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Altria's Tobacco Business Remains Resilient But Longer-term Growth Uncertainties Linger

Altria's third-quarter earnings report highlighted the tobacco category's resiliency during the pandemic.

With consumers spending less on gas and entertainment, plus having more opportunities to smoke while working from home, U.S. cigarette volumes increased last quarter for the first time in years.

Similarly, Altria's volume declines continued moderating from a 7% loss in early 2019 to a 1% dip last quarter. 

Management now expects industry volumes this year to be flat to down 1.5%. For comparison, Altria was projecting a 4% to 6% decline at the start of the year.
Source: Altria Earnings Presentation
Altria also realized a 5.9% price gain during the quarter and saw Marlboro's retail market share tick up sequentially to reach its highest level in a year.

Overall, Altria's third-quarter revenues net of excise taxes rose about 5% and its adjusted EPS was flat.

For the full year, management now expects adjusted EPS to grow 2% to 4% and result in a payout ratio of 80%, in line with the company's target.

Given this backdrop, we expect Altria's dividend to remain on solid ground for the foreseeable future.

However, the stock's high yield continues to reflect investors' loss of trust in management, plus the longer-term demand uncertainties facing the tobacco business.

During the quarter, management further wrote down the value of Altria's stake in e-vapor company Juul.

Altria bought 35% of Juul for $12.8 billion in late 2018, but the carrying value of this investment stands at just $1.6 billion less than two years later.

Juul and the vaping category ran into a slew of regulatory and legal challenges in recent years, significantly reducing its growth prospects (and the value of Altria's stake).

While this investment is a sunk cost and was not a bet-the-firm move (Altria maintains an investment grade credit rating), it has potentially created legal headaches for Altria.

At the end of 2019, Altria faced 101 cases related to Juul's e-vapor products, including 22 class action lawsuits. By the end of the third quarter, that figure had grown to 1,145 cases, of which 25 were class action lawsuits.

It's hard to estimate how serious these liabilities may be since no case has been set for trial, and it may take years for more information to become known.

What's more clear is that Altria's investment in Juul wasted billions of dollars and eroded trust in management to adapt the company for a future in which nicotine is consumed from products that are less harmful than combustible cigarettes.

To its credit, Altria does have some investments outside of cigarettes.

In addition to Juul, Altria owns 45% of Cronos (cannabis) and 10% of Anheuser-Busch InBev (beer). These investments are valued at around $12 billion, or close to 20% of Altria's market cap.

The firm also sells tobacco-free nicotine pouches and has exclusive U.S. rights to sell Philip Morris' IQOS device, which heats tobacco instead of burning it.

However, combustible cigarettes still account for around 85% of the company's revenue and profits today, with chewing tobacco generating most of the rest.

For comparison, Philip Morris International already generates around 25% of its sales from next-generation products (NGPs) which have lower risk profiles compared to cigarettes.

Altria's business mix is somewhat concerning since NGPs such as heated tobacco and e-cigarettes could account for over half of the industry's nicotine-based product volumes in 10 years, according to the company.

While the pandemic has buoyed short-term cigarette demand, it's hard to argue that the long-term secular decline rate of cigarettes has changed much.

To stay relevant, Altria may need to eventually increase the amount it invests behind its NGPs if it wants to be a leader in these markets of the future.

Getting consumers to adopt new offerings such as IQOS requires a lot of effort to build awareness and nationwide distribution, crimping returns until these businesses scale.

Not only could stepped up spending weigh on Altria's earnings growth, but the company's 80% payout ratio could make it difficult for the firm to retain sufficient cash flow if it needs to pivot the business more aggressively in the future.

This longer-term uncertainty will take time to be resolved and is the main reason behind Altria's Borderline Safe Dividend Safety Score.

For now, investors can continue relying on the dividend, which management raised by 2.4% this summer.

However, the decades ahead may look much different for the company as the nicotine market evolves.

Until Altria demonstrates an ability to scale its noncombustible portfolio and sustain profitable earnings growth, the stock may remain a "show me" story.

We plan to continue holding our shares in our Top 20 Dividend Stocks portfolio and will keep monitoring the situation. 

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