Summary
- Altria Group, Inc., British American Tobacco p.l.c., and Philip Morris International Inc. are three of the best-performing high-yield blue-chips in history.
- Today, Altria is struggling with its transition to a smoke-free future, but likely has sufficient time to make the leap.
- British American Tobacco is the cannabis and vaping leader among tobacco aristocrats, and has the best long-term growth prospects, and the best valuation.
- Philip Morris has the best balance sheet, management quality, and best RRP margins. It's also diversifying outside of nicotine entirely.
- My family's hedge fund owns just two of these high-yield aristocrats, though it's reasonable and prudent to own all three.
This article was published on Dividend Kings on Monday, February 27th, 2023.
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Do you know the best long-term industry to invest in? You might think it's software or something else in the tech sector. And indeed, tech companies like Apple Inc. ( AAPL ) and Amazon.com, Inc. ( AMZN ) have minted many millionaires.
Actually, since 1926 tobacco has delivered the best returns of any industry and the 2nd best volatility-adjusted returns.
In fact, over the last 90 years, Altria Group, Inc. ( MO ) was the best-performing stock, with 19% annual returns, turning $1 into $137,000 adjusted for inflation.
Naturally, industries change over time, and growth rates can slow, especially for an industry with the largest transformation in its history.
- a transition to a 100% smoke-free future.
However, when it comes to defensive aristocrat high-yield investing, tobacco companies, which are well on their way to becoming reduced-risk-nicotine companies that are no more deadly than alcohol sellers, are one of my family's favorite sources of very safe and steadily growing yield.
I've spent the last three weeks analyzing MO, British American Tobacco p.l.c. ( BTI ), and Philip Morris International Inc.'s ( PM ) latest results, so I could do a compare-and-contrast article.
One that highlights the pros and cons of these high-yield aristocrats and shows you who each is best for.
I'll also explain why my family's hedge fund owns British American and Philip Morris, but why owning all three is a perfectly reasonable and prudent choice.
Altria: The Best Choice For The Max Safe Yield Seeker
Further Reading:
Altria is one of the best 8% yielding blue chips you can buy if your goal is maximum relatively safe income today.
Consensus Long-Term Return Potential
Investment Strategy | Yield | LT Consensus Growth | LT Consensus Total Return Potential | Long-Term Risk-Adjusted Expected Return |
Altria | 8.0% | 5.5% | 13.5% | 9.5% |
British American Tobacco | 7.2% | 9.1% | 16.3% | 11.4% |
Philip Morris International | 5.2% | 8.6% | 13.8% | 9.7% |
(Source: DK Research Terminal, FactSet.)
If you're looking for a non-speculative, non-K1 tax form stock, you can buy no higher yield than MO today.
That being said, there are reasons to be concerned about MO, and whether or not it can actually deliver those solid 5.5% long-term growth rates analysts currently expect.
For many years, MO bears argued that "this time was different" and that at some point, volume declines would accelerate to much faster rates than seen in the past.
That's what we saw in 2022, when high inflation generally resulted in consumers trading down to lower-cost cigarette brands.
- MO's market share in the U.S. is 47.4% at the end of 2022.
Mind you, MO's market share remains nearly 50%, and it was able to actually grow its margins in 2022 thanks to good cost cutting and impressive pricing power.
For example, 9% price increases in Q4 were far above the rate of inflation, though this is likely going to make volume declines worse than previously expected in 2023.
MO's overall sales are expected to remain relatively flat in the coming years as reduce-risk products or RRPs scale up, but tobacco revenue begins a terminal decline.
- -2.6% per year
- at the former price hike guidance of approximately 7%, implying volume declines of about -10% per year through 2025.
What does a 10% decline rate mean for MO? According to Morningstar's long-term model, at 5% decline rates, MO had about 30 years before its traditional business model risked disruption.
At 10% decline rates, they have about 15 years to make the smoke-free RRP transition.
Now 15 years is a long time, but we can't forget MO has one major risk factor not shared by BTI or PM.
That would be the fact that MO only sells in the U.S. and is at the mercy of the FDA's plans to ban menthol and reduce nicotine in traditional cigarettes to "non-addictive levels."
