Many investors believe that the key to exceptional wealth creation is finding the next great growth stock.
In reality, some of the best investments are the most boring, dividend growth focused companies. There are numerous reasons to be a dividend growth investor (see them all here).
Altria (MO), for example, has been the single best performing stock of the last half century.
As seen below, Altria’s annualized return has more than doubled the S&P 500’s return since 1968.
|Company||Absolute Increase 1968-2016||Total Return (CAGR)|
|S&P 500||87 Fold||10.0%|
What’s even more surprising is that Altria has managed to maintain this level of outperformance during more recent times, when its tobacco products have come under increasing fire from the federal and state governments.
Since August 1995, MO stock has returned 3,551% compared to the S&P 500’s return of 476%.
Let’s take a closer look at Altria’s business model to see why the company has proven such an effective long-term wealth creator for shareholders.
More importantly, find out whether or not Altria remains a long-term buy today or whether this legendary dividend aristocrat’s best days are behind it (learn about all of the dividend aristocrats here).
Founded in 1919 in Richmond, Virginia, Altria is America’s largest tobacco company. The company split into three separate businesses in 2007 (Altria, Phillip Morris International, and Kraft), with Altria retaining all domestic tobacco operations.
The business sells cigarettes (under the Marlboro and Middleton brands), cigars (Black and Mild), smokeless tobacco (NuMark, MarkTen, Skoal, Copenhagen, and Green Smoke), wines (Chateau Ste. Michelle, Columbia Crest, 14 Hands, and Stag’s Leap Wine Cellars), and finance leasing services.
Altria also owns 10.2% of soon-to-be SAB Miller / Anheuser-Busch Inbev (BUD), the world’s largest beer company.
By far the company’s biggest business remains smokeable products, especially cigarettes, which accounted for 90.5% of operating income in 2015.
|Business Segment||2015 Sales||2015 Operating Income||% Of Sales||% Of Operating Income|
|Smokeable Products||$22.8 billion||$7.6 billion||89.6%||90.5%|
|Smokeless Products||$1.9 billion||$1.1 billion||7.4%||13.3%|
|Wines||$692 million||$152 million||2.7%||1.8%|
|Other||$71 million||-$468 million||0.3%||-5.6%|
|Total||$25.4 billion||$8.4 billion||100%||100%|
Source: 2015 Annual Report
It is no secret that smoking is in a secular decline. As the chart below shows, 16.8% of U.S. adults smoked cigarettes in 2014, down from more than 40% in 1965.
However, Altria has managed to do an exceptional job of maintaining steady sales and growing earnings and free cash flow (FCF) over time.
Note that due to the spin offs of numerous businesses including Kraft, Miller, and Philip Morris International, Altria’s existing business track record begins in 2009.
Even more impressive is how well management has squeezed out cost savings, improving margins and returns on shareholder capital in recent years.
What is the key to the company’s success? Simply put, when it comes to smokeable and smokeless tobacco in America, Altria is the undisputed king.
For example, Marlboro has been the largest-selling cigarette brand in the country for the past 40 years. Its market share is greater than the next 10 largest brands combined.
In fact, Altria’s market share in both U.S. cigarettes and smokeless tobacco is above 50%, thanks to the strongest brands in the industry. The company’s supply chain, distribution system, and marketing network are unmatched.
High market share and strong brand recognition allow Altria impressive pricing power, which helps to offset the long-term steady declines in volumes it’s facing from a decrease in overall tobacco use.
For example, in the most recent quarter, Marlboro and Copenhagen were able to command 29% and 26% premium prices to their rival’s products, respectively. This is very important to Altria because over the next decade analysts expect cigarette volume to decline by 3% to 4% a year.
Fortunately, the cigarette industry’s price elasticity has ranged from -0.3 to -0.4 over time, which means that consumption declines by 3-4% for every 10% increase in price.
Pricing is also helped by the tobacco industry’s ongoing consolidation, with British American Tobacco offering to acquire Reynolds for $47 billion in October 2016. There are even rumors that Altria could reunite with Phillip Morris after a series of legal wins have improved the U.S. market’s appeal.
The strong brand equity of Marlboro should allow Altria to completely offset the volume declines via higher pricing and keep overall cigarette revenue stable, perhaps even growing a little.
Better yet, because tobacco isn’t a cash intensive industry, Altria’s cost cutting efforts over the years have allowed it to increase its all-important FCF margin from 18.8% to about 26%.
Meanwhile, smokeless tobacco and wine, though representing a small portion of overall sales, continue to be growth leaders for the company, with revenues rising 10% and 9.3%, respectively, in the past quarter.
All told, the combination of the company’s growth products and ongoing cost cutting efforts should allow organic growth of 2% to 3%, with earnings growth in the 7% to 9% range over the long-term (on par with management’s guidance).
Without a doubt, the biggest risks facing Altria is its exclusive focus on the U.S. (Philip Morris International (PM) has all foreign sales rights).
The problem for Altria remains not so much litigation threats anymore, but increasingly stringent regulations. Specifically, the FDA has now gained full authority to regulate all tobacco (and vaping) products in the US.
This poses a significant threat to Altria’s ability to continue to find growth opportunities, as well as maintain market share and premium pricing power. For example, it recently began rolling out menthol flavored Marlboro, which has been met with much success.
However, the FDA has been threatening for years to ban menthol cigarettes, arguing that the more pleasant flavor makes people more likely to try or continue smoking.
