Chit Chat Stocks - Altria Group and the US Tobacco Market (Ticker: MO) with Devin LaSarre

Episode Date: April 6, 2023

Altria (Ticker: MO) is a publicly traded company that owns major tobacco brands and is diversifying into alternative products and cannabis investments amid declining sales and increasing regulation. Listen as Brett and Ryan ask questions about the company, its business model, and valuation. Enjoy the show! ***************************** This episode is sponsored by Stratosphere.io, a web-based terminal for financial data, KPIs, and more. Try it out for FREE or use code “CCM” for 15% off any paid plan. Sign up here: https://www.stratosphere.io/ ***************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney  Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Interested to see more of Devin's work? Check out their Twitter here: https://twitter.com/DevinLaSarre?s=20 Subscribe to Devin's Substack called Invariant: https://invariant.substack.com Contact us: [e-mail] Timestamps Tobacco Market | (3:51) Brand Loyalty | (20:40) Macro Concerns | (32:13) The Big 3 | (50:56) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. My name is Ryan Henderson, and I am joined by my co-host, Brett Schaefer, as always. Today, we have our Thursday deep dive episode where we interview an analyst or an investor to discuss a single stock or industry in this case. I guess it was kind of a mix of both. And today we had on the show, Devin Lassar, who I guess you could call kind of a generalist and with a little bit of a focus in tobacco. He is very thorough, has a very good understanding of the tobacco industry at large. And so we discuss kind of all the dynamics going on there, but also dig into Altria specifically, which I guess is a fun discussion. Did you have any highlights from it? I really enjoyed the discussion of

how the volume declines actually impact the bottom line, where it's not just volume declines, users smoke less cigarettes, and profits go down in a linear fashion. There's a lot more factors that actually go into play. So he lays it out greatly. Okay. But before we get to the interview, we want to talk about our presenting sponsor, which is Stratosphere. Stratosphere is in investing home screen for fundamental research. I think I speak for both of us when I say we use it every single day. It has tons of great data visualizations. It's got SEC file aggregation for all your companies. It's got press release aggregation, which is a bit of a new feature as well, which I think is just perfect if you're trying to build a watch list or a thorough watch

list, not just one that you kind of briefly look at every once in a while, but something you truly track. So go ahead, ditch Yahoo Finance, start investing with stratosphere.io or start expanding your investing knowledge with stratosphere.io. And if you're looking for a paid plan, which gives you unlimited custom-built KPI visualizations, go ahead and use our code CCM. You get 15% off any paid plans. Even if you're an individual investor, I recommend at least checking out the pricing because with the 15% discount, it could certainly be worth it for you. We found a lot of value out of the full paid plan. But anyway, if you're more interested in the platform, stick around after the episode. We've got a little three-minute interview with the founder

of Stratosphere, Brayden Dennis. I guess without further ado, here's our interview with Devin Lassar. Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts, and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest is not formal advice or a recommendation.

Now, please enjoy this episode. All right. Welcome in. Today, we are joined by now second-time guest, Devin Lassar. He is the author of The Invariant Substack, so we're going to link to it. Feel free to check it out. It'll be in the show notes. Everyone knows where to find that.

But Devin, welcome back to the show. We've got tons of questions about basically the state of the nicotine market, but I guess before we get into that, how are you? How have things been? Life is good. I have zero complaints. And yeah, things seem crazy in finance right now, but I'm kind of, as always, tuning out the noise, sticking to what I know, and just kind of writing it out, seeing where things

lead. I guess this is kind of a top-down overview, and it's not a very specific question, but if you wanted to encapsulate the current state of the nicotine market in the US, how would you describe it? overall uh hated uh to many maybe confusing and you know both of those things are just fine by me and one i think the one thing people focus on and we're gonna for any listeners we are gonna look at this through the lens of altria and then also some of their competitors that are potentially coming within the us market as well but the big thing that people are gonna immediately

think about and we either want to get basically this sort of topic out of the way or hit it first is cigarette usage has declined consistently in the united states since 1965 i would add that altria and its preceding companies have been the top performing stock during that time period uh is there any reason you see for this rate of decline to change and what i mean by that is kind kind of the second derivative, you know, either flatline and get better for someone like Altria or cigarette companies in the United States or accelerate and get worse. Right. So it has changed already. I mean, you can look at the long-term trend and say, if we just look at, say, the period of maybe 2016 to 21, like volumes decreased by about 3.6 per year, right? And that's been kind

of lockstep with where we see the smoking rate decline, which is also, as our buddy Lawrence Hamtel pointed out more recently, you know, part of that is a function of the denominator effect and just a growing population and younger people smoking less but with that you know in 21 we saw industry volumes down 6.5 last year down an adjusted you know eight percent which is pretty staggering relative to to the historical norm um i don't think that eight percent is a new normal just like if we go back and we look at 2020 when volumes were about flat i don't think that was terribly normal either right so i think we'll probably experience some degree of mean reversion uh but with that said i i think it's completely reasonable to think it's still elevated compared

to that maybe 3.6 percent so maybe we're talking about a mid single digit decline rate in cigarettes In terms of does that change on the longer term? I think definitely. No idea when that happens. We know it's accelerated. And maybe a small part of that is also these new categories, pulling volumes away from cigarette volumes. But if we look at some other markets that have lower smoking rates than the us it seems to be that you know you you hit a lower level and it kind of tapers off kind of like the bottom of a ski slope so maybe it starts to ease and maybe at some point you know it becomes apparent that you know at some point you're going to have a certain base of a population that just continues to want to use a certain product where is the us and kind of the global

grand scheme of things in terms of like cigarette volumes are they because i i hear all the time friends that like visit europe or something like that and they're like everyone smokes over there no one smokes over here that kind of thing um and i know brett mentioned that a lot a lot more people smoke where where he's at currently is u.s kind of further along in their transition to other forms of nicotine? I mean, definitely. So we are, as a country, we have a rate of smoking prevalence amongst adults of call it between like 12, 12 and a half percent, something like that. But if you break it down on a state level, you see some states that have single digit rates, some that have over 20% rates, right? And that's something

