In the world of tobacco stocks, many investors are concerned that the decline in smoking will result in a similar decrease in profits. Indeed, members of big tobacco such as Altria Group (NYSE:MO) and Lorillard (UNKNOWN:LO.DL) continue to grapple with a smaller pool of customers every year. The public's increasing distaste for smoking is sure to result in future drops in smokers as well going forward. This seems to make for an uncertain future for tobacco companies, which likely has investors worried.
However, management teams across the industry don't seem at all worried when they present their results. When it comes to Altria, the maker of Marlboro, management has a strong sense of confidence that they can keep delivering the kinds of returns that made the past century so profitable for investors.
Price increases offset volume declines
Altria's plan to keep revenue and earnings per share going in the right direction is fairly straightforward: Keep expenses down and prices going up. Remember that tobacco companies are essentially banned from advertising. And, due to the low manufacturing costs inherent in the production of cigarettes, it's fairly easy for Altria to keep a lid on expenses.
On the revenue side, the company fully acknowledged the decline in smokers when it presented at the Consumer Analyst Group of New York conference earlier this year. Despite a steady 3%-4% annual decline in the number of smokers for several years now, Altria still produced nearly 8% earnings growth compounded annually from 2007-2013.
Price increases are a major reason for its solid profit growth during that time. And, volumes are still growing for cigars and smokeless products, two markets in which Altria holds a leadership position.
It doesn't seem that Altria is overly concerned with the risk of increasing litigation, either. That stands to reason, since states and municipalities desperately depend on the excise taxes generated by sales of cigarettes and other tobacco products.
New product categories ignite growth possibilities
The issue getting the most attention right now for tobacco companies is electronic cigarettes. Growth in that category has been astounding as consumers flock to e-cigs as a safer and more fashionable alternative to traditional cigarettes. Big tobacco companies have made some high-profile acquisitions in the e-cigarette space to try and capture some of that growth.
Lorillard is hoping its aggressive expansion into this market will help mitigate some of the overarching uncertainty regarding its flagship Newport brand of menthol cigarettes. For example, last year Lorillard purchased SKYCIG, a U.K.-based manufacturer of electronic cigarettes, to boost its international standing in the category. This was meant to complement its existing considerable U.S. presence in the category. Lorillard is already the industry leader in e-cigarettes domestically. Its blu e-Cigs brand commands 48% market share.
Altria soon followed suit with its own electronic-cigarette expansion. The company recently rolled out its MarkTen brand nationally after strong test results in two states. And, a few months ago Altria bought the e-vapor business from Green Smoke for $110 million.
The growth potential of the electronic-cigarette industry as well as Altria's flagship Marlboro and other brands gave management confidence to reiterate its 2014 forecast of generating approximately 8% earnings growth. This would fall right in-line with the company's long-term target of 7%-9% earnings growth and allow Altria to continue increasing its dividend.
Altria has a very transparent dividend policy. The company pledges to distribute approximately 80% of its diluted earnings to investors via its dividend. Therefore, it's reasonable to forecast around 8% annual dividend growth over the long term, which is about what Altria has delivered over the past several years.
Let compounding interest work its magic
Altria isn't promising earth-shattering growth in the years ahead. After all, it operates in the tobacco industry, which inevitably has limited growth potential due to the decline in smoking. However, as long as Altria is able to pass along price increases at or above the rate of the smoking decline as well as realize growth from its other products, it should have no trouble passing along healthy dividend increases every year.
That's the formula that has made Altria such a fantastic stock to own. Its total return from 2008-2013 stands at 137%, well above the S&P 500 index's 44% return over the same period. Altria's high dividend yield, when combined with high single-digit dividend growth, is the magic formula that results in tremendous returns.