Juul and Pot Are Hazardous to Altria’s Bond Health

(Bloomberg Opinion) -- Altria Group Inc. is looking to the future with its recent acquisition of stakes in e-cigarette maker Juul Labs Inc. and Canadian pot company Cronos Group Inc. Bond investors, though, still seem dubious about the fate of the Marlboro cigarette maker.

The company on Tuesday is set to issue $11.5 billion of senior unsecured bonds in seven parts, which would be the second-largest corporate deal of 2019 behind Anheuser-Busch InBev NV. It includes 40-year debt that yields 320 basis points more than the longest-dated Treasuries. AB InBev, which has nearly identical credit ratings, priced its 40-year bonds to yield 275 basis points more than the benchmark. All else equal, Altria should have received at least as favorable pricing, considering that the average spread on corporate bonds has persistently narrowed in recent weeks since reaching a 30-month high at the start of the year, Bloomberg Barclays data show.

The elevated yield penalty in an otherwise frenetic credit market reflects that Altria has many characteristics that spook investors. Its pro forma leverage, according to Fitch Ratings, has surged to 2.7 times its earnings before interest, taxes, depreciation and amortization from just 1.3 times at the end of the third quarter last year. That’s largely because it’s paying $12.8 billion for a 35 percent stake in Juul Labs and invested $1.8 billion in Cronos. It fell into the lowest investment grade tier less than two months ago after downgrades to BBB by S&P Global Ratings and Fitch Ratings. Free cash flow this year is expected to decline because of much higher interest costs.

Perhaps the most pressing risk, though, is that Altria is firmly in the crosshairs of the Food and Drug Administration, which has suggested that the Juul stake flies in the face of the companies’ commitments to address what health officials have called an epidemic of youth vaping. FDA Commissioner Scott Gottlieb even went so far as to write to the companies last week, saying that within the next 30 days he plans to issue draft rules that restrict sales of most flavored e-cigarette products to vaping shops and online retailers that verify a purchaser’s age. Bloomberg Intelligence analysts released a report Tuesday titled “Juul, Altria Won’t Face E-Cig Ban, Yet Shouldn’t Breathe Easy.”

The same could probably be said for bond investors, though Altria did successfully sell 4.25 billion euros ($4.8 billion) of debt on Monday, its first euro bond offering in 20 years. The company reportedly held calls with investors in both the U.S. and Europe last week. The fact that it took the unusual step of borrowing in euros, when it relies heavily on the U.S. market for sales of its products, could be a sign that it needed to broaden out its investor base to get the deal done.

Altria does deserve some credit — it came to terms with the inevitable decline of traditional cigarettes and quickly diversified into potentially higher-growth businesses. But for anyone fluent in the language of credit-rating agencies, this passage from a Feb. 11 Fitch report speaks volumes about Altria’s current position after the acquisitions.

“Fitch views the execution risk as elevated given the substantial investments for minority stakes in companies at lofty valuations that generate relatively modest to no cash flows and could take significant time to scale up operations and improve profitability. As such, Fitch believes the willingness and urgency by Altria to place such a large bet that broadens the product portfolio speaks to the potential for material long-term erosion of the underlying core businesses from new reduced-risk product technologies, regulatory changes or product substitution.”

The risks are “elevated,” the investments “substantial,” the valuations “lofty,” and the companies offer “modest to no” cash flow. The only reason to quickly acquire the minority stakes, then, is “the potential for material long-term erosion of the underlying core businesses,” namely its Marlboro franchise. As Fitch notes, Juul’s revenue soared to more than $1 billion in 2018, compared with $200 million in 2017, but if that comes largely at the expense of traditional cigarettes, that leaves Altria merely treading water while dealing with a much larger debt burden. S&P, for its part, was more blunt when it downgraded the company in December: “We do not believe Juul or Cronos will provide significant near-term investment returns to Altria.”

That’s a lot of unknown variables, and 40 years is a long time to lend money. Who would have thought four decades ago, when Darrell Winfield was portraying the Marlboro Man, that cigarettes would be in a secular decline? Or, conversely, that several U.S. states would have legalized recreational marijuana? Even Altria’s 10-year debt has a spread that’s 90 basis points more than the average for the Bloomberg Barclays U.S. Corporate Bond Index. The company is in a volatile industry and doing its best to keep up with the ever-shifting landscape.

Fixed-income investors aren’t the type tseek out volatility, though. Altria is the type of established company they can eventually get behind, it just requires a larger cushion to soften the inevitable blows along the way.

Altria: A3 from Moody's, BBB from S&P, BBB from Fitch; AB InBev: Baa1 from Moody's, A- from S&P, BBB from Fitch.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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