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Morningstar | Right Asset But Wrong Price at Wrong Time: Altria Overpays for Juul. See Updated Analyst Note from 20 Dec 2018

We are lowering our fair value estimate of Altria to $62 per share from $64 following its investment in vaping manufacturer Juul at an egregiously expensive price we think will destroy value for shareholders. We model a decrease in medium-term ROIC of over 20 percentage points. Altria is acquiring a 35% stake in Juul for a staggering $12.8 billion. We think there is a great deal of strategic rationale for the investment, but at this valuation, we think the transaction prices in all of the opportunity but none of the risk to Juul's long-term cash flows.

Our concern with the deal is the valuation, plain and simple. In our note last month, we estimated a reasonable valuation to be $16 billion, in line with its implied value in July when it raised $1.2 billion in capital. At $38 billion, Altria is valuing Juul at more than double this level, and, according to Pitchbook data, at multiples of 40 times sales and 150 times EBITDA. Since the capital raise in the summer, Juul has continued to grow rapidly, and appears likely to grow revenue at around 400% this year, although disclosure is very limited and the financial terms of the deal are opaque. Going forward, it seems much of the growth will be driven by overseas markets. In addition, Juul is already profitable, unlike the vaping operations of the Big Tobacco companies.

Nevertheless, Altria is investing in Juul just as that growth is coming under threat. The FDA's stated goal is to reduce under-age use of nicotine products, and it recently imposed tighter age verification controls on the sale of vaping liquids. Further restrictions may follow in the future. This seems very likely to slow the growth of Juul, whose emergence has coincided with a sharp rise in nicotine product consumption among school children. The FDA recently cited data from the 2018 National Youth Tobacco Survey indicating there was a 78% increase in the number of U.S. high school children using e-cigarettes in 2017-2018 over the year-ago period.

Other risks include the risk 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 by more fickle consumer preferences than those in the combustible cigarettes 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.

The volume decline rate of combustible tobacco products in the U.S. has accelerated recently, to around 4.5%, outside of its long-term historical range of 3% to 4%, and we believe this is partly explained by the growth of the vaping category and the emergence of Juul, which has a share of around 75% of the vaping market in tracked channels and of around 30% in the total vaping market. So the investment in Juul is, arguably, a no-brainer for Altria, because if these trends continue, the equity income growth will shield some of its earnings from category share loss.

The investment in Juul has a modestly negative impact of just under 4% on our valuation of Altria. We assume the deal closes in the first quarter of next year and that Juul's earnings grow at 125% in 2019, driven by a doubling of revenue, thanks to stronger distribution and better shelf space through Altria's infrastructure, and international growth. Our assumption also implies some margin expansion from operating leverage. Thereafter, we assume growth slows to 5% in our steady state. The deal will be financed with floating rate debt, and we assume an interest rate of 3.5% to 4.5%. In conjunction with the Juul investment, Altria also announced a plan to achieve $500 million to $600 million in cost savings. Although this is an equity investment, and there are no direct synergies, we expect the bulk of this to come from Altria's cessation of the distribution of its own brands, which have resulted in elevated R&D spending in recent years. This helps to offset some of the value destruction (around $1 of our fair value change), and we think the company's statement that the deal will be earnings accretive by 2020 is accurate. However, at such a lofty valuation, we are highly skeptical that this transaction will ever add value to shareholders by being accretive to ROIC.