News and Research for Dividend Select Portfolio Holdings
Final Nail in the Coffin for Altria's Juul Investment, but FDA Ban Has Little Impact on Our Valuation
by Philip Gorham, CFA, FRM | Morningstar Research Services LLC | 06-23-22
The U.S. Food and Drug Administration, or FDA, may be about to drive the final nail into the coffin of Altria's investment in Juul Labs, after The Wall Street Journal reported on June 22 that the U.S. regulator is likely to order the removal of all remaining Juul products from the U.S. market. We have long been skeptics of Juul's outlook, and our $52 per share fair value estimate of Altria assumes Juul would barely be profitable throughout our forecast period. Therefore, the removal of Juul's contribution to Altria's earnings, which Altria reports as equity income, has no impact on our valuation. Although the 9% decline in the share price following the report seems like an overreaction, it probably reflects the deflation of optimistic assumptions around Juul and surprise at the blanket ban, as well as a reminder of the regulatory risk that accompanies investments in the tobacco sector. Our capital allocation rating of Altria remains Poor.
When Altria acquired a 35% stake in Juul for $12.8 billion in late 2018, management justified the valuation with highly optimistic cash flow assumptions that assumed generous commercial opportunities but overlooked the high-probability risk of regulatory intervention in the e-cigarette category. When the FDA subsequently intervened to limit fruity and sweet flavored nicotine liquids, sales of Juul plummeted and multiple write-downs followed. The carrying value of Altria's investment at the end of the first quarter was just $1.7 billion, and we now expect that to be written off in full if the FDA proceeds with a ban. An outright ban of all Juul products is a surprise, even to us, and is a clear indication of a more hawkish FDA. We had expected Juul to be allowed approval for a portfolio limited to tobacco flavored liquids. Now it seems the only opportunity for Juul to create value may be in international markets, but we expect other regulators to take a similar stance to the FDA in limiting the marketing of e-cigarettes to minors.
The ban on Juul will impact Altria but may create a volume opportunity for competitors. British American Tobacco, or BAT, and Juul are very close in terms of volume leadership in the U.S. market, and some of Juul's lost volume may be picked up by BAT, Imperial Brands and Japan Tobacco. However, we remain skeptical that vaping will ever be accretive to margins, so this is not likely to be an earnings driver for any of Altria's competitors. We expect Philip Morris International, or PMI, to be minimally affected, but if the deal to acquire Swedish Match goes through, it will have exposure to the U.S. market through the ZYN snus brand and the America's Best Chew chewing tobacco brand. The FDA statement refers specifically to "cigarettes and other combusted tobacco products," which suggests it may not be targeting chewing and other oral tobacco products at this time. U.S. regulation is a risk that should not be completely overlooked by investors valuing PMI, but thanks to its strategy to invest heavily to diversify its portfolio away from cigarettes, and its limited U.S. exposure, PMI appears to be the safest way for investors willing to own tobacco stocks to mitigate FDA risk.
A more broad-based risk to the U.S. industry is the FDA's long-mooted plan to reduce nicotine in tobacco products. The regulator indicated this week that it intends to introduce a maximum nicotine level that would make cigarettes nonaddictive or minimally addictive. The statement was vague on how such a rule would be implemented, and we believe an effective date remains several years away. Our base case forecasts for the tobacco companies already assume mid-single-digit cigarette volume decline rates in developed markets, and we make no changes to those assumptions as a result of the FDA's statement. We think the impact to volume could be mixed. While it is likely to cause the cessation rate to accelerate, those that continue to smoke may consume more cigarettes in order to sustain
their previous level of nicotine intake.
Bank Stress Tests 2022; Higher Stress Capital Buffers Likely Coming As CET1 Drawdowns Increase
by Eric Compton, CFA | Morningstar Research Services LLC | 06-23-22
We went into this year's Federal Reserve bank stress tests expecting a bit more pressure on stress capital buffers as multiple banks had warned in the preceding quarter that their SCB was likely to increase. This is indeed what played out, as we estimate that roughly seven of the 20 U.S. banks we cover that participated this year are likely to see a higher SCB once the assigned SCBs become official. It appears that JPMorgan, Bank of America, and Citigroup are all likely to see increases to their SCBs of close to 1% each. The biggest increase seems likely to come from M&T Bank, which we expect to increase close to 2.2%, going from 2.5% to roughly 4.7%. Meanwhile, we expect the SCB for 11 of the 20 U.S. banks we cover to remain stable, including for Wells Fargo, which had previously warned that their SCB could go up, so this is a slight positive surprise for the bank in our view. Finally, we think Goldman Sachs could see a slight decrease to its current SCB of 6.2%, potentially declining to 6%, while Discover could see a more material decline, going from 3.6% to 2.5%.