Even more dangerous is the risk that plain packaging laws might come to the US.
These are laws that require minimal brand labeling of cigarette packages, forcing gruesome pictographic warning labels taking center stage. Australia was the first nation to impose such regulations, and it has resulted in smoking rates falling significantly in the past three years.
If the FDA requires such packaging in the U.S., then there’s a risk that Marlboro would lose its brand appeal and decrease Altria’s ability to offset declining volumes with stronger prices.
Speaking of limited pricing power, we can’t forget the ongoing risk of ever rising tobacco taxes. For example, on Nov 8th California voters passed Prop 56, which more than tripled cigarette taxes, from 87 cents per pack to $2.87 per pack.
Thus far rising tobacco taxes haven’t hurt Altria’s ability to raise prices on its products, but if such aggressive tax increases continue, then at some point consumers simply won’t be able to continue paying more for its products, especially if a pack of Marlboro begins to exceed $7, $8, or even $9 per pack.
Finally, we can’t forget that Altria, as well as Philip Morris International, is counting on smoking alternative products, such as electronic cigarettes (which use vaporized nicotine liquid instead of burning tobacco) and heated tobacco products, such as its well selling iQOS brand, to offset the decline in smoking rates and falling cigarette volumes.
As you can see below, iQOS, (which heats tobacco instead of burning it, thus releasing far less toxic and carcinogenic chemicals) has proven popular overseas, and Altria has exclusive rights to sell it in the U.S.
However, first it must obtain FDA approval. Should that be denied, then Altria could lose its two most important growth prospects going forward.
Dividend Safety Analysis: Altria
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Altria has a Dividend Safety Score of 97, indicating that the dividend is extremely secure. This is a function of the company’s strong and consistent cash flow, as well as a strong balance sheet.
As you can see, Altria’s EPS payout ratio has been relatively high for years. However, that’s by design, with management putting the dividend as the highest priority when it comes to returning cash to shareholders, and maintaining a long-term payout ratio target of 80% of earnings.
The company’s high payout ratio is not a sign of dividend danger in this case because Altria’s business is very stable – cigarettes are addictive products that are recession resistant. In fact, Altria’s reported sales grew in fiscal years 2008 and 2009, the company recorded sturdy operating margins, and free cash flow generation was excellent.
Given the steady nature of Altria’s business, the trend in payout ratios is more important than their relatively high level.
That’s especially true given Altria’s strong balance sheet, which gives management flexibility to grow the company (via smokeless alternatives) while still maintaining the dividend as the priority.
At first glance the company’s high debt load and debt/equity ratio might make investors nervous. However, the low leverage ratio and high interest coverage ratio show that Altria has no problem servicing its debt.
|Company||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Debt / Equity||S&P Credit Rating|
As for high debt/equity ratio, that is actually due to the large amount of treasury shares the company holds, due to its large buybacks. This is the norm for the tobacco industry.
Slow organic growth requires that tobacco companies reduce their share counts over time to help grow EPS and FCF per share and continue to offer investors the attractive dividend growth they desire.
Speaking of dividend growth, let’s take a look at Altria’s to see if the stock is worthy of a spot in your income growth portfolio.
Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Altria has a Dividend Growth Score of 51, meaning that investors can expect dividend growth similar to that of other large blue chips.
While it may look at is Altria slashed its dividend in 2008 and 2009, when you adjust for its numerous spin offs (Miller, Kraft, and Philip Morris International), in fact Altria is well on its way to becoming a dividend king.
That’s because it’s raised its dividend for 47 consecutive years, including an 8% boost in August 2016. As seen below, Altria’s dividend growth rate has sat around 8-9% most years.
With management hard at work streamlining operations to cut costs and reduce its share count enough to maintain a 7% to 9% EPS growth rate, long-term investors can realistically expect 6% to 8% dividend growth in the years ahead (to give the payout ratio time to decline to management’s long-term target).
While 7% annual dividend growth may not sound exciting, it is enough double the company’s dividends per share over the course of a decade.
Perhaps the biggest risk with owning Altria is the sky-high valuation. As you can see, the current P/E ratio is close to the market’s frothy 26.04.
For a slow-growing company like this, you typically want to buy at a P/E ratio that’s close to or below the long-term historical norm. As you can see below, from that point of view Altria is overvalued.
|P/E Ratio||13-Year Median PE Ratio||Yield||13-Year Median Yield|
From a yield perspective, the current payout is far below what the market has historically offered for this company.
While the company’s dividend remains very secure with solid growth prospects, investors probably shouldn’t expect the kind of amazing market-stomping returns that Altria is famous for. At least not unless the price pulls way back from today’s near record high share price.
Closing Thoughts on Altria
Tobacco may be an industry in secular decline, but Altria’s fundamentals remain solid.
Thanks to the growth potential of cigarette alternatives, as well as a phenomenally cash-rich business model and very shareholder-friendly management team, Altria is likely to continue providing income growth investors many more years of generous, secure, and moderately fast growing dividends.
That being said, at today’s elevated share price and historically high valuation, investors interested in initiating a position in Altria may want to put it on their watch lists and wait for an inevitable correction to offer a more attractive share price and higher yield.
The company is a great option for retired investors living off dividends, but it’s still important to pay attention to valuation.
Do you know of any other company that has created similar amounts of wealth as consistently as Altria over the last 20 to 40 years?
Simply put, no. I’m sure there might be a couple, but Altria’s track record is really, really hard to beat.