that's interesting to focus on. But also there's considerations like affordability, which is absolutely critical, right? You have all these different levels of income across the world and the US has a very high level of income, disposable income that can be deployed to to purchasing these types of products and all kinds of different uh cultures social reasons uh education levels all kinds of these different factors that kind of uh you're gonna weigh into mathing out where you where you think that trend goes but um yeah i think the us has has a much longer runway ahead than than maybe the broad market is is pricing them right now okay we're We're going to talk a little bit about Altria specifically, and you recently had a write-up

primarily focused on them. So I recommend anyone that's interested in this conversation, interested in Altria, go check it out. But let's start with their sort of crown jewel, I guess you could call it. Not jewel literally, like not J-U-U-L, but jewel. Marlboro. Marlboro. They are the leading market share cigarette maker in the US. Do you see any reason that that changes over the next five to 10 years?

Right. So I don't see that their position changes. I think that the share can and certainly will change. Marlboro's share in the US market has been over 40% for over two decades. It's fluctuated. Past couple of years, I think it's been between like 40 to 43%. And more recently, you've seen this highlighted fact that with disposable income under pressure, some consumers are down trading to discount brands. I don't find that terribly concerning because while that's occurring, if you look at the premium cigarette subsegment, remember I was continuing to take share in that recently and if you look at what management has has highlighted they very much want to continue to focus on it being a premium product they don't want to chase low margin total

share when they can just have a higher share of the premium sub segment and you know maintain maintain that level no yeah that totally makes sense i think the big concern with this company is one, well, the big concern people have, and I'm sure the bulls do not have this concern, is the cigarette volume declines, as we talked about, it's been declining since 1965. But I think the number one maybe concern lately has been management. I think the first question here, maybe I'll combine it with this other one. Can management get out of its own way? And after the terrible disaster with Juul, can you trust them with capital allocation decisions anymore or does it not matter i wish i could say it doesn't matter but it it always matters right

like uh you know i wrote last year i think some line that goes along the way of you know any management can destroy a business if they dream big enough and you know commit to a few half-baked ideas right like an end of day nothing is indestructible uh with that said the the core business of ultra is rather remarkable as you pointed out you know for the last half century volumes declining and their operating profit from those operations basically nothing but up and to the right at a pretty remarkable clip right and so looking at capital allocation uh yeah i think there's some red flags and it doesn't matter how much value you produce if you turn around and incinerate that value, right? And no denying that that jewel was value destructive. I think if we

look at that, there are all kinds of things that just didn't make sense. One is obviously the valuation. Two, something that was problematic was the fact it was for a 35% stake, where Altria didn't have full control. And they were also in this awkward position where if they have Juul succeed, it maybe eats into their product, where they own 100% of that. So it's this really odd conflict of interest. And when they came in, there was no hiding the fact that Juul was all kinds of issues regarding their marketing, their positioning. They had all these lawsuits on every different level. And Altria really did help them clean up their act. They caught a ton of the marketing. They proactively pulled all their foodie flavors off the market and really

made sure that this company was going to start to operate a lot more responsibly. And when that happened, you also see Juul's market share just totally start to tank. And when it became apparent that maybe things weren't going to turn around for them regarding all the legal issues, Juul had started to distance itself, started providing less support to the company beyond legal capabilities. And along with that came all the write-downs.

And so with that fresh in the mind of everybody when they read about these new deals, it's totally fair to point to that and say, you know, can we really trust management? For me, I think that while that is one of the best, you know, examples of incinerating capital, if you look historically, I don't think management has been absolutely atrocious in terms of capital allocation decisions and how they run the business. Again, they've managed the core business exceptionally well, in light of all the secular and non-center dynamics that affect you know cigarettes cigars or oral tobacco if you go a

little bit further back you can see other deals like when they acquired john middleton ust when they when they acquired uh burger so sewn around the same year they acquired so uh chronos like all of these things made a lot of sense for the business and arguably put it in a much better position overall. And now when you look at both the more recently announced joint venture with Japan Tobacco and Enjoy, you know, I think that there's reasons you can criticize or be concerned about both of them, but there's also very good reasons of why I don't think either of them should be you know flagged as jewel 2.0 uh so which one would you guys like to start with back them up let's do let's do enjoy first that seems simple compared to maybe a strange partnership uh what

do they acquire what and what do you think about it right so uh haven't officially acquired it yet so still pending you know we're probably you know half a year out or something they still have to go through HRS, FTC, go through all the legal hoops and whatnot. The purchase price is $2.75 billion with a potential extra $500 million earn out with some contingencies. We'll get into those. And really, Enjoy is a company that, according to available information, did $150 million in sales last year so you're looking at a price tag of 18 times sales which sounds absolutely insane right if you just focus on that number but if you dig into it a little bit more you know it's maybe unfair to judge it just on that number where we don't really understand the price mix of how those

sales are being derived like enjoy really sells three things they have a disposable vape the enjoy daily they have a pod based system called the enjoy ace and then they have ace pods for that device and really don't know the full breakdown of sales though you know i do have some data suggesting that maybe they did around 115 million in pod sales last year um but we don't know what levels of you know promotional uh maybe aggressive discounting was occurring that's going to affect that we don't really know the unit economics you know what does it cost to produce all these how are they selling how are they marketing we don't have a good idea of their exact geographic footprint which matters because while there's not a you know a federal level

excise tax on these products there there are on different state levels right which is going to affect the retail price which is going to affect your contribution margin you know so on and so forth um what we do know is that enjoy all their their pod market share is only about three percent in the us which is extremely low when you look at you know both jewel and views alto now they're only in about 30 000 stores and they've been very conservative with their rollout with their marketing. They've made sure to kind of grow this business as responsibly as possible. Now, Altria, their footprint is getting into maybe 200,000 stores. And along with that, substantially improving the visibility of these products and raising consumer awareness.