While higher SCBs on average was one key theme, we think the second is that there simply is not as much room for capital return in general. Going into the stress tests, many banks were already close to or even below their targeted common equity Tier 1 ratios. After last year's tests, we calculated that roughly 5% of market cap was the average amount of excess capital per bank, whereas this year it is sitting at less than 2%. This has been driven in part by rising rates and the effects on accumulated other comprehensive income and also growing balance sheets. Several banks have also raised their common equity Tier 1 ratio targets as they prepared for potentially higher SCBs and also higher GSIB buffers in 2023 and beyond. We think the tests signal once again that the banking sector is in a good place to withstand a recession, but don't expect a share repurchase boom for the foreseeable future.
Thirty-three banks participated this year, compared with 23 last year, as this year was the "on" part of the cycle for the banks which only have to participate once every two years.
Digging deeper into the traditional U.S. banks, we estimate that JPMorgan, Bank of America, and Citigroup will all have to spend the next several quarters more focused on building capital, whereas Wells Fargo should be pretty close to their current capital targets. U.S. Bancorp, PNC, and M&T Bank all stand out to us as the traditional U.S. banks with the most excess capital in today's environment. We'll also emphasize that earnings growth should be strong in the near future as aggressive rate hikes feed through, so this should support some repurchase activity even as several of the bank under our coverage likely also focus on building some additional capital as well.
Charles Schwab's stress test results were fantastic, but we don't expect the company to materially increase its capital returns. Charles Schwab was the only bank in the stress test whose projected minimum capital ratios during the stress period were actually higher than its actual capital ratios at the end of 2021. However, Charles Schwab's capital situation will likely change over the next several years, and the company should be retaining earnings in anticipation of the change.
As we wrote in previous notes, the company is near $700 billion in assets, and if its balance sheet exceeds $700 billion for 4 consecutive quarters, it will become a category 2 institution and have to include unrealized losses in its capital ratios. Given the recent increases in interest rates, Charles Schwab has booked billions of unrealized losses on its fixed income securities portfolio. If the company were to include unrealized losses in its capital ratios, its Tier 1 leverage ratio would be relatively close to the minimum. Since the company will exceed $700 billion in assets, sooner or later, as it grows its banking operations to generate net interest income, it needs to build up a buffer of capital. The recent stress test didn't include the company's recently booked unrealized losses in its calculations.
Morgan Stanley and Goldman Sachs did fine on the stress test, but we don't expect them to significantly increase capital returns this year compared to the previous. Of the 33 banks in the stress test, Morgan Stanley and Goldman Sachs were among the top five in the magnitude of their common equity Tier 1 ratio drawdowns during the stress period. That said, their minimum ratios during the severely adverse scenario still remained a decent amount over regulatory minimums. For both, their Tier 1 leverage ratio and supplementary leverage ratio in the stressed case were closer to regulatory minimums than their common equity Tier 1, Tier 1 capital, or total capital ratios. Morgan Stanley's Tier 1 leverage ratio and supplementary leverage ratio minimums during the test were about 30% above the regulatory minimum. Goldman Sachs's respective ratios were about 15% above their minimums. Both of the banks in the previous year significantly increased their quarterly dividend, to $0.70 from $0.35 for Morgan Stanley and $2 from $1.25 for Goldman Sachs, but their payout ratios are likely more in line with longer-term management targets now, so they don't need another significant increase.
Diving deeper in the custody banks, these generally fared well in their stress scenarios. Under the severely adverse scenarios, common equity Tier 1 capital ratios were roughly flat for Northern Trust at the end of the stressed period and actually increased for BNY Mellon and State Street as the banks remain modestly profitable in the period. Under the severely adverse scenario, total loan portfolio loss rates were 2.2%, 5.4%, and 6.8% for BNY Mellon, State Street, and Northern Trust, respectively. State Street's and BNY Mellon's total loan portfolio loss rates are meaningfully below the average of 6.4% of the 33 participating firms and reflects the fact that the custody banks' business models involve considerably less credit risk vis-à-vis traditional financial institutions.
Consumer-focused banks, particularly Discover and Capital One, performed well in their stress scenarios. Both American Express and Discover saw their common equity Tier 1 capital ratios increase by the end of the stressed period to 12.5% and 15.7% respectively, while Capital One maintained reserves within management's long-term target range of 10% to 11% throughout the test. Projected loss rates were high across the board, ranging from 9.6% for American Express to 16.3% for Discover, reflecting the credit sensitive-nature of these firms and the high projected loss rates on credit cards.
Unlike many of their traditional banking peers, Discover and Capital One still have material amount of excess capital remaining, a consequence of surprisingly low credit costs on credit cards so far in 2022 and in 2021. These stress test results clear the way for Discover and Capital One to execute on their already announced $4.2 billion and $5 billion share repurchase plans, respectively, as both firms work towards their targeted common equity Tier 1 ratios.
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