Altria Group, Inc.

And welcome to the Altria Group 2018 Fourth Quarter and Full Year Earnings Conference Call. Today's call is scheduled to last about one hour, including remarks by Altria's management and a question and answer session. In order to ask a question, please press star followed by the number one on your touchtone phone at any time. Representatives of the investment community and media on the call will be able to ask questions from the conclusion of the prepared remarks. I would now like to turn the call over to Ms. Paige Magnus, Vice President of Communications for Altria Client Services. Please go ahead, ma'am.

Good morning. Thank you for joining us. We're here this morning with Howard Willard, Altria's CEO, and Billy Gifford, our CFO, to discuss Altria's 2018 business results and provide a deeper dive on the Juul opportunity and Kronos. Earlier today, we issued a press release providing these results, which is available on our website at altria.com and through the Altria Investor app. During our call today, unless otherwise stated, we're comparing results to the same period in 2017. Our remarks contain forward-looking and cautionary statements and projections of future results. Please review the forward-looking and cautionary statements section at the end of today's earnings release for various factors that could cause actual results to differ materially from projections. Future dividend payments and share repurchases remain subject to the discretion of Altria's The timing of share repurchases depends on marketplace conditions and other factors. Altria reports its financial results in accordance with U.S. generally accepted accounting principles. Today's call will contain various operating results on both a reported and adjusted basis. Adjusted results exclude special items that affect the comparability of reported results. Descriptions of these non-GAAP financial measures and reconciliations are included in today's earnings release. With that, I'll turn the call to Howard.

Thanks, Paige, and good morning, everyone. This morning, I'll focus on addressing key questions we've been getting, including our outlook for cigarette volumes, our strategic investments in Juul and Kronos, and the current regulatory environment. I'll also review our guidance for 2019. Billy will then briefly highlight our 2018 performance. We've included some slides to accompany some of my remarks. Altria closed out 2018 with excellent full-year adjusted diluted EPS growth of 17.7%, and we continued to reward shareholders by returning $5.4 billion in cash through dividends. PMUSA stabilized Marlboro and strengthened our combustible business. We also took proactive steps that we believe uniquely position us for long-term success. Altria enters 2019 with an evolved business platform that includes our strong core tobacco businesses and new strategic investments with tremendous potential for growth. First, our operating companies continue to give us the industry-leading portfolio in the U.S. through Marlboro, Black & Mild, Copenhagen, and hopefully soon, IKOS. But now, beyond these brands, our investments in Juul, as well as Kronos, once closed, give us exposure to new growth opportunities while also further diversifying our future income streams. The decision to pursue these investments stems from a desire to enhance Altria's long-term earnings and dividend growth, while also making progress on our harm reduction aspiration. to help adult consumers switch from combustible cigarettes to noncombustible alternatives. We believe that Juul and Kronos present unique opportunities to meaningfully participate in fast-growing adjacent categories. Before offering additional detail on the investments themselves, let's discuss the dynamics affecting U.S. cigarette category volumes and our outlook. The U.S. cigarette category is large and resilient and has absorbed many shocks over time. And despite significant evapor acceleration in 2018, the U.S. cigarette category volume decline rate accelerated only modestly from the recent long-term decline rate of 3% to 4%. Let's look at the last two years for some context. In 2017, we estimated that U.S. cigarette industry volume declined by 4%, which reflects the impact of a disruptive $2 per pack California state excise tax increase in the second quarter and initial signs of the e-vapor category returning to growth during the second half of the year. In 2018, Record growth in eVapor of approximately 35% and higher gas prices accelerated U.S. cigarette industry volume declines outside the 3% to 4% range to a decline of 4.5%. Given the significant interest in cigarette category fundamentals, let me provide perspective on the specific drivers of the decline rate and our outlook for 2019. We've previously cited a secular decline rate within a 2% to 3% range. This rate includes smokers who reduce their consumption, those who stop using tobacco products, and smokers moving to other tobacco categories. In 2018, we estimate that the secular decline rate was elevated due to increased movement by adult smokers across categories, which historically accounted for about one percentage point of the 2 to 3 percent secular rate. This acceleration is largely attributable to evapor category growth, especially in light of the decline in the smokeless category in 2018. In total in 2018, we believe evapor represented the vast majority of the one percentage point component plus an additional three-tenths. Of course, other factors also affect the decline rate. In 2018, we believe macroeconomic factors, specifically gas prices, accounted for about half a percentage point additional headwind on cigarette volumes. We believe the price elasticity component of the decline rate remains consistent with our long-term estimate of negative 0.3. Looking forward, we'll continue to closely monitor the various factors at play. We watch, for example, excise