Altria (NYSE:MO), the top tobacco company in America, might initially seem like an attractive dividend stock. It pays a high forward yield of 7%, it trades at less than 10 times forward earnings, and its flagship Marlboro brand controls over 40% of the domestic cigarette market.
But over the past five years, Altria's stock price has declined more than 20%. After factoring in reinvested dividends, it generated a meager total return of 2%. The S&P 500 nearly doubled during that period, so a low-cost index fund would have fared much better than Altria.
Nonetheless, Altria's stock gradually rose over the past few months as rising bond yields sparked a rotation from growth to value stocks. However, investors shouldn't assume that rebound will continue and make Altria a worthy dividend investment again.
A peaking share of a withering market
Adult smoking rates in the U.S. declined from 20.9% to 14% between 2005 and 2019, according to the CDC, and could easily drop to single-digit percentage levels during this decade. Rising excise taxes have also caused the price of a single pack of cigarettes to exceed $10 in several states.
Altria's market share growth has also peaked. Its cigarette brands controlled 49.2% of the domestic market in 2020, compared to 49.8% in 2010. Resilient rivals like Reynolds American, which was fully acquired by British American Tobacco (NYSE:BTI) in 2017, are making it tough for Altria to continue growing in a saturated and shrinking market.
Finite growth strategies
Altria is trying to offset its declining cigarette shipments by raising prices, cutting costs, repurchasing shares to boost its EPS, and expanding its portfolio beyond cigarettes and cigars.
But it will eventually run out of room to raise prices, especially as excise taxes rise, as well as ways to cut costs -- since it already reduced its headcount by nearly 30% over the past decade.
Altria reduced its outstanding shares by 10% during those 10 years, but it temporarily halted its buyback plan last April as the pandemic worsened. It resumed those buybacks earlier this year, but that cash might be better spent on expanding its smokeless portfolio or reducing its debt.
Meanwhile, Altria's expansion efforts -- which include a poorly timed investment in the e-cigarette maker JUUL, a speculative stake in the cannabis company Cronos Group (NASDAQ:CRON), a partnership with Philip Morris International (NYSE:PM) to sell its iQOS heated tobacco devices in America, and the development of On nicotine pouches -- still aren't generating enough revenues to meaningfully offset its slowing cigarette sales.
In the regulatory crosshairs
To make matters worse, the U.S. Food and Drug Administration (FDA) has been tightening its rules on e-cigarettes and scrutinizing newer products like iQOS and On. The Biden administration also reportedly plans to force cigarette makers to lower their nicotine content to non-addictive levels.
Reining in the tobacco industry is one of the few issues which has bipartisan support in Washington, and new regulations could make it even tougher for Altria to expand as it faces tough secular headwinds.
Don't let the fundamentals fool you
Altria has raised its dividend every year since it spun off Philip Morris International in 2008. It also spent 77% of its free cash flow on its dividend over the past 12 months, which seems like a sustainable cash dividend payout ratio.
Altria's near-term growth rates also look healthy. Its revenue (net of excise taxes) rose 5% to $20.8 billion in 2020 as it raised its prices, even as its retail market share dipped 60 basis points and its adjusted cigarette shipments fell 2%.
Its adjusted EPS, buoyed by tighter spending and buybacks in the beginning of the year, grew 4%. Analysts expect its revenue and earnings to rise another 2% and 5%, respectively, this year.
Yet Altria's longer-term outlook remains murky. It might generate positive growth for a few more years, but its foundations are still crumbling. That deterioration will force it to make more desperate investments -- which could boost its debt and throttle the free cash flow that feeds its dividends.
Altria is cheap for obvious reasons
Altria looks like an undervalued dividend stock, but it fails two crucial tests for income investments: Its declining stock price wipes out the gains that come from its dividend payments, and its core market is in a secular decline. Investors should stick with stocks that don't suffer from those issues, even if they pay lower dividends and trade at higher multiples.