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Altria's Stock Declines Again on Increased Regulatory Concerns

Shares of Altria (MO) slumped 7% today, pushing them to their lowest price in over four years while extending their decline to more than 30% since early November 2018.

As has been the case since Altria's stock peaked in mid-2017, regulatory fears continue weighing on investor sentiment. 

The latest development occurred on Friday, January 18, 2019. At a public hearing, Food and Drug Administration (FDA) Commissioner Scott Gottlieb stated that e-cigarettes could face an "existential threat" if youth use continues to rise. 

With markets closed on Monday in observance of Martin Luther King Jr. Day, today was the first opportunity investors had to price in this news.

While e-cigarettes were intended to help transition adult smokers off harmful combustible products and onto lower-risk products, use among high school students has skyrocketed.

Here's what Mr. Gottlieb noted on Friday:

"Unfortunately, data from the 2018 National Youth Tobacco Survey confirm that youth use of e-cigarettes has become an epidemic. From 2017 to 2018, there was a 78% increase in current e-cigarette use among high school students and a 48% increase among middle school students. The total number of middle and high school students currently using e-cigarettes rose to 3.6 million — that’s 1.5 million more students using these products than the previous year."

This is clearly a very serious issue that deserves attention. As it relates to Altria, the company actually discontinued its e-cigarette brands in early December due to their disappointing financial results and the complicated regulatory landscape they had to deal with. 

Private company JUUL Labs had also taken the e-cigarette industry by storm, capturing around half of the market and leaving Altria firmly in its rearview mirror. Unfortunately for JUUL, the FDA specifically called it out on Friday: 

"Reported e-cigarette use among high school students, which peaked at 16.0 percent in 2015, had decreased to 11.3 percent in 2016 and held steady in 2017. But, in late 2017 and early 2018, anecdotes from policymakers, from parents, and from the press suggested an alarming rise in youth use of e-cigarettes generally and, in particular, the product made by JUUL Labs. Indeed, the ubiquity of this one product became so entrenched so quickly that it gave rise to its own verb – juuling."

The FDA warned that it could exercise its power to completely halt the sale of e-cigarettes, effectively taking products off the shelves until industry players "successfully traverse the regulatory process."  

"I fear that the survey data that we’ll get for next year will show continued increases in youth use of e-cigarettes. We’ll be in the field between March and May with the 2019 National Youth Tobacco Survey. I’ll tell you this. If the youth use continues to rise, and we see significant increases in use in 2019, on top of the dramatic rise in 2018, the entire category will face an existential threat.

I find myself debating with tobacco makers and retailers the merits of selling fruity flavors in ways that remain easily accessible to kids. But if the epidemic continues to mount, I’m sure that the debate will change to one of whether these products should continue to be marketed at all without authorized pre-market tobacco applications. It could be “game over” for some these products until they can successfully traverse the regulatory process

I think the stakes are that high. And would be a blow for all of the currently addicted adult smokers who, I believe, could potentially benefit from these products."

Social concerns aside, with Altria's business still driven by sales of traditional cigarettes today and the company exiting its e-cigarettes brands in early December, wouldn't this be good news from a purely financial perspective? After all, fewer alternatives to traditional tobacco products would presumably slow the decline in smoking rates among adults, helping maintain the firm's main cash cow.

Unfortunately for Altria, on December 20, 2018, the company agreed to buy a 35% stake in JUUL Labs for a whopping $12.8 billion to complement its core tobacco business and improve its long-term growth potential. Just one month later, the FDA issued an "existential threat" to JUUL's U.S. business. Talk about poor timing.

Simply put, the FDA's announcement certainly clouds JUUL's outlook and presumably makes the business worth a lot less than what Altria valued it at in December, which investors already thought was a steep price.

I can't predict what actions regulators will ultimately take, but it seems unlikely that a major reduced-risk product category such as e-cigarettes would be taken away for a substantial period of time. Reducing adult smoking rates remains a core goal, and reduced-risk products help make that happen.  

However, as Mr. Gottlieb commented on Friday, addressing the rise in youth vaping appears to be becoming an equally important, if not even higher, priority:

"In fact, this past November, the Centers for Disease Control and Prevention reported that smoking rates among adults reached an all-time low in 2017 — 14% of adults reported cigarette smoking “every day” or “some day,” marking a 67% decrease since 1965.

Sadly, this progress is being undercut – even eclipsed – by the recent, dramatic rise in youth vaping. A few years ago, it would have been incredible to me that we’d be here, discussing the potential for drug therapy to help addicted youth vapers quit nicotine."

So all bets are off on the future of JUUL Labs, at least over the medium term. Should youth usage continue rising in 2019, it's possible e-cigarettes are taken off shelves as their manufacturers are forced to work through the FDA's regulatory approval process.

Your guess is as good as mine regarding how long this could take, how it could shake up JUUL's current dominance of the e-cigarette market, and how much it could ultimately cost.

With that said, Altria's $12.8 billion investment in JUUL Labs is a (major) sunk cost that still seems unlikely to threaten the firm's dividend (see our December 2018 analysis here). Thanks to the company's excellent financial health prior to this deal, plus the substantial cash flow it continues generating from tobacco sales, Altria appears to have what it takes to manage through a potential blow like this.

However, management's credibility certainly takes a ding, and the firm no longer has much margin for error should trends significantly change for the worse in its core tobacco business.

Ultimately, this latest regulatory development is a clear negative that threatens an important future growth driver Altria was banking on. But perhaps more importantly, it suggests the FDA might continue taking a more aggressive stance towards manufacturers of tobacco and reduced-risk products alike.

After all, since Scott Gottlieb was sworn in as the FDA's 23rd Commissioner in May 2017, he has announced plans to explore lowering the nicotine allowed in cigarettes to non-addictive levels, ban menthol cigarettes, and now threaten the very existence of e-cigarettes. 

Despite its impressive long-term track record, Altria increasingly looks like an income investment that needs to be more closely monitored over the next few years. While there is no imminent threat to its business or dividend, some clouds are forming on the horizon. 

In these situations – a financially healthy business dealing with hard-to-quantify risks and growth uncertainties – I prefer to simply hold my shares (no buying or selling), waiting for more information to emerge to take some emotion out of the decision-making process. Altria next reports earnings on January 31, and management will have plenty of issues to address with analysts. 

We will continue monitoring the latest regulatory developments and trends in Altria's core tobacco business, providing updates as necessary. In these more complex situations, the importance of maintaining a well-diversified dividend portfolio to reduce company-specific risk can't be overstated.

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