I don't know if you guys have checked out any stores around you, but around me, very few stores carry any of these products and if they carry them they're on the bottom shelf out of view with no signage nobody knows about these things even like you walk up to the clerk and ask them about enjoy they'll have like forgotten about it it's like oh yeah i guess we do sell that it just sits on the bottom there and nobody comes in because they don't know it exists right so if you you know rough math if you think you can maybe expand the footprint by you know times five times six improve uh visibility maybe you uh even more aggressively discount the device or maybe you know you do a device discount attached with this the sale of

of pods to spur uh trial and adoption you know maybe maybe ultra could acquire this and then rapidly grow it to take share. That's one of the things that I suppose makes sense about the deal. And the other part that kind of makes sense is that unlike Juul, Enjoy is the only pod-based vaping device in the US that has authorization through the PMTA process. right uh views alta is pending jewel is fighting the marketing denial order from their pmta application for their related devices you know enjoy already has a green light these products and we've seen seen this this growing uh number of of disposables and illicit vapes in the u.s market because the FDA really isn't as heavily enforcing as maybe they should. But we've seen

some signals and some reports and some reasons to believe that maybe they'll start to really enforce against a big chunk of the market. If that chunk of the market goes away, here's Enjoy authorized products that can maybe swoop in and take that share. I think that also kind of makes a lot of sense. So you look at the whole thing, big picture, wide range of potential outcomes, but certainly looks a lot different than Joule in terms of why they're doing this. And like worst case scenario is, you know, it's a much smaller deal than the size of Joule.

And if it ends up being a zero, which I certainly, you know, if it goes through, I hope it is not. But if it's a zero, you're getting rid of the only competitive, like competing product that has authorization through the PMTA process that isn't already owned by Big Tobacco. You're basically insulating the rest of Big Tobacco from whatever threat this may or may not represent in the future. Now, is that worth the price tag?

I think you could maybe argue long-term it is. Yeah, I think you could certainly make the case because they've got the distribution footprint and the resources to potentially create a leader out of a smaller player. Anecdotally, among my peer group, there's no brand loyalty in vaping. Maybe they just pick up whatever the disposable is at the local gas station. Do you see any reason that that would change? so so i mean that is the toughest thing for the e-vapor category right now especially when you're

when you're trying to you know compare it to legacy brands where they've been entrenched they have this tremendous brand equity brand loyalty where people stick stick to the brands that they know and love and you know part of that comes down to the aggressive promotions where you know you go in and you see your product isn't being currently discounted but you see a competing product is you know 80 off at the moment well maybe maybe like you say hey screw it you know i do like what i was using but 80 off is 80 off i'm gonna you know go over here for a little while um and you know if you look at all the products in the market right now there isn't a lot of product differentiation which i think might be you know a standout positive for enjoy at least for their

pod based system ace which is if you look at jules pod based system and you look at the views although they're incredibly similar in design and very similar to others uh that are on the market as well and they you know they're easy to use but kind of like cheap and they don't feel like a quality product whereas if you hold the enjoy ace you know it's not heavy but it's a little bit more substantial the materials it's made out of are just distinctly higher quality and you know all these products also are complex enough that they aren't 100 consistency in the user experience. And so if Altria could maybe refine the production of the ACE, make sure it's as consistent as possible, it feels high quality, maybe that's the start of an

equation that can lead to building some long-term brand equity for them. But it's certainly a challenge for that subsegment. Yeah. I mean, the VAP market is so speculative. It'll be interesting to see whether that subsector will rationalize over the long term now let's have the partnership with japanese or japan tobacco what is this i actually haven't as someone who loosely falls all tree this is the one part i haven't followed closely it seems like a strange announcement but maybe for the listeners um what are they doing here i don't know no um it's it is a little weird um and there there's reasons on paper where it makes sense but you can also like step back and i think the more i've thought about it the more i've kind of actually questioned this deal so so

basically it's meant to be basically a perpetual agreement where these two companies are working together uh regarding heated tobacco products and this joint venture is specifically a focus to get JT's heated tobacco product plume into the U.S. market, right? They have this new version that is, you know, new, but in certain markets like Japan is actually starting to take incremental share and starting to perform decently well, but needs help breaking into the U.S. market. Altria, again, has this massive, massive network relationship with wholesalers, you know, retail chains, unparalleled sales and distribution network infrastructure in the U.S. And so this agreement is basically, you know, JT will provide the device.

Altria is going to produce the heat sticks that are used for the device. And then we'll also be responsible for leveraging its infrastructure to spread it in the U.S. And the economic interest in the joint venture is 75% Altria, 25% JT. That all sounds fine on paper, kind of. But again, you can step back and see some clear issues. One is you have this non-100% interest in this joint venture that could maybe cannibalize volumes of your legacy business that you 100% own, which is maybe not a great thing for Altria. And two, something that I'm even more concerned about is the consumables for this product would be produced using the Marlboro brand, which in my view, it's the strongest asset that Altria has is this brand. And you need to safeguard that and protect it, you know, above everything else. Attaching it to a device that you aren't actually manufacturing yourself and in 100% control of is a risk, right?

And I haven't really seen anybody question that, but I think it maybe should be questioned. You know, that notwithstanding, you know, on paper, you can math it out where this deal kind of makes sense. It's very, very small capital layout for Altria, like $150 million up front. They have existing infrastructure where they can already produce the heat sticks. So no real capital intensity. And if they think that heated tobacco is going to break into the US market and start taking incremental share, maybe this makes sense in part of their overall equation. No, it totally makes sense. Great overview. Last thing, outside of the core Altria business, what was the dispute they had with Philip Morris International? I guess for context, for any listeners that don't know how these two companies relate, they used to be the same

company. 2009, they split up. Altria has Philip Morris USA, and that is only the US market. Philip Morris International has, as the name suggests, the international market. Although Now, within these risk-reduced products, there's a little bit of a competitive overlap that we're going to maybe talk about in the next section. They had this dispute. Has it been resolved? What was the outcome for Altria? Right. Mind you, you're exactly right. At one point, we're one company. We're doing all kinds of R&D on potential new products. When they split up, they each attained everything they had been working on, but then PMI started sinking a lot more resources into heated tobacco, right? They came up with their product, Icos, and since they are outside of the U.S. and wanted to introduce this product in the U.S., they had this agreement with Altria, where Altria would handle sales and distribution and get a nice pretty cut for doing so. So, again, similar to JT, it's like, yeah, but if this cuts into your cigarette volumes and you don't actually own 100% of this, like, is this really the best move for Altria?

