LEHMAN TOBACCO : Altria 3Q And Read Across Focus From PMI

Source from:  LEHMAN BROTHERS TOBACCO TEAM 10/22/2007

David Hayes Helen Brand dhayes@lehman.com hebrand@lehman.com Tel. +44 20 7102-1341 Tel : + 44 207 102-9698 Fax +44 20 7102-2155 Fax +44 20 7102-2155 DATE: 18 October 07 Altria (2-EW) - 3Q07 Results Beat Consensus Lifting Price Target * We outline detailed commentary on Altria 3Q07 performance below - this is from Michael Branca and the US tobacco team. Additional European Tobacco read-across focused commentary : * PMI organic volumes -1.9% in 3Q07 with organic net sales (exc tax) c. +3.6% - reflecting average price per unit of c.5.5%. Translates into a strong organic profit performance of 10.3% in 3Q07 compared to just 4.7% at the 1H07 stage. * Improvement in profit growth through cost savings, we estimate 3Q08 organic sales were up c. $193m but organic profit growth c. $222m. Indicates substantial lower SGA y-o-y. We continue to be concerned that a more focused PMI will likely achieve more aggressive cost efficiency which could then be channelled into additional brand support which threatens the current BAT (3-UW) model. * LatAm a key outperformer in the period with net sales organically increasing c. 7% and profit +13%. This compares to -5.2% at profit level in 1H07. Key drivers in the quarter are; Strong market share growth in Argentina (5%pts y-o-y) and Mexico (1.6%pts) offset by lower shipments in Brazil and Columbia.Better pricing in LatAm may also assist BAT but share loss in Mexico and Argentina could offset. * Another strong improvement was in Asia where we calculate org profit was +16% in 3Q compared to -7.4% in 1H07. This was driven by improvements in sales but notably lower costs. We calculate that organic sales were +c. $48m but op profit +71m organically. Japan is "disappointing" to PMI and they are focused on regaining share moving forward. BAT has been very successful in this market in the last few years re market share. * Strong pricing in EMEA (c. 7.3% average org price per unit increase) drives good organic profit growth in 3Q07 of 14%. Russia/Ukraine continues to be key driver with pricing and mix both strong in these stand out markets. Positive indications for BAT. * EU volumes weak at -4.8% in 3Q07 although pricing better as expected leaving organic sales flat. Cost saves (lower variable costs and initiatives) though helped drive some profit growth, with org profits +5.1% in 3Q compared to +7.7% in 1H07. Germany continues to be tough with downtrading and volume switch to MYO and cross-border. France benefited from pricing but suffered with volume sensitivity to this. Altria also see Poland pricing environment improving. Note : We remain restricted on Imperial Tobacco and Altadis so no read across commentary included for these names. Please see detailed commentary on the Altria 3Q07 results from our US tobacco team, Michael Branca: Lehman Brothers is acting as financial advisor to Altria Group Inc. on its spin off of Philip Morris International. The rating and estimates do not incorporate this transaction. This morning MO reported 3Q07 EPS of $1.21, which was a nickel ahead of our estimate and $0.07 ahead of Street forecasts. The company posted stronger-than-expected operating profit growth (8.8% vs. our 7.9% estimate) and was particularly helped by productivity savings -- which reduced SG&A as a % of sales by (-169bps) -- and very favourable currency swings. Management raised its underlying FY2007 EPS guidance range to $4.30-$4.35 (previously $4.23-$4.28) due to $0.04 benefit from currency and $0.03 from better results at PMI. So, we are flowing through today's EPS beat and raising our FY2007 EPS estimate to $4.35, the top end of management's underlying guidance range. We are also bumping our FY2008 EPS forecast to $4.70, ahead of the Consensus view. On the conference call, management indicated that the company would announce share repurchase plans for both PMI and PMUSA some time between the January 30th board meeting and the completion of the PMI spin (likely by April 2008). All in, MO seems to be on the right track to unlocking shareholder value and there are a number of potential catalysts through the next 6-8 months. That said, we still would not be as aggressive with the stock until next spring, as recent history of the stock has shown that most of the share appreciation occurs right around favourable events. What To Do with the Stock: We are bumping up our price target to $82, which is now based on a 17.5x P/E multiple on our 2008 EPS estimate of $4.70. Our old $79 target was predicated