Altria: The Future Of The Cigarette Market

Summary:

• Altria offers a compelling investment with a low P/E ratio and an 8.2% dividend yield despite facing volume declines and regulatory risks.
• The US market remains highly profitable for Altria, but the lack of diversification and regulatory threats pose significant risks.
• Vaping and other alternatives are accelerating cigarette volume declines in the US, but Altria’s pricing power and buybacks support profitability.
• Altria’s efforts in smokeless products have been disappointing, but its dividend appears safe in the midterm, making it a buy at current valuations.

Altria (NYSE:MO) probably doesn’t need an introduction, but for those unfamiliar with it, the company is the leading tobacco company in the US, mostly known for its popular Marlboro brand.

It has been the best-performing stock of the last century, returning 265,528,901% (you’ve read that right) over the last 98 years, resulting in a CAGR of 16.3% with dividends reinvested. With such a track record, you would expect shares to trade at premium valuations, as investors around the world would like to own a piece of that. But far from it, Altria is selling at less than 10x forward earnings and boasts a mouth-watering dividend yield of 8.2%, making it one of the highest dividend-paying stocks in the S&P 500.

With such a strong track record, the stock has a loyal fan base, and it keeps attracting new dividend-seeking investors due to its modest valuations. As we’ve all learned by either experience or reading about it, a high dividend yield may come with high risk, but is that really the case for Altria or does MO really stand for Must Own and More Money?

In this article, we take a step back from short-term data and day-to-day fluctuations of the stock price. I won’t be pushing buttons yelling sell, sell, sell or buy, buy, buy. Instead, we’ll look at Altria’s history and make assumptions about the company’s profitability moving forward. As a long-term value investor, I am particularly interested in the safety of its dividend going forward, so we’re going to do some easy calculations to see where the company and the industry could be headed.

The US Market is Highly Profitable

Altria is unique, as it’s the only major tobacco company that sells its products only in one country, the US. That fact is both a curse and a blessing.

On one hand, the US is by far the most profitable cigarette market in the world. To give you a comparison, Altria sold 76 billion cigarettes in 2023, generating $8.8 billion in adjusted earnings. That’s $2.32 in net earnings for a pack of 20 cigarettes.

In comparison, during the same period, Japan Tobacco (OTCPK:JAPAY) sold 540 billion cigarettes for a net profit of just $3.2 billion, or $0.11 per pack. And these calculations even include their small pharmaceutical and food business, which contributed to earnings in that period.

So, the US combustible business remains highly profitable, even compared to other developed countries in Europe. Altria is the biggest player in that market, but its focus on only one country also comes with additional risks.

The most obvious one is that Altria lacks diversification, which in a highly regulated industry like tobacco, that some politicians would like to see outlawed, is even riskier than in other sectors. The recent discussions about menthol bans or even lowering nicotine to non-addictive levels highlight these risks.

If you think about it, slashing nicotine levels by 95% or more, would almost equal an outright ban. It’s similar to reducing the alcohol contents in spirits by 95%; who would buy vodka with an alcoholic content of just 2%?

Now, some investors argued lowering nicotine levels would make smokers smoke even more. I am skeptical about that, it would probably make smokers switch to smokeless alternatives and at the same time create a huge black market for cigarettes that actually contain sufficient nicotine.

But since the discussions about possible menthol bans and lowering nicotine levels have quieted somewhat in recent months, let’s set that aside and focus on another risk, which comes with operating in a mature market like the US.

Vaping And Other Alternatives Are Replacing Cigarettes

I’ve been traveling around the world and I can’t help but view the countries through the lens of an investor. In Europe, smoking cigarettes is still common, and I still see many young people picking up the habit, at least according to my observations.

Smoking alternatives are of course available, but the majority still opt for traditional combustibles, at least when it comes to countries like Germany and Spain. Also, the preferred choice of nicotine consumption depends on the country. While in the UK vaping is popular, in Italy or Greece, people rather prefer heated tobacco.

In the US, however, the progress towards a smokeless world is much further along. Vaping and oral nicotine are increasingly replacing traditional cigarettes. During the British American Tobacco’s latest Capital Markets Day, the company reported that almost as many people are vaping than smoking now. This trend is also reflected in the accelerated volume declines in the US in recent years.

