Altria Group: A Value Proposition

With a possible spin-off of Kraft Foods ahead, S&P says shares of the consumer-products giant present a good opportunity

We believe Altria Group's shares are significantly undervalued and present an attractive buying opportunity for a number of reasons. First of all, we think the domestic tobacco litigation environment will continue to improve, thus reducing risks to future cash flows. In addition, we believe international tobacco companies will continue to experience a wave of consolidation, providing Altria (MO; recent price, $88) with an opportunity to make accretive acquisitions in markets with growing tobacco-consumption trends.

Last, and perhaps most important, we view the potential spin-off of Kraft Foods (KFT) as a potential catalyst to unlock shareholder value for this growing and, in our view, undervalued company. With a 3.9% current dividend yield, we believe the shares present a compelling buying opportunity and have a 5 STARS (strong buy) recommendation on the stock.

Altria's various units make and market various consumer products, including cigarettes and packaged foods. These subsidiaries include Philip Morris and Kraft Foods. Altria's segments for reporting purposes are domestic tobacco, international tobacco, North American food, international food, and financial services.

High-Profile Brands

The company is highly geographically diversified. International operations accounted for 58.6% of sales and 53.4% of operating profits in the first nine months of 2006.

Philip Morris USA is the largest U.S. tobacco company, with total U.S. cigarette shipments amounting to 185.5 billion units in 2005, accounting for 50% of total U.S. cigarette market shipments. The company's most recognizable brands include Marlboro (the largest-selling cigarette brand in the world), Virginia Slims, and Parliament in the premium category, and Basic in the discount category.

We believe PM USA's domestic market share increased in 2006, to approximately 50.5%. Philip Morris International's total cigarette shipments rose 5.7% in 2005, to 804.5 billion units. Domestic contributed 18.3% of total company sales and 27.9% of operating profits year to date through the 2006 third quarter, while international accounted for 48.4% of total company sales and 47.2% of operating profits.

Sliced in Two?

Majority-owned (88.6%, as of November 30, 2006) Kraft Foods is the largest packaged-food company in North America and second largest in the world. It produces a wide variety of snacks, beverages, cheese, grocery, and convenient meals in the U.S., Europe, the Middle East, Africa, and Asia/Pacific. Kraft's North American operations accounted for 22.6% of total company sales and 21.7% of company operating profits in the first nine months of 2006, while Kraft Foods International provided 10.2% of sales and 6.2% of profits.

Altria also owns a significant stake in one of the world's largest brewers, SABMiller. As of November 30, 2006, this stake represented a 28.7% economic interest and voting interest.

Altria is looking at a number of restructuring alternatives, including the possibility of separating into two, or potentially three, independent entities. At the next board meeting, scheduled for late January, we expect directors to make an announcement regarding the potential breakup of the company. In our view, such a move would be a catalyst for unlocking shareholder value by enabling each of the individual segments to become more strategically focused, leaner, more nimble, and potentially less constrained by overarching corporate goals that may run counter to the immediate needs of the respective segments.

High Court Review

Another potential catalyst for the shares, in our view, is the continual improvement seen in the domestic tobacco litigation environment. Altria won an appeal of a $10.1 billion judgment in the Price (formerly known as Lights) lawsuit, and in late 2006, the court refused to rehear that case.

The Florida Third District Court of Appeals overturned a trial verdict against Altria and other defendants in the Engle case, reversing an award of $143 billion in punitive damages for the plaintiffs, and decertified the Engle class due to a lack of commonality of class member issues.

Although the tobacco industry lost theJustice Dept. case, the Supreme Court eliminated the $280 billion disgorgement claim. We still await the Supreme Court review of the Williams case, which could cap punitive damages for the entire industry, and a review of the Schwab class certification, which has been permanently stayed.

Altria continues to increase its top line through market-share gains, price increases, and acquisitions, funded primarily from its significant operating cash flow. Longer term, we see recent deals with the China National Tobacco Co. for the global distribution of Chinese cigarette brands, and a license to sell Marlboro branded products in China as potential profitability drivers.

