Stuart Shaw, CFA

“PM USA estimates that total cigarette industry volume declined approximately 4% in the first quarter. For the full-year 2008, PM USA estimates a total cigarette industry volume decline of approximately 3%.” Altria Group’s tobacco manufacturing and distribution business, PM USA expects this trend to continue with industry shipment volume declining 2.5% - 3.0% annually over the next few years. So, why would anyone own Altria Group (MO)? I do, and here’s why:

Altria dominates the U.S. tobacco industry with powerful brand names. The company has a commanding 50.9% share of the cigarette retail market. Marlboro boasts a 41.5% share. Acquired last December, John Middleton placed Altria in a leading position in the machine-made large cigar market with a 26.8% share. Middleton’s key Black & Mild brand controls 25.9% of that market.

Altria has a fortress balance sheet with lots of cash and low debt. The company ended this year’s first quarter with $4.8 billion in cash and cash equivalents, and long-term debt as a percentage of total capital of 13.5%.

Altria has always been and still is a cash machine. Right out of the box post spin-off the company delivered free cash flow of $1.9 billion in the first quarter.

Management is implementing a strategy that should support earnings growth in a shrinking market. The strategy calls for: cutting expenses at rates that exceed declines in cigarette volume; growing market share; and extending product lines and leveraging distribution through acquisitions and internally developed products.

Here’s how the company is performing so far:

1. Management plans to slice $1 billion out of the company’s cost structure by 2011. Selling, general and administrative expenses will drop by $600 million. Corporate headquarters functions have been restructured, including the relocation to Richmond, Virginia from New York, and should yield annual savings of $250 million starting next year. Another $156 million will come from the closing of the Cabarrus, North Carolina manufacturing facility and subsequent consolidation with the Richmond, Virginia facility by 2010.
2. Market share grew in the first quarter from a year ago. The company’s share of the cigarette retail market gained 0.5% on the back of Marlboro’s 0.7% increase.
3. John Middleton is in a segment of the industry that’s growing 4% - 5% per year. Middleton posted a first quarter volume gain of 8.2% with Black & Mild increasing its market share by 3 points.
4. New products have not worked out so well. Marlboro Ultra Smooth, a high tech filter cigarette, was recently pulled from the marketplace due to low acceptance. Other failures include a cigarette with a battery-powered holder to heat the tobacco, and a spit free chewing tobacco. I believe that shareholders would be better served if management would abandon this part of their strategy and redeploy these resources on what they know and already are doing best.
5. Altria has started 2008 with a solid earnings performance. Earnings per share (adjusted for one-time items and from continuing operations) came in at $0.37 in the first quarter, up 12.1% from the same year earlier period on a 2.8% gain in net revenues. Management affirmed their forecast for 2008 earnings per share at $1.63 - $1.67, for an increase of 9% - 11% off of a 2007 base of $1.50, and set an objective of growing earnings 8% - 10% over the next few years. Projections by Street analysts are at the high end of these ranges.

Altria has a 28.6% ownership interest in SABMiller, the world’s largest brewer. At the end of the first quarter, Altria’s investment in SABMiller was carried on the books at $4.1 billion and had a recent market value of nearly $10 billion.

The company is returning cash to shareholders. The Board of Directors set the initial quarterly dividend at $0.29 per share, and is targeting a 75% payout ratio. They also approved a $7.5 billion share repurchase program to be completed over 2 years. The company began buying back shares in April.

Altria’s shares are attractively valued with a price / earnings ratio and yield that compare favorably with the S & P 500. The shares’ price / earnings ratio, at 12.9x 2008 earnings per share of $1.63, is below the S & P 500’s 14.5x based on S & P’s earnings estimate of $88.04 for this year. The shares also offer a fat 5.5% yield, well above the S & P 500’s 2.4%.

Informed opinion almost always advocates the popular course, so you must steel yourself to stand apart. To be a contrarian is to be an outsider – until you’re proven right.

David Dreman, Contrarian Investment Strategy, 1979

Pfizer (PFE) reached a high of $48 a share in June 2000, and now trades at about $20. Twenty-one analysts are following the stock, but only 6 are recommending purchase. The contrarian investor in me had to take a look.

First, I put Pfizer through the Fast Track screen. The stock passed my rule of failing no more than 3 categories, so I continued to do more research using the Company Stock Risk Profile research tool. While Pfizer came through with a Medium Risk rating, having failed 19 of the 50 categories, the stock missed being rated Low Risk by only 2 categories.