But again, you can math it out and see how maybe this made a whole lot of sense for both of them. With that said, the test markets and the rollout was really slow initially. Initial versions of ICOS are authorized through the PMTA process. But then a couple of years ago, the ITC issued an injunction against PMI for ICOS, saying that the device infringed on a few patents held by Reynolds and said, you know, you can no longer import this device to sell because of this infringement, which left PMI with a couple of choices. They could go through the whole PMTA process with a new version that isn't reliant on those infringing patents and eventually get that into the U.S. market. Or they could produce ICOS in the U.S., which, you know,

if you're producing it in the U.S., you don't have to import it. You can kind of skirt around, you know, the injunction around importation. Now, PMI, they bought Swedish Match, which I know you guys weren't super happy with. You guys were a Swedish match shareholders. But now PMI has their own distribution and sales infrastructure in the U.S. They can, in theory, produce at least the ICOS-3 in the U.S. and sell that, working on getting the new ICOS Aluma through the PMTA process,

which will still take time, though that's a far superior product by by all measures uh looking at just user user experience and user satisfaction um but with it with their own existing infrastructure they said you know we don't really want to have this agreement in place with all trade it makes more sense for us to do it on our own have 100 percent control over everything 100 economic interest and you know the initial agreement was going to run through 2024 and with with a potential like option to re-up it to 2029 and pmi basically handed ultra a big bag of cash saying no let's just cut it at the end of 2024 here's 2.7 billion that's both you know part ways and so you know looking at it i think it makes sense for for both of them

you know at the time ultra is really not able to fulfill its end of the deal anyways 2.7 billion in cash is a lot of cash just so happens to be almost exactly the same amount of what they're paying for enjoy right and now pmi gets 100 economic interest and control over you know trying to reintroduce icos into the united states so you know i think it makes sense for both of them but i guess something you touched on in your article that i think was an interesting point is around macro concerns. I've always thought of Altria as kind of, or maybe cigarettes in general as a pretty resilient category, regardless of kind of the macro situation. But this year, it seems to have had a bit of an impact. So I guess, how do you think inflation impacts Altria?

and actually I'll just leave it there. How are they impacted by it? Yeah, I mean, it depends is my like really bad and vague answer, but inflation means a lot of different things. There's all kinds of different types of inflation and they can all occur to varying degrees. And so, for example, if you were to talk

about wage inflation concerning demographics that maybe smoke more, that's probably a really good thing for Altria, right? Those groups of people suddenly have more income to spend on products, probably a net benefit. However, like, you know, if you have broad inflation, outpacing wage inflation of that specific demographic, that's clearly bad.

If you have input cost inflation for the goods that Altria produces, certainly a negative headwind, right? So there's all these different types of inflation that can push and pull uh on the outcome but you know at the core of it you have these products that are extremely cheap to produce outrageously high margin you have inelastic you know uh demand you know people just want to buy these products almost regardless of where we are in the economic cycle um you're going to see some extreme resiliency occur now more recently you know

you compare all those dynamics to also seem like spike in gas prices and pressure on disposable income. Well, you know, that has a more pronounced effect. But even so, you know, Altra at least has navigated exceedingly well, you know, all things considered, and most certainly compared to a lot of other industries, has handled it much better. All right. That's a great overview on Altria. We're going to come back to the valuation of Altria after we hit reduced risk products, which leads to my next question. And this is the one I think a lot of investors are interested in. Is the state of the nicotine pouch market, or maybe broader, maybe it's not just nicotine pouches, it could be oral non-tobacco products. Can the

success of these products on the West Coast of the United States be replicated across the country? And what companies would be impacted by these developments? Right. That is the multi-billion dollar question, right? And certainly one of the big question marks that maybe leads some people to steer away from the space. If you look At industry volumes in the U.S. broadly, in 2017, you had oral and e-vapor make up about 17% of volumes. Last year, that was 26%. So incrementally taking total industry share in volumes, right? If you look specifically in the oral tobacco segment,

Now, Altria is the clear leader in terms of total share. You have MST and SNUS, which is like 40% share. Then you have Ahn, which is just under 6%. So let's call it 46% total. Now you have PMI that acquired Swedish Match. You have Zin, which is just under 15% share total oral. And then you have General SNUS, which is high single digit share. then way at the bottom there's a british american tobacco's velo which in terms of oral tobacco like

one percent share and also their volumes declined last year like the the u.s version of velo is just an inferior product and he's struggling on all fronts um but what's interesting if you look at the sub-segment of oral you look at into the modern oral sub-segment it actually grew rapidly last year, from about 15.5% of the oral category to almost 22% in a single year. And along with that, both Zin and Ahn just grew rapidly. Zin's volumes were up 70% year over year. For the modern oral segment, Zin's share has come down a little bit, but it's still at 67% in the US.