taxes at both the federal and state level, gas prices, economic conditions affecting the adult tobacco consumer, like housing starts, unemployment rates, and consumer confidence, and the regulatory environment. We also know that over half of adult smokers are looking for alternatives. With the recent evapor growth almost entirely driven by Juul in 2018, and more alternative tobacco products available in the marketplace, we expect the 2019 U.S. cigarette industry volume decline rate to be in a range of 3.5% to 5%. This range, this wider range, covers a potential for higher levels of adult smoker trial of and conversion to noncombustible products similar to 2018. For 2019 through 2023, our estimate for average annual U.S. cigarette industry volume declines is 4% to 5%. Let's now move to our recently announced strategic investments, starting with Juul. Through Juul, we have found a unique opportunity to not only participate meaningfully in the eVapor category, but to also support and even accelerate transition to non-combustible alternative products by adult smokers. The JUUL investment provides Altria with a significant stake in the largest and fastest growing evapor company with a highly talented management team, successful in-market products, a strong innovation pipeline, and significant international opportunity. When you add to JUUL's already substantial capabilities, our underage tobacco prevention expertise and ability to directly connect with adult smokers, we see a compelling future with long-term benefits for both adult tobacco consumers and our shareholders. We are excited about JUUL's domestic growth and international prospects and their potential impact on our investment. JUUL's 2018 growth was quite remarkable. Juul had net revenues in excess of $1 billion in 2018, up from approximately $200 million in 2017. Juul overwhelmingly re-accelerated the U.S. eVapor category growth rate, growing Juul's volume by nearly 600% to over 450 million refill kit pods. We estimate Juul represents over 30% of the overall eVapor category across open and closed systems and all trade classes. After evapor growth plateaued from 2015 to 2017, rapid growth was reignited in 2018, and we expect U.S. evapor volume to grow at a compounded annual rate of 15 to 20 percent through 2023. As a reminder, Altria's share of JUUL's international evapor income would be 100 percent incremental to Altria. We believe the global evapor and heat-not-burn segments, with estimated sales of roughly $23 billion in 2018, have substantial room to grow. Juul currently operates in eight countries with plans for additional expansion this year. We expect the Juul product features that have driven Juul's success in switching adult smokers in the U.S. to strongly appeal to international adult cigarette smokers. And Juul has designed products in international markets to meet applicable regulatory requirements and also has significant new innovations in its pipeline. Though still early days, some information from recent launch markets shows rapid growth and helps affirm our assumptions that Juul's product development and commercialization capabilities can solve for different regulatory restrictions and adult consumer preferences. Let's look at two examples. First, in Canada, while distribution is limited, Juul reports that retail takeaway grew to more than 60% dollar share in stores selling their products after only three months at retail. Juul is also seeing encouraging performance where they have achieved distribution in Europe. For example, in the Sainsbury chain in the UK, Juul tells us that it recently became the number one eVapor brand in the chain. with a dollar share in excess of 23% in less than 12 weeks after launch. And just to remind you, the UK operates under the Tobacco Products Directive adopted by many EU countries, which limits the nicotine concentration level. Ultimately, we expect the international revenue and income opportunity to end up being as large as or larger than the US opportunity. Our 35% investment was based on a deep strategic, operational, and financial analysis of Juul and the marketplace. Clearly, we look at this opportunity over the long term, but for context, let us provide a view five years out. Some of our independently developed key assumptions over the next five years that informed that analysis include... A U.S. eVapor category that grows volume between 15% to 20% annually. Juul continuing to be the primary growth driver for the eVapor category. Attractive Juul operating margins that achieve current cigarette-like margins due to the benefits of increasing scale and automation in the supply chain. International revenues that equal domestic revenues by 2023. and international margins that approach current international cigarette margins. Under our assumptions, our investment in Juul would generate an after-tax return exceeding our weighted average cost of capital in 2023. Additionally, with five-year eVapor category volume growth in the range of 15% to 20% annually, we would expect the U.S. cigarette category volume decline rate to be consistent with a decline rate estimate of 4% to 5%. I'll remind you that in 2018, with eVapor category volume growth of 35%, the cigarette category decline rate was 4.5%, including a half of a percent headwind from gas prices. Combined with the earnings and cash generation engine of our core tobacco business, We believe this investment in JUUL will support consistent returns over the long term by providing Altria with a significant stake in the fast-growing evapor category. Briefly touching on the regulatory environment, the FDA and many others are concerned about an epidemic of youth evapor usage. We share those concerns. This is an issue that we and others in the industry must continue to address aggressively and promptly. We understand that the long-term opportunity of tobacco harm reduction is threatened by