Pfizer’s Risk Profile highlighted these negatives:

1. Pfizer is not delivering any growth, as sales have been essentially flat since 2004. Reported earnings have been extremely erratic, impacted by ongoing “purchase accounting adjustments, acquisition related costs, discontinued operations and certain significant items.” Adjusted for these items, as management does, earnings are smoother, but still are not growing. First quarter 2008 sales declined 5.0%, and reported and adjusted earnings per share dropped 12.8% and 10.3%, respectively.
2. Pfizer is being hurt by multiple patent expirations on very successful pharmaceuticals – Zithromax (antibiotic) in November 2005, Zoloft (depression) in August 2006, and Norvasc (hypertension) in March 2007. Lipitor (cholesterol) produced sales of $12.7 billion in 2007, and its patent is up in March 2010. As an example of what could happen to Lipitor’s sales, Zoloft’s sales went from $3.3 billion in 2005 to $531 million last year. Generics, as well as branded competition, already are eating away at Lipitor’s U.S. sales, which fell 8% in 2007 and 18% in this year’s first quarter.

I’m not presenting anything new here, as these issues are well known and baked into the stock price. The following positive factors also are there for investors to see, but are being overlooked:

1. Pfizer has a fortress balance sheet. The company ended the first quarter with cash and cash equivalents and short-term investments of $28.6 billion, which is up from $25.5 billion at year-end 2007 and $22.5 billion a year earlier. Long-term debt as a percentage of total capital is at a low 10.8%. And if that is not enough, net current assets (current assets less current liabilities) are more than 3 times long-term debt.
2. Pfizer remains a strong cash flow generator. Cash flow from operations was $13.4 billion last year, and after capital expenditures, free cash flow was $11.5 billion. These same numbers in this year’s first quarter were $3.3 billion and $2.8 billion, respectively. 2007 free cash flow could drop 25% and still cover the dividend. Management is forecasting operating cash flow of $17 - $18 billion this year, and expects “to continue to generate strong operating cash flow beyond 2008.”
3. Pfizer has 102 medicines in its pipeline – 47 in phase 1, 37 in phase 2 and 16 in phase 3. Two drugs are in registration. Management’s goal is to have 15 – 20 submissions in 2010 – 2012. Whether any blockbuster drugs emerge is, of course, uncertain. But investors have no expectations anyway, leaving plenty of room for positive surprises.
4. Newer drugs already on board are doing well, and posted robust sales in this year’s first quarter: Lyrica (fibromyalgia) - $582 million, up 47%, Sutent (cancer) - $190 million, up 86%, Chantix (smoking cessation) - $277 million, up 71%.
5. Management is streamlining the company. Costs are targeted to drop by $1.5 - $2.0 billion by the end of 2008, as compared to 2006.
6. Pfizer is a cheap stock. The shares failed only 2 of the 12 Company Stock Risk Profile valuation measures. Pfizer offers a dividend with a juicy 6% yield, which I believe is safe based on the strength of the company’s balance sheet and cash generating capability.

Investors with the fortitude to take the road less traveled should consider Pfizer. Whether Pfizer delivers a positive surprise down the road is anyone’s guess. But if the company should, the stock would be a rewarding investment indeed. In the mean time, you’re getting paid a very attractive dividend and own a stock that I believe has minimal downside risk.

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
John D. Rockefeller

Dividends are real cash in our pockets that we can use to reinvest or spend as we please. They are a clear reflection of management’s confidence in the future of their business.

That’s why Xerox caught my attention when the company announced on November 19, 2007 that it would be reinstating its dividend. Shareholders will be paid their first quarterly dividend in six years on January 31, 2008 amounting to 4.25 cents a share.

I did a quick study using the Company Stock Risk Profile Fast Track. Xerox failed 3 out of 10 categories, so I took a closer look.

Xerox lost money in 2000 and 2001 stemming from both operating and financial problems that surfaced in 1999. Subsequent concerns about the company’s liquidity led to credit ratings downgrades. The stock price reached a low of $3.75 a share in December 2000. Anne Mulcahy was appointed the new Chief Executive Officer the following year.

Ms. Mulcahy set out to turn the company around by cutting costs, redirecting the business to color printing and away from traditional copiers, focusing on cash, strengthening customer relationships, and maintaining research and development to produce new products.