on a 17.3x multiple on our previous 2008 EPS estimate of $4.57. Our revised price target is also factoring in an updated sum-of-the-parts valuation for the PMI/PMUSA split -- which we believe will be completed by April 2Q08. We now expect MO shares to trade within our new $66-$82 trading range (previously $65-$75) over the next 6-8 months, as investors gear up for that restructuring. Management indicated that a share repurchase program would be announced sometime between the January 30th board meeting and the completion of the PMI spin (April 2008), although we will have to wait for more details including magnitude and timing of the program. With that said, history has shown that MO shares tend to appreciate close to favourable events. Increasing Estimates on Improved Fundamental Outlook: We are flowing through today's EPS beat and raising our FY2007 EPS estimate to $4.35, the top end of management's underlying guidance range. We are also bumping our FY2008 EPS forecast to $4.70, still ahead of the Consensus view. That said, we would expect Street numbers to move up towards our number, as today's beat is factored into estimates. Management now looks for FY2007 EPS in a range of $4.30-$4.35, excluding all charges and a one time benefit from the tax gain. The company expects 2% underlying operating profit growth in the US, at the top end of the previous 1%-2% estimate. At PMI management still expects volume to grow 2%-3% including acquisition territories, although now looks for organic shipments to decline (-1%), vs. expectations for flat organic volume after last quarter's earnings release. PMI continues to project 5%-7% underlying operating profit growth in FY2007. Current Guidance for 2007 $4.20 - $4.25 + Charges $0.09 - $0.09 + PMUSA Charges $0.12 - $0.12 + PMI Charges $0.03 - $0.03 - Tax Favourability $0.08 - $0.08 - PMCC Recoveries $0.06 - $0.06 --------------------------------------- Underlying Guidance $4.30 - $4.35 Lehman Estimate $4.35 Source: Company Reports and Lehman Brothers Estimates Share Buyback: On today's conference call, MO management indicated that the company would announce its share buyback programs in the time between the January 30th board meeting and the completion of the PMI spin. While many investors have presumed the inevitability of a reinstatement, clarity on the timing was surely welcomed. Some on the Street would suggest a very large program in aggregate. The strong financial position of the company could provide ample support for such a program, as many believe MO will have no net debt by 2008. A 5% reduction in the share count (near what has been a historical trend line on buy back activity) could prove nicely accretive to earnings on an annualized basis. 3Q07 Results Better than Expected: 30Q07 operating results were better than expected, helped significantly by better productivity savings and currency benefit, although there were also a few bright spots on the top-line as well. Below the line, MO realized substantial benefit from reduced interest expense, due to lower outstanding debt. Compared to our original forecast, the reduced interest cost boosted EPS by $0.03. MO also enjoyed a lower tax rate in the period -- 100bps below our 33.5% forecast heading into the 3Q07 results. All in, below the line items - including a lower than anticipated share count - accounted for $0.04 of the EPS upside compared to our original expectations. PMUSA Breaking the results down by geography, PMUSA net revenue grew 3.2%, after accounting for excise taxes, ahead of our 2.7% forecast. PMUSA volume declined (-1%) in the quarter, which was a sizable sequential improvement vs. 1H07, although volume was likely down (-3%) after adjusting for calendar differences and changes in trade inventories. The Marlboro brand was particularly strong, up 0.2% growing retail market share by 0.5 points to 41.1%. PMUSA believes that total cigarette industry volume declined 3%-4% in 3Q07, which is the same as its full year 2007 industry forecast. PMUSA reduced promotional allowances on the four focus brands during the quarter, down $0.50 per carton for Marlboro, Parliament & Basic and $2.00 per carton for Virginia Slims. All in, underlying operating income grew 3.7% at PMUSA -- accelerating from the 1.4% growth in 1H07. Profit growth was driven by both lower promotion allowances and reduced SG&A costs in the quarter. PMI Top-line results at PMI were a little more disappointing, as total international volume grew just 0.6% including the acquired volume at Lakson Tobacco. If we pull out acquisition territories, PMI volume fell (-1.9%), below our expectation for flat organic shipments. As a result, total PMI net revenue after excise taxes grew 9.3% which was below our 10.2% estimate. However, a very favourable currency benefit ($138 million) and productivity savings helped PMI grow underlying operating profit by 16.0%, considerably above our 9.9% forecast. EU The European Union once again struggled, as volume fell (-4.8%) due to challenges in the Czech Republic, Germany and Poland. Germany has proven a difficult market for PMI, as consumers trade down to lower priced brands. PMI's cigarette shipments declined (-9.0%) in Germany, resulting in a 1.3% loss of market share. Tax driven price increases in Poland led to a total market decline of (-10.5%), although PMI profitability nearly tripled due to higher pricing. All in, better pricing and $100 million of favourable currency offset steep volume declines as operating income grew 14.1% on an underlying basis. This excludes the asset impairment and exit costs in the current and year ago periods. Eastern Europe, Middle East & Africa EEMA volume grew slightly, 0.3%, benefiting from favourably shipments in Algeria, Bulgaria, Egypt, Lebanon and Ukraine. This helped offset the unfavourable timing of shipments in Kuwait and soft results in Serbia. Russian volume fell (-1.0%), resulting from unfavourable inventory deload. In Serbia shipments fell (-10.6%) resulting in a (-1.9%) reduction in market share. In aggregate, underlying EEMA operating income increased 22.0%, boosted by $44 million of favourable currency impact and higher pricing. Asia From a volume perspective, Asia was the bright spot for PMI, however much of this strength was due to the addition of acquisition volume from Lakson in Pakistan. Including the acquisition territories, PMI cigarette volume grew 9.6% in Asia. In Japan total in-market cigarette volume grew 13.4% due to a favorable comparison from the 2Q06 inventory load ahead of the July excise tax increase. That said, PMI shipment volume was flat as an inventory de-load completely offset favourable in-market sales. PMI shipment volume grew 10.0% in Korea, off of market share gains from Parliament and Marlboro. Underlying operating income grew 14.3% in Asia, resulting from favourable pricing and lower costs, somewhat offset by a negative currency impact of $9 million. Latin America Latin America net revenue grew 17.2%, after accounting for excise tax payments, driven by higher pricing. PMI cigarette shipments declined (-1.5%) due to weakness in Brazil and Colombia. In Brazil, PMI shipments fell (-2.8%) resulting in a 0.2 share point loss. Shipments in Colombia declined 17.6%, due to distortions in distributor inventory levels. PMI shipments in Mexico fell (-1.7%) driven by lower consumption rates following the January 2007 tax increase. All in, underlying operating income grew 7.5% for PMI in Latin America. David Hayes Senior Vice President Consumer Equity Research : Tobacco Lehman Brothers Tel: 44 (0)20 7 102 1341 Fax: 44 (0)20 7 102 2155 E: dhayes@lehman.com on behalf of the: LEHMAN BROTHERS EUROPEAN CONSUMER TEAM Analyst Certification: We, David Hayes and Helen Brand, hereby certify (1) that the views expressed in this research email accurately reflect our personal views about any or all of the subject securities or issuers referred to in this email and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this email. Important Disclosures Lehman Brothers does and seeks to do business with companies covered in its research reports. 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Other Material Conflicts: Lehman Brothers is acting as financial advisor to Altria Group Inc. on its spin off of Philip Morris International. The rating and estimates do not incorporate this transaction. British American Tobacco (BATS.L - STG17.84) 3-Underweight / Negative J Risks Which May Impede the Achievement of the Price Target: The risks to our rating on BAT are that: a) economic conditions in the company"s main markets may deteriorate; b) foreign exchange movements; and/or c) the company may not execute its stated strategy as effectively as forecast, all of which may cause shortfalls versus our earnings projections. Disclosure Legend: D: Lehman Brothers Inc. or an affiliate has received compensation for investment banking services from the subject company within the past 12 months. E: Lehman Brothers Inc. or an affiliate expects to receive or intends to seek compensation for investment banking services from the subject company within the next three months. 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