The menthol ban isn't as dangerous to MO as it might sound at first. For example, in 2018, the EU banned menthol, resulting in BTI's EPS growth coming in at 0% before rebounding to 6% growth in 2019 and 10% in 2020.
However, nicotine regulation is a much larger threat. Not necessarily immediately. If the FDA gradually reduces nicotine levels then it might actually help MO in the short-term.
Why? Because imagine if the FDA were to cut nicotine in cigarettes by 50% per year. In year-one Marlboro smokers, which studies show to be the most brand loyal consumer staples customers of all, it would potentially double how many cigarettes they smoked.
Falling nicotine levels in U.S. cigarettes could decrease volume decline rates for one to two years unless prices are so high that smokers can't afford it.
But you can see how if MO doesn't offer RRP alternatives after a few years, it would likely lose market share to BTI and PM's RRP offerings in the U.S.
MO's RRP plans are a 75% joint venture with Japan Tobacco (MO gets 75% of revenue) to market its Horizon heat sticks in the U.S.
Management plans to unveil more plans for competing with BTI and IQOS vaping products with an Altria in-house vaping solution in its March annual investor day presentation.
The good news for MO is that under the $2.7 billion IQOS licensing agreement it struck with PM, Philip Morris won't be able to market IQOS under the Marlboro name.
However, that's not that big of a coup because PM has been trying to market IQOS as its own brand worldwide and found a lot of success.
In fact, IQOS is the 4th most popular brand of cigarettes/heat sticks in the world.
Marlboro is #1, and so for at least a few more years, MO has plenty of financial firepower to try to ramp up its RRP plans in the U.S.
British American: The Best Choice For The Deep Value Safe Yield Income Growth Investor
BTI is the 2nd highest-yielding tobacco aristocrat and just raised its dividend for the 23rd consecutive year (at least), a healthy 6% in local currency.
Further Reading:
BTI has three main things going for it.
First, it's the global king of menthol, which remains the favorite global flavor of tobacco. That's why it leveraged up back in 2017 to buy the remaining part of Reynolds it didn't already own.
Next, we have BTI's investments in cannabis. BTI ventures have partial stakes in 13 cannabis startups, 13 times more than MO owns.
PM doesn't have any cannabis investments because it focuses on RRPs and medical vaporizers.
If you want to know who is most likely of these companies to become the #1 name in cannabis once it's legalized at the Federal level, it's BTI.
And most of all, BTI's RRPs portfolio is growing like a weed and is focused mostly on vaping.
RRP sales in 2022 grew 37% in constant currency, faster than either MO or PM.
- in 2023, PM is guiding for 43% volume growth in heat sticks, so it will likely regain the RRP growth crown.
While I can't find data on how young nicotine users of legal age consume nicotine, the CDC's annual National Youth Tobacco Survey indicates that vaping is approximately 9.4X as popular with young nicotine users as heat sticks.
Juul regained some market share in 2022 due to the courts blocking the FDA's attempts to remove it from store shelves.
However, BTI's Vuse vaping brand is a close second, and no one even comes close. If the FDA succeeds in killing Juul, which appears to be its goal, then BTI will be the undisputed king of vaping in the U.S. and globally.
It should be noted that BTI isn't yet making profits on Vuse or RRPs. But in 2022, its net losses on RRPs fell 61%, and it's confident that within a few years, it will be generating strong profit margins on these products, just as PM is doing now with IQOS.
