For a long time, some of the best-performing stocks came from the tobacco industry as these companies were able to steadily raise prices on packs of cigarettes, fueling steady earnings and dividend growth even as fewer and fewer people smoked cigarettes.
But as we sit here in 2023, investors are doubting that these industry dynamics will continue. Competitive threats from reduced-risk products have added uncertainty (but also opportunity) for the tobacco giants. Altria Group (MO -0.37%) is one of these companies. The stock trades at a price-to-earnings ratio (P/E) well below the market average and sports a sky-high dividend yield of 8.5%, indicating that Wall Street doubts whether the U.S. seller of Marlboro cigarettes can continue to grow its dividend.
Altria management thinks otherwise. At its recent investor day, it set a goal of growing the stock's dividend at a mid-single-digit rate (meaning 4% to 6%) every year, which looks highly attractive considering its current yield of 8.5%. Can Altria's dividend continue to grow? Or is Wall Street right to doubt these goals? Let's investigate.
Tobacco's cash cow remains (for now)
The majority of Altria's profits comes from its cigarette operations, mainly selling packs of Marlboros. Even though the number of U.S. adults smoking cigarettes has declined by 2.5% annually in recent years, Altria has grown its revenue by a cumulative 16.8% over the last 10 years due to consistent price increases to retailers.
Higher prices on the same product lead to margin expansion, which has enabled Altria's underlying profitability to grow even quicker than top-line sales. Operating income is up 44% over the last 10 years, about triple the company's revenue growth.
With 10% of the adult U.S. population still smoking cigarettes, Altria's earnings can still grow for at least the next five years -- if not longer -- through consistent price increases despite annual usage declines of 2.5%.
Competitive risks are growing
But what about over the long term? All indications point toward cigarette usage in the United States to continue declining, which means eventually tobacco companies such as Altria need to transition their business model to reduced-risk products like nicotine pouches and vaping.
Altria is facing an uphill battle from its former business unit Phillip Morris International in risk-reduced products. The latter company, the international seller of Marlboro cigarettes, owns the dominant nicotine pouch, Zyn, in the United States along with the top international heat-not-burn cigarette replacement, Iqos.
The company just bought back the rights from Altria to sell Iqos products in the U.S. If this product is as successful in the U.S. as it has become in Europe and Japan, Altria could see customers stop smoking Marlboros at an accelerated rate in the coming years.
To be fair, Altria has seen some decent growth from its nicotine pouch ON! and just bought a leading vaping company, NJOY, but the company has a poor track record of investing outside of tobacco. It burned over $10 billion buying a stake in Juul (which just filed for bankruptcy) and bought a large stake in Cronos Group at the height of the cannabis bubble.
If Altria is going to continue growing its dividend past the next five years, it will need to succeed with reduced-risk nicotine products such as ON! and NJOY. Within five years, the company believes its smoke-free products can reach $5 billion in annual sales. Investors should hold management to that target and track whether it can actually achieve this goal.
MO dividend per share (TTM) data by YCharts. TTM = trailing 12 months.
The math should work
Another positive influence for the dividend will be share repurchases, which management says will continue with excess cash after its dividend payouts. A declining share count means a company can grow its payout per share even if consolidated earnings are flat.
Altria has around 1.77 billion shares outstanding and paid $6.69 billion in dividends over the last 12 months, for a dividend per share of $3.76. If Altria reduces its shares outstanding to 1.5 billion over the next five years, the company will be able to pay a $4.45 per share dividend without raising its total annual payout, which would be right around its 4%-plus annual growth target.
In the long run, management forcing itself to target mid-single-digit dividend growth could be a blessing as it might keep it from destroying shareholder value investing in the next Juul or Cronos Group and instead reduce its shares outstanding. The faster its share count declines, the more room it will have to grow its per-share payout.
Despite the long-term business dangers in risk-reduced products, it looks like Altria is still in a great spot. If the company can continue raising prices on cigarettes, buy back stock, and grow its dividend at 4% or more each year, shares look mighty cheap at a trailing yield of 8.5%.
