5 Things I Learned From Reading Altria's Annual Report

"Other guys read Playboy. I read annual reports."

-- Warren Buffett

I'm not quite as fanatical as Warren, but I do enjoy digging into a company's annual report to learn something new. Especially for companies I own.

Over the next few weeks I'll be reading the 10-Ks of all the companies I own shares in, first page to the last. This week: Altria (MO 0.92%).

Here are five things I learned from Altria's annual report (which you can read here).

1. Cigarettes: Revenue flat, earnings up.
The big risk Altria investors face is a decline in cigarette consumption, which has been ongoing for decades. Part of the decline in cigarette volume is made up for through higher sales prices. But Altria has also boosted margins thanks to lower costs. Operating margins in the cigarette segment have grown nicely over the last three years:

Smokable products

This can't go on indefinitely. But it helps explain why the company has fared so well even with a declining customer base.

2. Excise taxes outweigh profits.
State and federal governments spend more than $1 trillion a year on health care, so it's not surprising that they try to recoup part of the cost of high medical bills by taxing unhealthy products. Over the last three years, the excise taxes Altria has paid on cigarette sales far outweigh the company's profits:

A recent study on cigarette taxes by the Congressional Budget Office writes:

A 1 percent rise in the price of cigarettes results in roughly a 0.3 percent decline in the number of smokers. The total reduction in cigarette consumption from such a price increase is significantly greater than 0.3 percent, according to past research, because it reflects both the decrease in the number of people who smoke and a decrease in the average number of cigarettes consumed by people who continue to smoke.

3. Volume among Altria's big brand is falling faster than I thought.
Cigarette volumes are falling slowly -- that much I knew. But the decline at Altria's flagship Marlboro brand is pretty severe. Total volume is being held up by better performance of the company's discount brands:

Shipment volume (sticks, in millions)

 Altria writes:

The willingness of adult consumers to purchase premium consumer product brands depends in part on economic conditions. In periods of economic uncertainty, adult consumers may purchase more discount brands and/or, in the case of tobacco products, consider lower-priced tobacco products.

4. Litigation results mostly favor Altria.
Altria's annual report is 81,000 words long, 25,000 of which is devoted to explaining various lawsuits waged against the company, past and present. Litigation has been a likely factor in the company's consistently below-average valuation. But the results stand:

Trial Results: Since January 1999 ... verdicts have been returned in 52 smoking and health, "Lights/Ultra Lights" and health care cost recovery cases in which PM USA was a defendant. Verdicts in favor of PM USA and other defendants were returned in 35 of the 52 cases. 

The biggest winners in this situation are the lawyers.

5. Regulation isn't only getting tougher, but more creative.
Altria writes:

The Village Board of Haverstraw, New York, enacted a tobacco product display ban in April 2012. It would have barred tobacco retailers from displaying any tobacco product in a manner that a consumer could view the product prior to purchase. Retailers could maintain a "tobacco menu," listing the types and prices of tobacco products available for sale, but the menu could only be given to a consumer, over the legal age to purchase tobacco products, who requested it.

The ban was eventually overturned, but this is a good example of regulators and municipalities becoming more creative in their push to lower smoking rates. Given the declining number of citizens who smoke, my guess is regulators will eventually win this battle.