Ons is around 23%, Velo around five, and then you have like Rogue and some other small pouches that make up the rest, but like they're basically non-contributors. But yeah, I think if you look at the rollout, like as you mentioned, West Coast and, you know, going onward, you know, Zyn basically exploded on the scene. on the scene. And as they started to scale, just gained in popularity, then Altria through aggressive promotional discounting, tried to take share of that, which has been succeeding so far. But you look at these two companies' total volumes, and you look at how management is guiding. For both these companies, they're generally conservative in how they talk about volumes broadly they're they're kind of letting you know that this isn't swinging down like this trend is going to keep sweeping through and and you know it wouldn't surprise me to see modern

oral continue to take incremental share of total oral um until you know it just flips and it basically continues to cannibalize volumes um with that you know i i think that's pretty exciting for these companies while at the same time you like you contrast that to the vaping which again remains a little uncertain regarding volume growth and not just volumes but really just like retail value and profitability where you have these guys doing basically alternating between steep steep promotional discounting to try to take share you have all this looming kind of regulation a lot of illicit uh vapes non-authorized vapes um from foreign producers especially that are continuing to take share elf bars are huge right now ballooning right they're colorful and

people like the flavors that's right and yeah and the thing is is we can see some recent enforcement actions done that might signal that the FDA is going to get more serious about trying to clean up the illicit market, but they can't do it by themselves. They need to work with a whole host of other governmental bodies, and especially when you're trying to enforce against all these different types of producers. It's much easier to enforce against domestic manufacturers rather than these foreign manufacturers. And so, you know, it's not easy. It doesn't necessarily mean it's going to happen fast, even if they try to make it happen fast.

And so, you know, there's a lot of different outcomes that can occur with the vaping space. You know, you pair that on top of the the issue with lack of brand equity and brand loyalty. I think that the pouch segment looks much more favorable compared to vaping, especially another big reason is like you look at youth usage incidents. It's almost nonexistent for these modern oral pouches. And it's come down considerably in the past couple of years for vaping, which is excellent. But pouches don't have that overhang or that stigma because it's never really been an issue for them. We've hit on a lot of the questions in some way, and so I'm going to try to consolidate a couple of the ones we have.

You mentioned the market share statistics of Modern Oral and how there's, it seems like, and you can correct me if I'm wrong, there's pretty good brand loyalty in that market, especially relative to vaping. I'm just going to give you a general question here. What do you think of Philip Morris's acquisition of Swedish Match? Who do you think, I don't want to say, I guess, who do you think wins in that? And is there any way that Zinn kind of loses its share? Right. So a couple of things to touch on there. I think it makes total sense from the perspective of PMI. The modern oral segment represents a gigantic opportunity that they were really behind on. If you recall, they were trying to work with Shiro, their own brand that nobody heard of knew of and they had these test markets and just like it kind of went nowhere and they suddenly had this opportunity to use attractively priced debt to acquire the the leader right leader in the us and pretty dominant in in europe and if you look at the the terms of the deal

um what i think it was like 17 times trailing operating income something like that i don't know Off the top of my head, but you math it out, you look at the growth trajectory, the tremendous operating leverage that they're able to recognize as they scale up production. And then long-term, you're competing for share, but in theory, if you develop that brand loyalty, you're able to exercise that pricing power down the line as well. So if you kind of scale pricing power and then on top of it, PMI's global distribution, meaning, you know, maybe they accelerate getting Zin to all these other markets where it has no presence. And it would have taken Swedish Match as a standalone way, way longer to try to do that. And by that time, maybe they would have lost share. Right. So you see all these ways that it makes total sense. On top of the fact, as we covered, like with the Swedish match sales and distribution infrastructure in the US, it sets PMI up for reintroducing ICOS in a much more favorable way. So, you know, I think it makes sense for PMI. I know you guys had voiced some disappointment. You wanted Swedish Match to stay like that peer play, right? That standalone play. So what are your thoughts on-

It was a beautiful business. It was wonderful. fair price we'll see the next two three years but I think to be honest for PMI fair price

was about 40 times operating income given how much that operating income could balloon back up to could double really within

a few years time and get it back down to a much more reasonable earnings multiple but you know that's in the past and maybe

old Swedish match shareholders should just buy PMI Ryan anything else to add there well I just yeah I mean you look at it like

They paid not that steep of a premium on Swedish matches current earnings, but Devin just mentioned too, they get kind of that potential earnings unlock with their own distributions. So the 40 times, that number quickly, the E in that P quickly comes down if the distribution works out globally. Yep. Yep. All right. Wrapping up RRPs. which for any listeners, risk-produced products, these sort of things. And this is a bit of a speculative question, but how do you see the size of the RRP market in the United States three to five years from now? And maybe frame it in the lens of how it could help or hurt Altria, since we're trying to focus on that stock for this episode. Okay. Yeah. Super, super speculative. I wish I could see exactly up five years and

and pinpoint with precision, but nobody can. I mean, something I've tried to distill down in my own thinking is like, what are these products actually competing against? And I don't know that it's one, you know, the RRPs are competing against one another. It's more competing against legacy products, right? You have these products that have tremendous brand loyalty,

familiarity that are simple and straightforward they've been around forever you know everybody is is very familiar with the idea of how you would use a cigarette right um and also when you compare it to to a product like marlboro which is a premium product that's hyper consistent you're also having a very high quality and consistent experience you know setting aside the obvious health risks. But you're going to have that experience that's very consistent with every single cigarette in theory. You compare that to some of the newer products. Again, we get into maybe why there's some of that lack of brand loyalty in eVapor. Each of these products have different pain points, whether it's not being able to use a device while it's charging,

or the pods leak a little bit or you know it doesn't heat and produce a similar hit each time you use it um that kind of inconsistency is a big detractor at the same time you also have complexity of certain products like disposable vapes are very easy to use like mindless to use pod based are pretty intuitive then you have like open tank which like the big guys don't really deal with that's more of a you know niche space but that's much more intimidating and seemingly complex um but you have like added health benefits they can be discounted or they can be priced cheaper than legacy products but still be more profitable for the manufacturers right and there's some big advantages to these products too for vaping there's no

smoke or lingering smells discreet you can take a hit put it back in your pocket or it's like if you light a cigarette you know you want to stand outside and smoke the whole thing you look at modern oral even more discreet nobody can tell you you pop one of these pouches into your mouth you don't have to spit there's no smell stain anything like that because of that like that's also really popular amongst basically the whole adult population whereas like traditional mst like dip is really like a male dominated product right 95 male use users and then there's like heated tobacco which some people really question you know can heated tobacco make it in the us when vaping is so dominant and you know i think it can simply for the that it can do well