Better Margins Ahead

We expect Altria Group's revenues to rise 4% in 2007, benefiting from growth in international tobacco, market-share gains, pricing power, a positive mix shift in domestic tobacco, and improved volumes at Kraft Foods. We expect sales volume to rise, driven by brand investments and new products, led by major cigarette brand Marlboro. We foresee managed price gaps supporting a 3% rise in domestic revenues. In December, 2006, the company effectively raised prices by 10 cents a pack by reducing promotional discounts.

We look for international tobacco sales to increase 6%, on acquisitions and volume gains in most countries. Altria's recent acquisitions include a 70% stake in Lakson, a leading tobacco company in Pakistan; the purchase of the 40% stake it didn't already own in E. Leon Jimenes, a Dominican tobacco company; regaining ownership of its Marlboro brand in some Asian markets from Japan Tobacco; and the signing of a long-term joint venture agreement with China National Tobacco Co.

We expect Philip Morris International's margins to widen due to improving volumes in some markets, in addition to currency gains. Also, we look for margin improvement for Philip Morris USA on decelerating growth in marketing outlays, aided by a narrowing price gap between premium and discount brands. Furthermore, we project that food margins will improve, benefiting from ongoing restructuring.

Multiple Expansion

All told, Altria's operating margin is expected to widen on higher overall volumes and well contained costs. We see a lower effective tax rate and reduced interest expense boosting 2006 operating earnings per share to $5.55. In 2007, we see volume growth and positive pricing sustaining gross margins, boosting EPS to $5.69.

At recent market prices, the shares traded at 15.5 times our 2007 EPS estimate of $5.69. This puts the total enterprise value—stock market capitalization plus net debt—of the company at 11.3 times earnings before interest, taxation, depreciation, and amortization (EBITDA). While these multiples are in line with the recent average highs for shares of Altria over the past several years, they're well below the averages seen for other consumer-staples stocks. Moreover, while the current multiples are in line with domestic cigarette manufacturers, they're well below those of Altria's international tobacco company peers.

We believe this can be explained by the heightened risk to future cash flows represented by the domestic tobacco litigation environment. However, we believe domestic tobacco companies have reached a point of inflection, and the tide of litigation will turn in the tobacco companies' favor. As such, we think multiple expansion is highly likely in upcoming years.

Strong Board

Because the largest component of Altria Group is its PM International, we apply a low price-earnings multiple of 20, conservatively below the average p-e of 24 for international tobacco company peers, to our 2007 EPS estimate. This results in a relative value of $114. By applying the 13 times enterprise value/EBITDA multiple recently seen for international tobacco companies, we derive a relative valuation of $112 per share.

Based on our analysis, we calculate the net present value of expected free cash flows at about $107 per share. For the purposes of our model, and with no certainty as to the breakup of Altria Group, we look at contributions from the entire company. Our 12-month price target of $110 is based on our relative valuation and discounted free cash flow analyses.

Overall, we view Altria's corporate-governance policies favorably, and believe the company is a leader among its peers. We see the following factors as positive: The board is controlled by a supermajority (greater then 90%) of independent outsiders; the nominating, compensation, and audit committees are composed solely of independent outside directors; the company has a committee that oversees governance issues that meets regularly; board elections aren't staggered; there's a single-class ownership structure; and the company hasn't been subject to scrutiny for option repricing or restating results.

Remaining Risks

Conversely, we view the following factors negatively: Shareholders don't have cumulative voting rights in director elections, the chief executive officer and other board members have been involved in company "related party" transactions, shareholders may not call special meetings, and the board may amend bylaws without shareholder approval.

One of the largest risks to our recommendation and target price is the possible pressures on trading multiples as investors remain cautious about tobacco litigation. As of November 1, 2006, Altria had at least 228 tobacco-related cases pending, down from 268 at 2005 yearend. Legislation curbing tobacco use or significantly increasing excise taxes remains a threat to the tobacco industry. Also, there are execution risks associated with a possible restructuring of Altria into two or three separate entities.

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