FIN 4274: Equity Securities: Analysis and Management

Professor Billingsley: MW 2:30

April 20th, 2015

Written By:

Justin Wooldridge

Brian Fioravante

Charles Cornett

Catherine Wilson

Jake Seraphin

Wenhui Lin

Table of Contents

I. Porters 5 Forces:

A. Threat of New Entry

B. Buyer Power

C. Threat of Substitution

D. Supplier Power

E. Competitive Rivalry

II. SWOT Analysis:

A. Strengths

B. Weaknesses

C. Opportunities

D. Threats

III. Comprehensive Financial Statement Analysis:

A. FCF Valuation

B. WACC

C. Discounted Cash Flow Model

D. Comparable Sheet

1. Relative Valuation

2. Multiple Valuation

3. Dupont ROE Analysis Equity Valuation

E. Analysis of Excess Earning

IV. Analysis of Results and Conclusion

V. References

VI. Appendices

Porters Five Forces: Tobacco Industry

Threat of New Entry:

Tobacco companies have low threat of new entry because of high barriers to entry

through high required capital expenditure, competition with large established brands, and

competing with the high economies of scale currently in use by existing firms. Entrance into the

tobacco industry requires a very large investment in factories and machinery to make tobacco

products. Furthermore, the competitive environment that exists in the tobacco industry consists

of few companies that make the majority of all tobacco products used. These companies already

have huge market shares and loyal customers through their well known brands. In addition,

existing companies in the industry obtained high economies of scale through years of operations

and expansions, and it would be hard for a new company to compete with the large established

companies. The threat of new entry in the tobacco industry is low for the short and long term

because it would be very expensive and difficult to break into and obtain market share in the

industry.

Buyer Power:

Buyer power of customers is low for the tobacco industry. The industry is highly

regulated and taxed which has led to high prices for tobacco products. In addition, the major

tobacco brands has established very loyal customer bases that will pay any price to obtain their

favorite products. Also, the nicotine in tobacco is highly addictive, and once customers become

regular users it is very hard for them to stop buying tobacco products, no matter the cost. Overall,

the tobacco industry faces low buyer power because it consists of very loyal customers and an

addictive product that allow companies to command high prices for their products.

Threat of Substitutes:

The threat of substitutes is low for the tobacco industry due to the unique effects

customers experience when using tobacco products. Customers enjoy the euphoric feeling from

using tobacco products, and there aren’t any similar products that can offer the same effect that

are easily obtainable or legal. While there is no direct substitute for tobacco products, customers

may choose to quit tobacco by substituting it with other products including: nicotine

supplements, sunflower seeds, and chewing gum. Furthermore, the culture in the United States is

shifting to healthier lifestyles which could hurt the tobacco industry. To hedge against this risk,

tobacco firms are investing in new technologies, such as electronic cigarettes, to make using

tobacco less harmful to the health of users. Overall, the threat of substitutes for tobacco is low;

however, the possibility exists of customers ceasing to use tobacco products because of health

and other concerns.

Supplier Power:

The power of suppliers within the tobacco industry is considered to be a low power

threat. A low power threat of suppliers occurs when there are many suppliers for an industry or

the demand for supplies is less than the supplier’s capacity to satisfy all demand. The materials

required for tobacco manufacturing include various types of paper, cellulose fibers, and a variety

of additives. However, the most important raw material used by tobacco manufacturing

companies is tobacco leaves, which are purchased directly through tobacco farmers or at auction.

Globally, the number of tobacco suppliers exceeds demand causing some countries to enforce

contracts to purchase domestically. For example in America, Congress passed a domestic content

law that required manufacturers to use at least 75 percent domestic leaf in U.S.-manufactured

cigarettes. That law was found to be inconsistent with the General Agreement on Tariffs and

Trade and the domestic content law was replaced with a tariff rate quota, which assesses a 350-

percent duty on imports beyond a fixed quota.

