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Altria Group (MO) is a leader in both traditional cigarettes as well as smokeless tobacco products in the U.S. Despite a 2.8% decline in its revenue in the second-quarter, the company reported 5% growth in earnings per share. This decline was a resultant of consumers shift towards a healthy lifestyle. According to the latest figures released by the Federal trade commission in May 2013, the number of cigarettes sold in the U.S. declined to 273.6 billion in 2011 from 281.6 billion in 2010. Amid declining traditional cigarette sales, smokeless tobacco products like "dipping tobacco" and "e-cigarettes" are gaining popularity, which creates an opportunity for Altria. Let's discuss how Altria can cash in on this opportunity and provide steady returns to investors.

Smokeless tobacco products to drive revenue growth

Demand for traditional cigarettes is declining and consumers are shifting towards a healthier lifestyle in the U.S. Traditional tobacco cigarettes are highly regulated and heavily taxed in the U.S. On the other hand, e-cigarettes provide consumers with a cheaper tobacco free way to fulfill their nicotine addiction. One e-cigarette is equivalent to 15 traditional cigarettes in terms of nicotine quantity. According to Wells Fargo, total e-cigarette sales are expected to reach $1.7 billion by the end of this year compared to $500 million in 2012.

Decline in traditional cigarette sales and increasing popularity of e-cigarettes led Altria to launch its own e-cigarette brand, "MarkTen". MarkTen will hit the market this month. The company is using "Four Draw" technology for production of MarkTen. This technology is a trademark of Altria, and it gives the smoker a similar smoking experience as compared to a traditional cigarette. It will sell MarkTen in classic and menthol tobacco flavors and will cost around $9.50 at retail stores. Altria is known for its promotion and marketing activities. It has a robust marketing plan for MarkTen. It can promote MarkTen intensely to gain market share in e-cigarettes as it did with Marlboro, which accounts for 43.7% of its cigarette market share in the U.S. With its strong brand recognition, we expect Altria's traditional cigarette customers may make a switch to e-cigarettes. E-cigarettes do not have similar restrictions as traditional cigarettes. Also, there is no age limit for buying e-cigs. Due to this, e-cigarette use is rising among youth, and we expect that Altria's MarkTen will attract new customers.

On the other hand, smokeless tobacco products are considered safer than cigarettes and can be used where smoking is banned. U.S. tobacco companies spend approximately half a billion dollars every year on advertising smokeless tobacco products. Altria dominates the U.S. smokeless tobacco market with 55% market share. The company has brands like Copenhagen and Skoal, which enjoy a combined market share of 50.7%.

Regulatory restriction could hinder the growth

The Food and Drug Administration, or FDA, keeps imposing regulatory restrictions on the U.S. tobacco industry. The FDA is mulling an option to ban online sales of e-cigarettes to prevent sales to minors and is expected to publish its formal proposal in October this year. Online sales of e-cigarettes are estimated to be between $500 million to $625 million this year, approximately 29% to 37% of total sales. Online sales will play a major role in the growth of e-cigs. A possible ban could hinder the growth of e-cigarette sales, and Altria's MarkTen is yet to come on the market.

Regulatory scrutiny of menthol based cigarettes is another challenge for the tobacco industry since Menthol based cigarettes account for one-third of cigarette sales in the U.S. According to a scientific review issued by the FDA, mint flavored cigarettes easily attract non-smokers towards smoking and are disproportionately more detrimental to public health than regular smoking.

An expected ban on menthol by the FDA would affect all three major tobacco companies. However, the magnitude of effect will be different for each company. Altria will be least affected with this ban as its menthol based cigarettes account for only 20% of cigarette sales. However, its competitors Lorillard (LO) and Reynolds American (RAI menthol based product sales account for about 90% and 30% of total sales respectively. However, these two companies have already launched e-cigarette brands, which are giving them a competitive edge over Altria in this segment. But, Altria's e-cigarette will be superior in quality with the use of "four draw" technology. It has strong brand recognition, and Altria can really heat up competition in the e-cigarette market.

Indication of steady returns to shareholders

Altria's commitment towards increasing shareholders' return was reiterated with a 9.1% increase in its quarterly dividend to $0.48 per share from $0.44 per share declared in May 2013. Also, the company is expanding its share buyback program by $700 million, which was originally $300 million, and will complete it by the third quarter of 2014. As the company normally buys back shares at premium of prevailing market prices, investors can expect a rise in share price as the buyback takes place.

The company's EPS growth of 5% in second quarter may not be impressive for investors; however, in the scenario where the number of cigarettes sold has been declining, it can be considered decent growth. Moreover, the company has revised its full-year outlook for 2013. It expects its adjusted diluted EPS to range between $2.36 and $2.41, signifying 7% to 9% growth in EPS year over year. Investors can further expect rise in dividends as the company reiterated its commitment to maintain its payout ratio of 80%.

Valuation

Altria Group

Lorillard

Reynolds American

EPS (TTM):

2.19

3.21

2.75

P/E :

15.48

13.18

17.32

Forward P/E(FY 2014)

13.23

12.02

13.85

Dividend Yield

5.7%

5.2%

5.3%

Source: Yahoo Finance

The dividend yield for Altria's stock is 5.7%, higher than the 10 year treasury at 2.93% as on August 22, 2013. Altria is a good buy considering its financials and its smaller reliance on menthol based products. At 5.7%, Altria pays slightly better dividends than Lorillard and Reynolds American. Lorillard and Reynolds American trade at 13.18 and 17.32 times EPS respectively, in line with Altria's 15.48. Based on current prices, Altria's forward P/E of 13.23 indicates earnings growth potential of 17% by 2014. Moreover, Altria's $1 billion share buyback program will aid its upside potential.

Conclusion

Investors can't deny the risks associated with any possible ban instated by the FDA on online sales of e-cigs and menthol based products. However, traditional smoking habits won't change significantly, and cigarettes will remain the largest selling tobacco product for some time. Altria already has presence in the U.S. with brands like Copenhagen and Skoal. People may shift their taste preferences from one tobacco product to another, but this industry isn't going to vanish. We recommend long-term investors buy this stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. Fusion Research is a team of equity analysts. This article was written by Madhu Dube, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.