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Summary

  • Dividends offered by the company remain sustainable due to backing of solid cash flows.
  • Litigation issues will increase legal risk and attached costs for the company.
  • Multiple expansion will be limited due to litigation issues.
  • Price "Lights" case expected to drag on for several years.

U.S. tobacco stocks have been popular investment prospects for dividend hunters as they offer impressive dividend yields. Also, tobacco companies, in recent years, have been successful in growing their earnings and dividends, while cash flows remain solid. Despite the fact that earnings and dividends for tobacco companies are growing (owing mainly to price increases, cost cuts and share buybacks), top line growth remains a challenge for the industry. Sturdy regulations, increasing consumer health consciousness and growing popularity of alternate tobacco products have adversely impacted sales volume growth for not only the U.S. Tobacco Industry, but for the global Tobacco Industry as a whole. In the present situation, price increases have remained key to supporting top line and bottom line growth. The table below displays the sales volume growth trends.

2011

2012

2013

U.S.

-3.5%

-2.3%

-4.6%

International

-1.0%

-0.75%

-3%

Total

-1.3%

-0.8%

-3%

Source: Companies' reports and other public data sources

Other than the above mentioned factors, litigation has been another concern for tobacco companies. Recently, an Illinois State Appeals Court reinstated a $10.1 billion 2003 judgment against the Altria Group (NYSE:MO) in the Price "Lights" case. Altria is accused of misleading consumers as to risks attached to consuming "light" cigarettes. Lorillard (NYSE:LO) and Reynolds (NYSE:RAI) are the other leading U.S. tobacco companies that are facing litigation and lawsuits. The ongoing menthol review for Lorillard and the accusation on Reynolds of money laundering (revival of an old lawsuit) are the other ongoing cases in the industry. Given the current situation, litigation costs are likely to be a prominent part of the cost structures for U.S. tobacco companies.

The reinstatement of the prior $10.1 billion Price "Lights" case judgment, in my opinion, is likely to remain an overhang on the stock price, as it creates uncertainty and increased legal/litigation risk. In 2003, the case judgment came against the company awarding $10.1 billion in damages, comprised of $3 billion in disciplinary damages and $7.1 billion in compensatory damages. However, in 2005 the decision was reversed by the Illinois Supreme Court, explaining that the usage of "low tar" and "light" was allowed in advertising by the federal regulator. Then in 2008, the case was revisited when the Federal Trade Commission (FTC) mentioned that it had never dealt with the use of those terms.

Altria has appealed against the judgment and the Illinois Supreme Court is expected to rehear the case. The case is expected to drag on for several years. If the Supreme Court chooses not to rehear the case, the judgment will be reinstated and the case will be returned to the trail court. It will then move ahead according to the normal appellant process. Also, the company might also be required to post a $250 million bond if the Illinois Supreme Court does not rehear the case.

The financial impact of the case is unknown at this point in time. However, what is certain is that litigation costs will continue to impact the company's bottom line numbers in upcoming quarters. Also, in my opinion, the case will create uncertainty, and it has increased litigation/legal risk. Furthermore, it will remain an overhang on the stock price. In addition, the case might limit multiple expansion for the company, which is an important source of return for investors, and cap the upside stock price potential as the stock is already trading at an all-time high of $40.68 (at a forward P/E of 14.75x).

Moody's said that the reinstatement of the 2003 ruling in the Price "Lights" case is a credit negative for the company. Altria is currently assigned a 'Baa1' long term credit rating.

In addition to the Price "Lights" case, the recently proposed regulations by the FDA to regulate the e-cigarettes (e-cigs) market could prove to be an additional regulatory risk for the company and other U.S. tobacco companies, which could impact valuations. The proposed regulations, if finalized, will reduce competition in the e-cigs market and favor big tobacco companies like Altria in the long term. But in the near term, proposed regulations would add to the costs of bringing new products to the market because of costs attached to pre-market studies and achieving quality standards. Also, as Altria is aggressively spending in establishing its e-cigs market, the proposed regulations expose Altria to additional regulatory risk.

(To read more about the proposed regulation, read my recent article on the topic, "E-Cigarettes: Proposed Regulations Could Prove To Be A Game Changer.")

Conclusion

In my opinion, dividends offered by Altria are sustainable as they are backed by strong cash flows, the company offers a dividend yield of 4.7%, which is supported by a free cash flow yield of 6.25%. However, Price "Lights" does bring uncertainty and exposes the company to increased legal/litigation risk. Also, this will increase litigation costs for the company and will impact its earnings. This will in turn limit multiple expansion for Altria.

Source: Altria Remains A Dividend Stock Despite Litigation Headaches