Source: Phillip Morris.

Big tobacco companies such as Philip Morris (NYSE:PM), British American Tobacco (NYSE:BTI), and Altria (NYSE:MO) are a matter of much debate among dividend investors. These companies pay generous dividend yields, and their dividends look sustainable from a financial point of view... at least for now.

On the other hand, declining tobacco demand is a major risk for investors in the industry. Are dividend stocks in the tobacco industry a smoking-hot opportunity, or a toxic idea for dividend investors?

Phillip Morris
Phillip Morris is a global industry leader benefiting from a dominant presence in emerging markets, and the competitive strengths provided by leading brands such as Marlboro and Parliament. Scale, brand recognition, and significant exposure to Asia, as well as the Eastern Europe, Middle East, and Africa regions, are big positives for the company in terms of competitive strengths and overall financial performance.

Phillip Morris has consistently raised its dividends in every year since 2008, and has recently announced a 6.4% increase in distributions to $4 per share annually. The new dividend payout ratio is reasonable, in the area of 78% of earnings estimates for 2014, and at 4.8%, the dividend yield is generous.

However, total cigarette shipments across the company´s different brands declined by 2.7%, to 222.8 billion units, during the second quarter of the year. Volume increased 2.4% in the European Union during the quarter, but it declined marginally overall during the first half of the year. Asia delivered a decline of 6.1% during the second quarter, while volume in Latin America and Canada fell 1%, and the Eastern Europe, Middle East, and Africa regions delivered a decline of 2.8% in volume.

Total reported revenues fell 1.5%, to $7.8 billion, while revenues, excluding currency fluctuations and excise taxes, grew 4.5% during the period on the back of strong pricing and a favorable product mix.

British American Tobacco
British American Tobacco owns several popular cigarette brands targeting different segments of the pricing spectrum. This includes names such as Dunhill, Kent, Pall Mall, and Lucky Strike. Like Phillip Morris, British American Tobacco is benefiting from strong pricing and market share gains; but cigarette volume is still declining in most regions.

The company announced a 0.6% decline in total volume during the first half of 2014, from 346 billion units to 344 billion. Volume increased in the Asia Pacific region, but it declined in the Americas, Western Europe, and the Eastern Europe, Middle East, and Africa regions.

British American Tobacco pays a dividend yield in the area of 4.2%, and the payout ratio is also quite safe, in the neighborhood of 64% of earnings estimates.

Altria is the market leader in the U.S. tobacco industry. As the parent company to Phillip Morris, it also relies on the widely popular Marlboro brand , which, according to management, has an impressive market share of 44% as of the second quarter of 2014. Still, even if Altria owns a huge piece of the cake, the U.S. tobacco market is not a particularly tasty cake.

Sales have consistently declined during the last several years, and the last quarter was no exception. Total cigarette volume declined 5% during the second quarter of 2014, to 32.13 billion sticks versus 33.82 billion in the same quarter last year. Sales volume for the iconic Marlboro segment fell 4.9% year over year. Pricing power allowed Altria to buffer the sales decline to a considerable degree, so total revenues fell only 0.8%, to $6.26 billion.

The company has a truly remarkable trajectory of dividend growth, as it has increased payments 48 times in the last 45 years; this includes a big increase of 8.3% announced on August 21. The dividend yield is 4.8%, and management intends to distribute approximately 80% of adjusted earnings per share in the form of dividends over the long term.

A matter of time frame
Phillip Morris, British American Tobacco, and Altria have similar characteristics. The three companies pay dividend yields well above average levels, and their payout ratios are not excessively high.

In addition, the tobacco business generates tons of free cash flows due to its high profitability and low reinvestment requirements. This means that the three companies have safe and stable cash dividend payout ratios, indicating that cash flow generation is more than enough to sustain dividend payments.

PM Cash Dividend Payout Ratio (Annual) data by YCharts

Baring any abrupt deterioration in industry conditions, there's no reason to expect dividend cuts from these companies in the medium term.

However, things look very different from a long-term point of view. According to statistics from the Centers for Disease Control and Prevention, smoking rates in the U.S. have dropped by half from 1965 to 2006, falling from 42% of adults to 20.8% over that period. Tobacco consumption continued declining, although at a slower rate, in the following years, data from 2012 indicates that the percentage of adults who smoke cigarettes in the U.S. declined to 18.1%.

Based on a research report by the University of Washington, the global smoking rate dropped from 26% to 18.7% during the 1980 to 2012 period. According to this study, countries which apply tobacco-control measures such as higher cigarette taxes and restrictions on advertising are seeing bigger declines in smoking rates, which shows that policies recommended by the World Health Organization are working, and that governments have an effective set of tools at their disposal to reduce smoking.

Even if price increases and cost disciplines are buffering the decline in sales volume to a considerable degree for big tobacco companies, these factors can't sustain growing dividends forever. As long as industry volume continues on a secular decline, investing in tobacco stocks can be hazardous to the health of your portfolio.

Andrés Cardenal has no position in any stocks mentioned. 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.