Perhaps the biggest concern surrounding big tobacco giants like Altria, (NYSE:MO) and Lorillard, (NYSE:LO) is the decline in smoking rates. That's especially true for Altria, which operates entirely in the United States after spinning off its international component Phillip Morris International (NYSE:PM). The bottom line is that smoking is declining steadily in the United States, and when you combine that with the threat of litigation, you have to wonder how Altria will keep growing.
And yet, that's exactly what Altria does. It's kept on growing earnings year in and year out, despite the risks . Plus, it's continued to increase its dividend every year along the way. At this point, you might be curious how this could even be possible.
The answer is that management has a plan. Rest assured, that the decline in smoking in the United States has not surprised Altria. Furthermore, it has no intention to combat the decline in smoking. It simply plans to grow despite the headwinds; here's how.
Modest earnings growth plus dividends
That's been the formula behind Altria's amazing track record of success over the past several years. Noted economist Jeremy Siegel calculated in his book The Future for Investors that Altria was the single best stock to own from 1925 to 2003. You might naturally assume that Altria generated most of its returns when smoking was in its heyday.
But keep in mind that smoking has been on the decline for decades now and Altria has outperformed the market all along. This even includes in recent years, when smoking has never been more taboo. . According to the company, its total return from 2011 to 2013 stands at 83%, well above the S&P 500 57% return over the same period.
One of the reasons for Altria's success is pricing power. Even though the number of its customers is falling, it's able to steadily raise prices to maintain growth. In addition, Altria offers smokeless tobacco products, cigars, a wine business, and a significant stake in SAB Miller that all contribute to profits. Last but not least, Altria maintains strict cost controls that boost earnings. Last year alone, Altria generated $400 million in cost savings , achieved primarily through lower cost of sales.
Future cost savings will be achieved by a sizable debt financing conducted in the fourth quarter last year. Altria bought back $2.1 billion in existing debt and sold $3.2 billion in new, lower-cost debt that will effectively reduce interest expense. Going forward, Altria's weighted average coupon interest rate dropped from 7.2% at the end of 2012 to 5.9% at the end of last year.
Despite a steady 3% to 4% annual decline in smokers, Altria still produced nearly 8% earnings growth compounded annually from 2007 to 2013. This falls right in-line with the company's long-term financial objectives. Management has publicly stated that it aims for between 7% to 9% annual earnings growth.
This is why, even though Altria is under constant pressures from regulatory and public scrutiny of cigarettes and ongoing litigation, it's nevertheless increased its dividend 47 times in the last 44 years. By the way, it's worth noting that these are not token increases. Its last dividend increase was a solid 9% raise.
New product categories represent another catalyst
It might seem foolish to include tobacco and innovation in the same sentence, but that's exactly what's happening in the industry today. Electronic cigarettes represent a compelling opportunity, especially in the United States, as consumers look for alternatives to traditional cigarettes.
Lorillard has the early lead in e-cigarettes. It holds the Blu brand, which controls nearly half the e-cig market share. To complement its leadership position, Lorillard purchased SKYCIG, a U.K.-based manufacturer of electronic cigarettes, last year.
But Altria isn't sitting idly by while Lorillard gains control of the market. Altria rolled out its own e-cig brand, MarkTen, in two states for initial testing. After satisfactory results, Altria is rolling out its product nationally starting this month.
Light up your portfolio with Altria
Altria maintains an impressive track record of growth and shareholder returns. But before you assume its best days are behind it, think again. Altria plans to keep generating returns, thanks to gradual price increases and annual cost savings. In addition, new products like e-cigarettes represent a unique innovation in the tobacco industry.
As a result, Altria should have no trouble meeting its long-term earnings forecast, which will allow it to keep growing and paying its hefty dividend.
Bob Ciura owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. 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.