BTI's Value Proposition Is Out Of This World
Metric | Historical Fair Value Multiples (all years) | 2022 | 2023 | 2024 | 2025 | 2026 | 12-Month Forward Fair Value |
13-year median yield | 4.56% | $61.62 | $61.40 | $61.40 | $73.46 | $72.81 | |
25-year Average Yield | 4.29% | $65.50 | $65.27 | $65.27 | $78.09 | $77.39 | |
Earnings | 13.30 | $60.12 | $62.64 | $66.37 | $73.02 | $80.33 | |
Average | $62.33 | $63.06 | $64.27 | $74.79 | $76.72 | $63.27 | |
Current Price | $38.76 | ||||||
Discount To Fair Value | 37.82% | 38.54% | 39.70% | 48.17% | 49.48% | 38.74% | |
Upside To Fair Value | 60.82% | 62.70% | 65.83% | 92.95% | 97.93% | 70.47% | |
2023 EPS | 2024 EPS | 2023 Weighted EPS | 2024 Weighted EPS | 12-Month Forward EPS | 12-Month Average Fair Value Forward PE | Current Forward PE | Forward Cash-Adjusted PE |
$4.71 | $4.99 | $3.89 | $0.86 | $4.76 | 13.3 | 8.1 | 7.9 |
BTI isn't just the most undervalued tobacco aristocrat; it's one of the most undervalued blue chips of any kind, period, full stop.
It's trading at 8X earnings, pricing in -1% growth, while it's actually expected to grow at 9.1%.
- 7% to 9% is management's long-term guidance.
BTI 2025 Consensus Return Potential
How fast has BTI grown over the last 20 years? About 7.4% per year.
How fast does management think it will grow in the future? 8%.
How fast do analysts think it will grow? 9%.
And BTI is making steady progress on moving away from all tobacco. In the future, its products will be no more dangerous than alcohol, and in many cases, less dangerous.
So tell me, if BTI's growth outlook is slightly better than its historical growth rates, and its risk profile is improving by the year, why should we expect it to trade at 8X earnings forever?
If BTI selling 100% tobacco and growing at 7% is worth 13.3X earnings, then what is BTI, selling no tobacco and growing at 8% to 9%, worth? I would argue at least 13X to 14% earnings, its historical market-determined fair value.
And guess what? Alcohol companies like Diageo (DEO) historically trade at 21.5X with similar growth rates as BTI and PM.
If anything, a smoke-free future should result in higher P/Es in the future, now lower.
British American Rolling Returns Since 1985
So, what do we have with BTI? A 7.2%-yielding global aristocrat with the best growth outlook in the industry, and the dominant name in global vaping.
Trading at the lowest valuation in 20 years. The last time BTI was this undervalued, it delivered 30X returns over the next 17 years, an incredible Buffett-like 25% annual returns.
So BTI offers not just Buffett-like returns for the next few years but potentially for the next decade and a half.
And long term, it offers its historical return potential for decades to come.
Philip Morris: The Best Choice For Those Seeking Maximum Safety And Quality
Further Reading
PM is the highest-quality tobacco company by most measures, including credit rating and management quality.
PM was the first big tobacco company to really get into RRPs, and its IQOS brand has become the global leader in heat sticks.
- PM is 33% RRP sales
- BTI is 15% RRP sales
- MO is less than 12% RRP sales.
Thanks to buying Swedish Match (SWMAY) for $11 billion last year, PM now gets about 1/3rd of its sales from smoke-free products. Management is confident it can crack 50% by 2025 and even stop selling cigarettes entirely by 2030 in some countries.
PM has spent over $9 billion developing IQOS and other RRPs, and that's almost entirely what its R&D spending now goes to.
In 2021, PM was getting over 50% of sales from RRPS in seven markets. In 2022, it was up to 17.
PM was the first out of the gate on RRPs and is the only one to earn a profit on them. In fact, gross margins are higher on iQOs than on traditional cigarettes.
And 73% of traditional smokers who try IQOS permanently switch and stick with it.
And with approximately 75% global market share in heat sticks, PM is sitting pretty with older smokers (the vast majority).
Heat sticks most closely approximate traditional smoking, and that's why they have proven more popular with older smokers than vaping.
That's not to say PM isn't competing in vaping because that's most popular with young nicotine users, and they are the industry's long-term future.
PM is launching several brands of heat sticks targeting IQOS technology across the entire pricing spectrum.
They are also looking to replace chewing tobacco with oral nicotine pouches, and Zyn has 76% market share in the U.S.
- PM now owns Zyn.
Iluma is PM's 2nd generation heat stick tech, which gets around BTI's patents, which caused the IQOS launch to be postponed in the U.S.
Like with the first gen IQOS, it was launched in Japan first, and PM's new Iluma brands have done very well.
