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Is Cigarette Maker Altria Digging Its Own Grave?

Photographer: Gabby Jones/Bloomberg© 2018 Bloomberg Finance LP

Few companies have delighted investors more than cigarette giant Altria Group , the owner of the Philip Morris brand, now also a large investor in JUUL Labs after agreeing to pump $12.8 billion into the smokeless cigarette unicorn at a $38 billion valuation. Over the past ten years, Altria’s returned 18.5% annually, besting the S&P 500 Index by five percentage points annually, and that figure doesn’t even count the spin of its stakes in Kraft Foods and Philip Morris International to shareholders.

Some investors like David Winters of the Wintergreen Fund have all but anointed cigarette stocks like Altria a sure thing in their portfolios, spotting a potent combination of an addicted customer base yielding bumper profits and stellar long-term performance. Altria, after all, earns nearly $2 billion a quarter and carries a single-digit price-to-earnings multiple.

Cigarette sales are down sharply in the U.S., but if you think that’s impacted profits think again, as Lawrence Hamtil of Fortune Financial Advisors noted in April. Citing research from BofA, Hamtil points out that an about 25% decline in U.S. cigarette sales from 2005 to 2016 coincided with an about 70% surge in industrywide profits. Talk about a sticky product with amazing pricing power and a stock market discount. What’s not to like?

Unfortunately, like its own customers, there are signs Altria has been digging its own grave over time. It may not happen today or tomorrow, but time appears to be an inevitable enemy of Altria.

Here’s a surprising reality behind the company’s amazing stock market run: A decade ago, Altria had no net debt. Now, inclusive of a $14.6 billion term loan used to buy Juul, Altria’s likely to have more than $28 billion in net debt and leverage of nearly 3x. The bean counters at Standard & Poor’s seem to have taken notice of Altria’s leverage. They cut the company’s credit rating two notches to BBB on Thursday.

Even so, are Altria’s rising financial risks well understood? Perhaps not.

With the $28 billion in pro forma debt Altria’s amassed over the past decade, virtually none of it has translated into increased revenues. When subtracting excise taxes, Altria’s sales have gone from $16 billion in 2008 to $19.5 billion over the past 12 months. Put differently, more than every dollar in sales Altria earns in 2019 will be accompanied by a dollar of debt. That’s a stark contrast to the glory days of tobacco stocks in the 2000s, when Altria’s net debt-to-revenue ratios were at 0.25x-to-0.33x and significant earnings came from nonlethal Oreo cookies and Oscar Meyer hot dogs, made by Kraft Foods.

As Altria levers up, will it be able to lean on the math, which makes Hamtil such a bull he can find no better stock to bet on over the next decade? Tobacco companies solved for falling cigarette consumption by increasing prices. There’s no dispute that the profits are gushing in, and if the trend continues, Hamtil’s absolutely right.

But the bull case could highlight a growing arithmetic problem.

Cigarette makers used to sell half a trillion cigarettes in the U.S. annually; now that figure’s headed to 250 billion. That’s no problem if smokers pay more per puff. The industry’s fewer customers have simply reached deeper into their pockets over the years. But will this shrinking cohort of smokers–each far more important to Altria than they were in the past–act the same in the future? It seems Altria is worried.Why else pour billions into smokeless cigarette brands like Juul and Nu Mark, and cannabis companies like Cron Group?

So far, however, Altria’s investments in smokeless products have failed to yield a revival of growth, and it’s to be seen if these bets eventually become meaningful. Through 9 months, Altria’s $150 million in smokeless revenue growth hasn’t offset its declining cigarette and cigar sales. Total revenues exclusive of excise taxes are little changed year-to-date. Now comes its about $16 billion punt on pot and Juul over the past few months.

Will it be enough to revive growth? S&P doesn’t seem particularly convinced. “We do not believe Juul or Cronos will provide significant near-term investment returns to Altria,” they said when taking an ax to its credit rating.

However, these investments better pan out for bullish investors like Winters of the Wintergreen Fund, who has plowed about 5% of his portfolio into Altria and 20%-plus in tobacco stocks overall. That’s been a painful bet for Winters’ woefully performing fund, which is off 20% year-to-date and has returned nothing over the past five years.

Once a stock market darling, the reality is Altria looks headed towards an inevitable disaster. Behind its lethal profits and increasingly expensive bets on customer change is a growing mountain of debt. With core sales mired in long-term decline, that pile of borrowing could send investors over a cliff.

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