Competitive Rivalry:

Within the tobacco industry, the overall threat of rivalry is high considering there are

only a few companies that serve this market. The three leading players are Altria, Reynolds and

Lorillard. Having such a small amount of players makes for intense rivalry because competitors

are constantly seeking ways to reach a competitive advantage over one another to gain market

share. Companies, such as Altria, have used mergers and acquisitions as a tool to improve their

market position. Furthermore overseas expansion offers attractive growth due to rising income

levels and less regulation and added scale allows these corporations to better withstand

competition from small discounters at the retail level. The pursuit for an advantage over

competitors can lead to businesses changing their prices of their products or increasing the

amount of capital for product innovation, both of which have a negative effect on profits. In

addition to only having a few competitors within the industry there are also a significant amount

of brands and products available to consumers resulting in an increase in competition.

SWOT Analysis:

Strengths Weaknesses

● Largest tobacco manufacturer in

the U.S.

● Strong market position with high

bargaining power

● Purchasing power and product

innovations

● Declining domestic cigarette volume

sales by 3-5% per year since 2012

● Reliance on cigarettes as major source

of revenue

Opportunities Threats

● Growth in International markets

● Development of Electric Cigarette

technology

● UST acquisition allowed entry into

smokeless tobacco market

● Increased government regulations

● Rising Federal and State Excise Taxes

● Growing awareness of health and

social consequences

Strengths:

Altria is the largest U.S. tobacco company and accounts for 50.6% of total U.S. cigarette

sales (as of 2013). It’s leading focus brand is Marlboro, which attributes to the highest volume

of cigarettes sold in the world. The Marlboro brand gives Altria a high bargaining power

because not only are cigarettes addictive, but the consumers in this industry stay loyal to their

brand. Altria also has a high purchasing power and that can be seen through the growth they

have sustained through acquisitions and new product innovations. In 2007, Altria acquired John

Middleton Inc., a leading manufacturer of machine-made cigars for $2.9 Billion and then in

2009, Altria acquired UST,Inc which is the largest U.S manufacturer of smokeless tobacco

products for $11.7 Billion. Their newest product innovation in 2007 of the Marlboro Menthol has

been driving domestic gains. These acquisitions and new technologies show that Altria has been

a dominant force in this industry and is liking to continue to control the market for tobacco.

Weaknesses:

The biggest issue in the tobacco industry is that cigarette sales have been been steadily

declining 3-5% per year since 2012. This is most likely due to increases in cigarette prices,

growing health and societal concerns, new government regulations, and anti-smoking and

tobacco campaigns (tobacco companies are required to fund these campaigns). Altria also relies

on cigarette sales for more than three quarters of their revenues indicating their need of

diversification. This puts future revenues at risk if the new societal trend moves away from the

conventional cigarette. Altria is trying to prevent lower revenues by moving into the smokeless

market domestically and internationally.

Opportunities:

Altria has a vision to grow internationally, and they have the resources and capabilities to

do so. With global cigarette volume sales increasing by 7% between 2001 and 2013, Altria is

trying to take control of that market. Nearly 80% of the world’s smokers live in low- and

middle-income countries and with Altria already having the highest domestic share, their goal is

to target these emerging international markets. Their idea was to dominate internationally due to

the fact that most foreign countries had less strict government laws and regulations than the U.S.

They recently signed a cross-licensing agreement with their former subsidiary, Philip Morris

International, to commercialize it’s e-cigarette brand internationally. In regards to the Electric

Cigarette, Altria has been innovating through the development of this new technology. They are

hoping to market to consumers who have health and social concerns with smoking. Regular

cigarettes contain chemicals and these chemicals burn with the tobacco which emits an odor,

whereas electric cigarettes are odorless and only contain tobacco. The acquisition of UST has

also given Altria access to the smokeless market. Some of the smokeless products such as

Copenhagen, Skoal, and Marlboro Snus (MST) have been extremely profitable in Europe and

Altria has hopes that their popularity can spread to the United States and other parts of the world.

Altria is in a solid position to grow due to their resources, domestic and global market share, and

recent innovations and acquisitions.

