Dividend stocks with high yields can sometimes indicate a risky stock. Tobacco company Altria Group (MO 0.73%) fits that bill; its dividend yield of more than 8% is much higher than most other stocks pay.
But sometimes, there are exceptions to the rules, and Altria could be one. Here is why investors looking for a reliable income stream can feel good about Altria's dividend payout.
The anatomy of dividends
Mature companies pay dividends to return value to shareholders when there are no better uses for their free cash flow. They have profitable business models and are past their hyper-growth phase, no longer needing to invest in taking market share in their industry.
For investors, dividends can be an incentive to hold a company's stock. The dividend yield reflects the return an investor has by dividing the dividend amount per share by the share price to calculate it.
In other words, when a stock trades lower, the dividend yield rises. The lower a stock trades, the higher the yield is, increasing the incentive for investors to own shares. High dividend yields can represent risky stocks because the market has traded them lower, creating a high dividend yield. If the stocks were desirable, they wouldn't have high yields!
Is Altria an exception?
Altria's dividend yield currently exceeds 8%, so compared to the average yield of stocks in the S&P 500 (roughly 1.3%), it's a considerable outlier! At face value, this makes sense. Altria is a tobacco company and owns the Marlboro brand of cigarettes among a portfolio of other tobacco products sold in the United States.
The first thought most people have about tobacco today is that it's terrible for your health, and you shouldn't do it. That's why the prevalence of smoking in the U.S. has steadily declined from over 40% in 1970 to the low-teens today.
Altria generates the overwhelming majority of its profits from selling traditional cigarettes, and its volumes have declined from 125.3 billion sticks in 2014 to 101.4 billion sticks in 2020, a 19% decline in cigarette volumes.
Despite this significant decline in volume, Altria's revenue and free cash flow have continued to grow, as seen below. How is this possible?
Altria has long relied on the demand for its products to continually raise the price of them to counter the decline in volume over the years. Revenue has grown at an average of 2% each year, despite the decrease in volume.
Can Altria keep it up?
The obvious risk in Altria's business is whether it can indefinitely raise its prices to offset fewer people smoking. The company has other assets like minority stakes in Anheuser-Busch InBev, Cronos, and Juul Labs but gets about 90% of its operating profits from its smokable products.
Altria's dividend payout ratio is currently 78%, so the ability for the dividend to be funded and raised moving forward depends on the company's ability to grow by increasing its cigarette prices continually.
While this model has worked for decades, enabling Altria to increase its dividend payout over the past 49 years, it's certainly not guaranteed to work forever. Inflation is high right now, which could put further strain on consumers. At some point, smokers could feel increased financial motivation to attempt to quit smoking, or at the very least, cut back on their consumption.
Looking for a margin of safety
Fortunately, Altria has some levers to pull to keep its dividend payout going. After a multiyear lock-up on its stake in Anheuser-Busch InBev, Altria is now free to sell its stake as it pleases. It's a roughly 10% stake in the business, worth more than $9 billion based on market cap.
Management has indicated that it intends to keep the stake for the time being because the valuation of Anheuser-Busch is currently depressed. Still, a potential sale could be on the table to free up needed capital over the long term.
Altria is also buying back stock, removing shares from the open market. Each share that the company buys back increases its earnings and free cash flow per share and decreases its total dividend expenses, which helps slow the rise of its dividend payout ratio despite the actual dividend per share increasing each year.