Seven years ago, Altria (MO +1.22%) spun off Philip Morris International (PM +2.02%), splitting the tobacco empire in two. Altria retained the domestic business, while PMI moved abroad. PMI would concentrate on expanding into higher growth markets, while Altria cut costs, dealt with lawsuits, and raised prices to maximize profits from a shrinking market of American smokers.
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That strategy initially worked, but Altria and PMI's positions have since reversed. With most of its legal troubles now in the rearview mirror, Altria is now the stronger of the two, thanks to a robust U.S. economy, low gas prices, and plenty of room to raise prices. Its bottom line, which consists entirely of American profits, is also protected from the strong dollar. Meanwhile, PMI is suffering from sluggish sales in several overseas markets, which are further drained by currency impacts. Therefore, the idea of Altria buying PMI has gained some attention recently.
If Altria and PMI merged, the combined entity would claim 17% of the worldwide tobacco market and become the second largest tobacco company in the world after China National Tobacco. The two companies recently started working together to develop new products like e-cigarettes, which "could be a step toward an eventual recombination," according to Bloomberg Intelligence analyst Ken Shea.
How would a merger work?
Two key developments occurred since Shea made that statement in July. First, the Tobacco Transition Payment Program, which compensated U.S. tobacco farmers for the deregulation of tobacco farming in 2005, expired in early September. Since Altria reportedly paid that program $1.1 billion over its final three years, the company can now save a few hundred million dollars per year.
Second, discussions of a merger have reportedly started between Anheuser-Busch InBev and brewery SABMiller. Altria owns 27% of SABMiller, which is worth nearly $24.7 billion before taxes. If Altria sells that stake, it could receive a pre-tax cash windfall which would be equivalent to about a fifth of PMI's market cap. Both developments should boost Altria's cash position from the $1.12 billion it reported at the end of last quarter. That would leave Altria with more cash to buy PMI, but most of the takeover would still have to be funded with stock.
Would it be a logical move?
Speaking to Bloomberg, spokespeople for both Altria and PMI stressed that the reasons for the 2008 spinoff remained relevant. When we look at the key figures from their most recent quarters, a merger would likely harm Altria instead of helping it.
|
Year-over-year growth (most recent quarter) |
Altria |
PMI |
|
Revenue |
6.8% |
(12%) |
|
Diluted Earnings |
15.6% |
3.4% |
|
Cigarette shipments |
1% |
(1.4%) |
Source: Quarterly earnings reports
Altria is in better shape, but its revenues would only account for just over 40% of the combined company's top line. Altria investors would be clearly getting the short end of the stick, while PMI could use Altria's U.S. business to offset its weak overseas results.
Altria could also spend the extra cash saved from the end of tobacco subsidies and the potential sale of its SABMiller stake to simply boost buybacks and dividends. PMI's trailing 12-month free cash flow has declined 24% over the past five years, while Altria's has risen 68%. If Altria inherits PMI's cash flow issues, its ability to raise dividends and buybacks could also take a hit. That move wouldn't make sense considering how hard Altria has tried to keep earnings and dividend growth intact with price hikes, job cuts, and buybacks.
Lastly, buying PMI would raise red flags with antitrust regulators both in the U.S. and abroad. Reynolds American, the second largest U.S. tobacco company, was only allowed to buy Lorillard after the former sold off four cigarette brands and the latter sold its e-cigarette business, all to Imperial Tobacco. Those compromises were presumably to help Imperial, a multinational company, gain ground in the U.S. market to keep Altria and Reynolds' market dominance in check. Therefore, it's highly unlikely that regulators will let Altria more than double in size buying back PMI.
The bottom line
The idea of Altria merging with PMI is intriguing, but it doesn't really make much sense. PMI had a few rough years due to currency fluctuations and tepid demand in certain regions, but that doesn't mean that the company won't bounce back in the long-term.
Once the dollar weakens, foreign currencies stabilize, and PMI tightens its grip on developing and emerging markets with higher smoking rates, it could look like a stronger investment than Altria. When that happens, some people might start speculating that PMI could turn around and buy Altria instead. Of course, that wouldn't make sense for the exact same reasons.
