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Morningstar | Decent 4Q for Altria; Short-Term Guidance Looks Conservative but Juul Deal Still Appears Expensive

Altria reported a decent fourth quarter of 2018, with volume in both the smokeable and smokeless divisions falling slightly less than our forecasts. This trickled down the income statement and resulted in modest upside to our earnings estimate. The company guided below our forecasts for 2019, however, due to the mix effect of the Juul and Cronos acquisitions, as well as increased investment ahead of the anticipated launch of iQOS in the United States this year. We shall adjust our near-term forecasts accordingly, but the impact to our $62 fair value estimate will be immaterial.

Altria's fourth-quarter organic revenue decline of 0.2% was modestly above our forecast, with volume accounting for the beat. Marlboro retail share stabilized this year at around 43% after coming under pressure from the discount segment for the last two years. If macro trends remain in place, this is likely to be sustainable in the short term, meaning Altria's volume should track closer to that of the industry this year. Management has guided to a domestic industry decline of 3.5%-5.0% next year, which strikes us as being a fairly wide range and a little conservative, given the risks to the vaping category, but this range probably accounts for the high probability that Philip Morris International and Altria are granted the right to market iQOS in the U.S. this year. Although we expect iQOS adoption to be fairly slow (more in line with Europe than Asia), commercialization is likely to cannibalize the cigarette category somewhat.

The outlook for this year also appears somewhat muted, with management guiding to EPS of $4.15-$4.27, below our $4.54 estimate, and implying an earnings growth rate of 4%-7%. Cost savings of $575 million will be more than offset by some below-the-line headwinds, including a higher tax rate and interest expense. Guidance assumes no EBIT contribution in 2019 from the Juul and Cronos investments.

Management also provided some details of its assumptions behind the very high multiples paid for a 35% interest in Juul at the end of last year. Among the assumptions are a U.S. vaping category growth rate of 15%-20% over five years with Juul continuing to lead category growth, international revenue equal to domestic revenue by 2023 (which at the midpoint of the guidance for the domestic industry implies international revenue of around $2.1 billion), and international margins "that approach current international cigarette margins." Given that Altria sells no cigarettes internationally, it is not clear what this means, but at a 35% margin, it implies that Juul makes $1.5 billion in annual EBIT by 2023. We think there are significant risks to these assumptions, but even if they prove to be accurate, this still implies that Altria paid a multiple of 24 times 2023 EBIT for Juul. We believe these assumptions are optimistic because of the risks of the imposition of a federal excise tax on vaping and a plateauing in Juul's product cycle in a category in which the cycle has been fairly short due to the fast pace of product development and more fickle consumer preferences than those in the combustible cigarette category. The blu brand, for example, now owned by Imperial Brands, has been overtaken as market leader by Juul and British American's Vuse, with its value share having declined from around 45% to less than 10% over the last five years. Altria cited some early evidence that Juul's appeal is being transferred to the United Kingdom and Canada, but in a category with low barriers to entry, we would not hang our hats on Juul being accretive to Altria in the medium term.