Threats:

For quite sometime now, tobacco companies have been subject to many regulations by

the FDA and they have been steadily increasing. In June 2009 President Obama signed the

Family Smoking Prevention and Control Act, which gives the FDA the authority to regulate the

manufacture, distribution, and marketing of all tobacco products. This law, among other things,

ended Altria’s ability to introduce new products without oversight, ushering in a new era where

tobacco products are subject to public health-based regulation. In addition to the Family

Smoking Prevention and Control Act, in 2010 the FDA mandated that manufacturers could no

longer produce cigarettes or cigarette tobacco with a characterizing flavor other than tobacco or

menthol. If the regulations and policies implemented by the FDA continue to tighten then it

could lead to a substantial increase in the cost associated with Altria’s products. Along with

increasing regulations, the government taxes have also been increasing. On April 1, 2009, the

largest federal cigarette excise tax increase in history went into effect, bringing the combined

federal and average state excise tax for cigarettes to $2.21 per pack. This increase in tax will

likely cause many consumers to possibly quit smoking or find a substitute for cigarettes. To put

this into perspective, the CDC reported that a 10% increase in the real price of cigarettes is

estimated to reduce consumption by nearly 4%.

Another major threat to this industry is the growing awareness of health concerns of

tobacco. The U.S. has been trending toward a health-aware society and the societal view of

smoking is shifting to being “socially unacceptable”. The only advertisements related to tobacco

are all about the negative effects of it. Smoking in some public areas (restaurants) has been

banned due to health issues caused through second-hand smoke. Altria has tried to salvage this

shift by developing Electric Cigarettes for safer smoking and smokeless tobacco to avoid odors

caused by smoking.

Comprehensive Financial Statement Analysis

Altria Group (MO) was valued using a variety of absolute methods applicable to a

number of sectors, including FCFF, FCFE, and WACC. In addition, several relative valuation

techniques were used, including the EBITDA multiple and ROE/ROA analysis, that reflected the

firm’s position in comparison to their main competitors.

Free Cash Flows:

2013 2014 2015 2016 2017 2018 2019 Terminal Value

Revenue 25748100 27035505 28387280.25 29806644 31296976 537748736.7

COGS 15448860 16221303 17032368.15 17883986 18778185 319900952.1

Gross Profit 10299240 10814202 11354912.1 11922657 12518790 217847784.6

Operating Exp. 2574810 2703550 2838728.025 2980664 3129697 53316825.34

EBIT 8,582,000 7724430 8110651 8516184.075 8941993 9389092 164530959.3

Less: TAX -2703330 -2703550 -2838728 -2980664 -3129697 -3286182 -55982666.61

Add: NCEXP 208000 257481 270355 283872.8 298066.4 312969.7 5331682.534

Less: NCREV 0 0 0 0 0 0 0

Less: ΔRC -146000 -257481 -270355 -283872.8 -298066.4 -312969.7 -5331682.534

Less: ΔNWC -2000 -2040 -2080.8 -2122.41 -2164.86 -2208.16 -37617.74457

Less: CAPEX -163000 -171150 -179707.5 -188692.87 -198127.5 -208033.8 -3544018.649

Equals: FCFF 5,865,670 4,847,689.5 5,090,135 5,344,704.3 5,612,003 5,892,668 104,966,656.30

PV of FCF 5,865,670 4,514,938.5 4,415,332 4,317,922.3 4,222,660 4,129,498 104,966,656.30

sum of

PV

(x1000) 132,432,678 # of shares 1,957,884,615 price $67.64

For our free cash flow analysis, several factors were taken into account when determining

the assumptions for the growth rate. The historical growth of the company’s revenues was one

aspect, but external factors such as the overall decline in cigarette sales and other

economic/political market forces impacted our forecasting. Recent history suggests positive yet

modest growth, appropriate for such a mature firm while declining sales volumes for the sector

suggest limited future growth potential. We decided on a five percent growth rate for the

forecasted years of 2015-2019, a figure more in line with the company’s historical growth. A

terminal growth rate of 1.5 percent was chosen based on the somewhat bleak outlook of the

