Altria (NYSE:MO), the top tobacco company in America, is often considered a stable investment for income investors. Its core products are addictive, it generates stable earnings growth, and it's raised its dividend every year since spinning off its overseas business as Philip Morris International (NYSE:PM) over a decade ago.
The stock looks cheap today at eight times forward earnings, and it pays a whopping forward dividend yield of 9.2%. That dividend also remains sustainable, since it consumed just 77% of the company's free cash flow over the past 12 months. That high yield and low valuation could set a safety net under Altria's stock, but I still wouldn't touch this stock, for five simple reasons.
1. Two long-term challenges
Altria still generates most of its revenue from cigarettes, but this core business faces two long-term challenges.
First, adult smoking rates in the U.S. declined from 20.9% to 13.4% between 2005 and 2018, according to the CDC, and could easily drop to single-digit levels within the next decade. Higher excise taxes across America are exacerbating that decline.
Second, Altria's core brands have been ceding market share to domestic rivals like Reynolds American, which was acquired by British American Tobacco (NYSE:BTI) three years ago. In the first nine months of 2020, Altria's retail share of the domestic cigarette market fell year-over-year from 49.9% to 49.2%, with declines across its Marlboro, premium, and discount brands.
These two ongoing challenges caused its adjusted shipments of cigarettes (which exclude trade inventory movements and other factors) to decline 7% in 2019 and drop another 2% year-over-year in the first nine months of 2020 -- even as smokers stockpiled more cigarettes during the pandemic.
2. An unsustainable business model
Altria has repeatedly tried to offset the industry's broader decline and its market share losses by raising prices and cutting costs. As a result, Altria's revenue, excluding excise taxes, declined just 1% in 2019 and rose 5% in the first nine months of 2020.
Altria's adjusted EPS rose 6% last year, and grew another 6% in the first nine months of 2020. For the full year, it expects its adjusted EPS to increase 4%-7%. That bottom-line growth looks stable, but it's inflated by constant price hikes, ongoing layoffs, and big buybacks:
This chart illustrates a company that is treading water instead of swimming forward. But it can't tread water forever, and the secular decline of the cigarette industry should eventually pull it under.
3. Desperate investments
Altria realizes its core cigarette business will continue shrinking, and its smaller businesses -- which include cigars, smokeless tobacco, and wine -- can't adequately offset that decline.
That pressure forced Altria to make some desperate investments, including a $1.8 billion stake in the cannabis company Cronos Group and a $12.8 billion investment in the e-cigarette leader Juul.
However, Altria's stake in Cronos isn't generating any significant revenue yet, and the business struggled throughout the COVID-19 crisis as retailers shut down. Juul struggled with safety issues and tightening regulations, and Altria took a $4.5 billion writedown on the ailing investment last year.
The only two newer brands that show promise are iQOS, the heated tobacco developed by Philip Morris International, and On nicotine pouches. Altria recently started selling PMI's iQOS devices, which heat up sticks of tobacco instead of burning them, in the U.S. It also started selling On pouches at more retailers.
But it's too early to tell if iQOS will catch on as it did overseas, and On's nicotine pouches are still being scrutinized by the FDA. In short, investors shouldn't believe any of Altria's new products will meaningfully diversify its top line away from cigarettes.
4. The dividends aren't saving the stock
Altria's high yield looks tempting, but a comparison of its stock price with its total return -- which factors in reinvested dividends -- indicates those dividends aren't offsetting the stock's long-term declines:
5. Its business model is built on addiction
Back in the late 1980s, Warren Buffett professed his love for tobacco companies: "I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."
But Buffett also said he wouldn't buy any tobacco stocks himself, saying he was "wealthy enough" to not "need to own a tobacco company and deal with the consequences of public ownership."
By "consequences", Buffett was referring to the ethics of investing in companies that sell addictive products that cause cancer. That's also why I'm not willing to buy any more tobacco stocks.