Shares of domestic tobacco giant Altria Group (NYSE:MO) have soared over 50% over the past 12 months, easily outperforming a 12% gain from the S&P 500. That is great news for Altria shareholders like myself, but investors might be wondering if the stock is due for a pullback. Let's take a look at three factors that could influence share performance in 2015.
1. What the valuation tells us
The first thing to acknowledge is that the trailing price-to-earnings of 22 times is quite high compared to previous levels from the last five years, which have generally fallen between 12 and 19 times. It is also higher than the broader S&P 500 at 20 times. However, Altria remains cheaper than its domestic rival, Reynolds American, which trades at 27 times trailing earnings.
Wall Street analysts expect Altria earnings to rise 9% year-over-year to $2.80 per share in fiscal 2015. If Altria maintains its P/E ratio, a reasonable price target for the stock would be $62, indicating upside potential of over 11%. However, if the multiple cools back down to between 12 and 19 times, the stock would be worth $33 to $53 per share, meaning the stock is currently overvalued.
2. Rising interest rates could hurt Altria
Momentum over the past year was not driven by top or bottom-line growth. After all, fiscal 2014 saw revenue and adjusted earnings rise just 0.2% and 8% year-over-year, respectively. Instead, shares have been fueled by low interest rates, which make high-yielding stocks like Altria look more attractive than bonds. However, the price volatility of stocks still makes them riskier than bonds with comparable yields.
The Fed is widely expected to hike interest rates in either June or September, which will cause bond yields to rise and possibly trigger a sell-off in dividend stocks with higher valuations like Altria. To make matters worse, yield has slipped to a five-year low due to the recent jump in share prices.
Yet that does not necessarily mean Altria will be crushed by rising interest rates. Its long tradition of increasing payouts ever since spin-offs of Kraft Foods (UNKNOWN:KRFT.DL) and Philip Morris International (NYSE:PM) could prevent long-term dividend investors from selling.
3. A surprisingly sustainable business model
The adult smoking rate in the U.S plunged from 42% in 1965 to 18% in 2012, according to the Surgeon General's Report on Smoking and Health. The bears point to that figure and claim that the business of domestic tobacco is unsustainable.
However, Altria offset declining cigarette shipment volumes with two main strategies: cutting jobs and raising cigarette prices. In 2014, cigarette shipment volumes fell 4% year-over-year to 125.4 billion units. That is a 26% decrease from the 169.4 billion units shipped in 2008, but annual revenue still rose 27% during that period.
Cigarettes currently cost an average of $6.36 per pack (including taxes) across the country, but Altria still has plenty of room to raise prices. A pack of cigarettes costs just 0.14% of the average U.S. monthly income, according to UNECE and ILO figures. The U.S. and Australia have similar smoking rates, but Australian smokers are still willing to pay an average of $12.14, or 0.47% of their average monthly income, for each pack. This means Altria should have quite a bit of room to raise prices, offsetting future shipment declines.
The bottom line
Altria has other opportunities for growth beyond cigarettes, including cigars, snuff, a stake in SABMiller, and e-cigarettes. However, those businesses are still dwarfed by the traditional cigarette business.
In my opinion, Altria investors should brace for a pullback in 2015, due to its lofty valuation and interest rate risk. However, if you intend to hold Altria shares for a longer time horizon, its core business is rock-solid, dividends will keep rising, and its smaller segments could eventually evolve into new pillars of growth. Therefore, I would personally consider any pullbacks to be opportunities to add shares, not sell them.