the degree is you know uncertain but it can do well simply because it offers maybe the the physical experience that's as close as you can get to smoking a cigarette without actually combusting the product, right? Without smoke, without ash. You have these actual tobacco compressed sticks. You have the ritual, the physical ritual that's very similar. And maybe that makes it a much more approachable product and something that ends up providing a much more satisfying user experience. Certainly, that's been the case in other markets. So I wouldn't count it out in the US. Regarding trajectories, again, a lot of it comes down to how the FDA handles, one, authorizing additional products, as well as taking enforcement actions

against unauthorized products, that's going to really dictate the trajectory of RRPs. Then you see competitive dynamics, which is going to be led by who makes a better product, who can raise consumer awareness, who's going to spur trial and adoption by various pricing strategies. All these things lead to a wide variety of outcomes. What I think is most likely, though at least for the short and medium term is that these products are going to grow in volumes but the the vast majority of the profit pool is still going to stay with the legacy products where you're not doing this aggressive discounting you're actually taking price every year and while volumes are diminishing you know the the aggregate profitability of operations kind of

kind of expands okay one of our one of the questions i think we got from a lot of uh when we asked publicly on twitter when brett asked was about basically the big three and so i'll try to lump that in with altria's current valuation i guess this is maybe a tough question but between philip morris international altria and british american tobacco which do you think will perform the best over the next five to ten years and why i assume maybe you can lump ultra's valuation uh question in there as well yeah that's a it's a good question um yeah i'll i'll do it in reverse i'll start with ultra's valuation which is like you know i'll walk you through just like basically how i think about the company which first off is like

it's clearly old boring written off by most hated vilified um all things that to most maybe don't make for the most you know appealing of investment and just so happens to be like exactly the kind of company i like um and you know why do people write it off or hate it it's like well there's obviously some either like moral or esg concerns right so there's a huge pool of investors whether retail or institutions that just aren't going to touch this stuff anymore aren't going to touch ultra let alone the industry and then there's a large group of people that look at the decline in smoking rate and look at the volume declines and look at new products and they just kind of write off the whole thing go you know the future isn't going to be as bright as the past and it

doesn't make sense and you know there's there's better opportunities out there and that's where i kind of dig in and i see something different um which is you know there's some common mistakes people make by by focusing strictly on volume declines and even you know citing uh the fact that these companies and ultra especially can take price up every single year um that really doesn't highlight the mechanics of what's going on which is you know volumes go down so your cost of goods sold associated with those volumes also happens to disappear the excise taxes that you would have paid on those old volumes are no longer there right so your aggregate But costs in that regard go down.

And so when you raise price, what's actually happening is you aren't just making up for that loss in volumes. You're creating this massive differential between price and these two major costs shrinking. And so like last year, for Altria, volumes were down a staggering 9.5%. The retail, average retail price went up 6.5%, but their net price realization was up over 11%. Again, it's that dynamic between pricing and then you're seeing fewer excise taxes for your cost of goods sold. So it's like, you know, you look at it in that way and you realize maybe volume declines if you have this embedded pricing power. maybe even volume declines aren't above maybe it's more of a feature for this company and you know then there's a question well this can't continue forever right it's like well no like

nothing lasts forever but again as we touch on you know you look at different smoking rates in different states different levels of disposable income different cultures different different different societal trends, different taxation dynamics, et cetera. You can break out and look at this where volumes will probably decline at a rate higher than the total historical trend, but come down from the past two years. Along with that, Altria has best-in-class infrastructure, analytics, pricing capabilities, relationships with wholesalers retailers to really uh pinpoint and master masterfully manage sales and and pricing to maximize you know long-term value creation where you know i think there's

you know many many more years ahead for these dynamics to continue and then of course when it reverses and they finally can't keep actually expanding margins and increasing operating income and those start to contract you're working off of a much higher base right and people have it in their mind that like once that reverses it just kind of like right off a cliff but like no you still have this this decelerating period where you know you still have an outrageously high margin business where it will uh decline probably more gracefully than people think and then um along with that is the fact like this business isn't just cigarettes it's like yeah that's that's most of the business like 80 82 percent of revenue but you have cigars which are

grouped into their smoke smokeable segment right uh they purchased john middleton in late 2007 since 2007 volumes are up 40 on these cigars they take price every single year um since the acquisition, I think, you know, they don't break out the exact operating income contribution of cigars. But by my math, I think cigar operating income has probably gone up at least 200% in that timeframe. Tremendous margins, pricing power, and kind of different user base and different reasons for using that product, right? Like cigars, whether they're large cigars or machine-made cigars, a little bit more indulgent, used to celebrate, not necessarily a product used exactly like cigarettes.

So you see that as a long-term secular trend. There's a chance that even though volumes came down a little bit in 2020, which I would attribute to the fact that Altria took kind of outrageous pricing last year compared to the historical trends, you know volumes could still grow for that and that's going to be around for a long time and then you have this huge segment of the oral segment right or again since they acquired usg in 2009 volumes are up for the past like four years been near near stable in volumes and you've seen the legacy products being cannibalized by zin and on but they have this product on that's growing

rapidly um still growing rapidly despite discounting less so it's going to flip to profitability you know aimed within the next two years but you look at those things paired with the idea of kind of the the well-known cigarette pricing algorithm you realize that like yeah this this company's probably going to be around longer than than most people would assume um And so you look at this company, you look at the numbers. It's like we have a company with a market capital of around $80 billion, $4 billion in cash, maybe $26.5 billion in debt. Their investments in ABI and Kronos, $13 billion. You get an enterprise value of $90.

