has been around for more than 40 years.
These bans not only discouraged competitors, but also helped Altria -- which could coast on its long-established stable of well-known brands -- slash its marketing expenses. In fiscal 1991, the company spent $13.3 billion in marketing, administration, and research costs, representing nearly 24% of its operating revenue for the year. By 2019, those costs had plunged to $2.2 billion, or roughly 9% of operating revenue.
As the consequences of smoking became more widely known, Altria started to see lawsuits roll in. The first suits came from individuals who lost loved ones or had to pay expensive medical bills, but later on, state governments filed their own litigation. Mississippi led the legal charge in 1994 with an attempt to recoup losses from having to pay out Medicaid to individuals. In 1998, 46 states came together in a $206 billion settlement with the four main tobacco manufacturers.
The $206 billion would be paid out over the next 25 years, but the payments to the states will go on indefinitely, so long as the citizens of the states continue to receive Medicaid. In the first nine months of 2020 alone, Altria spent $76 million on tobacco and health-related litigation costs. For Altria, this sum represents less than 1% of its adjusted annual earnings, but for smaller companies who could also be susceptible to big lawsuits, fines of this size could damage their entire businesses.
Once again, while this doesn't look like a great result on the surface for the big tobacco producers, it certainly discourages up-and-comers. The long, arduous, and capital-intensive legal battles demonstrate just how much time, effort, and money is spent in the courtroom -- an expense only a few companies can afford.
Besides the litigious difficulties of continually operating a tobacco business, starting one might be even tougher. The FDA and the individual states have their own regulations and rules around selling or manufacturing cigarettes or tobacco products. Many states have a limited number of permits and conduct comprehensive background checks during the application process, ultimately adding yet another hurdle for new entrants to overcome.
Copious capital to spend
In the end, all this regulation has really done is insulate the existing leaders in the industry. In the first nine months of this fiscal year, Altria generated $8.3 billion in operating income, of which roughly 80% was distributed to shareholders in the form of a dividend. Altria can afford that payout because it simply doesn't need the additional money to operate. With so few competitors, it scarcely needs to spend money on marketing or other competitive costs. In the last nine months, less than 7% of revenue was spent on marketing, administration, and research costs combined.
Any excess profits Altria creates are typically spent gobbling up other sin stocks and diversifying its existing business. For example, e-cigarettes and vaping have been gaining dominance in the tobacco industry as of late, and privately held Juul has become one of the leaders in the space. Many consumers and investors alike saw this potentially disrupting Altria's traditional tobacco business. To combat this, in 2018, Altria acquired a 35% stake in Juul for an exorbitant $12.8 billion.
However, shortly after Altria's investment, users of other vaping products started reporting serious lung ailments that were later traced to dangerous additives, and Juul itself got hit by 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% haircut from its initial valuation.
While most investors would look at this investment as a clear mistake, Altria looked at it as life insurance. Sure, it looks wasteful in hindsight, but without government intervention, there's no telling what Juul could have done to Altria's traditional smoking business.
"Sinful" but lucrative
While the ethics around Altria's business model are still heavily debated, its ability to generate profits is hard to argue. In the last eight years, the stock has only risen about 25%, compared to the S&P 500's roughly 150%-plus growth. But in the same period, adjusted diluted earnings per share are up more than 100%, and trailing-12-month free cash flow has grown more than 150%. Meanwhile, annual dividends per share have nearly doubled; when you add those payouts to Altria's stock performance, its total return for the period rises to roughly 90%.
Understandably, that relatively subdued stock performance might discourage many investors. But over the long run, stocks tend to follow their earnings, and I don't see how Altria would be any exception.