[We updated this article on 4/9/03 to correct a factual error. The Miles case is a class action suit, though it is a weak one and limited to the state of Illinois.]
If you were to simply look at the numbers on Altria Group (NYSE:MO), its current stock price would make absolutely no sense at all.
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Altria earned more than $8.6 billion in free cash flow last year, fairly consistent with its performance in the two years before that.
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Its business has grown by an average of 2.9% over the last five years.
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In calendar 2002, it repurchased $6.3 billion of its own stock on the open market, following a purchase of $4 billion in 2001.
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Its gross profits exceed 36%, net profits 10.5% (netting out the gain on the sale of Miller Brewing). These margin levels include the payments Philip Morris USA (Altria's subsidiary) must make to satisfy its obligation under its 1998 state litigation settlements.
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It has substantial debt, more than $5.7 billion of which comes due in 2003. But it is more than capable of covering this obligation from cash flow.
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Pays out more than $5 billion in dividends, or about 46% of total earnings.
And yet, the company trades at a price-to-free cash flow ratio of 6.6, has a dividend yield of 8.5%, and has dropped by nearly 35% in the past month. Neither the cigarette business nor the food brands managed by Kraft (another subsidiary) is showing significant declines -- this is not a business with a top line in peril.
Oh, but then there's this: Late last month, an Illinois court smacked Philip Morris USA with a $10.1 billion verdict in Susan Miles, et al. v. Philip Morris Cos. for marketing light cigarettes as healthier than your everyday Marlboro Heavy. The verdict represents a potential hit to Altria's bank account, but a more immediate problem lies in the laws of Illinois. In order for Philip Morris to appeal the verdict, it must post a bond for the full value of the verdict plus interest, in this case a whopping $12 billion. Philip Morris USA doesn't have that kind of cash lying around. Nor does mama Altria.
The choices for the company at this moment thus appear to be: Don't appeal the verdict, which equals probable bankruptcy for Philip Morris USA, or appeal the verdict, the process of which means probable bankruptcy for Philip Morris USA. Credit agencies responded to the crisis by lowering ratings on Altria, Philip Morris, and Kraft (NYSE:KFT) debt to just above junk status. This for a company with billions in free cash flow!
Philip Morris informed the states late last week that it was unsure whether it could make a $2.5 billion payment scheduled for April 15 under its previous settlements under the 1998 Master Settlement Agreement. Given that state governments in the U.S. are already straining from substantial budget shortfalls, you can bet that this disclosure was met with alarm. Several state attorneys general, for whom this hearing suddenly becomes a big deal, are considering helping the company through the potential cash crunch required by the bond. The Illinois Legislature may rush through a cap on appeals bonds -- something that many states already have.
That's right. The states, terrified of losing their massive $200 billion-plus cash cow, are rushing to assist a company they've demonized more than any other, excepting perhaps Enron. They don't want to lose Flip Mo's portion of a cash annuity from the 1998 settlement that is supposed to be paid out over the next 20 years. Those revenues, naturally, are baked into their already-strained budgets.
If you ask me, the whole thing stinks of a giant, corrupt mess. The states want to run Philip Morris and the other cigarette manufacturers out of business... but slowly.
Why Altria won't disappear
That the states have an interest in seeing Philip Morris survive gives me more than a little comfort that the tales of its imminent demise are a tad overstated. Still, the current situation for Philip Morris deeply resembles its class action travails in Florida three years ago, when litigation fears pressed the company's stock down below $20 a stub. For those of you playing the home game, this means that from the last time it was considered down for the count, its returns have pounded the averages, even before you added in its dividend.
We've said many times in the past that an investing thesis should not be based upon the outcome of a legal proceeding, or even several ones. This goes doubly in the case of Altria. But what's the worst thing that can happen here? Let's say that the award, or a facsimile thereof, holds. Philip Morris USA would have to declare bankruptcy, because it likely could not meet its litigation obligations and its debt servicing obligations of $5.7 billion in 2003.
So what then? Philip Morris USA comprises 29% of Altria's revenues -- for the first time ever in 2002, the company generated more sales of tobacco products overseas than it did in the U.S. A quick back-of-the-envelope calculation places the remainder of Altria at somewhere between $18 and $24 per share, though in addition to the loss of capital investors would likely have to wave bye-bye to that fat dividend.
This stands as a worst-case scenario for this particular litigation. Again, it stands to reason that a default by Philip Morris USA on its payments to the states would be a disaster. First, many state budgets would be affected. Second, many states and the District of Columbia have floated tobacco bond issues to securitize their expected payments -- meaning that they have sold the rights to some of those future cash flows to investors in order to generate revenues for their coffers today. The states could, of course, default on these bond issues and leave the bondholders in the lurch, or they could cover their debt obligation with other cash. Neither is a desirable outcome, as states' borrowing costs are likely to skyrocket in either case.
All of this suggests that (a) the risk to Altria shareholders is somewhat mitigated by the fact that only Philip Morris USA is on the hook, and (b) states' budgets are at enormous risk should this verdict hold. I'm not one to subscribe to conspiracy theories, but I cannot imagine that a higher court -- if and when it hears the appeal -- won't be fully aware of the ramifications of a negative outcome for Philip Morris.
And why it might
The frightening thing about this particular suit is that it is limited to the state of Illinois. Even if the award in this particular case is trimmed down to next to nothing, the fact that it is about false advertising, not some tort, brings up fears of other class actions against Philip Morris and other companies in other jurisdictions.
Whatever one thinks about these types of cases, they aren't heard in a court of opinion, or even in a court of common sense -- they're heard in courts of law, where once the jury goes out, anything can happen. This case, for example, was about claims made in advertising. News flash: There's no tiger in your tank, nor is there a little man in a rowboat in your toilet bowl. A bar of Snickers, though it "really satisfies," is NO meal replacement. And I'm pretty sure the fifth dentist doesn't exist. It's not like Marlboro Lights had a "Surgeon General's Light" warning. No, these cigarettes still clearly mentioned the fact that their use could kill you.
None of this matters in a court of law, not where tobacco companies are the defendants. And should this case see any success, it will become precedent. More frightening to me, frankly, is the fact that Philip Morris is more and more dependent upon foreign income sources. How much time do you think it will take before some foreign government chooses to go after the big-pocketed American company in a modern-day reprisal of distribution of wealth?
Bottom line
Despite the fact that Altria has another highly successful business in Kraft, its star is deeply tied to the tobacco industry. As long as cases like Miles are first heard in state, not federal, courts, these sorts of runaway awards remain not just possible, but both probable and recurring. Even in federal courts, where we can expect a little more uniformity in the application of law, the litigation risks to tobacco companies remain huge. It's too bad, for tobacco sellin' is right up there with the best businesses in the world from an economic perspective. You know, except for the death part.
Altria stock is priced as if Philip Morris USA is in real trouble of evaporating. The average investor, having no legal insight into this or any future cases against the company, is almost completely unable to figure the odds on the probability of the outcome. That's the nature of the law. But from a "what we know right now" perspective, Altria common stock doesn't look like that bad of a purchase at the current price of $28.
But what do I know -- I'm not a lawyer. And for what it's worth, none of the lawyers I know have any idea what's going to happen, either.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann does not own shares of any companies mentioned in this article, though he has beneficial interest in RJR. He is senior editor of The Motley Fool Select, where you can find his best Foolish stock ideas that you won't find anywhere else. The Fool is investors writing for investors.