Let’s look at the results:

1. Moody’s upgraded the company’s senior unsecured debt in November 2006 with a positive outlook. Fitch did the same in December 2007 with a stable outlook.
2. Revenues began growing in 2007 after being essentially flat since 2002. Revenues posted increases of 7.2% in the nine months and 11.9% in the third quarter. Post equipment sale and financing revenue are an attractive captive component. Management refers to this as the company’s annuity stream, which accounts for more than 70% of total revenues. In addition, research and development is paying off as two-thirds of equipment sales are coming from products launched in the past two years.
3. Profitability has been improving. Operating profit margins (before taxes and non-operating items) expanded from 8.6% in 2002 to 9.6% in 2006 and 10.3% in the latest 12-months.
4. Cash flow is healthy. The company is projecting cash flow from operations of $1.6 billion this year, up from an estimated $1.5 billion in 2007, and $1.4 billion in 2006.
5. Earnings are growing. Adjusted for tax benefits and other one - time items, earnings per share increased 16.7% to $1.05 in 2006. Reported earnings beat the Street’s consensus estimates for the last four quarters. Management is forecasting double - digit earnings growth going forward, averaging 12% through 2009.

Although the fundamentals are moving in the right direction, I would like to see a stronger balance sheet. Long-term debt as a percentage of total capital, at 49.4% at the end of last year’s third quarter, is on the high side of my comfort level. Cash on hand ended the third quarter at $848 million, which is down from $1.5 billion at the end of 2006 and $1.3 billion a year earlier.

What does management think? Ms. Mulcahy offered the following advice to CEO’s in a Wall Street Journal interview last November: “….don’t rush to reinstate the dividend until your recovery is rock-solid.” She backed up her confidence about Xerox’s prospects by adding 10,000 shares to her existing holdings last August. Lawrence Zimmerman, Chief Financial Officer, also purchased 10,000 shares, and Ursula Burns, President, bought 5,000 shares.

What does the Street think? Ten analysts are covering Xerox. Five analysts rate the stock hold, and one analyst is carrying an underperform rating. There’s ample room for expanded coverage and ratings upgrades. One analyst upgraded the stock from sell to hold last October, and another initiated coverage with a buy rating last November.

Xerox has a Medium Risk Company Stock Risk Profile rating. Having failed 19 of the 50 categories, the stock missed being rated Low Risk by two categories. Valuation was a standout variable with the stock failing only two of the 12 valuation categories.

Those who recognized Xerox’s turnaround early and had the fortitude to buy and hold made a lot of money. While it may look like the easy money has been made, and maybe so, the company’s improving fundamentals still have yet to be fully reflected in the stock price.

As investors, we are always looking for purchase candidates. At the same time, we are literally inundated with possible ideas from many sources: the media (print, web and TV), companies we deal with every day, and tips from stockbrokers, financial advisors, friends and relatives. I use the Company Stock Risk Profile Fast Track™ stock screen to help me quickly and easily filter out all this noise and focus my search. Stocks that pass this screen are filtered again as I put them through the entire Company Stock Risk Profile™ research process. Using these investment tools, my search for potential purchase candidates is organized, disciplined and objective.

To illustrate, in my July 2007 article, “The Dow on Fast Track”, I screened 30 Dow stocks using he Company Stock Risk Profile Fast Track™ and uncovered six possible ideas: Boeing, Disney, Exxon, Hewlett Packard, Pfizer and Wal-Mart. I then researched each of these stocks using the Company Stock Risk Profile™.

Disney was the only stock that got a Low Risk Profile rating, having failed 17 of 50 categories. The range for a Low Risk Profile rating is failing 0 – 17 categories.

Disney is one of the great brand names, and it cannot be duplicated. The company’s history is all about delivering creative product by successfully leveraging brand power using multiple platforms and technologies. This is at the core of the company’s vast entertainment franchise, which today spans media (internet, cable and network broadcasting), parks and resorts, movies (animation and live) and consumer products.

But stocks with Low Risk Profile ratings do not automatically get on my list of purchase candidates. They must have strong operating and free cash flow and a solid balance sheet, as these strengths are vital for a company to successfully compete in its markets and grow.

Disney has been demonstrating these strengths. Cash from operations rose to $6.1 billion in fiscal 2006 from $2.3 billion in fiscal 2002, and continued to grow to $6.3 billion in the latest 12-months. Although free cash flow (cash from operations less capital expenditures), at $4.7 billion, was about flat in the latest 12-months as compared with fiscal 2006, it also showed strong growth from $1.2 billion in fiscal 2002. Cash also has been flowing onto the balance sheet having ended the June quarter at $3.4 billion, up from $2.0 billion a year earlier. While the Company Stock Risk Profile™ favors companies with percentages of long-term debt to total capital of 20% or lower, Disney’s 27.1% is still quite sound.