Outside the US, the decline rates for cigarettes aren’t as steep. According to Philip Morris’ annual reports over the last 5 years, cigarette volumes outside the US and China declined by just 1.3% a year, heated tobacco included.

In the US, however, the situation looks a lot different. In the same timeframe, Altria’s cigarette volumes dropped from 110 billion in 2018, to just 76 billion in 2023, or a decline rate of 7.12% a year. This trend has even accelerated recently, and Altria reported another decline in shipment volume of 11.5% in the first half of 2024. This trend is not limited to Altria, as the second-largest player in the US, British American Tobacco, has reported similar results.

The reasons for the accelerated decline rates in the US compared to other parts in the world have various reasons. Not only are illegal vapes and modern oral taking away customers from traditional cigarettes, but most consumers are now in lower-income brackets which are hit particularly hard by rising inflation, leading them to switch to cheaper deep discount brands where major tobacco companies have almost no presence.

If you listen to the conference calls of Altria and British American Tobacco, they claim it’s just a temporary phenomenon and that decline rates will surely return to historical levels of around 5%-6% once the economic situation improves. I am not so sure about that, and I definitely wouldn’t include it into my calculations for the future to make sound investment decisions.

The Economics of Tobacco

While decline rates for major US tobacco companies have been concerning in recent years, the profitability remains robust.

Although Altria saw its cigarette volumes decline by more than 30% in just 5 years, it’s adjusted diluted EPS increased from $3.99 to $4.95 or a CAGR of 4.41%, that’s not too bad for a company trading at single-digit P/E ratios.

Sure, buybacks played a role in this, but Altria didn’t need to raise much debt to fund them, as Capex is generally low for tobacco companies. In 2024, Altria expects profits to rise another 3%, which should lead to its 56th year of dividend increases. The question remains: can it continue despite accelerating volume declines?

To answer this, we have to take a deeper look into the economics of tobacco, which are quite different from any other product in the consumer staple space. For one, its customers are addicted, which gives the industry enormous pricing power. As the industry is highly concentrated, tobacco companies raise their prices every year, instead of engaging in price wars.

And the most important reason for the continuing profitability is that Big Tobacco has another business partner, namely the government. In the US, on average, roughly half of the retail price goes to taxes or MSA payments. The retailer gets a small share of the price and the rest goes to Altria. Given that less than 50% of the retail price goes to the tobacco companies, they can raise their prices by 10% and less than 5% of the price hike will be felt by the consumer if taxes stay the same.

To make conclusions about future profitability and dividend payments, let’s do some simple calculations. To be on the conservative side, I assume decline rates will stay high at 8% per year for the next decade. Altria reported 76 billion shipment volume and revenues net of excise taxes of $17.9 billion for its combustible business. That equals on average $4.71 per pack in net revenues.

To offset the 8% volume decline, they would need to raise prices by roughly 8% a year. I also assume the government wants to keep its share, so it raises taxes by 5% a year. What would cigarette prices look like in ten years?

Year	Volumes (-8% a year)	Net revenues for Altria per pack (+8% a year)	Taxes (+5% a year)	Cost per pack at retail
1	76	$4.71	$4.29	$9
2	69.92	$5.09	$4.50	$9.59
3	64.33	$5.49	$4.73	$10.22
4	59.18	$5.93	$4.97	$10.90
5	54.45	$6.41	$5.21	$11,62
6	50.09	$6.92	$5.48	$12.40
7	46.08	$7.47	$5.75	$13.22
8	42.40	$8.07	$6.04	$14.11
9	39.00	$8.72	$6.34	$15.06
10	33.01	$9.42	$6.66	$16.08

Click to enlarge

On average, the consumer would pay $16 per pack, or an inflation rate of 5.92% per year. Keep in mind, that taxes and retail prices in the US vary widely, state by state. So smokers in New York would probably pay more than $20, while smokers in Missouri could still snap up some relatively cheap smokes.

The question remains would smokers pay that much for a pack of cigarettes? As I’ve already discussed in this article, Australia is a good case study, since it currently has the highest cigarette prices in the world.

