TLRY - Altria: The Cannabis And Smoke-Free Thesis Are Falling Apart

Summary

• After the Juul and Cronos impairment, it appears that MO is shifting gears and refocusing on its core business segment for now.
• Despite this, MO may face intense competition from Reynolds and Philip Morris, as its smoke-free product is unlikely to launch until 2024 and Ploom by 2025.
• The declining smoker population in the US from 35% in 2001 to 11% by 2022 is not promising as well, with more consumers switching to cannabis and smoke-free products.
• The worsening macroeconomics does not help matters as well, potentially triggering more sideways trading action, temporarily supported by its forward dividend yield of 8.94%.

The Cannabis Investment Thesis Is Falling Apart

Altria Group ( MO ) has recently abandoned its warrant to purchase additional common shares of Cronos Group ( CRON ) at CAD$19.00, suggesting the former's lack of confidence in the latter's stock recovery indeed. The cannabis stock has continued to trade below CAD$6.00 over the last twelve months, closing at CAD$3.68 on the day of MO's announcement. MO had previously acquired 45% of CRON's shares for CAD $2.4B or $1.8B in December 2018, in the hopes of " a new growth opportunity in an adjacent category that is complementary to Altria's core tobacco businesses ."

The US Cigarette/Cannabis Smoking Rates, by Age Group

The initial investment was likely attributed to the increased trend of adults switching to smoking cannabis instead. The latest report by Gallup showed that 26% of young adults aged between 18 and 29 years old prefer cannabis by 2022, compared to 17% in 2013. The same is witnessed in adults aged between 30 and 49 years old, growing to 15% by 2022, against 9% in 2013. The development is alarming indeed, since these age groups made up nearly 40% of the US population .

The same has been observed with Tilray Brands ( TLRY ), a Canadian cannabis company aiming to enter the US market upon federal legalization. The former had acquired alcohol businesses with the aim of creating THC-infused alcohol, including SweetWater Brewing Company in November 2020, Breckenridge Distillery in December 2021, Green Flash Brewing and Alpine Beer Company in December 2021, and Montauk Brewing Company in November 2022.

Unsurprisingly, MO expects to report a capital loss of $483M on its FY2022 federal income tax return, as a result of the warrant abandonment. By FQ3'22, the company had recorded massive CRON-related impairment by -76.6%, from a carrying value of $1.8B in FY2018 to $0.42B in FQ3'22 .

The same charges have been observed in MO's Juul investments by -97.3%, from $12.8B in FY2018 to $0.35B in the latest quarter. The Anheuser-Busch InBev SA/NV ( BUD ) investment similarly suffered a -50.1% decline, from $18.1B to $9.04B at the same time. Despite the fact that these are non-cash impairments, the management's underperforming investments are painfully evident.

For now, MO continues to own 156.5M shares of CRON valued at $0.39B (based on $2.54 at the time of writing). It is unknown whether the tobacco giant will opt to lighten its balance sheet, in light of the worsening macroeconomic outlook and prolonged legalization process. While we remain interested in MO's future investments in the cannabis sector, the short-term prospects are gloomy indeed.

MO Has Renewed Its Smoke-Free Efforts After The Juul Fiasco

On the other hand, some of these headwinds may be tempered by MO's stellar financial performance thus far. The company reported revenues of $20.6B and GAAP net incomes of $4.6B over the last twelve months ((LTM)), despite the notable -$3.8B writedowns at the same time. It also reported a more than decent balance sheet, with $2.48B of cash/investments and $1.1B of inventory in the latest quarter.

Declining Smoker Populations In The US

Most importantly, MO also owned 51.4% of the US tobacco market shar e, primarily attributed to the success of Marlboro at 45.8% by Q3'22. However, it is evident that the management cannot rest on its laurels for too long, since the percentage of cigarette smokers in the US has also rapidly declined to 11% of the population by 2022, compared to 35% in 2001 and 25% in 2007.

In the intermediate term, MO may choose to refocus on the smoke-free market as a Juul replacement, since the consumer trend has shifted toward vaping as well. The company aimed to submit its own heated tobacco stick ((HTS)) products for US FDA approval by sometime in 2023. Notably, consumers prefer smoke-free products due to the supposed reduced health risks compared to conventional cigarettes, despite the inherent nicotine content. With up to 5.6M American adults already using smoke-free products, it is unsurprising that 15% of young adults prefer the former by 2022.

