Philip Morris's Potential Merger With Altria Has Trade-offs; No Change to Dividend Safety Score

Philip Morris International (PM) surprised investors last week when the firm confirmed it was in discussions with Altria (MO) about a potential all-stock, merger of equals.

After all, these two tobacco giants had separated just over a decade ago when Altria spun off Philip Morris International in 2008.

The idea of a potential reunion has not been received well by the market. On August 27 shares of Philip Morris International plunged nearly 11% on the news and remain 7% below their pre-announcement price.

Combining with Altria seems to go against Philip Morris International's business strategy. Unlike Altria, for years Philip Morris International has invested heavily in developing reduced-risk products with a goal of one day replacing cigarettes.

Since 2008 the firm has invested $6 billion in R&D, with the majority of that spending focused on smoke-free offerings. Today the company markets four reduced-risk products: two that heat tobacco to produce a vapor, and two that produce a nicotine-containing vapor without tobacco (e-cigarettes).

Thanks to these efforts, reduced-risk products accounted for "nearly 20%" of Philip Morris International's net revenue in the second quarter of 2019, according to management.

That's up from 0.2% in 2015 and about halfway to the company's 2025 goal of deriving 38% to 42% of its net revenue from smoke-free offerings.

Simply put, Philip Morris International has proactively adapted its business to help position it for the continued rise of cigarette alternatives.

In 2018 reduced-risk products accounted for just 4% of the international nicotine market (excluding China and the U.S.). As more consumers quit combustible cigarettes and switch to presumably lower-risk alternative offerings, this piece of the market will likely grow significantly over the next decade.

In fact, the Global State of Tobacco Harm Reduction report (GSTHR) estimatesthat by 2021, over 55 million people will be using e-cigarettes or heat-not-burn tobacco products and that the global market will be worth $35 billion.

This trend can severely impact cigarette demand. For example, in Japan, which has led the adoption of heated-tobacco products, combustible cigarette sales fell by 27% in two years, which the GSTHR called "an unprecedented national decrease in smoking."

Disruption is happening at different paces around the world, and Philip Morris International is trying to lead the transition so it can maintain a strong position in the nicotine markets of the future.

Besides technology investments, Philip Morris International shareholders also appreciate the company's geographic diversification and lack of exposure to the dynamic U.S. market. The firm operates in more than 180 countries, lessening its dependence on regulatory and consumer developments in any single market.

Importantly, the countries Philip Morris International operates in also appear to be more resistant to cigarette volume declines than America. Through the first half of 2019, Altria estimates U.S. cigarette shipments fell 5.5%, while Philip Morris International's cigarette volume slipped just 1.5%.

As you can see, the industry volume trend across the firm's markets has been stable for years.

With just over 50% of the company's net revenues and more than 70% of its total volume derived in emerging markets, Philip Morris International's combustible cigarettes business also seems less likely to be quickly disrupted by reduced-risk products.

Standard & Poor's believes that developing markets are seeing steadier volumes because "smoke-free alternatives are generally more expensive and less available than cigarettes." The populations in these countries are usually younger and faster-growing compared to America's, too.

Unfortunately, Altria's business, which operates almost exclusively in the U.S., has found itself on the wrong side of these trends. 

When Altria spun of Philip Morris International in 2008, U.S. cigarette consumption was declining at a 3% to 4% annual rate, according to The Wall Street Journal. 

That manageable pace of decline largely continued through 2016 but has since accelerated due to the continued aging of older smokers, growth in alternative products such as e-cigarettes, and many states raising the legal age to purchase tobacco products to 21.

As a result, in July 2019, Altria expanded its estimated range for annual average U.S. cigarette industry volume declines through 2023 to 4% to 6% from a range of 4% to 5%, doubling the pace of decline seen in Philip Morris International's markets.

Unlike Philip Morris International, Altria was largely caught off guard by the rise of vaping and other nicotine products with perceived lower risk.

In an effort to catch up, in late 2018 the firm somewhat desperately invested $14.6 billion for minority stakes in privately held vaping giant Juul Labs and cannabis company Cronos (CRON) to begin scaling its non-combustible portfolio.