sector and Altria’s limited prospects moving forward. Cost of goods sold was determined as 60%

of revenue based on historical figures. Operating expenses was projected as 10% of revenue

based on historical calculations. The terminal rates are the same for the both of these

components, as it was believed that such a mature firm had already obtained any possible

operating efficiencies. Depreciation was set at a constant one percent of revenue based on the

historical financials. The change in net working capital was the most difficult value to assume

and is the biggest concern regarding the reliability of our valuation. Change in net working

capital for 2014 was $2,000,000. However, in previous years Altria had incurred huge negative

changes in its net working capital as they incurred current liabilities largely in excess of current

assets, excluding cash. It didn’t seem sustainable for Altria to consistently divest in net working

capital, so for our forecasts we simply indexed the $2,000,000 change for 2014 for inflation and

carried that two percent rate to its terminal value. In all of the historical financials we sorted

through we could never find any spike in CAPEX. Thus, we assumed that internally Altria

already had “smoothed out” the “lumpy” CAPEX and growing the normalized value based on

the historical trend would be appropriate. However, if we were incorrect in our assumption, that

would have led to an understatement of CAPEX and hence an overvaluation of the cash flows.

Altria’s calculated average effective tax rate was thirty five percent. This value was applied for

the forecasted years and terminal value. Once the FCF was determined for all forecasted years

and terminally, the present value of these values was taken, discounted at the WACC (calculated

below). These discounted free cash flows were then summed, and divided by the number of

Altria’s outstanding shares to determine our valuation of the share price.

WACC:

To find the WACC we first found cost of equity. To find the cost of equity, we used the

return of Altria, which we calculated using the growth rate of five year dividends and the current

dividend yield, and the ten year treasury bond rate of 1.9% as well as the market beta of 0.79 to

calculate the cost of equity of 7.83%. Next, we calculated the cost of debt. We used a table of

bonds and their coupon rates that we found on MorningStar to calculate the average interest on

the bonds which gave us the cost of debt 5.83%. We then plugged in these figures into the

WACC equation to find the weighted average cost of capital of 7.32%.

Altria Group Inc. R.J. Industry

Reynolds

Relative Valuation

ROA 14.71% 9.67% N/A

ROE 168.21% 32.51% N/A

Operating PM% 44.00% 32.00% 33.00%

Beta 0.78 0.80 1.00

Multiples Valuation

P/E 20.24 27.19 22.16

P/S 5.71 4.66 4.66

EBITDA Multiple 14.43 15.99 N/A

Relative Valuation:

The metric we chose to use to value margins was the operating profit margin percentage.

Altria has a operating profit margin of 44% while the industry average is 33% along with their

comparable, Reynolds, who has an operating profit margin of 32%. Altria’s operating profit is

about 11% larger than the average, meaning Altria is substantially outperforming the market

which is highly attractive to investors. The substantial difference between Altria’s profit margin

and the industries could be attributed to effective cost controls through good management

practice.

Next we compared Altria’s Return on Assets and Return on Equity to the largest

competitor, Reynolds, and the industry as a whole. ROA gives us an idea as to how efficient

management is using its assets to generate earnings. After calculation we found that Altria has a

ROA of 14.47%, which is about 4.5% percent higher than their largest competitor. Further more

Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company

(or more specifically, its management team) is managing the equity that shareholders have

contributed to the company. With that being said Altria is substantially outperforming their

competitors with a 168% return on equity, which is more than 5 times the ROE of their

competitors. ROE is one of the most important metrics for evaluating management effectiveness

and in Altria’s case, it seems that their management has made decisions that positively affect the

company and in turn please the investors.

