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Altria, Philip Morris reunion could strengthen smoke-free tobacco future

A merger between Altria Group Inc. and Philip Morris International Inc. could strengthen the global reach of the tobacco giants at a time when the industry faces declining traditional cigarette sales and intense scrutiny on newer smokeless products, analysts said.

But a combined company, which would be worth more than $195 billion based on current market caps, could face a more aggressive regulatory environment as health concerns mount over vaping, and Altria and Philip Morris team up to launch a new smoke-free product in the U.S.

The tobacco giants announced Aug. 27 ongoing discussions of a potential all-stock merger of equals. The companies are weighing the merger more than a decade after Altria spun off Philip Morris International to handle cigarette sales outside the U.S. in 2008.

Since the spinoff, the market for traditional cigarettes has increasingly declined as the health risks of smoking have become more widely known and a number of states have raised the smoking age to 21. Another factor in play is the rise in popularity of e-cigarettes and the subsequent backlash against uncertainty over the public health risks they create.

"A potential Philip Morris and Altria merger would create a combined entity with a strong business profile and robust position in the heated tobacco and vaping sectors, through Altria's stake in Juul Labs, as well as in the declining combustible tobacco business," Moody's Senior Vice President Roberto Pozzi said in an Aug. 27 statement.

A closer look

The companies declined to comment to S&P Global Market Intelligence about further details of a potential merger.

However, Philip Morris could control about 59% of the combined company under a merger, The Wall Street Journal reported Aug. 27, citing unnamed sources. The all-stock deal would not include a premium to shareholders in either company, the Journal reported.

Philip Morris shares closed down 7.8% on Aug. 27 to $71.70 while Altria shares dropped 4% to $45.25 after initially spiking following news of the potential deal.

Since splitting in 2008, Philip Morris' global footprint has led to higher revenue and net profit than Altria's business, which is limited to the U.S., according to financial data compiled by Market Intelligence.

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In 2018, Philip Morris reported $29.63 billion in total revenue and $7.91 billion in net income. Altria reported $19.63 billion in revenue and $6.96 billion in net income for the same year.

Stocks in both companies have more than doubled in value since the split. Altria shares jumped 284.8% since March 31, 2008, through Aug. 26, while Philip Morris shares rose 154.9% in the same window.

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A boon to both

Some analysts have anticipated a merger for years even as the announcements confirming the talks raised eyebrows about some of the specifics.

"We think it does make sense, more so for Altria because they've seen sales decline for many years now," Garrett Nelson, a CFRA analyst, said in an interview.

A merger also makes sense for Altria because its investments in e-cigarette startup Juul Labs Inc. and Canadian cannabis producer Cronos Group Inc. significantly expanded its debt load, Nelson said. The company spent $12.8 billion for 35% of Juul and another $1.8 billion for a 45% stake in Cronos.

A merger with Philip Morris would help speed along the time needed to get a return on those investments, Nelson said. Philip Morris could stand to gain by leveraging the investments in Juul and Cronos in non-U.S. markets where Philip Morris already has a presence, Nelson said.

Nevertheless, the merger could be a tough sell for shareholders skeptical of why Philip Morris needs to expand in the U.S. market, Nelson said. The announcements of the merger talks described a potential merger of equals, yet Philip Morris is valued at $111.55 billion compared with Altria's $84.42 billion valuation, according to Market Intelligence.

The difference in market capitalization implies that Philip Morris would possibly be paying a significant premium in a merger of equals, Nelson said.

Still, the combined company would benefit from greater scale in the competition for reduced-risk products, a stronger and more predictable cash flow, and a more diversified geographic exposure to reduce the impact of currency exchanges, Wells Fargo Senior Analyst Bonnie Herzog said in an Aug. 27 note.

"We see significant value creation for shareholders," Herzog said.

Smoke-free future

Philip Morris' expansion of its IQOS device around the world has led to growth in its smoke-free products. IQOS heats a tobacco plug without igniting it to produce flavored vapor.

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The growing heated tobacco business accounted for 13.8% of Philip Morris' revenue in 2018. Altria recorded 10.9% of its revenue from smokeless products in the same year, including chewing tobacco, snuff and its now-discontinued e-cigarette line.

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Philip Morris sells its flagship smoke-free device called the IQOS in at least 40 countries as of July. Altria is also handling the marketing of the IQOS in the U.S., where it will be introduced in September.

Altria is also growing its access to smoke-free products through Juul and Cronos.

But e-cigarettes have come under greater regulatory scrutiny in the U.S., where teen vaping has been declared an epidemic and the first death tied to e-cigarette use was recently reported. Outside the U.S., India is reportedly considering a ban on the production and import of electronic cigarettes.

An Altria-Phillip Morris International merger could be seen as a strange option in light of the ongoing regulatory scrutiny of Juul in the U.S., Ryan Tomkins, a Jefferies analyst, said in an Aug. 27 note.

"Maybe [Philip Morris] are willing to take this risk as they believe it can easily be offset by the potential international opportunity for Juul under their distribution and the value of fully owning IQOS in the world's biggest reduced risk market," Tomkins said.

There could be significant disagreement over the valuation of Altria's and Philip Morris' newer smokeless products as well as the uncertain impact of future regulatory actions, S&P Global Ratings analysts Barbara Castellano and Brennan Clark said in an Aug. 27 note.

"We believe there will be significant roadblocks to completing the transaction," they said.