Tobacco Trends Improve; Altria Still Undervalued

Altria MO reported a resilient second-quarter performance, with revenue slightly above our expectations, although smokeless margins were a little light. Underlying trends in the U.S. cigarette industry improved during the lockdown period, and we expect some degree of mean reversion next year. We are modestly raising our forecasts for this year, but retain our $54 fair value estimate and wide moat rating. Altria, like the rest of the tobacco group, remains undervalued relative to our estimate of its intrinsic value.

Reported cigarette shipment volume was down by almost 9% in the second quarter, offset by 6% pricing. After adjusting for inventory trade movements, however, the underlying smokeable volumes fell by just 2%, a significant improvement from the 4% to 5% decline of recent years. We think this is for two reasons. The first is the temporary effect of smokers staying at home and having more time, social freedom and discretionary income to spend on smoking. The second is the structural effect of nicotine consumers switching back to smoking from vaping, following the clampdown on flavored nicotine liquids by the Food and Drug Administration, or FDA. While it is difficult to quantify the impact of these factors, and management has refrained from reinstating medium-term guidance, we believe our medium-term estimate of a 3.5% annual volume decline in a normalized environment remains realistic, and assumes a material contraction in the vaping category.

The top line in the smokeless division was also respectable, with revenue up 10% on adjusted volume growth of 0.5%. This was driven by industry growth, however, and Altria again lost share, most likely to the emerging category of oral nicotine pouches. Altria's distribution capabilities, one source of its wide economic moat, should allow it to grow share in this category with on! Smokeless margins were slightly disappointing, down 120 basis points year over year.

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