Two companies that I have always paid particular attention to are Altria Group Inc. (MO, Financial) and Philip Morris International Inc. (PM, Financial). I don't own either of these stocks today, but I have in the past.
These two tobacco companies have followed the same business model for decades. Before they separated in 2008, Altria and Philip Morris were one combined global tobacco behemoth that owned the rights to the Marlboro brand around the world. Prior to 2007, the group also owned Kraft.
The three businesses were effectively forced to separate as the market was not giving the combined group the valuation it deserved.
Altria's legacy obligations linked to tobacco settlements have always been a drag on the business. By spinning off Kraft (with no legal settlement obligations) and Philip Morris, investors could concentrate on these businesses' individual qualities rather than focusing on Altria's drawbacks.
Despite Altria's drawbacks, the company has outperformed its peer over the past decade.
If one can get over the ethical considerations of investing in tobacco companies, Altria has produced a total return of 9.1% per annum over the past 10 years. Meanwhile, Philip Morris has yielded 5.4%. Both companies have underperformed the S&P 500, which has returned 15.9% per annum since 2011.
Despite these mixed performance figures, the two companies look cheap today. Philip Morris is trading with a dividend yield of 5.8% and a forward price-earnings multiple of around 13. Altria sells at a price-earnings ratio of 9 and offers a yield of 8.4%.
The elephant in the room is the tobacco business. Cigarette sales are declining worldwide, so it is only a matter of time before profits evaporate entirely.
As well as this headwind, these companies score poorly on environmental, social and governance credentials. This is going to discourage investors and may hold back the performance of the shares indefinitely.
That being said, both companies are pursuing initiatives away from their traditional cigarette businesses and profits are growing.
Wall Street thinks Philip Morris can earn $10 billion in 2022, up from $8 billion in 2020. According to analysts, Altria's net income could hit $8.7 billion in 2022, up from $7 billion in 2018. The two companies have a return on capital employed of 21% and 46%, respectively.
These figures do not show companies in distress. They support the thesis that these are highly profitable enterprises with solid brands and fat profit margins, which look cheap compared to their potential. Profit figures also suggest these businesses can support their dividends for the foreseeable future.
Difficult to value
This calculation requires a certain level of visibility over a company's cash flow. One has to have a high level of confidence that a business will still be earning money 10, 20 or 30 years out. That is why it is so hard to value Philip Morris and Altria.
Both of these companies have incredibly attractive business qualities, but predicting what the tobacco industry will look like two decades from now is almost impossible. Regulators could move to ban cigarettes tomorrow, and it would eliminate most of Altria's revenue overnight.
Some investors may be comfortable making this judgment. Considering the valuations on offer, there may be a margin of safety present that compensates for the high level of risk.
In a market crowded with expensive equities, these stocks offer an attractive proposition for value investors willing to take a risk.