Altria: Do Not Be Fooled By The 9.6% Yield (NYSE:MO)

Altria Group, Inc. (NYSE:MO), a major player in the global tobacco market, attracts a lot of attention from investors eyeing income. The company offers a hefty $0.98 dividend, equating to a 9.6% yield. But I have concerns: its payout ratio sits at a high 76.8%, and its dividend growth has been sluggish at 5.6% CAGR over the last five years. While for some, dividend growth might not be a priority if the near-double-digit dividend meets their financial needs, there’s a bigger issue at hand.

Despite Altria’s significant coverage, there’s a lack of honest analysis that acknowledges the challenges it faces. The company operates in a shrinking market, and there’s a real possibility that future generations might not even recognize cigarettes, considering the bans on smoking in numerous countries for those born after specific dates.

The negative perception surrounding smoking’s health impacts has significantly impacted the company’s stock performance. Over the last decade, Altria’s stock price has remained nearly stagnant, failing to outpace inflation. Its total return heavily relies on dividends, lagging far behind the broader market represented by the SPDR S&P 500 Trust ETF (SPY) and other options like Schwab U.S. Dividend Equity ETF (SCHD), which offers income and better potential for dividend growth.

I believe the ongoing underperformance will persist, and Altria’s ability to grow its dividend will dwindle. Instead, there’s a likelihood of a decrease in dividends as price hikes won’t offset the decline in sales volumes in the future.

Let me show you why I believe it’s the right time to sell Altria shares.

Price Increases Will Not Offset The Declining Market

It’s no secret that smoking has lost its appeal. Altria has coped with the declining market by hiking prices to offset the dwindling customer base, but this strategy might not be sustainable in the long run.

According to Gallup’s research, the number of US adults aged 18-29 who reported smoking a cigarette in the past week has hit historic lows, plummeting from 35% in 2001 to a mere 12%. And this shift isn’t exclusive to one age group; across all age brackets from 30 to 65+, there’s a noticeable mid-single-digit to double-digit decline in smoking over the past two decades.

With customers exploring alternatives such as vaping or recreational marijuana, and with fewer new customers opting for combustible cigarettes, Altria confronts a significant challenge: a shrinking customer base. Their EPS stability heavily relies on efficiency improvements and price hikes alone. Ironically, raising prices could accelerate the move away from their products, potentially causing a decline in EPS in the coming years, similar to what we seen reported in Q3 2023.

In Q3, Marlboro, Altria’s largest brand, faced a hit in market share due to price increases, leading inflation-conscious consumers to opt for more budget-friendly brands like USA Gold. This shift resulted in a 5.3% decline in net revenue from smokeable products, as higher prices only partially offset reduced shipment volumes and increased spending on promotions.

Consequently, Altria revised its annual profit forecast downward. More smokers choosing lower-priced cigarettes or alternatives caused the Marlboro maker’s shares to drop by approximately 3.5% on that day in October. Altria now anticipates an adjusted profit ranging from $4.91 to $4.98 per share for the year, down from the previous projection of $4.89 to $5.03 per share.

As some customers opt to safeguard their health and that of their loved ones by quitting, certain countries are taking a more proactive stance. New Zealand, for instance, has announced a ban on tobacco sales to individuals born on or after January 1, 2009. Similarly, the UK is exploring the idea of creating a “Smokefree generation” by considering a ban on cigarette sales to those born after 2008. While Altria garners most of its revenue from the US, I anticipate other nations will follow suit in the coming years pressuring the US as well. Smoking stands as the leading cause of preventable death, placing a significant strain on healthcare systems.

It’s important to note that Altria runs a highly efficient business model, boasting a Gross Margin of 69.5% and an Operating Margin of 56%. This is notably better than its peer Philip Morris (PM) but falls behind British American Tobacco (BTI). This suggests there’s some room for further efficiency improvement, possibly lowering the cost of goods sold in the near term. However, in the long run, it’s expected that there is a limit where efficiency gains and price hikes won’t suffice to counterbalance the decline in sales volume.

Altria has indeed managed to navigate the declining volume effectively, showcasing an average 7.3% CAGR in EPS over the past six years. This growth has been fueled by improved profit margins and price hikes. Considering the projected full FY23 EPS midpoint at $4.95, it’s a respectable performance for a business facing a downward trend.

However, my anticipation is that the forward EPS for the next 3-5 years will be lackluster, hovering around 2-3% annually. This growth rate will barely outpace inflation. Beyond that period, I foresee the business entering a phase of declining EPS.

