Morningstar - Winter 2019 - 20

Dispatches

firm veteran Michael Cohen, who is stepping into
an interim role.
There's precedent for Capital Group navigating
unexpected manager changes well. After
James Rothenberg's July 2015 death, the firm
quickly and effectively reassigned his $5
billion in assets while keeping portfolio turnover
to a minimum. Capital Group should be able
to do the same with Denning's assets in Capital
World Growth and Income, EuroPacific
Growth, and New World, given the size of those
teams and the relatively modest amount of
strategy assets Denning managed in each. Those
three funds retain their Gold ratings.
With New Economy's aggressive strategy, matters
are more complicated. Denning ran around
15% of the fund's $12 billion asset base,
had a specific role oriented toward non-U.S. stocks,
and was one of only four named managers.
Redeploying Denning's assets won't be a problem,
but his loss hurts. In nearly four decades
at the firm he distinguished himself as a savvy,
if aggressive, value-oriented manager. This
fund's analyst rating has been dropped to Silver
from Gold.
Alec Lucas, Ph.D., is a senior analyst with Morningstar
Research Services.

Big Value in Big Tobacco
The only surprise about President Donald
Trump's proposal to ban non-tobacco-flavored
vaping liquids is that it took so long.
We believe vaping regulation is still in its early
stages, and future developments could
include higher taxes and control over ingredients.
Nevertheless, Trump's proposal significantly
accelerates U.S. regulation and could decimate
the category in a few years.
We are retaining our fair value estimates for
all the tobacco companies we cover until we know
more about the extent and timing of any
regulation, but our worst-case scenario analysis
shows that Altria MO is the most affected,

20

Morningstar Winter 2019

Big Tobacco on Sale
Company/Ticker

Morningstar
Rating

Price ($)

Fair
Value ($)

Price/
Fair Value

Altria Group MO

QQQQQ

40.90

58.00

0.72

Wide

British American Tobacco BTI

QQQQQ

36.90

59.00

0.58

Wide

Imperial Brands IMBBY

QQQQQ

22.60

48.00

0.47

Wide

Philip Morris International PM

QQQQQ

75.93

102.00

0.75

Wide

Economic Moat

Source: Morningstar Direct. Data as of 09/30/2019.

having recently acquired 35% of Juul, while this
latest development is probably a net positive
for Philip Morris International PM. We
believe there is significant value in the group at
present. We see particular upside to Imperial
Brands IMBBY and British American Tobacco BTI,
while Philip Morris is our quality pick for its
leadership position in heated tobacco and strong
combustible portfolio.
After recent reports of breathing problems among
several hundred vaping consumers in the
United States, the Trump administration will seek
to ban the sale of non-tobacco-flavored liquids,
bringing forward a Food and Drug Administration
proposal to review the category in 2022.
Manufacturers may be able to reintroduce their
products later, subject to FDA approval. While this
would not solve the issue of youth access to
the products, it may allow the FDA to take greater
control of product quality and ingredients.
We estimate that around two thirds of the roughly
$9 billion U.S. vaping market is composed
of nontobacco liquids and that this could be as
high as 80% for market leader Juul. The worst-case
scenario is that volume of this magnitude
is lost to the regulated category, with users
either quitting or finding black-market alternatives
rather than switching consumption to other
tobacco products.
The following analysis assumes that 66% of the
U.S. vaping market by value is nontobacco
liquids; none of this volume elimination migrates
to other categories in the portfolio; a ban
occurs on June 30; and international markets are
unaffected by the events in the U.S.

The greatest impact of a ban would be felt by Juul,
which holds a U.S. market share of around
75%, and by association Altria, which acquired 35%
of Juul in December 2018. We estimate that a
vaping ban would lower Altria's earnings per share
by $0.03 in 2020, or less than 1%, but the impact
would magnify to around $0.17, or 4%, by 2023.
Altria would almost certainly be forced to take an
impairment charge on its $12 billion investment
in Juul, probably about $5 billion, but excluding
that destruction of shareholder capital, we
estimate the impact of lower equity income to the
intrinsic valuation of the company would be
almost $3 per share, or around 5%, if a ban comes
to fruition.
Perhaps a more pressing issue for Altria is the
implied valuation of Juul in its proposed
nil-premium merger with Philip Morris. We do not
think the potential for a ban on vaping
eliminates Philip Morris' motivation for the deal,
which we believe is iQOS distribution.
(IQOS is a device that heats a tobacco plug
without burning it.) But it throws a wrench in the
works on valuation. The nearly 8% decline
in Altria's stock since Trump's announcement
probably prices in a reasonable allowance
for a valuation impairment of Juul, but the issue
could make negotiations more complex.
Imperial Brands would also be affected. It acquired
then market leader Blu from Lorillard in 2014,
and although it since has lost its leadership position
to Juul, Blu has expanded internationally. Blu in
the United States accounts for a maximum
of 1.5% of total revenue, and margins are currently
much smaller than those in the combustible
business (which we believe are around 40% in the
Morningstar - Winter 2019

Table of Contents for the Digital Edition of Morningstar - Winter 2019
