ALTRIA GROUP, INC. quarterly report, Q2 FY2012

Business context and reporting period

Altria Group, Inc.’s unaudited Form 10-Q covers the three and six months ended June 30, 2012. Its businesses include U.S. smokeable and smokeless tobacco products, wine, finance leases through PMCC, and an approximately 27% equity-method investment in SABMiller. Results are compared with the corresponding 2011 periods.

Financial performance and liquidity

• Net revenues rose 4.9% for the first half and 9.6% in Q2. Revenue includes excise taxes. Gross profit was $4.696bn for the half and $2.494bn for Q2; calculated gross margins were approximately 38.7% and 38.4%, respectively, versus 35.6% and 33.3% a year earlier.
• First-half operating income increased 24.2%; Q2 operating income increased 44.9%. Earnings growth was also affected by unusual prior-year charges and 2012 SABMiller gains and tax benefits, not solely underlying operations.
• Six-month operating cash flow was negative $85m, compared with positive $479m in 2011. The $456m IRS payment and $514m pension contribution were significant cash uses. Investing activities provided $510m, principally from finance-asset proceeds; financing activities used $2.167bn, including $1.674bn of dividends and $360m of share repurchases.
• Cash was $1.528bn at June 30, down from $3.270bn at year-end 2011. Current assets of $5.143bn were below current liabilities of $6.081bn, a working-capital deficit of approximately $938m. Management said it expected to fund working-capital needs through operating cash flow and/or short-term borrowing.
• Total debt was $13.7bn, including $600m current maturities; the $600m UST notes matured and were repaid in July 2012. A $3.0bn revolving credit line was undrawn at quarter-end. The company reported covenant ratios of debt/EBITDA of 1.8x and EBITDA/interest of 6.5x, against limits of 3.0x maximum and 4.0x minimum.
• Dividends declared were $0.82 per share for the first half, versus $0.76 a year earlier. The annualized dividend rate was $1.64; management’s target payout ratio was approximately 80% of adjusted diluted EPS.

Material changes versus the prior comparable period

• Reported net earnings increased 75.2% for the first half. Management attributed the improvement to higher operating income, increased SABMiller equity earnings, a lower effective tax rate and fewer shares outstanding. For Q2, reported net earnings more than doubled from $444m.
• First-half SABMiller equity earnings were $743m versus $344m, including Altria’s share of noncash strategic-alliance gains. The investment’s balance rose to $6.486bn from $5.509bn at year-end.
• The 2011 comparison included a $627m PMCC leveraged-lease tax charge. In Q2 2012, an IRS closing agreement produced a $68m net earnings benefit, mainly from lower-than-estimated interest on tax underpayments. Altria paid $456m of federal tax and estimated interest in June and expected approximately $50m of state tax and interest payments in the second half.
• First-half financial-services results swung to $87m operating companies income from a $442m loss, primarily reflecting the lower PMCC tax-related charge and higher asset-sale gains. Smokeable products income rose to $3.079bn from $2.952bn; smokeless products income rose to $432m from $415m; wine income rose to $37m from $31m.
• Reported first-half cigarette shipments fell 1.2%; discount-brand shipments rose 21.0%, while premium-brand shipments declined. Altria reported U.S. cigarette retail share of 49.7%, up 0.6 percentage point. First-half smokeless shipments were nearly flat, with Copenhagen growth offset by declines elsewhere; wine shipments increased 4.2%.
• Altria revised its first-quarter 2012 statements after identifying $342m of omitted SABMiller noncash gains. The omission understated first-quarter net earnings by $222m and diluted EPS by $0.11; it had no cash-flow effect. The company concluded the error was not material and reflected the revision in the six-month statements.

Guidance, management commentary, risks and unusual items

• In July 2012, Altria forecast full-year reported diluted EPS of $2.29–$2.33 and adjusted diluted EPS growth of 7%–9% over 2011 adjusted EPS. The reported forecast included an estimated net $0.10 per share from specified special items. Management expected adjusted EPS growth to moderate in the second half, with stronger growth in Q4 than Q3.
• The 2011 cost-reduction program had incurred $253m in net pretax charges through June 30; approximately $47m of additional charges were expected in the remainder of 2012. Management said the program remained on track for $400m in annualized savings by the end of 2013. The June severance liability was $97m.
• Management cited pricing, cost control and brand initiatives, while noting declining cigarette-category volume and shifting consumer preferences. The filing describes substantial risks from tobacco litigation, FDA regulation, excise taxes, marketing and product restrictions, illicit trade, competition and tobacco-leaf supply. Wine and finance-lease operations also face competition, regulatory and credit risks.
• Litigation remains a material uncertainty. Management said it had not concluded that losses were probable and reasonably estimable for pending tobacco-related cases, and therefore had not recorded provisions for those cases except for identified matters. Unfavorable judgments or settlements could materially affect a period. The filing reported approximately 6,547 Florida Engle-progeny cases involving approximately 7,749 plaintiffs as of July 23, 2012.
• The PMCC portfolio included $3.012bn of net finance assets and a $188m loss allowance. American Airlines’ bankruptcy remained a risk: after quarter-end, a court approved a lease sale expected to result in a $60m write-off in Q3, with other leases potentially subject to rejection or restructuring.
• Altria had repurchased 23.7m shares for approximately $688m under its $1.0bn program by June 30 and intended to complete the program by year-end, subject to market conditions and board discretion.

Most important facts for investors to verify

• How much of EPS growth and the 2012 guidance depends on noncash SABMiller gains, the PMCC tax benefit and other special items, versus recurring operating performance.
• Whether cigarette volumes, premium mix and market share trends support the forecast, and whether pricing and cost savings can offset industry declines.
• The sustainability of cash generation after the IRS payment and pension contribution, and the capacity to maintain dividends and repurchases while cash is lower and working capital is negative.
• Developments in major tobacco litigation, Engle appeals, settlement-payment adjustment proceedings and any resulting cash, bonding or judgment requirements.
• PMCC lease recoveries and credit exposure, including the expected American Airlines-related write-off and the adequacy of the allowance for losses.