Altria (MO 0.27%) and SABMiller (NASDAQOTH: SBMRY) are both quality companies, if I could I would own both stocks. Well I say 'could', I can, but I choose not to because I believe there is more value to be had in Altria than SAB. Altria owns nearly 30% of SAB, as it turns out, and it is cheaper to acquire a share in SAB through Altria because of the way that Altria accounts for its holding in SAB.
The value on offer
SABMiller's primary listing is in London, where presently the company has a market capitalization of approximately GBP 45 billion, or $75 billion. Altria holds a 27.1% stake in SABMiller worth about $22.4 billion. Now, according to data supplied by the Financial Times, SABMiller currently trades at a trailing-12-month P/E of 22, what some might call expensive. Altria, in comparison, trades at an unadjusted trailing-12-month P/E of 16 -- relatively cheap .
The Financial Times also tells us that SABMiller earned GBP 1.28 per share on a trailing-12-month basis -- that's roughly $2.10. With 1.6 billion shares outstanding, we can estimate that through its stake in SABMiller, Altria earned $1 billion on a trailing-12-month basis, which is confirmed later.
However, Altria's share of SABMiller is booked on its balance sheet at only $6.5 billion, which indicates that you can buy SABMiller through Altria at a trailing-12-month P/E of only 6.5!
Why the low valuation?
Why does Altria understate its holding in SABMiller? Well, this understatement results from the generally accepted-accounting-principles, or GAAP, equity method of valuation. Specifically, Altria's stake in SABMiller is less than 50%, and the company only has three seats on SABMiller's 11-seat board, so Altria does not exercise control over SABMiller.
As a result, Altria cannot fully consolidate SABMiller onto its balance sheet, and neither is the company allowed to mark the stake up to its current value. So, Altria can only record the book value of its SABMiller holding on its balance sheet, and as I discussed above, this holding is actually worth much more than it first appears.
Is Altria going to dispose of the holding?
Is Altria likely to sell? No, I doubt it because the company's management has previously answered this question by stating that the tax on realized gains would mitigate much of the capital gain from the sale. Altria would sell its SAB share for a price far in excess of book value and as a result the company would have to pay 33% federal and 6% state taxes on the gain -- ouch.
On a fundamental level, aside from the issue of tax, it would make no sense for Altria's management to sell the holding. According to Altria's management, the SAB investment generated pre-tax income of approximately $1 billion for Altria during the full year of 2013. Based on Altria's initial $6.5 billion investment, that's an annualized return-on-investment of 15.4%. $1 billion is also around 13% of Altria's annual earnings-before-interest-and-tax, or EBIT, so the company would lose out drastically if it disposed of the beverage giant.
Nevertheless, a tax-efficient spin-off would be a possibility. This would allow Altria to avoid a hefty tax bill, investors would benefit by receiving SAB shares, and Altria would be able to keep a share of the spin-off.
With Altria's seriously undervalued holding of SAB on its balance sheet and around $1 billion in extra income a year hitting the company's bottom line from the investment, it would be reasonable to assume that the company trades at a premium to its domestic tobacco peers. This is not the case. Based on forward, or estimated 2014, figures Altria trades at a P/E of 12.8. In comparison, peers Reynolds American and Lorillard (LO.DL) trade at a forward P/E of 14.
Now, it is understandable that Lorillard would command a premium over Altria, as the volume of cigarettes being sold by Lorillard is still grinding higher. Meanwhile Altria's sales are declining. However there is a problem here. You see, the risk at issue here is the impending regulation of menthol-cigarette products. I recently covered the key facts of the menthol argument here. Let's not get caught up in the "will they or won't they" argument, the most important thing we need to know is that more than three-quarters of Lorillard's revenue comes from the sale of menthol cigarettes, which could be problematic if menthol regulation occurs.
If we think about things logically, it is not unrealistic to suggest that if the U.S. Food and Drug Administration moves against menthol cigarettes, Lorillard will not lose all of its sales overnight. The company is likely to lose some of its sales, but it is more than likely that smokers will switch from menthol to regular cigarettes and stay with Lorillard's Newport brand. Still, with this risk hanging over the company, I'm left wondering whether or not Lorillard actually deserves a valuation premium over Altria.
So all-in-all, it would appear that investors undervalue Altria's holding in SABMiller and indeed Altria as a whole. Not only is the SAB holding contributing significantly to Altria's bottom line but the holding is worth tens of billions of dollars and provides a double-digit return for Altria.