At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Here, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
And speaking of the best ...
Their business is tobacco, and business is booming. Over the past few days, investors in the global cigarette czars have been treated to a flurry of "earnings beats." We haven't heard from British American Tobacco
Said downgrade emanated from Argus Research -- one of the strongest institutional stockpickers, boasting 53% accuracy on its picks, and a record that outperforms 90% of the investors on the planet. According to Argus, Altria's recent improvement in operating income (which the Fool's own Colleen Paulson praised last week) was little more than smoke and mirrors -- the product of "a one-time inventory benefit in the cigarette segment."
Meanwhile, Argus keyed in on "weak" volumes of cigarettes and smokeless tobacco at Altria as reasons to downgrade. As Colleen also pointed out, cig sales were down 6.4% by unit volume. More crucially, Colleen also noted that Altria "lost market share all around," handing a good 1.2 percentage points of share to its rivals. Not good. Not bad enough to push Argus over the edge and recommend a sell rating, mind you, but not good enough to justify keeping Altria at "buy."
Old habits are hardest to kick
Despite the downgrade, Altria's stock actually tracked the Dow higher yesterday, ending up almost 1% for the day. So apparently, not everyone agrees with Argus ... but maybe they should. Here's why:
Let's begin with the analyst's record. Like I said before, Argus is one of the better analysts out there, outperforming better than 90% of the investors we survey on CAPS. It hasn't publicized any previous tobacco picks, which makes it difficult to gauge Argus' precise accuracy within this industry. We do know, though, that Altria has outperformed the market over the past 12 months -- a period during which Argus says it has been recommending the stock.
We also know that Argus has enjoyed some measure of success with other stocks that, like tobacco, have suffered from Americans' litigious streak. Among the analyst's winning stock picks we find Yum! Brands
The high cost of litigation
Which brings me to my own, private reason for wanting to stay away from Altria: The price. You see, at first glance Altria doesn't look all that expensive. The stock sells for about 14 times earnings, is expected to grow its profits at roughly 5.6% per year over the next five years, and pays its shareholders a 5.8% dividend yield at the same time. Those are figures that are only a bit below what you'd ordinarily like to see in your average 14 P/E stock.
But that's just the thing: Altria is decidedly not your average 14 P/E stock. To the contrary, it's a business that operates day in and day out under a haze of bad PR, stringent government regulation, and incessant litigation. Given this, I'd think investors would prefer to see the stock returning a bit more than 14% a year, rather than a bit less. And in fact ... maybe a whole lot less.
Foolish final thought
Consider: Altria did not include a cash flow statement in last week's earnings release. But we know that last year, its free cash flow of $2.6 billion amounted to just two-thirds of reported net income. So if we assume free cash flow in the first quarter increased at about the same rate as net income did (3%), then Altria's annual free cash flow tally probably reads about $2.7 billion today -- implying the stock is selling for around 20 times FCF.
And that's the real problem. Right now, Mr. Market is asking you to pay a pretty high multiple for a litigation-dogged business that I see as unlikely to return much more than the 11% in combined profit growth and dividend yield annually over the next five years. To me, this seems too high a price to pay. Argus' response to this valuation is to tell you to hold onto the shares -- give them some time to grow into their valuation. As for me, I think this may take longer than many investors will want to wait. Meanwhile, better opportunities beckon.
My advice: Sell Altria, and put your money someplace where it has a better chance of earning a real profit.
Fool contributor Rich Smith does not own (nor is he short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 560 out of more than 170,000 members.
Philip Morris International is a Motley Fool Global Gains choice. McDonald's is a Motley Fool Income Investor pick. Motley Fool Options has recommended writing puts on Lorillard. The Fool owns shares of Altria Group, Philip Morris International, and Yum! Brands. Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.