Multiple Valuation:

To value Altria we used the price to earnings multiple ratio, price to sales multiple ratio,

and the EBITDA multiple. Altria had a P/E ratio of 20.24, a P/S ratio of 5.71, and an EBITDA

multiple of 14.44; Reynolds, Altria’s main competitor, had a P/E ratio of 27.19, a P/S ratio of

4.66, and an EBITDA multiple of 15.99. The P/E ratio of Altria compared to Reynolds shows

that Altria’s price per share of stock is lower than Reynolds based on earnings. When comparing

both company’s P/E ratio to the industry average of 22.16, it shows that Altria is undervalued by

the market and Reynolds is overvalued. However, looking at the P/S ratio for both companies

shows that Altria’s ratio of 5.71 is higher than both Reynolds, 4.66, and the industry average,

4.66. This means that based on sales that Altria’s stock price is slightly overvalued when

compared to its competitor and the industry.

The last multiple used to value Altria was the EBITDA multiple. This is found by

dividing the enterprise value of the firm by its EBITDA. This is considered a reliable way to

value a company when compared to a accurately comparable company. When valuing Altria

based on Reynolds EBITDA multiple of 15.99, a price per share of $65.91 is found. This is

significantly higher than the price of 51.75 that Altria is currently trading at, and means that,

based on the EBITDA multiple valuation, Altria is being undervalued by the market.

Analysis of Excess Earning:

We using excess earning valuation because the it adjust the valuation for the present

value of the difference between the company’s free cash flow and earning as long as we using

clean-surplus accounting and the excess earning method is algebraically equivalent. When we

decide the excess earning of Altria, we determine the initial investment capital value and use the

WACC to calculate the firm value which is basic framework of excess earning value. We found

that the different between the free cash flows and the excess earning is equal to the initial

invested capital

Analysis of Results and Conclusion:

The tools we used for our valuation methods helped us evaluate Altria’s performance

individually, as well as a look at how they compare to the tobacco industry and some of their

competitors in that industry. We considered internal and external factors related to Altria and to

their industry in our analysis, and determined Porter’s Five Forces and a SWOT analysis would

be good tools. The key takeaways we found were that Altria has a dominating market share and

in the past has taken advantage growth opportunities through innovation and by expanding

internationally. Also, the tobacco industry has a high competitive rivalry in terms of Porter’s

Five Forces, but the rest of forces pose minimal threat.

The valuation methods that included financial calculations to analyze Altria’s

performance were Free Cash Flow, Weighted Average Cost of Capital, and Relative and

Multiple Valuations. From these we concluded that Altria was undervalued in it’s industry. The

current stock price sits slightly above $50 per share, but the Discounted Free Cash Flow Method

of valuing the stock price indicated it should be around $68 per share. We also used the

EDITDA multiple of 15.99 that we found through their main competitor, Reynolds American

Inc., and determined the stock price found through this method would value Altria at about $66

per share. In terms of relative valuations, some of the items we compared were the Return on

Assets, Return on Equity, and Operating Profit Margin Percentages of Altria, Reynolds

American Inc., and the entire tobacco industry. Altria has an operating profit margin that is 11%

higher than the tobacco industry and their main competitor, while maintaining a slightly higher

Return on Assets. The Return on Equity, however, is above 100% and is about 5 fives more than

Reynolds American Inc., indicating they greatly outperform their competitors.

Our valuation says that the tobacco industry is undervalued, however we feel there are

external factors that lead us to believe that Altria will not be able to maintain a competitive

advantage. These external factors may also explain the current discrepancy in pricing between

the market and our valuation. In recent news there have been rumors indicating a likely merger

between Altria’s top two competitors, Reynolds and Lorillard. Assuming these two companies

will divest the necessary assets and/or brands to make this merger possible (avoiding antitrust

concerns), the combined firm will then have the same amount of market share as Altria. We also

believe the new government regulations and a change in the outlook of tobacco by the public

also jeopardizes this undervaluation. New government regulations have increased the taxes on

tobacco, put restrictions on the public areas people can smoke in, and tobacco products are now

subject to health based policies. Along with laws regulating tobacco, the public is becoming

more and more aware of the negative effects and health concerns related to tobacco. Smoking is

now being viewed as “socially unacceptable”. The financial valuation methods did indicate

Altria was undervalued, but we still believe the non-financial factors are more important in this

case in determining future performance.

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