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Why You Can Count on Big Dividends From Big Tobacco

By Bob Ciura – Jan 18, 2014 at 7:30AM

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To combat falling smoking rates, major tobacco companies are turning to new product categories to keep profits steady.

The state of the tobacco industry is constantly evolving, due to rapidly changing consumer preferences. Smoking rates continue to decline in the United States, leaving many industry players contemplating new product categories. The tobacco industry has long been valued for its steady operating results and reliable dividends. Those dividends are likely the primary reason investors flock to tobacco stocks, as companies like Altria Group (MO -0.85%) reward their shareholders with hefty yields.

Despite a constant wall of worry facing the tobacco industry, the outlook for many industry heavyweights remains promising. In particular, Altria's unparalleled brand strength and diversified business make it a compelling opportunity, and other tobacco companies aren't far behind.

Presence in new product categories won't vaporize
The new hot topic in the tobacco world is e-cigarette alternatives. To combat stagnating cigarette volumes, particularly in the United States, some see e-cigarettes as a legitimate threat to traditional cigarettes. This is where Lorillard (LO.DL) has reason to brag, as its blu eCigs control approximately 49% of retail market share.

Plus, Lorillard acquired British-based SKYCIG in the third quarter, giving it a foothold in the international electronic cigarette market. The company is betting that its significant marketing and sales expertise will allow its new purchase to leverage the Lorillard name to make major in-roads internationally.

Altria won't allow itself to fall too far behind in the e-cig market. It recently signed a promising agreement with Philip Morris International (PM 0.38%) that makes sense for both companies. Philip Morris, which Altria spun off, will provide Altria with two of its heated tobacco products for distribution in the United States. In turn, Altria will license its e-cigarette products to Philip Morris for commercialization outside the United States. And, going forward, each party will cooperate with each other on periodic scientific assessments and any future product improvements.

Altria's MarkTen product represents its own foray into e-cigarettes in the United States. So far, results don't seem to be overly encouraging, as the product is available only in Indiana and Arizona. That's why the licensing pact with Philip Morris represents an important resource for expanding its presence.

Traditional cigarettes haven't gone anywhere
While the e-cigarette market holds a certain level of promise, both Lorillard and Altria continue to generate most of their profits from traditional tobacco products. Lorillard is still very successful in this regard, as its net sales and adjusted earnings per share climbed 10% and 15%, respectively, in the third quarter.

Altria, meanwhile, relies on its Marlboro brand, one of the most valuable in the world, to make up the bulk of its profits. To be sure, Altria has a stable of industry-leading products other than Marlboro. For instance, it holds a voting interest in SABMiller, as well as leading smokeless brands such as Copenhagen and Skoal. In addition, Altria has a wine business under the Ste. Michelle label. That being said, Altria still derives the vast majority of its profits from Marlboro cigarettes. Fortunately for shareholders, business in that segment is doing just fine.

Marlboro holds a 43% retail share of U.S. smokable products, and Altria's chewing tobacco brands together control 51% of the U.S. smokeless product market. In all, Altria's adjusted earnings are up 9% through the first nine months of the fiscal year.

Keep counting on tobacco dividends
It's likely that most investors flock to tobacco stocks for their big dividend yields. Of course, those dividends will only continue if the underlying profits keep flowing to support the high payouts. Thankfully for investors, while smoking rates continue to decline, major U.S. tobacco companies are able to make up the difference with gradual price increases and new-product categories. That's why Altria, Lorillard, and Philip Morris International should keep paying their hefty dividends for many years to come.

Fool contributor Bob Ciura owns shares of Altria Group. The Motley Fool owns shares of Philip Morris International. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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