Consumer Staples Stock Recommendation

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Consumer Staples Stock Recommendation

• John Drum

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Sector Presentation Recap

• Sector is trading in line with means
• Constricting margins with modestly improving
  turnover worrisome
• Recent growth unsustainable
• Other sectors will outperform consumer staples
• Recommendation maintain underweight

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Recommendation

• On March 31, Altria will spin-off 0.7 shares of
  Kraft for each share
• Sell Kraft spin-off shares
• Use entire proceeds to buy Altria
• Market Value invested in Altria will remain the
  same.

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Recommendation
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Altria Overview

• Parent Company of
• Phillip Morris USA,
• Phillip Morris International,
• Phillip Morris Capital Corporation
• Kraft
• Also own a 28.6 ownership stake in SAB Miller

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Phillip Morris

• Brands
• USA Marlboro, Virginia Slims, Parliament, Basic
• International 7 of top 20 best selling brands
• Marlboro, Lark, Chesterfield, LM

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Tobacco Outlook-USA

• Consumption declining (2 in 2007)
• Expected to decline 21 by 2011
• CAGR 2001-2006 -3.5
• Excise tax increases
• California tax increase defeated in 2006
• Litigation environment cooling
• Recent case dismissals in FLA, and Supreme Court
• Price Improvements
• PM USA increase prices 0.10
• PM market share 50.3

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Tobacco Outlook - USA

• FDA Tobacco Legislation
• Pressed by key Democrats
• Potential parameters
• FDA order changes in products
• Ban addition of flavors, except menthol
• New products subject to FDA approval
• FDA reduce nicotine content
• Restrict FDA from banning existing products
• Further restricts advertising

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Tobacco Outlook - International

• Volume declines in developed markets
• Market Value expected to increase 11 by 2011
• Pricing Improvements
• Consolidations
• Reach emerging markets
• Mass
• Excise taxes
• China National Tobacco
• PMI market share 16.8

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Revenue Make-up 2001
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32
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Revenue Make-up 2002
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Revenue Make-up 2003
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Revenue Make-up 2004
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Revenue Make-up 2005
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Revenue Make-up 2006
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Phillip Morris International 2006

• Shipment volume up 3.4 (0.4 w/o acquisitions)
• International shipments down for industry 0.9
• Driven by sales to developing nations
• Asia and Latin America
• Volume declines in EU
• Operating Profit up 8.1
• Higher pricing

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Phillip Morris USA 2006

• Operating income up 5
• Primarily due to lower promotional allowances
• Shipment Volume down 1.1
• Market volume down 2.2
• Market share up 0.3 to 50.3
• Marlboro and Parliament shares up

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Outlook for Phillip Morris

• Strong brands
• Sustainable competitive advantage
• Favorable environment
• Growth Opportunities in developing markets
• PMI operating profit growth
• Consolidation in the industry
• Benefits from KFT spin-off

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Kraft

• N/A Food showing negative earnings growth past 3
  years
• International food earnings very volatile
• Market is skeptical of turnaround plans
• More marketing spending, nothing new
• Divesting from smaller brands
• Cream of wheat

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Valuation

• Current Price MO 85.38
• Current Price KFT 33.26
• MO DCF 93.33, 6 upside
• KFT DCF 32.85, 2.1 downside
• Multiples MO 76.35, 10 downside
• Sum of parts

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Altria Valuation Sum of Parts
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Benefits of Spin-off

• W/O KFT, MO turnover much more inline with
  sector
• KFT Operating margin, turnover behind sector
• Most ratios well ahead of CG and RAI

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Recommendation

• Altria will benefit greatly from Kraft Spin-off
• Biggest, most profitable player in a declining
  industry
• Improved environment
• Kraft shows little promise
• Sell Kraft, use proceeds to purchase Altria
  shares
• Buy approx. 4,087 shares MO
• Possible hedging opportunity
• Sell out of money calls