Why Altria Has Become Expensive

| About: Altria Group, (MO)

Summary

During the last 12 months, Altria has rallied 36% while S&P has lost 3%.

Therefore, investors have become increasing concerned that the stock may have reached overvalued territory.

The article discusses why the stock has become so richly valued.

Altria (NYSE:MO) has vastly outperformed the market during the last 12 months. To be sure, the stalwart has advanced 36% while the S&P (NYSEARCA:SPY) has lost 3% during that period. As the stock keeps posting one all-time high after another it's only natural that many investors wonder whether the stock has now become overvalued. These concerns are enhanced by the remarkably high forward P/E ratio of the stock, which currently stands at 22. Therefore, it is critical that investors understand the reasons behind the rich valuation of the stock so that they do not react emotionally at the first meaningful correction.

First of all, it is remarkable that the stock has defied all the negative headlines that are related to the tobacco industry. More specifically, California recently raised the smoking age from 18 to 21 while another 10 US states are currently considering similar legislation. Moreover, Australia and UK have forbidden logos and brand colors in all cigarette packs produced in these countries and hence it has become more likely that some US states may follow at some point in the future. These negative developments are only a few of the plentiful measures of many countries against tobacco companies. Therefore, it is somewhat surprising that Altria keeps posting new all-time highs on a regular basis.

The negative trend in the broad tobacco industry was evident in the Q1 results of Altria as total cigarette volume declined 1% over last year. However, Altria reported excellent results with its revenue from smokeable products up 5%. The great performance resulted from a 6% hike in the price of its products. Fortunately for the company, the demand for its products is highly inelastic and hence the company keeps raising its prices at its discretion without losing many customers. Despite all the headwinds in the tobacco industry, Altria raises its prices at a high pace year after year and thus keeps growing its earnings.

Thanks to the inelastic demand of its products, the stock has been remarkably consistent for decades. More specifically, it is one of the 44 US stocks that have returned over 10,000% in the last 30 years. In addition, thanks to its consistency, it is characterized by markedly low volatility, with a beta of 0.69. This defensive behavior makes it a great stock during market downturns when investors need solid performance in order to avoid panic-selling and sleepless nights.

It also is remarkable that Altria has raised its dividend for 46 consecutive years. Even better, it is expected to grow its earnings per share by about 8% per year for the next five years. Therefore, as management has declared its intention to maintain a payout ratio around 80%, the company is expected to keep growing its dividend by about 8% per year for the next five years. The current dividend yield is 3.4%, which is very attractive to most investors, particularly given the prevailing record low interest rates. Moreover, the company raises its dividend every September. Hence investors are looking forward to the announcement of the next dividend hike in August and thus they have driven the stock price to its current all-time high. Given that the interest rates now seem more likely to remain suppressed for longer due to Brexit, it is only natural that investors rush into high-yield dividend aristocrats. While markets were crashing on the day after Brexit, Altria was rallying to new all-time highs.

The other major reason for the rally for the stock this year has been the merger of Anheuser-Busch Inbev (NYSE:BUD) and SABMiller (OTCPK:SBMRY). Thanks to this deal, Altria will receive about $2.5 billion in pre-tax cash. The investment community has been enthusiastic about this deal and has thus led Altria to rally. Moreover, there has been some speculation about the potential uses of the proceeds, such as a surprisingly big dividend hike or share repurchases or debt repurchase. While an unusually big dividend hike is unlikely, given that it is a commitment for many years ahead, the optionality provided by the extra cash has certainly helped the stock.

Investors should keep in mind that Altria is one of the few stalwarts that operate only in the US and thus is fully protected from the strong dollar. While all the multinational companies, such as Philip Morris (NYSE:PM), have suffered from the strong dollar in the last two years, Altria is not affected at all. In addition, the US economy is still the best house in the global market. Therefore, investors have good reason to hold this stock.

To sum up, while Altria may be somewhat overvalued after its sustained rally, there are good reasons behind its rich valuation. More specifically, the high dividend yield amid the prevailing record-low interest rates and the anticipation of the next dividend hike in September have certainly helped the stock rally. In addition, the mega-brew deal has been a contributing factor. Investors should be well aware of these factors so that they formulate their strategy accordingly whenever some of these factors change.

Disclosure: I/we 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.