NJOY – Too Little Too Late

Altria, is heavily dependent on smokable products. Smokable products account for a staggering 88% of Altria’s revenue, making the company’s fortunes closely tied to the popularity of tobacco. However, the tide is turning against smoking, and Altria’s cigarette sales are plummeting.

The volume drop in Q3 wasn’t a one-time event; Altria’s cigarette sales plummeted by a significant 8% compared to the same period last year. This decline isn’t fleeting; it’s a consistent trend. In 2022, Altria manufactured only 84.7 billion cigarettes, marking a 9.7% drop from 2021. Looking back a decade to 2012, Altria produced a massive 134.9 billion cigarettes. That’s a staggering 37% reduction in the company’s flagship product in just ten years. This pattern isn’t sustainable.

While it’s common for consumer staples companies to rely on cash cow businesses to fund their growth, Altria has failed to find a suitable replacement for its declining cigarette empire. Its ventures into marijuana and smokeless tobacco have yielded disappointing results, leading to massive write-downs and further casting doubt on the company’s ability to adapt to changing consumer preferences.

Altria’s recent acquisition of NJOY, a company with regulator-approved smokeless tobacco products, may offer a glimmer of hope. However, even if NJOY proves successful, its growth will start from a small base, unlikely to fully offset the losses in cigarettes. It’s uncertain whether NJOY can ever fill the void left by Altria’s shrinking tobacco business. Remember, NJOY reported $150 million in revenue in 2022, which is less than 1% of the $20.68 billion reported by Altria.

In my opinion, investors seeking steady income from their portfolios should exercise caution when considering Altria. The company’s heavy reliance on cigarettes, coupled with its track record of failed investments in alternative products, raises concerns about its ability to generate sustainable returns in the long run.

ESG Investing

The surge in Environmental, Social, and Governance “ESG” considerations is indirectly impacting Altria. With ESG strategies gaining traction in investment circles, Altria faces exclusion from ETF funds adhering to sustainability principles because of the health risks associated with its business in the tobacco industry. Consequently, this diminishes the demand for Altria’s stock, potentially leading to its devaluation relative to the broader market.

Even though some people brush off ESG as a passing trend, its popularity has soared lately. According to Morgan Stanley, nearly 8% of total AUM is currently allocated to sustainable funds. This marks a significant increase from the 5% reported in H1 2018, highlighting the increasing importance of ESG considerations in investment choices.

It’s not just the exclusion from ETFs that might affect Altria’s prospects. There’s also a significant reputation risk attached to its image as a harmful entity in the public’s perception. This could invite more government regulations and higher taxes, as people increasingly urge authorities to regulate major tobacco players. Altria might face intensified scrutiny of its operations and potentially even bans on certain products, much like what we saw with Juul, which wiped away Altria’s $13 billion investment into what was once called “the next growth driver.” All these factors combined could make it increasingly challenging for the company to sustain profitable operations.

Cheap For A Reason

One of the positives about Altria is its valuation.

Despite having a market cap of $72 billion, which is roughly half the size of Philip Morris, both companies are expected to have similar growth profiles. Altria, however, trades at a considerable discount.

Its Forward PE, standing at 8.31x its FY24 earnings, is 27.8% lower than its 5-year average.

Also, the Forward EV/EBITDA, at 7.81x, is 16% lower than its historical average.

This suggests the stock is undervalued by approximately 21.9%, with its fair value estimated around $48 per share, compared to the current trading price of $41.

However, as highlighted in the article, given the lack of future growth catalysts and mounting pressure on the tobacco industry, Altria’s inexpensive valuation might be justified. I don’t anticipate a shift towards fair value unless the company can diversify away from its heavy 88% reliance on tobacco products and reinvent itself.

Conclusion

Altria holds a special place among income investors for a reason. Its 9.6% dividend yield, combined with low dividend growth, makes it an attractive choice for those relying on dividend income.

However, the core cash-generating business is on a downward spiral. More and more people are either quitting smoking or switching to alternatives, and some countries are even enforcing bans to create “smoke-free generations.” This puts Altria’s business at considerable risk, and the continuous price hikes, which already started impacting market share of its flagship brand Marlboro, are not sustainable in the long run.

Despite its highly efficient business model and historically robust profit margins, I foresee a turning point on the horizon. In the next 3-5 years, I believe the business will reach a tipping point where EPS begins to decline. This could strain the dividend and potentially lead to negative returns for investors.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.