The tobacco industry is a good bet for value investors, because nicotine is a profitable, habit-forming product that sells in any macroeconomic environment. Here's why investors seeking low valuations and large, sustainable dividend yields should consider adding Altria Group (NYSE:MO) and Phillip Morris International (NYSE:PM) to their portfolios. 

Cigarettes wrapped in dollar bill

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Altria Group: Strong pricing power and a large dividend

Altria is a large-cap tobacco company known for manufacturing and marketing the Marlboro brand of cigarettes, America's best-selling cigarette label for the past 45 years. The rock-solid Marlboro brand makes up 87% of Altria's cigarette sales volume, and gives the company enough pricing power to continue returning value to shareholders despite the secular decline of the tobacco industry. 

Altria's sales volume for cigarettes and cigars has fallen at an annual CAGR of -5% since 2015. But despite the negative trend in cigarette sales volume, Altria bolsters its revenue by increasing prices. According to Goldman Sachs analyst Bonnie Herzog, The company's Philip Morris USA subsidiary increased cigarette prices by $0.11 per pack in February (a roughly 2%-3% increase at retail). This follows three price hikes in 2019, and shows that consumers don't balk at higher prices when it comes to getting their nicotine fix. 

Altria's revenue fell 3.8% to $6.37 billion in the first quarter, but the company is on track for strong full-year performance, which indicates that its pricing strategy is leading to sustainable results on the bottom line.

Altria's operating margins have grown steadily over the last five years (from 33% in 2015 to 41% in 2019), which has helped the company consistently grow EPS. Management is guiding for an adjusted annual EPS between $4.21 to $4.38 in 2020, which at the low end would equal the prior year's figure of $4.21. The company's adjusted P/E multiple of 9.5 falls dramatically below the S&P 500's average of 28, and it boasts a dividend yield around 8.5%.

 

Phillip Morris: New products and international expansion 

Philip Morris International shouldn't be confused with Altria's subsidiary Philip Morris USA, which goes by a similar name. Altria and Philip Morris split up in 2008, with Altria focusing on the U.S. market and Phillip Morris targeting the international market. Unlike Altria, which focuses on squeezing profits out of its cigarette sales, Philip Morris is developing an innovative line of reduced-risk, smoke-free tobacco products to counteract volume declines in the industry. 

Phillip Morris has developed IQOS, a system that heats tobacco without burning it, potentially making it less harmful than traditional cigarettes, according to company-funded research that has been corroborated by the British Committee on Toxicity. The company is also working on another heated tobacco platform called Teeps, along with a tobacco-free electronic cigarette called Mesh. These reduced-risk products comprised 10.3% of total shipment volume, and their sales growth helps offset volume declines in the company's traditional cigarettes.

Net revenue fell by 13.6% in the second quarter because of lockdowns in Europe and other coronavirus-related headwinds. However, sales volume for the company's heated tobacco products grew 24.3% to 18.7 billion units, which now represents 24.1% of total net revenue. 

Phillip Morris has made a convincing pivot to reduced-risk products, which makes the business well-suited to weather the global decline in cigarette sales volume. Investors are further rewarded by the company's low valuation and hefty dividend. The stock trades at 16 times EPS and boasts a dividend yield around 6%. Management expects 2020 EPS to come in between $5.00-$5.07 per share, which is 7% higher than the prior-year period ($4.67) on the low end. 

Two different corporate strategies

Altria and Philip Morris International  use different strategies to counteract declining tobacco sales volumes. While Altria focuses on its established brands and pricing power, Phillip Morris aims to drive growth by launching innovative reduced-risk products. Both companies are great bets for investors who want massive dividends and consistent earnings growth, but Phillip Morris seems to have a more sustainable long-term strategy because of its focus on developing new products. 

 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.