continued underage use. Juul has already taken significant action to address these concerns. Today, it remains the only evapor company to have stopped shipping flavored products other than tobacco, menthol, and mint to retail. These shipments stopped on November 13th. Juul has taken additional steps to enhance its online age verification processes for sales on its website to adult tobacco consumers 21 years of age or older, as well as developing a restricted distribution system for retailers. Juul has also halted all promotional use of U.S. social media platforms and will continue to monitor and remove inappropriate material from third-party accounts. Ann Jewell is developing new technologies to further restrict youth access. We know more can and must be done. That's why we're engaged in unprecedented efforts at the federal and state level to raise the minimum legal age to purchase all tobacco products to 21. We believe it is the single most important step we can take today and will be stepping up our efforts in the coming months. Already this year, we are supporting legislation raising the legal age in both Washington State and Virginia, and we continue to engage nationwide in this effort. We recognize that some of these actions may impact the short-term growth of the eVapor category. We also know that preserving the long-term opportunity of harm reduction for adults is critical. We remain committed to being part of the solution to this issue. Farm reduction remains central to our view of the future for the tobacco industry. In addition to the significant opportunity presented by eVapor, we remain very excited about the prospects for heat-not-burn in the U.S. It is now approaching two years since PMI submitted the ICOS PMTA, and we are fully prepared to commercialize ICOS in the U.S., We remain fully committed to the success of ICOS in the U.S. and are excited to deploy our robust commercialization plans. PMUSA is establishing brick-and-mortar stores, including locations in multiple cities, within the first year of launch. They've already hired personnel to support prelaunch activities and are collaborating with key partners to best position ICOS at retail. Let's now turn to Kronos. While the transaction is subject to customary closing conditions and expected to close in the first half of 2019, Altria's agreement to acquire a 45% stake in Kronos with a warrant to achieve majority ownership will create a new growth opportunity in an adjacent category poised for rapid growth. It complements our strong core tobacco businesses and expands our income opportunity beyond the U.S., After years of evaluating adjacent opportunities, the cannabis category is quite attractive and delivers on some key considerations, including accretion to our long-term financial performance and synergy with Altria's capabilities, allowing our combined resources to accelerate Kronos' growth. While a range of estimates exist, a recent third-party report projects the 10-year global cannabis revenue opportunity to be in a range of $40 billion, under a similar legal landscape to today, to more than $250 billion, assuming a fully legal market worldwide. We believe the growth opportunities are significant and will extend across the globe as cannabis markets open. Selecting the right partner in this category was critical, and we've done just that. Kronos' strong management team has built unique capabilities to compete globally across the medicinal, recreational, and nutraceutical categories. Our investment will allow Kronos to more quickly expand its global footprint and production capacity. We also expect it to accelerate the execution of its strategic initiatives, including investments in cannabinoid innovation and developing differentiated products and brands across medicinal and recreational categories. We look forward to helping Kronos realize its significant growth potential. In summary, 2018 was a transformative year for Altria. We are pleased with the performance of our core tobacco businesses as PMUSA stabilized Marlboro through its equity investments. We made strategic investments in rapidly growing categories that we believe strengthen our long-term financial profile, enhance our growth prospects, and better position the company to deliver long-term value to shareholders through earnings growth and dividends. And of course, we had significant earnings growth and increased our dividend twice. We look forward to sharing more with you at Cagney in a few weeks. Turning to 2019 guidance, we expect to deliver full year 2019 adjusted diluted earnings per share of $4.15 to $4.27. This range represents a growth rate of 4% to 7% from a 2018 adjusted diluted EPS base of $3.99. Our guidance reflects our expectation for a higher full year adjusted effective tax rate, primarily resulting from lower dividends from AB InBev. It also includes increased interest expense from the debt incurred related to the Kronos and Juul transactions, although we expect that expense to be mostly offset by savings from our previously announced cost reduction program. Our plans also take into account increased investments related to PMUSA's lead market plans for ICOs, once authorized by the FDA. And lastly, our guidance assumes little to no earnings or cash contributions from the Kronos and Juul investments. In the first quarter, we'll have the increased interest expense without the full benefits of our cost reduction program and one fewer shipping day in the smokable segment. Therefore, we expect the growth to come in the last three quarters of the year. We have a proven track record of delivering against our objectives. and we maintain our long-term financial goals to grow adjusted diluted EPS at an average annual rate of 7% to 9% and to maintain a dividend payout ratio target of approximately 80% of adjusted diluted EPS. I'll now turn it over to Billy to provide more detail on our 2018 results.