ALTRIA GROUP, INC. quarterly report, Q2 FY2011

Altria Group, Inc. — Q2 2011 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2011. Unaudited consolidated results. Altria’s businesses include U.S. cigarettes, smokeless tobacco, cigars, wine and financial services, plus a 27.1% equity-method investment in SABMiller. Unless noted, amounts are in U.S. dollars.

Financial performance

Metric	Q2 2011	Q2 2010	Six months 2011	Six months 2010
Net revenues	$5.920B	$6.274B	$11.563B	$12.034B
Gross profit	$1.972B	$2.374B	$4.120B	$4.458B
Operating income	$1.295B	$1.529B	$2.834B	$2.959B
Net earnings attributable to Altria	$444M	$1.042B	$1.381B	$1.855B
Diluted EPS	$0.21	$0.50	$0.66	$0.89

• Reported gross profit as a percentage of net revenues was approximately 33.3% in Q2 (versus 37.8%) and 35.6% for the half year (versus 37.1%). Net revenues include excise taxes.
• Reported earnings were significantly reduced by a one-time $627M PMCC leveraged-lease tax charge in Q2. Management identified the charge as $0.30 per diluted share; the charge comprised a $490M reduction to revenue and a $137M increase in income-tax provision.
• Income from the SABMiller investment was $155M in Q2 and $344M for the half year, up from $113M and $251M, respectively.
• Operating cash flow was $479M for the half year, versus $291M. Investing activities provided $90M; financing activities used $819M. Capital expenditures were $40M. Cash declined $250M to $2.064B.
• At June 30, total debt was $13.688B, all reported as long-term debt, versus $12.194B at year-end. Cash was $2.064B; there were no short-term borrowings. Current assets of $5.657B compared with current liabilities of $5.446B, which include $2.137B of settlement charges.
• Altria issued $1.5B of 4.75% senior notes due 2021. It replaced prior revolving facilities with a $3.0B five-year credit agreement. Covenant ratios were 1.9x debt to EBITDA and 6.4x EBITDA to interest, within the stated limits of 3.0x maximum and 4.0x minimum, respectively.
• Dividends paid were $1.589B in the first half; the declared dividend was $0.76 per share for the half year. The annualized dividend rate was $1.52 per share. Altria repurchased 22.8M shares for approximately $616M under its $1.0B one-year program.

Material changes and business drivers

• For the half year, revenue fell 3.9%, operating income 4.2%, and attributable net earnings 25.6%. The $627M PMCC charge and higher effective tax rate were major drivers of the earnings decline; higher SABMiller earnings and stronger cigarette and smokeless operating results partly offset them.
• Q2 revenue declined 5.6%, operating income 15.3%, and attributable net earnings 57.4% year over year. The reported Q2 tax rate was 61.6%, versus 22.9% a year earlier; the half-year rate was 47.0%, versus 29.5%.
• Cigarette operating income rose 7.6% for the half year, helped by price increases and lower restructuring costs, but domestic cigarette shipment volume fell 3.5%. Management estimated volume would be down about 5.0% after adjusting mainly for trade inventories; reported first-half shipments benefited from inventory building.
• Smokeless operating income increased 10.4% for the half year, while reported shipment volume declined 1.7%. Cigars operating income fell 33.0%, reflecting promotional investment and competition. Wine operating income rose to $31M from $19M, supported by premium shipments.
• Financial services reported a $442M operating loss for the half year, versus $60M of income, primarily reflecting the PMCC charge and lower asset-sale gains. PMCC’s finance assets, net, were $3.869B, down from $4.502B at year-end; the $202M loss allowance was unchanged. PMCC reported all lessees current on payments.

Outlook, risks and unusual items

• Altria revised 2011 reported diluted EPS guidance to $1.70–$1.76 from $2.00–$2.06 after the PMCC charge, and reaffirmed adjusted diluted EPS growth guidance of 6%–9% over 2010 adjusted EPS. Adjusted EPS is a non-GAAP measure.
• Management expected first-half trade inventory gains to reverse in Q3, negatively affecting cigarette shipments and income; it expected adjusted EPS growth to be stronger in Q4 than Q3 and second-half adjusted EPS growth to exceed first-half growth.
• Management cited a challenging environment, including pressured consumers, high unemployment and intense tobacco competition. Other key risks include declining cigarette consumption, excise-tax increases, FDA regulation, product restrictions, illicit trade, tobacco litigation, and changes in tobacco leaf cost or availability.
• The PMCC charge followed an adverse 2011 court decision involving another taxpayer’s leveraged leases. Altria had paid approximately $1.1B in federal tax and interest for 1996–2003 while pursuing refunds and expected further disallowances that could require about $1.0B in additional payments, excluding potential penalties. The amount and timing depend on audits, challenges and litigation; the company said the charge excluded potential penalties.
• Altria disclosed extensive tobacco-related litigation. Management stated that it had not concluded a loss was probable or estimable for pending tobacco-related cases generally, and therefore had not recorded provisions for those cases, except as specifically discussed. The Scott case provision totaled approximately $71M at June 30. Unfavorable litigation outcomes could materially affect results or cash flows in a period.
• State settlement, FETRA and FDA user-fee costs were approximately $2.5B for the first half and are estimated by the company at about $5B in 2011 and each year thereafter, subject to volume, market-share, inflation and other adjustments. Disputed MSA payment adjustments remain under proceedings; recovery is uncertain.
• Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

• Reconcile reported and adjusted EPS guidance, including the treatment of the $627M PMCC charge and any future tax or interest payments.
• Track PMCC lease-tax litigation, IRS audits, potential additional payments and the status of refund claims.
• Assess the sustainability of cigarette pricing and market share, shipment declines, and the expected Q3 inventory reversal.
• Monitor tobacco litigation, including the Scott case, Engle progeny cases and MSA adjustment proceedings, for changes in recorded provisions or cash exposure.
• Review debt maturities, credit-agreement covenant headroom, settlement-related cash requirements, and the funding of dividends and share repurchases.