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The tobacco industry is under the scanner of the FDA on approval of menthol usage in cigarettes. Major cigarette manufacturers will get affected by this decision but not Altria group (NYSE:MO). It has been able to create a broad product portfolio with large brands in the cigarette category. The company has shown dividend growth rate of 7.3% during last year. In the 2nd quarter of fiscal 2013, it has achieved 5% growth in earnings and reported EPS of $0.62. Now, let's discuss a few points in detail.

Diversification towards smokeless products will drive growth

The smokable cigarettes segment is strictly regulated and with other alternatives available now, this segment is facing decline in consumption. Altria Group is diversifying its product portfolio more towards smokeless products. Chewing tobacco and snuff are two other product categories which are also preferred by consumers. In the 2nd quarter of 2013, smokeless products posted strong results with sales growth of 7.6% and operating margin growth of 12.5%. At present, smokeless products category has ~20% share in the total sales but it will increase with growing Copenhagen and Skoal brands. The company will drive its long term sales growth through its diversified products portfolio.

Pricing can be decisive in margins growth

Altria group has achieved operating margin growth of 1.5% in the smokable cigarette category, despite missing the volume target. It has increased prices to offset the decline in cigarette consumption. The demand of cigarettes is declining and it throws a challenge to the company for right pricing to drive sales growth. As industry trends for volume growth are very low, price-mix along with cost savings in the category will drive margins in the short term.

E-cigarette launch can be growth driver

E-cigarette is another fast growing category and came across as an alternative to traditional cigarettes. E-cigarette is now a worldwide $3 billion category and Altria group is also coming up with a new e-cigarette brand. The company is all set to launch MarkTen e-cigarette in the test markets of Indiana. This is a key innovation for the company and if successful, it will be rolled out across the markets to drive sales growth. This product category has seen better margins, which will help it to establish itself in the emerging markets.

Peer Analysis

In the Tobacco industry, the other two major peers of Altria Group are Philip Morris International (NYSE:PM) and Lorillard (NYSE:LO). Philip Morris has faced headwinds in the last six months. Apart from the currency problem, it has seen less than expected sales from the major markets. The subsidy cut on fuel in Indonesia, excise tax increase in Philippines and the anti-tobacco bill passed in Russia are major reasons for the drag in volumes. It has missed the consensus EPS target in the 2nd quarter of fiscal 2013 by $0.11 despite increase in price. If macro conditions improve in the near term, the company can come back stronger with large brands in its product portfolio.

Lorillard has reported positive sales growth in convenience stores, compared to other channels. It has benefited by the price mix but this channel has reported better volumes. It has reported above consensus EPS of 0.81. Despite the FDA issue on menthol, it is positive on its Newport brand with increased promotional activities. It will also gain from alternative options like e-cigarettes. In the 2nd quarter of fiscal 2013, it has also increased its domestic retail share with 14.9% domestic sales.

Op. Margin

1 yr. Fwd. P/E

PEG

Altria Group

46.82%

13.57

1.88

Philip Morris

43.54%

14.4

1.62

Lorillard

47.37

12.2

1.11

Source: Yahoo Finance

Altria Group has reported an operating margin of 46.82% higher than Philip Morris but lower than the relatively small player Lorillard. It is trading at one year forward P/E of 13.37 with PEG of 1.88. Lorillard is a small player but is still trading at the lowest forward P/E of 12.2 and with the highest operating margin.

Conclusion

Altria Group is diversifying its product portfolio due to declining smokable cigarette volumes. Smokeless products and e-cigarettes are the key product categories, which can drive growth in the long term. It will continue to use pricing to offset the volume drag to achieve the overall sales growth. I recommend buying it as it has big brands to drive its growth along with new products in the pipeline.

Source: What Makes Altria Group A Good Buy?