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Potential Nicotine Reduction Proposal Weighs on Altria's Longer-term Outlook

The Biden administration is considering proposals to ban menthol and reduce nicotine levels in cigarettes to non-addictive levels, the Wall Street Journal reported on Monday.

If these policies move forward, they will almost certainly face legal challenges from the tobacco industry and take years to implement.

Altria’s short-term outlook arguably has not changed. But the long-term consequences of these policies, if enacted, could be severe.

Lowering nicotine levels has for decades been discussed as a potential endgame for combustible cigarettes. With less of this addictive chemical in each cigarette, more smokers would quit or pursue other forms of nicotine delivery, and prospective smokers may never develop the habit.

The U.S. Food and Drug Administration (FDA) regulates the American tobacco industry. In 2018, the FDA funded a study to look at the implications of one possible policy scenario for reducing nicotine levels in cigarettes to make them "minimally addictive."

According to this model, if this policy was put in place by 2020, approximately 5 million additional adult smokers – or about 15% of total U.S. smokers – would quit smoking within just one year after implementation compared to the baseline scenario.

The outlook gets worse beyond the first year. The study also estimated that the percentage of American adults who smoke cigarettes could fall from around 14% in 2020 to just 4% by 2030.

For comparison, the study's baseline scenario, which assumed no change in nicotine levels, projected 11% of adults would still smoke cigarettes in 2030; nearly three times as many smokers would still be in the market compared to the reduced nicotine scenario.

Meanwhile, use of noncombusted tobacco products (including smokeless tobacco and e-cigarettes) could potentially double as smokers are forced to seek other less harmful sources of nicotine. But overall tobacco use would still settle in around 20% below the baseline scenario.
Source: The New England Journal of Medicine; FDA-funded study

We believe Altria could struggle to maintain its large dividend if this environment materialized.

Management has been slow to adapt the company for a future in which nicotine is increasingly delivered by other products that are less harmful than combustible cigarettes.

Cigarettes still account for around 85% of Altria's revenue and profits, with chewing tobacco representing most of the remainder. The company depends on cigarettes remaining a cash cow so it can fund investments in nicotine markets of the future.

These opportunities could include e-vapor company Juul (Altria owns a 35% stake), tobacco-free nicotine pouches, and Philip Morris International's IQOS device, which heats tobacco instead of burning it (Altria has exclusive U.S. rights to sell this product).

But getting smokers to adopt new offerings requires a lot of spending to build awareness and ramp distribution nationwide. Unlike Altria's high-margin Marlboro brand, these businesses are all in reinvestment mode and probably won't be positioned to provide the firm with meaningful cash flow for years.

This could be a problem if the pool of U.S. smokers starts shrinking more rapidly in response to policies that make cigarettes less addictive.

Altria's payout ratio already sits near 80%, limiting the amount of cash flow the business retains for reinvestment. If Altria's cash flow from cigarettes declines and pressure rises to invest more aggressively in reduced-risk products, lowering the dividend could be prudent to free up more funding.

For now, trends in Altria's business remain steady and supportive of the dividend. Cigarette volumes in 2020 were little changed, and analysts expect the company's earnings per share to grow 5% this year.

Based on what we know today, we are reaffirming Altria's Borderline Safe Dividend Safety Score. Our outlook could change if a nicotine reduction proposal becomes an official standard and is phased in relatively soon, but that outcome faces plenty of uncertainty.

By law, the FDA cannot ban cigarettes or lower nicotine levels to zero. Reducing nicotine to the point that cigarettes are no longer addictive might be viewed as a de facto ban on cigarettes, making the proposal a nonstarter.

The FDA could also struggle to identify scientific evidence supporting specific nicotine thresholds that make cigarettes addictive, and such a sweeping policy would need to be closely studied given the various unintended consequences that could arise.

For example, addicted smokers may increase the number of cigarettes they smoke to compensate for lower levels of of nicotine, and illicit trade could develop.

Capping nicotine levels in cigarettes at non-addictive levels has never been enacted anywhere before, so it remains to be seen how smokers would actually respond to this type of policy. It could be many years before we find out.

Shares of Altria have fallen 10% from Friday's close through Tuesday as investors digest the latest regulatory uncertainty facing the U.S. tobacco industry.

Given the potential severity of this risk, we expect it to remain an overhang on the company's valuation. Altria's stock now trades at a forward P/E ratio near 10, reflecting concerns about the company's ability to achieve long-term growth.

While expectations look low, investors should understand that Altria could become a value trap in the years ahead if these rumored proposals become law and cause smoking rates to plunge. We will continue monitoring this situation and provide updates as needed.

Income investors looking for a less risky option in this space could consider Philip Morris International. This business owns the international rights to Altria's famous brands, including Marlboro. With operations in over 180 countries, Philip Morris's regulatory risk is diversified (no direct exposure to the U.S.), and reduced-risk products already account for close to 30% of its revenue.

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