2/13/08

What Happens to Altria & Honeywell Now?

As you may know, Altria (MO) and Honeywell (HON) are being dropped from the Dow Jones Industrial Average on February 19, 2008. They will be replaced with Chevron (CVX) and Bank of America (BAC).

Getting deleted from the DJIA may seem like a bad thing for the stocks, but Mark Hulbert over at MarketWatch.com says this isn't necessarily the case. He examined changes to the DJIA in 1999, when four companies were replaced in the index, and in 2004 when three were replaced.

Hulbert found that the four companies deleted in 1999, Goodyear Tire & Rubber Company (GT), Sears Roebuck, Union Carbide, and Chevron (Chevron is now being added back) have since gained 27% on average. That's not a very good return over nine years (Good Year, for example, is still below what it was in 1999 although it's substantially off its 2003 lows), but the four stocks replacing them in the DJIA, Home Depot (HD), Intel (INTC), Microsoft (MSFT), and SBC Communications--renamed AT&T (T), have since averaged a loss of 40%.

The three stocks replaced in 2004, Eastman Kodak (EK), International Paper (IP), and AT&T (different from the AT&T above), lost 2% on average while their replacements, AIG (AIG), Pfizer (PFE), and Verizon (VZ) on average lost 23%.

While this in no way tells us which direction Altria and Honeywell will go after they're replaced, it shows that being taken out of the DJIA isn't necessarily a bad thing for a stock's price.

Altria

Altria, which sells tobacco products (including the well known Marlboro brand) and holds around 30% of brewer SABMiller, is a company in transition. At the end of March of this year it will spin off its international business, Philip Morris International. As a result its stock price will to around $22, and shareholders will be given a 1 to 1 stake in Philip Morris International, whose stock price will be around $50. That is, suppose you have 100 shares of Altria. After the spin off, you'll have 100 shares of Altria and 100 shares of PMI. The dividend rate will stay the same after the spin off, but PMI will pay $1.84 a share while PMUSA will pay $1.16 a share. PMUSA will have a payout ratio of 75% while PMI will payout 65%. More on the spin off here.

Immediately after the spin off, the value of your holdings should be what they were when Altria was one company. After that, however, it's unclear what will happen. Will investors abandon the domestic for the international company, which has higher growth prospects and a bigger dividend, or will they favor the domestic company, which, because it'll be less leveraged, would likely initiate an aggressive share buyback program? Or will they hold both?

What could make Altria's stock rise

PMI's joint venture with China Tobacco gives it exposure to the world's largest cigarette market, China, which smokes about one third of the world's cigarettes. PMI's market share in Western Europe is around 40%; in South America it's around 60%. PMI should be immune to tobacco litigation in the US.

PMUSA just launched Marlboro Moist, a smokeless tobacco product. The Marlboro brand name and a lower price than its competitors should help PMUSA gain market share in this growing market. In the domestic cigarette market, PMUSA has 50% market share.

Some Potential Problems

There is the perpetual threat of lawsuits domestically. Also, it seems new smoking bans and tobacco taxes are always in the works. Internationally, tobacco will probably be regulated more stringently as well.

In the US and Western Europe smoking is said to be declining (for some reason, though, I see many more people smoking, especially those in their 20s and 30s). Corresponding with this decline there are declines in cigarette sales, which are falling around 2-3% a year.

Although PMUSA and PMI will operate in different markets, they may pose problems for each other in that there will be two companies controlling the same brands.

Honeywell

Honeywell is a conglomerate operating in four segments, aerospace products, products for process controls and various sensing and security instruments, specialty materials, and transportation products.

Honeywell recently bought Maxon Corp, which makes various products for industrial businesses, for around $185 million. Maxon has about $100 million a year in sales. Honeywell has also bought UOP (supplies catalysts to oil and natural gas companies). This has resulted in an operating margin boost for its specialty materials unit.


Good things at Honeywell

Its recent quarterly report was pretty good, with total sales growing by 12% from the previous quarter. Income grew by 26%, and Honeywell's operating margin grew by 1.4%.

Honeywell will supply Airbus with mechanical systems for Airbus' A-350 jet. This could be worth as much as $15 billion over the next 20 years. Strong demand is supposed to continue in the commercial aerospace industry, and Honeywell is the market leader.

Cash flow is going up while debt is staying the same. Moreover, in 2007, Honeywell bought back around $4 billion worth of its shares, and it plans to raise its dividend by 10% for 2008.

Some Bad things at Honeywell

Over the past few years, Honeywell has taken over $4 billion in charges for restructuring. Productivity hasn't yet risen enough to make this worthwhile. Demand in the specialty materials market seems to be slowing. Honeywell's transportation unit's operating margin fell by 1.5% despite sales increasing by 5.9%.