The company's producing over $12 billion in operating profit, $8 billion in free cash flow. I mean, it's, you're talking about an EV to EBIT multiple that's just, you know, high single digit, about 10, the equity is about 10 times free cash flow right now. And if you model out a basic DCF, I've published a few of these, assuming things just occur in terms of the core business as they have in the past, but to maybe like half the degree in terms of like uh price and margin expansion you can get a dcf that implies the the equity is maybe worth around 70 a share where it's trading like mid 40s right now and of course some people say like you know maybe a terminal terminal value in a dcf standard dcf is too high and this thing ain't going to be around forever right eventually you're going to see that accelerated decline and no i went through the other day and i made a

model that's much less elegant but instead of you know taking a terminal value after a 10-year period it just calculates out the next 25 years where 2023 is kind of stagnant on net revenues you know revenues net of excise taxes take a little bit of price the margin expands but then that starts to shrink each year and every single year revenues decline faster and faster and faster to like year 20 it starts to be like uh 10 12.5 15 75 and like you know last year they just uh you know false 25 or something like you can model

something like that and then nothing after 25 years and get to around like 45 46 dollars in you know present value of those cash flows to equity so right around fair value right now so it's like you know i i wonder can it do better than that is there going to be something left after that are is this dynamic gonna persist longer than that is it gonna you know uh do any better than that and i i'm inclined to believe yes for you know a whole list of reasons that's laid out. And so I think it's just simply very, very boring cash flows that are mispriced by the market. That's a great overview. And you'll get your current stock price in dividends probably over the next 10 to begin with. That's right. They pay out a lot in dividends, which people

can go, yeah, look at that historical, those payouts yourself. I want to hit some Twitter questions because we've got a few interesting ones, some of them as they tend to be a little bit trolly. But one important one, I think this might come down to why the stock is so underpriced from maybe your view. And it was a bit of a leading question from our friend Lawrence, but it's why are the two most hated tobacco companies, which is Imperial Brands, I believe, and then Altria Group, outperforming the two most loved ones, which I believe were Philip Morris and british american tobacco over the last few years do you think i think my thesis there is that it's all psychological and that the narrative of that everyone hates it can be so helpful especially

when they're paying out such a large portion of their free cash flow out to shareholders yeah i mean so it's it's interesting a lot of this is just strictly driven by sentiment and I've touched on it. Lawrence Hamtel has done a great job touching on it, where if you look at the fundamentals of these businesses in terms of their ability to grow operating income, convert that to free cash flow, return that cash to shareholders, absolutely tremendous. And yet multiples broadly have been compressed. And, you know, if you look at something like Altria, there's some very good reasons why it might fare better than the others in that, like, it operates solely in the U.S. And U.S. basically represents 50% of the total profit pool, right, for nicotine around the world, excluding China. just it's such a lucrative market here um and ultra exclusively operates here um it makes sense

along with that you have the strong u.s dollar which you know historically has really hurt companies like pmi right um and the trade-off is is that you have this regulatory concentration right you're in one you're in one country like the fda goes and makes some big moves that hurt you You know, you're particularly sensitive to that if you're not operating in a bunch of other countries. At the same time, you know, as I've laid out in some of my writing, historically, it seems to be that the FDA does a very good job of helping out Altria and insulating its, you know, legacy volumes. And so these companies, they're much more reliant currently, that is Imperial and Ultra on legacy volumes, compared to where BAT and PMI are in terms of the growth and development of their next-gen products. products. But at the end of the day right now, the legacy products are really what are keeping the lights on. It's what's paying the bills. It's hyper lucrative. And while there's still these looming uncertainties around a lot of the dynamics for RRPs, where don't get me wrong,

there's tremendous amount of opportunity for the large players to turn these into uh huge you know growth categories that are profitable um the legacy products are much more established you know brand loyalty pricing regulation it's just much more rigid and so you look at what especially something like imperial where they're being very measured in how they're rolling out where they're rolling out new products and they're really putting most of their efforts into managing the their cigarette business and they're not you know aggressively investing into new products which is again is keeping profitability you know higher and then you know they've come out and said you know our equity is dirt cheap and we're going to start

buying it back and if you look at the rate that they started buying back shares at the end of last year and how much they'll be able to buy back in the future um you know maybe they can just generate an outsized return compared to the rest of the basket just on the back of legacy cash flows paired with you know massive buyback just really juicing that that equity return right so um i at least for me um you know i i like the basket broadly i i focus on on holding you know not investment advice obviously but i i hold ultra pmi and bat some simply because you know when i look at the big picture i am not wanting to pick an individual winner i'm much more interested in just betting on nicotine's future regarding the you know uh the human experience and i think you

know you look at like legacy cash flows very impressive you look at the opportunities for next-gen products very impressive um but i don't want to pick one winner i think the entire basket is maybe like maybe just mispriced and so i think in the aggregate you know holding a basket approach like uh might lead to to you know an appropriate return for you know my my needs and i think it makes sense just to take a basket approach simply because they don't have a crystal ball okay let's wrap things up we're going to do a pre-mortem on ultria but since you did talk about the basket approach i want to do a pre-mortem on just nicotine stocks in general and maybe just the big ones um what are the risks that make nicotine stocks not work say this decade

over the next 10 years as a shareholder because from my point of view i look at maybe exclude BTI or BAT. And I think it's very difficult to lose money if you own both Altria and PMI in varying different scenarios over the next decade. But I'm curious from someone who's studied these businesses closer than we have, why do you think they would greatly underperform or investors would lose money owning them great question um so i i think one of the largest fears are again the as exciting as the next gen products might be there isn't this long-term track record right and let's say all of these companies can continue to pour more and more money into r d and developing infrastructure for these new products and all these new products cannibalize

their legacy volumes that are extremely profitable but there isn't that brand loyalty and they're continually having to to discount against one another um all of a sudden you go from an environment where there's a small number of players engaging in kind of rational pricing together to a race to the bottom right between that and then also you know i while i think it's exceedingly unlikely you could have regulators in different countries suddenly become more lax on who can manufacture some of these new products all sudden again you have all kinds of new competitors that are again trying to aggressively take market share you know more competition is not good for your ability to take price normally. So I think that's a very real fear, especially