The Australian Case Study

In Australia, cigarettes now cost at least US$23 for a pack of 20 for the lowest-priced discount brands. If you want some Marlboro’s or other premium brands, it’s even more expensive.

As a result of the high cigarette prices, Australia has a growing black market. What’s astonishing is that even with plain packaging and outrageous cigarette prices, 8% of the population still chooses to smoke. Compare that to the US with its current 11% smoking rate and there’s not much difference.

Before the Australian government started its price hikes, smoking rates were around 15%, so it has almost halved since 2010. However, in the US and other developed countries, decline rates were similar even though prices are more affordable.

In my opinion, it’s very questionable if Australia’s measures were even effective. Smoking alternatives like vaping, social stigma, and a more health-conscious consumer seems to be the main reasons for the decline in smoking rates around the world in the last few decades.

It seems like smokers who refuse to quit or switch will accept price increases that no other consumer product could get away with. Could there even be a baseline of smokers, that won’t ever quit or switch to alternatives, let’s say 5% of the population, no matter how high prices would get? I don’t know the answer to that question, but it’s an interesting one to think about.

I believe even with higher decline rates, Altria’s dividend is safe, at least for the midterm. Continued buybacks should help to remain in profitability, even if the underlying business would be stagnant or in a modest decline. For every dollar Altria buys back its shares, it saves more than 8% in dividend payments at current valuations. The lower the share price goes, the more the company saves.

Altria’s Next-Generation Products

Now we’ve covered already a lot in this article, and to go into depth on Altria’s future beyond cigarettes would probably fill another article. But so far, Altria’s efforts into transforming the company into a smokeless future have been greatly disappointing, to say the least.

Long-term investors surely remind the missteps by overpaying for JUUL, where the management panicked and paid $12.8 billion for a 35% stake in a company that had less than $2 billion in revenue, just to write down most of it shortly after.

To me, although less costly, the NJOY acquisition will be a future writedown as well. The product looks like it would have been a promising alternative to cigarettes ten years ago, but in 2024 it’s surely outdated.

Altria is competing against hundreds of emerging Chinese companies that are selling illegal bubble gum flavored disposable vapes with colorful LED screens where you can play games on. The world of vaping has changed rapidly since NJOY was released. If enforcement keeps almost non-existent in the US, Altria doesn’t have a chance with its outdated menthol and tobacco-flavored vapes.

The efforts with Japan Tobacco to capture the market in heated tobacco doesn’t seem promising as well. Philip Morris already tried to gain a foothold with its heated tobacco product IQOS in Canada many years ago. It flopped as vaping is already the dominant choice. In the US, I expect similar results for the category as consumer preferences are aligned and vaping is already the dominant category.

Even if somehow heated tobacco would be successful in the US, how does Altria plan to compete against Philip Morris’ IQOS or even the promising Glo Hilo shown at British American Tobacco’s recent Capital Markets Day? Japan Tobacco’s Ploom didn’t even have a chance in its home market, Japan, but Altria’s management expect it to be different in the US? It just shows how management seems to be out of touch with the new generation of consumers.

There’s hope, however. Altria’s ON! has shown promising growth rates and is a distant second in the promising modern oral category.

The FDA’s lengthy PMTA process doesn’t make it easy for Altria and other major tobacco companies to compete against illegal products, so if enforcement would change, Altria may have a chance to at least stay over water even beyond cigarettes. The recent vape directory in Louisiana seems promising, as the legal part of the vaping market has returned to growth after implementing it.

For now, I discount management’s efforts for transformation and cross my fingers that they don’t fall for another JUUL. They should focus their efforts on managing the decline of cigarette volumes and raising dividends, hopefully for another 55 years.

Given that I expect combustible profits to be stable even with higher decline rates, I still consider Altria a buy at current valuations. In the next Q3 report, I will monitor volume decline rates, revenues and adjusted net profit to see if my investment thesis is still intact.

While I bought Altria shares during its lows in 2020 and enjoy the dividends, British American Tobacco is still my favorite choice in the tobacco sector. They’re further ahead with their next-generation products, provide international diversification, and valuations are even lower right now. I’ve recently written an article about the company here.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of MO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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