Furthermore, MO may re-enter the US and global HTS market from 2025 onwards, with a joint venture with Japan Tobacco ( JAPAF ), Horizon Innovations LLC, through the latter's HTS product, Ploom. The former has already committed $150M, owning 75% of the economic interest in the joint venture. Ploom HTS has seen moderate success in Japan by offsetting the falling consumer demand for cigarettes, with an increased HTS volume of 13.6% and nearly doubled market share to 7.9% in the latest quarter.

However, MO's near-term prospects in the smoke-free market still look uncertain, with Philip Morris ( PM ) likely to enter the US market with its iconic IQOS product from April 2024 onwards. In addition, other tobacco companies such as R.J. Reynolds Vapor Co., continue to expand their e-cigarette market share in the US by 0.3 points sequentially to 40.7% by December 2022, against Juul's rapid decline by 0.6 points sequentially to 27%. This is unsurprising, due to the protracted legal proceeding between the US FDA and Juul Labs thus far.

Therefore, given the recent developments in MO's cannabis and smoke-free investments, the market sentiment surrounding the stock will likely remain pessimistic in the near term, significantly worsened by the 70% chance of a recession in 2023. We explain below why we believe a recession would be impactful.

So, Is MO Stock A Buy , Sell, Or Hold?

MO 1Y EV/Revenue and P/E Valuations

MO is currently trading at an NTM P/E of 9.18x, lower than its 3Y pre-pandemic mean of 15.70x and slightly moderated than its 1Y mean of 9.64x. Based on its projected FY2024 EPS of $5.22 and current P/E valuations, we are looking at a moderate price target of $47.90. This mirrors the consensus estimate's target of $45 as well, suggesting a minimal margin of safety for those who add here.

MO 1Y Stock Price

Nonetheless, we must also applaud MO's excellent feat of sustaining at current levels, despite the uncertain macroeconomic outlook and the Juul fiasco. The stock has only suffered a minimal -9.32% correction over the past year, compared to the S&P 500 Index's plunge of -14.16%. The labor market in December 2022 proved robust as well, with jobs growing by 223K and unemployment remaining stable at 3.5%, pointing to sustained salary growth supporting discretionary spending for the time being.

In the meantime, we may also see a quick reversal in the Fed's dovish stance thus far, with the recent meeting minutes suggesting prolonged interest pain through 2024. Assuming so, it is uncertain if vice industries, such as tobacco, will survive another downturn as they did in the previous recession in 2008. At that time, both MO and PM reported minimal top and bottom lines impact, suggesting the necessity of tobacco products for coping with uncertain macroeconomics. This theory cannot be verified personally since we are not smokers.

While some may have posited that the tobacco industry is recession resistant, the market trend is drastically different now, due to the growing popularity of smoke-free products and expanding state-level cannabis legalizations. Early signs are not promising as well, since the December CPI reports show a deceleration in the consumer index. The index for cigarettes fell by -0.1% sequentially in the December CPI reports, compared to the 0.7% gain in November and 0.5% gain in October. The index for tobacco products similarly declined by -0.2%, against 0.5% in November and -1.1% in October. Only time will tell if these are seasonal declines or permanent shifts in consumer behavior.

However, the biggest difference between the 2008 recession and now, would be MO's inflated long-term debts of $6.83B in FY2008 (+63.6% YoY to $11.2B by FY2009) and $24.8B in FQ3'22 (-8.1% YoY). While the company may well afford the current $1.1B of annual interest expenses (in line YoY) from $12.2B of annual operating income (+1.4% YoY), its leverage has also expanded over the years, from total debt/EBITDA of 1.39x in FY2008 to 2.02x in the latest quarter.

MO's cash flow from dividends paid out and shares repurchased also grew by 7.4% YoY to $8.7B over the LTM. While shareholder returns have been excellent, deleveraging has been consequently slower. Then again, with only $2.6B of long-term debts due through 2024, we are not overly concerned, since it also reported robust Free Cash Flow generation of $8.1B over the LTM.

Nonetheless, we prefer to continue rating the MO stock as a Hold for now, due to the reduced margin of safety. In the meantime, dividend hunters willing to weather some volatility may consider nibbling here. The company's projected FY2024 dividends of $4.06 look tempting indeed, suggesting a forward dividend yield of 8.89% against its 4Y average of 7.4% and sector median of 2.45%. Naturally, portfolios should also be sized appropriately, since the pessimistic macroeconomic outlook is unlikely to lift in the short term.

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