if you really think that this would rapidly cannibalize the legacy volumes. So you're losing this huge would-be stream of cash flows on one side, and you're throwing it all into something that's maybe going to incinerate money. Now, I don't happen to think that that's terribly likely. I think the most rational outcome is, you know, you have governments that recognize the science substantiating the reduced risk qualities of these new products. They set a very high bar for manufacturers to prove that their products do what they say they do. They incentivize adoption by taxing them at lower rates. um and and maybe even down the line if you think about it you know if prices if price influences usage you know we can look at the nominal price but then we can look at the cost to one's health

on these products if these new products have substantially reduced risk qualities um you know if use usage might go up social acceptance might go up you know maybe long term you get some type of a growth story along with that even if they don't retain their qualities that allow them to be more profitable in theory due to taxation dynamics even if that goes away you have something that's that's long term in secular growth and volumes still able to, you know, engage in some level of rational pricing, you know, I think you get a pretty impressive outcome there. The other thing that I think maybe worries me that, well, mostly worries, because I think it's so unlikely, but you never know what government's capable of.

I think time and time again, in each of their own special ways, governments around the world kind of amaze us in their brilliance and some of their decisions, right? And really, when you look at some of the dynamics around these products, you're kind of limited in what you can do. And a lot of the regulatory levers have been pulled in terms of restricting where you can use the products, how you tax the products. who can manufacture so on and so forth and they've kind of run out of ways to try to curb usage and one obvious thing is like well we can just jack up the excise taxes on all these right to try to

curb usage even more but if you do that too fast you just push people into a black market and the last thing you want is a growing black market that you don't have eyes on that you have to devote tons of resources to dealing with creates all kind of you know second order and third order problems and on top of that while you're deploying all these resources to tackle this black market you're no longer getting the excise taxes right you raised them but it's all going to elicit markets so you're not actually recognizing you know the proceeds um nonetheless like it wouldn't surprise me to see some governments really mess up create some kind of you know black market scenario that grows proliferates. And obviously, if the US doesn't engage in

enforcement against things like illicit vapes, that's going to be a growing and more pronounced headwind against the major companies that will undoubtedly affect their profits to varying degrees. Okay. I think that's all the questions we have. Brett is giving me the thumbs up here. So that is going to do it. Anyone that wants to follow you, keep up with your work, why don't you, I guess, name some resources, some places to do that? Yeah. I'm on Twitter, D-E-V-I-N-L-A-S-A-R-R-E. Pretty straightforward.

I also write invariant.substack.com. So, yeah, reach out. I'm happy to talk about these companies. I'd love any pushback, any criticism. I find it fascinating, and I like to connect with other people interested in this stuff. So thank you, guys. Yep, of course. We should throw a disclosure on this.

We want to remind listeners that Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat Money is not formal advice or recommendation. We are, however, general partners at Arch Capital, so clients may have positions in the securities discussed in this podcast. Thanks again, everyone, for tuning in. And thank you, Devin, for joining us again. And we will see you all next time. Okay, I'm welcomed by the founder of our exclusive sponsor, Stratosphere.io, Brayden Dennis.

Brayden, welcome. I wanted to basically give listeners that are interested in Stratosphere more context around what the platform is. So let's start there. What is Stratosphere? And then why did you decide to start it? Yeah. Thanks for having me. I appreciate it. And I'm glad to be sponsoring the podcast as a listener myself. I like the deep dives. I like the different guests, the different perspectives on some interesting companies. So I think it's a good concept for a podcast, which is kind of what led me down to making Stratosphere in the first place, which was I was making content online and frustrated with the tools that were available to me.

So I started building a very scrappy version of the product just for free, just to figure out how can I overlay 10 years of financial side-by-side up to 35 years we have now, and how can i actually build out a proper database of of company kpis that are not just revenue but like if you're looking at like costco like how many warehouses do they have how many paid members are are in like our costco members or you know if i want to do a comp against like the streaming like how many netflix subs versus uh hbo plus discovery plus no disney plus like how do i build out proper comps of those because those are the metrics that actually move the business those are the ones that actually move the needle more than any like gap financial metric you'll find

and so it started off as just purely a passion project and i figured let's just make the leap into entrepreneurship and uh see where it goes and you know it brought brought us here today yeah and like you mentioned it is the stuff that you can't find anywhere else at least not in a i I mean, you could find it page by page on their financials. Exactly. You can go through 35 PDF filings and find it. Be my guest. And that's basically what we did for a long time. So what do, I guess, maybe describe the pricing model so people know, but you're going to say it, there's a free platform.

What do free users get? Yeah, good thing. Because our mission was to always build a free platform. And so we really kept true to our mission and give like an amazing platform for free, which gives you 10 years of financial statements on 40,000 global security. So we don't list you just to US securities. It's on global stocks. We give you a watch list, the screener, comparisons on competitors, fundamental charting up to 10 years, filings, transcripts. you can look at the press releases right inside the app, news, ETFs, funds, super investors,

hedge fund letters, investor holdings, and financial calendars. Those are all the features you'll get on the free tier. Now, on the middle tier, the personal tier, you're going to unlock up to 35 years of financials and just kind of like nice to have, like quality of life, like notifications being built in, price targets for building models, like business owner mode, where you can hide prices, like kind of like just that next level for individual investors who want to level up. And then the top tier is for like investment teams and professionals who want to unlock that KPI data and request KPI coverage as well. Like a firm will be like, here, we want these 10 names in our coverage and in your coverage. And then you'll have basically our

entire universe that we're looking at, which is great, right? Because like earning season comes around and we have it updated within 15 minutes when Netflix comes out with their net subscriber ads, like it's right there in one place, especially easy to handle around the peak of earning season that matters a lot for these people. And so we have a premium tier for that as well. That's the three plans that are available today. And now a perfect time to shameless plug our code. If you use CCM, you get 15% off any of the paid plans, but I think that covers it pretty well. If you're interested, please go ahead and check out stratosphere.io. We'll have a link in the description as well, but thank you, Braden, for joining us.

Brian, keep it up. I really like what you and Brad are doing and I'll be listening along.