Large, pricey acquisitions and accelerating cigarette volume declines worried investors enough, but the U.S. regulatory environment has made Altria's investment case even more complicated.

As we've discussed in past notes, Altria's regulatory risk profile has deteriorated. In recent years, the Food and Drug Administration has announced plans to explore lowering the nicotine allowed in cigarettes to non-addictive levels, ban menthol cigarettes, and potentially halt the sale of e-cigarettes if youth vaping continues to rise.

Merging with Altria would raise Philip Morris International's U.S. exposure from 0% to nearly 40% of net revenues, introducing a complex set of regulatory risks for investors to digest.

So why would Philip Morris International even consider merging with Altria if it already has a superior smoke-free product portfolio, better geographic diversification, and a more favorable set of regulators?

I see three potential benefits. First, today the vast majority of Philip Morris International's smoke-free business consists of its heated tobacco IQOS product. The firm does have two e-cigarette offerings, but they are not as far along on the commercialization curve.

Altria is in the opposite position. The company doesn't have its own heated tobacco product, opting instead for an exclusive license to sell Philip Morris International's IQOS in America. Meanwhile, Altria has focused the bulk of its investment on vaping by acquiring a minority stake in Juul, which has around 70% share of the U.S. e-cigarette market.

Merging with Altria would give Philip Morris International access to an even more well-rounded portfolio of smoke-free products, increasing its chances of being a leader no matter which direction (combustible cigarettes, heated tobacco, vapor, cannabis, etc.) its various markets head.

Given Juul's ambitions to expand aggressively outside of America, Philip Morris International's established distribution network overseas could help the combined company scale its e-cigarette portfolio faster too.

Scale is a second potential benefit. In addition to creating a more comprehensive portfolio of reduced-risk products, a merger with Altria would lift Philip Morris International's revenue from about $30 billion to approximately $50 billion.

Tobacco is far from a capital-intensive industry, reducing the magnitude of potential cost synergies, but developing and distributing next-generation products is very costly.

The combined business would likely be better positioned to produce and scale reduced-risk offerings covering the full spectrum of vaping and heated tobacco products.

Costs could also be taken out of the business by eliminating duplicative corporate overhead costs, ensuring the dividend remains covered without compromising on making necessary "smoke-free" investments for the future.

Finally, Philip Morris International might believe Altria's current valuation more than discounts the regulatory risks the firm faces, creating a timely opportunity to combine given the potential upside.

In fact, some Altria investors are concerned that an "all-stock, merger of equals" could represent a takeunder of the company, leaving value on the table given Altria's depressed valuation today.

The companies have not said anything about the terms of the potential merger they are discussing, but a "merger of equals" seems to imply that Philip Morris, which is the larger of the two firms, is unlikely to pay a premium for Altria.

Altria's stock sports a paltry forward P/E ratio of just 10.0, less than half the multiple it traded at as recently as late 2017 and well below Philip Morris International's 13.4 ratio.

PM's valuation multiple premium over Altria has not been this large in years (maybe ever), which could give its shareholders a more favorable stake in the combined company. (Someone briefed on the deals terms told The Financial Timesthat Philip Morris would own between 57% and 59% of the combined company).

However, very few details are available about the proposed combination, and both firms have said there can be no assurance that any deal will result from these discussions. After all, any transaction would be subject to the approval of the two companies’ shareholders, and the initial reaction was negative on both sides.

From a financial perspective, it's also too soon to make many claims since we don't know what the combined firm's capital structure will look like or the financial policies management will implement.

However, given each company's dedication to its dividend, plus Altria's 50th consecutive annual dividend increase announced just last week, I would expect income investors in both firms to be kept whole in any transaction.

I'd also be surprised if the combined entity did not maintain an investment grade credit rating, and the transaction seems likely to be structured as a tax-free combination if it reaches the finish line.

Overall, no change is expected in Philip Morris International or Altria's Safe Dividend Safety Scores based on what we know today. 

As more information is released about what a transaction might look like, we will keep everyone updated. For now, we plan to continue holding the shares of Philip Morris International and Altria we own in our Conservative Retirees and Top 20 Dividend Stocks portfolios.