and the lights were going up on 2007, Altria Group was awash in good news. About one year earlier, chairman and c.e.o. Louis C. Camilleri noted that 2006 would be “a year of robust progress for Altria.” The seeds planted in 2005 bore fruit in 2006.
Addressing a group of investors in New York in November, Camilleri cleared up two issues of concern to the Altria faithful. First he stated that the company’s board of directors will finalize its decision, including the precise timing, on the spin-off of Kraft on Jan. 31, 2007. Most likely, Kraft will be officially spun off by mid-2007. Regarding tobacco litigation, Camilleri said, “The alignment of the company’s business practices with society’s expectations, improvements in the environment in which these cases are litigated, and the strength of our defenses have brought clarity, predictability, and stability to the litigation we confront.”
As a result it is expected that Altria is looking at net debt (excluding Kraft) of $2.3 billion at year-end 2006, and for the first time in its history, projects that cash will exceed debt in 2007 by close to $2 billion. With the extra cash Altria may begin buying back its shares and/or raise its dividend. Reductions from new pension and tax reserve accounting also would have an impact on stockholders’ equity. Total cash flow before dividends and acquisitions for Altria, excluding Kraft, is forecast to reach a cumulative level of some $51 billion over the five years 2006 through 2010. But is the party coming to an end?
“Altria Group has been a great long-term investment,” said Jim Freeman of Boston-based broker-dealer Cantella & Co. “It’s a cash-cow company that now pays over $6 billion a year in dividends to shareholders. Earnings are expected to increase again next year, but such performance is already reflected in the share price. The easy money has already been made in Altria.”
Other Altria holdings include Philip Morris Capital Corp., an investment company whose portfolio consists of leveraged and direct finance lease investments and other tax-oriented and third-party financing operations, and Altria also has a nearly 30% economic and voting interest in SABMiller, the world’s second-largest brewer.
For the third-quarter of 2006 Altria reported diluted earnings per share of $1.36 vs. $1.38 in the same year-ago period. Upon removing various items that impacted results, earnings per share were up 1.5% to $1.39.
“Our third-quarter results were in line with our internal expectations and we remain on track to meet earnings target for the full year,” said Camilleri. “Our income performance during the third quarter was adversely affected by Philip Morris International’s continued challenges in Spain and the anticipated inventory depletion in Japan following the July 2006 price increase.”
An International Presence
Philip Morris International remains a leading global international tobacco company and produces seven of the top 20 best-selling global cigarette brands. In October, Philip Morris International and Altadis entered into a strategic alliance establishing a framework for long-term license agreements to manufacture, distribute, and market Altadis’ Gauloises and Gitanes brands in select Asian countries.
“This framework agreement between PMI and Altadis will benefit both companies, allowing PMI to add Gauloises and Gitanes to the portfolio it offers consumers and expanding the global reach of Altadis’ key brands through PMI’s manufacturing, marketing, and distribution infrastructure in Asia,” said André Calantzopoulos, president and c.e.o. of PMI. The company, based in Lausanne, Switzerland, held a 15.0% share of the international cigarette market in 2005 and its brands, led by Marlboro and L&M, are sold in more than 160 countries.
In 2006 Spain’s government announced that it will increase the minimum reference tax on cigarettes. The new tax increase bodes well for PMI. About 40% of its portfolio in Spain is premium brands. This helps decrease any price gaps and may help companies such as PMI increase prices on premium products during 2007. The tax will increase the minimum tax on 1,000 cigarettes to 70 euros, up from a previous level of 55 euros for some brands, meaning a 1.95 euro packet will now cost 2.11 euros ($2.72). Spain raised the minimum tax on tobacco to make cheap cigarettes more costly after its earlier tax hikes had the result of sending smokers to cheaper brands.
Also in mid-November, Philip Morris International announced the reorganization of its tobacco and beer equity holdings in the Dominican Republic.
A PMI subsidiary held a nearly 50% stake in E. Leon Jimenes, C. por. A. (ELJ), which has equity holdings in tobacco and beer operations in the Dominican Republic. PMI said its subsidiary will exchange its ELJ interest for 100% ownership of ELJ’s cigarette subsidiary, Industria de Tabaco Leon Jimenes, S.A. (ITLJ) and approximately $427 million in cash. Upon completion of the transaction, PMI will own 100% of the cigarette business and no longer have an interest in ELJ’s beer business. The reorganization is expected to increase Altria’s 2006 consolidated net earnings by 15 cents per share, encouraging the company to increase its full-year 2006 forecast to $5.63 to $5.68 per share (earlier estimates were between $5.48 to $5.53 per share). In Indonesia, Philip Morris International projects operating companies’ income of close to $600 million in 2006.
Big Back in the States
Philip Morris USA is the largest tobacco company in the United States and has half of the U.S. cigarette market’s retail share. Camilleri added that he expects Philip Morris USA will have “moderate share growth” for the full year 2006.
“In our domestic tobacco business, Marlboro continued to gain share of both the total cigarette market and the growing premium segment,” Camilleri said. “Kraft posted solid earnings gains. However, achieving its goals for stronger top-line growth and sustainable earnings momentum will require continued investment in innovation and brand-building initiatives.”
Removing a great deal of anxiety about Altria’s U.S. future were the results of the 2006 mid-term elections. Tobacco companies faced votes on four state ballots with propositions aimed at increasing cigarette and other tobacco product (OTP) excise taxes. Altria can be credited with supplying a great deal of the opposition funding as only two of the initiatives were passed.