Remember when PM tried to buy MO to get back into the U.S. market? That deal was scuttled because of regulatory concerns about Juul.
PM is a U.S. company and wants as many U.S. sales as possible to minimize its currency risk. This is also the most lucrative nicotine market on earth, with $20 billion in annual profits.
Now, without having to buy MO at all, PM has gained access to the U.S. market as soon as its gains FDA approvals for its RRP products.
PM is like the old MO but has reduced regulatory and legal liability risk.
And once their RRP rollouts get underway, PM has none of the heat stick/cigarette cannibalization concerns MO has.
Bottom Line: All Three Are Great High-Yield Choices, But Two Are Best For My Family's Needs
Don't get me wrong, owning all three high-yield tobacco aristocrats is a strategy that is likely to work out well for long-term income growth investors.
MO is a great choice for ultra-yield deep, value investors who are confident that management can get its RRP house in order before the FDA starts regulating nicotine levels in the U.S.
In my opinion, BTI is a superior ultra-yield choice, thanks to far better geographic diversification and an RRP portfolio growing like a weed.
- BTI also owns stakes in 13 cannabis startups
- if you want to profit from legal cannabis, BTI is the best option.
And PM is the high-yield tobacco dividend king who was the first to start working on the future smoke-free transition and is the only one turning a profit from RRPs.
IQos margins are slightly higher than cigarette margins, which bodes well for MO and BTI once they finally achieve critical RRP economies of scale.
Quality and safety are paramount for my family hedge fund, and maximum long-term income and total return potential (which income tracks) are also a top priority.
Dividend Kings ZEUS Income Growth Portfolio: My Family's Hedge Fund
That's why we've tweaked ZIG's long-term asset allocation plan to prioritize those high-yield blue-chips that can best serve our goals and risk profile.
- ZIG began at a 4% yield and 12% long-term return potential
- and is now up to a 4.2% yield and 14.6% long-term return potential.
Our goal is a simple and easy-to-manage hedge fund with 20 stocks and ETFs or less.
- based on Buffett's recommended portfolio size
- confirmed by studies showing above 20 generates rapidly diminishing diversification benefits.
That's why we sold our MO position in order to switch to PM, which is now the highest quality and lowest risk tobacco company on earth.
PM will soon have a global presence, with a likely dominant position in U.S. heat sticks. Thanks to its purchase of Swedish Match, it already owns 76% of the oral nicotine pouce market.
And we can't forget that growth outlooks will shift over time. So long-term income investors should consider which of these high-yield aristocrats have the most downside risk to their growth plans.
- MO's smoke-free future execution has been poor so far
- BTI's has been very strong
- PM's has been excellent.
MO has just a few years to scale up its RRP offerings before the FDA could significantly reduce its moat with non-addictive levels of nicotine.
BTI's RRP growth has been around 40% per year for the last five years, and they are maintaining those growth rates because they are the world leader in vaping.
PM's growth prospects temporarily took a beating after the invasion, but they are now back on track to potentially achieve pre-invasion guidance of 9+% EPS growth.
- 43% RRP volume growth guidance in 2023.
I estimate that in terms of long-term growth risks, meaning outlooks fall in the future these aristocrats look like this:
- MO: highest risk that growth disappoints
- BTI: 2nd lowest risk
- PM: lowest risk (due to the top brands in the world and dominance in heat sticks).
Ultimately the reason I like BTI and PM more than MO comes down to this.
BTI is the global king of vaping and cannabis, strategies that are popular with younger nicotine users.
PM is the global king of heat sticks and is diversifying into non-nicotine (mostly medical vaporizers). They are the favorite for older nicotine users.
MO is the U.S. king of traditional cigarettes...for as long as the FDA doesn't regulate nicotine levels (probably 2027 or 2028).
Two of these high-yield aristocrats own the future of the nicotine industry, and one owns the past.
And so, while there is a strong case to be made for buying MO here, for my family's needs, we're planning on skating to where the puck is going, not where it's already been.
For further details see:
Altria Vs. British American Vs. Philip Morris: Battle Of The High-Yield Aristocrats