Disney’s operating performance has been favorable. Supported by substantial profit margin expansion from operations, that is before non-operating items and taxes, return on equity rose consistently from 5.7% in fiscal 2003 to 11.6% in fiscal 2006, and continued to climb to 14.6% in the latest 12-months. Reflecting this performance, Disney reported positive earnings surprises versus Street estimates for each of the last four quarters.

Disney’s quality and sound fundamentals also come with a stock that offers good value. The Company Stock Risk Profile™ has 12 valuation categories, and the stock failed only two.

Street opinion about the stock is divided. Twelve of the 28 analysts covering Disney rate the stock hold and one analyst is recommending sell. There is ample room for ratings upgrades. Two brokerage firms initiated coverage in September with buy ratings.

I am concerned about how a slowing economy or a recession would impact the company, particularly the theme parks and resorts. Tom Staggs, Disney’s Chief Financial Officer, stated at a Merrill Lynch media conference on September 17, 2007 that bookings for the fourth calendar quarter are up over last year, and that “there’s no current evidence of a downturn”. Nevertheless, Disney’s products and services are not necessities. A trip to Disney World can be easily postponed when times get tough.

I believe Disney is a good idea. I used the Company Stock Risk Profile’s™ stock screen and research tools to find Disney and focus on the key variables. Admittedly, I am biased since I developed these tools. Use the research tools and methods that are right for you. What is most important is doing the research so that you know what you are buying and the risk you are taking.

Early April we learned that Warren Buffett’s Berkshire Hathaway spent $3 billion for an 11% ownership position in Burlington Northern Santa Fe (BNI), one of the country’s major railroads. The stock jumped 6.5% on the announcement reflecting the perception that if Buffett owns this stock, it must be a good investment.

While we should look to a great investor, such as Buffett, for ideas, we should never invest blindly without knowing what we are buying. Moreover, he purchased the stock at lower prices, and his investment objective and tolerance for risk may not be the same as ours.

Not knowing anything about Burlington Northern, except that it is a railroad, I used the Company Stock Risk Profile™ research tool to find out for myself. The stock’s rating was Medium Risk, having failed 20 out of 50 categories (the range for Medium Risk is failing 18-33 categories). Here are the key points.

POSTIVE:

Burlington Northern has a leading market position in its industry with 32,000 route miles in 28 states and two Canadian Provinces. The company ships a diversified range of products in the industrial, agricultural, consumer and energy sectors. Corn, ethanol, petroleum products and coal caught my attention. Most of the coal comes from the Powder River Basin of Wyoming where the coal is low in sulfur and in high demand.

The company has been generating a lot of cash. Consistently growing since 2002, cash from operations amounted to $3.1billion in 2006, up from $2.6 billion in 2005. Subtracting capital expenditures from cash from operations, free cash flow totaled $1.1 billion last year. The company started 2007 on a strong note with cash from operations at $1.1 billion and free cash flow at $ 611 million in the first quarter.

Burlington’s shares still represent good value. The Company Stock Risk Profile™ uses six valuation methods encompassing 12 catergories giving a comprehensive result. Burlington failed 4 of the 12 catergories.

NOT SO POSITIVE:

The balance sheet was not as strong as I expected. Long-term debt as a percentage of total capital ended this year’s first quarter at 39.8%. While certainly not onerous, long-term debt is not at a level that I would consider low risk. The current and quick ratios are at .56 and .41, respectively, well below the 2.0 and 1.0 that I like to see.

Earnings performance has been somewhat of a mixed bag. Relative growth in earnings per share has been unremarkable as Burlington’s growth rate for the last five years has been only about on par with the railroad industry and the S&P 500. Return on equity, the bottom line measure of a company’s profitability, has been higher than the industry, but below the S&P 500. While reported earnings have not disappointed the Street, the consensus earnings estimate has been declining for this year and next.

Management has been consistently selling stock for the last 12 months. It would appear that management may have a less positive view about Burlington’s prospects than Buffett.

To gauge potential buying power for a stock I look at Street coverage and institutional ownership. I like to see less than half the analysts following a stock recommending purchase and less than 50% of the outstanding shares owned by institutions. Of the 19 analysts covering Burlington, 8 are recommending purchase. But institutional investors hold 74% of the outstanding shares.