California voters, who represent 9% of the smokers in the country, defeated Prop 86, a proposal that would have raised the excise tax per pack of cigarettes by $2.60 to $3.40 — making it the country’s highest. Similarly, Missouri’s proposed 80-cent-per-pack excise-tax increase was also rejected. South Dakota and Arizona voters, however, did raise their cigarette excise taxes by $1 and 82 cents, respectively. In Arizona the initiative also increases the tax on OTPs and creates smoke-free workplaces and restaurants. In Ohio, the SmokeFree initiative makes all workplaces in the state smoke-free, including restaurants and bars. Nevada also passed a ballot measure prohibiting smoking near slot machine sections at supermarkets, gas stations, and convenience stores as well as in bars serving food.
California voters barely defeated Prop 86, as both R.J. Reynolds and Philip Morris collectively channeled some $65 million to halt the effort with an ad and media campaign that began about two months before Election Day. Proponents of the measure spent about $14 million. “We’re particularly gratified that voters in California rejected Proposition 86,” said Camilleri. “It would have significantly increased taxes in California.” Tobacco companies spent about $84 million in all four states that had ballot initiatives.
“Given the lack of voter support for California’s huge excise tax increase, states may be more hesitant to propose such steep increases in the future,” noted Citigroup tobacco analyst Bonnie Herzog. “This has the obvious effect of not significantly increasing the absolute price of cigarettes, but also saves tobacco manufacturers tens of millions of dollars in money spent to fight proposed tax increases.”
“Shares of tobacco companies are higher following an election day that saw voting on smoking-related ballot initiatives in several states,” noted Standard & Poor’s analyst Raymond Mathis. “Proposed cigarette excise tax increases were defeated in California and Missouri. However, a partial smoking ban in public places was passed in Nevada providing exception for casino areas and bars while more restrictive no-smoking laws were passed in Ohio and Arizona. We view election results as a partial win for tobacco companies and expect better results in future state ballot initiatives.”
Camilleri noted that during the recent election, an increase in cigarette excise taxes was considered in 27 states and enacted in six. Analysts had expected that a lawsuit involving all makers of light cigarettes to tie up the spin-off until later. The divestiture plan was put on hold Sept. 25 following class-action certification of the suit. Operationally, Altria expects that its U.S. business will finish 2006 on track with moderate market share growth and earnings growth in the mid-single digits.
Goldman Sachs analyst Judy Hong remarked that Camilleri’s presentation, which was broadcast over the Internet, “was even more positive than we envisioned.” She later raised her rating on Altria to “buy.” Hong added that it was “very clear” that the Kraft spin-off announcement “is not contingent upon any legal development between now and then” — music to Wall Street’s ears.
Another Day in Court
On Nov. 17, a federal appeals court in New York agreed to review the grant of class-action status against Philip Morris USA and other cigarette makers, giving them the right to appeal a lower-court decision authorizing a class-action that aimed to claim $200 billion in damages on behalf of light-cigarette smokers. While a trial of the claim had been scheduled for January, the new ruling delays any proceedings in the case, which was declared a group suit in September. The suit is known as the “Schwab case,” for lead plaintiff Barbara Schwab, and it represents the biggest potential legal liability for the tobacco industry since the U.S. government unsuccessfully sought $280 billion in a 1999 case against the companies. It’s widely speculated that the decision to review the case may remove any further hurdles for the Kraft spin-off.
“Philip Morris USA looks forward to presenting its arguments before the U.S. Circuit Court of Appeals for the Second Circuit as to why the class certification in the Schwab case should be overturned,” said Altria’s associate general counsel William Ohlemeyer in a statement. Until further notice, cigarette companies will be able to use the words “light” and “mild” in their marketing.
At about the same time north of the border, however, Canada’s largest tobacco companies agreed to stop using “light” or “mild” when marketing cigarettes. Canada’s Competition Bureau said Imperial Tobacco Canada (British American Tobacco), Rothmans Benson & Hedges (Altria), and JTI-Macdonald (Japan Tobacco) will voluntarily remove such phrases on cigarette packages before forthcoming legislation requires them to do so. Canadian lawmakers, similar to their U.S. counterparts, argued that such words gave the impression that such smokes are less dangerous than regular ones.
‘Krafting’ a Future
Dissecting the company’s main components offers a partial glimpse into where the cash comes from. Kraft Foods, although a relatively disappointing acquisition, is not without bright spots. It is the largest food and beverage company headquartered in North America and second-largest in the world. It has tremendous equity, well-recognized brands such as Maxwell House coffee, Oscar Mayer meats and Oreo cookies, a great distribution network (with its products on nearly every grocery shelf in North America), and in-depth research facilities. Kraft shares will be distributed to Altria shareholders should the spin-off take place.
In September, Kraft acquired United Biscuits’ (UB) Iberian operations, as well as the recovery of the rights to key Nabisco trademarks in Europe, the Middle East, and Africa, for such brands as Oreo, Ritz and Chips Ahoy! for approximately $1.07 bn.
“Bringing our Nabisco trademarks back into our product portfolio, coupled with the addition of strong local Iberian biscuit brands, is another step in increasing shareholder value as we further improve our growth potential in this key region,” said Joachim Krawczyck, group v.p. & president, Kraft EU region. “This transaction gives us an enhanced platform for innovation and extends Kraft’s competitive position in the EU.”
“Our third-quarter results were mixed,” said Irene B. Rosenfeld, c.e.o. “Our restructuring efforts have enabled us to fund a number of successful initiatives in some key growth areas, including better-for-you products, snacking and convenient meals. However, while income growth was strong, our aggregate top-line growth is not where it needs to be. We must continue to invest to build our momentum and generate growth more broadly.”
The past few years have been tumultuous for big tobacco but a steady lineup of business deals, favorable election results, a better legal climate and healthy core business are adding up to a winning hand for Altria.