ALTRIA GROUP, INC. quarterly report, Q3 FY2015

Business context and reporting period

Altria Group, Inc.’s unaudited Form 10-Q covers the quarter and nine months ended September 30, 2015. Its businesses include U.S. cigarettes and cigars, smokeless tobacco, wine, innovative tobacco products and finance assets; it also held approximately 27% of SABMiller and accounted for that investment under the equity method.

Financial performance and position

Reported gross margin was approximately 45.5% in Q3 and 43.9% for the nine months, versus 41.2% in each prior-year period. Operating margin was approximately 34.4% and 33.5%, respectively, versus 30.8% and 31.3%. Net margin was approximately 22.8% in Q3 and 20.9% year to date, compared with 21.5% and 21.0%. Margins use reported net revenues, which include excise taxes.

For the nine months, cash from investing activities was $95 million and cash used in financing was $5.599 billion; capital expenditures were $162 million. Cash fell by $1.414 billion to $1.907 billion. At September 30, total debt was approximately $12.9 billion, down from $14.7 billion at year-end 2014. Current assets of $5.511 billion were below current liabilities of $6.567 billion; management said it could fund working-capital deficits through operating cash flow and/or short-term borrowing. The company had $3.0 billion available under its revolving credit facility. Its credit-agreement debt/EBITDA and EBITDA/interest ratios were 1.4x and 11.2x.

Material changes versus the prior comparable period

• Q3 revenue rose 3.2%, operating income 15.4%, net earnings 9.4% and diluted EPS 9.9%. For the nine months, the respective increases were 4.7%, 12.1%, 4.2% and 5.2%.
• Management attributed improved operating results mainly to smokeable products, including pricing, lower costs after federal tobacco quota buy-out payments ended, and favorable non-participating manufacturer (NPM) adjustments. Q3 also benefited from lower investment spending in innovative tobacco products.
• Smokeable products operating companies income increased 15.3% in Q3 and 13.0% year to date; smokeless income increased 2.1% and 3.2%. Wine income increased 12.9% and 19.8%, supported by higher shipments and premium mix.
• SABMiller equity earnings declined 43.0% in Q3 and 27.5% year to date, reflecting special items and unfavorable currency translation. Nine-month results also included a $228 million pretax loss on early debt extinguishment.
• Operating cash flow increased $1.030 billion year over year, principally from higher smokeable-product revenue and the end of quota buy-out payments, partly offset by higher settlement payments. Financing outflows increased, including debt repayments and higher dividends.

Outlook, commentary, risks and unusual items

• Altria reaffirmed expected 2015 adjusted diluted EPS growth of 7.5%–9.5% over 2014 adjusted diluted EPS. Management expected moderated adjusted EPS results in Q4, citing comparison effects, potentially moderating cigarette trade inventories, a higher effective tax rate on operations and possible unfavorable currency translation at SABMiller. The forecast 2015 effective tax rate on operations was 35.3%. Adjusted measures exclude specified items and are not GAAP measures.
• The Board increased the quarterly dividend 8.7% to $0.565 per share, or $2.26 annualized; the stated target payout ratio is approximately 80% of adjusted diluted EPS. A new $1.0 billion repurchase program was authorized in July 2015, with expected completion by year-end 2016, subject to market conditions and Board discretion.
• Q3 included a $126 million pretax reduction in cost of sales from the New York NPM settlement, $67 million in tobacco and health litigation charges including interest, and tax-related items. The NPM benefit is subject to settlement terms and verification. The debt tender offer and related $228 million loss occurred in Q1.
• Altria supported a possible AB InBev combination with SABMiller and said it was prepared, subject to final terms, to elect the partial-share alternative. A firm offer and its terms were not certain as of the filing.
• Material risks include extensive tobacco litigation and potential adverse judgments, regulation and FDA action, excise taxes, declining cigarette-industry volume, competitive and consumer shifts, illicit trade, agricultural supply, and currency and business risks related to SABMiller. Management said pending tobacco-case losses generally were not considered probable and estimable, so no general provision was recorded; it warned outcomes could materially affect a particular period. The filing also describes outstanding litigation-related judgments, appeals and settlement contingencies.
• Management stated disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.

Investor verification priorities

1. Reconcile reported EPS with adjusted EPS and assess the effects of the $126 million NPM benefit, litigation costs, SABMiller items, tax items and debt-extinguishment loss.
2. Track tobacco litigation developments, including Engle progeny cases, the federal Engle settlement approval, appeals, bonding requirements and the reported $3.216 billion accrued settlement-charge balance.
3. Verify the timing and cash impact of state settlement and FDA user-fee obligations, including management’s estimated $4.7 billion of 2015 charges and approximately $4.8 billion annually thereafter.
4. Monitor cigarette and smokeless shipment trends, market share, pricing, trade inventories and consumer down-trading that underpin segment performance and guidance.
5. Assess the SABMiller transaction outcome and resulting implications for Altria’s investment value, earnings, cash dividends and currency exposure.
6. Confirm continued liquidity, debt-covenant compliance, dividend capacity and execution of the new share-repurchase program.