Why did Buffett buy such a large position in Burlington Northern now, and not, for instance, in 2004 at less than half the current price? What could be changing perception? One idea I would propose is that railroads are a more energy efficient way to transport goods. Taking this theme a step further, rising demand for rail transportation would make the industry less cyclical leading to higher valuations for the stocks.

Based on this investment theme Burlington’s fundamentals and investor perception should move in a favorable direction. Valuation measures are positive and there’s room for ratings upgrades. I’m going to carefully consider Burlington Northern’s shares for inclusion in my portfolio.

Change moves stock prices. Let’s look at McDonald’s. The shares dropped precipitously from a high of $48 in November 1999 to a low of $12 in March 2003. In January 2003 Jim Cantalupo, a former McDonald’s president, came out of retirement to take over as CEO. He stopped the slide in profitability that began in 2001 and positioned the company for significantly higher returns. Mr. Cantalupo’s return to the company was the inflection point of major positive change at McDonald’s. Sales and profitability have been expanding since.

Reflecting McDonald’s turnaround, the shares currently are trading at $32. I put McDonald’s through the scrutiny of the Company Stock Risk Profile’s™ 50 category analysis. The shares came out with a Medium Risk Profile rating. This doesn’t seem intriguing at first glance, but let’s look behind the rating:

1.  The company failed 5 out of 7 categories under profitability, namely producing profit ratios below historical performance and relative to the industry and S&P 500. But McDonald’s has been in a turnaround mode, and what’s important here is the positive change occurring in margins and return on equity. Furthermore, since the current level of profitability is considerably lower than what McDonald’s has been able to achieve in the past, there still is room for improvement.
2. I would prefer a much lower long-term debt to total capital ratio than 40.1%. However, McDonald’s generated $2.7 billion in free cash flow in the latest 12-months through last year’s third quarter, up from $2 billion in 2003. Cash on the balance sheet grew to $1.6 billion at the end of the third quarter, up substantially from $493 million at year-end 2003. Reflecting management’s confidence in the business and continuing strong cash flow, the company boosted the annual dividend 38% to $0.55 per share last September, and this was on top of a 67% increase in 2003.
3. I like to see no more than 50% of the analysts covering a stock recommending buy. While the percentage for McDonald’s is 57%, there still is plenty of room for upgrades. An upgrade to buy just came through the other day. Although gradual, earnings estimates have been moving higher also.
4. McDonald’s failed only 3 out of 12 valuation categories. The company’s improving fundamentals have yet to be fully reflected in the share price.

It is not often that an industry leader with a solid franchise falls into the rubble pile as McDonald’s did a few of years ago. Those investors who found the stock there were richly rewarded. McDonald’s turnaround is now well on its way. While the easy money has been made, the shares continue to offer good value.

I looked in the rubble pile, and I found Merck. It isn’t often that a quality, large-cap issue winds up here. Merck got hit with what drug stock investors dread – product recall. The company had to withdraw its Vioxx painkiller from the market due to potential cardiac problems. Generating $2.5 billion in sales, Vioxx was a blockbuster drug. The stock is down nearly 40% since the announcement on September 30.

What do the company and stock look like now? I processed all the key data and information through the Company / Stock Risk Profile™ to get an objective assessment. Merck failed 16 out of 50 categories giving a “Low” Risk Profile Rating.

Merck remains a leading company in its industry. The balance sheet is solid. Cash from operations and free cash flow, although both are down some in this year’s nine months, continue to be strong. Profitability measures outpace the Industry and the S&P 500. The Company / Stock Risk Profile™ uses six methods to value stocks. Merck passed with flying colors, except for one. The stock failed the PEG ratio (P/E / Earnings Growth Rate) because Street analysts have slashed their long-term forecasts for earnings growth. Most analysts have abandoned Merck. Only 3 analysts are recommending purchase out of a total of 29 analysts covering the stock, according to Yahoo! Finance. The Company / Stock Risk Profile™ rates this an important positive factor. See “Know a Stock’s Street Sponsorship to Anticipate the Potential for Change” posted on the Articles page of this website.

The principle issue is litigation from Vioxx users who suffered cardiac events. While the impact on the company could be substantial, it is an unknown variable. I expect the uncertainty to hang over the stock for some time. However, the shares, yielding a hefty 5.5%, may appeal to a contrarian investor taking a long-term view and with the stomach for a potentially highly volatile stock as litigation proceeds.