Altria's Long-Term Appeal Is High

| About: Altria Group, (MO)

Summary

Rising interest rates and increasing regulations pose a threat to Altria's outlook.

But a dovish Federal Reserve and pricing power mean Altria's long-term appeal is high.

The company's exposure to Reduced Risk Products (RRPs) and its sound finances make the stock an appealing income play.

Altria (NYSE:MO) is viewed by many investors as a relatively safe income stock. After all, it has increased dividends 50 times in the last 47 years and operates in a relatively resilient industry. However, the company's status as an ever-reliable income play has come under threat from the potential for higher interest rates and new regulations on tobacco products. In my view, these risks pose a threat to Altria's short-term share price performance, but its long-term income appeal remains high.

Regulations

Across the globe, tighter regulations on smoking are causing cigarette volumes to decline. In the US, the situation is no different, and California Proposition 56 could cause volumes to fall further. California Proposition 56 seeks to increase excise tax from $0.87 per pack of cigarettes to $2.87 per pack. This could hurt demand for cigarettes because Altria and its peers would be likely to pass on the vast majority (if not all) of the tax increase to consumers. As such, the company's reported fall in cigarette volumes of 3% in its most recent quarter could increase.

However, the reality is that tobacco products have a price elasticity of demand of around minus 0.5. This means they are relatively demand inelastic, and price increases are unlikely to cause a fall in volume of the same magnitude.

Further, with the company's Marlboro brand having a 44% market share in the US, Altria has a high level of customer loyalty. This provides it with greater scope to increase prices compared to its peers, and may mean that in a market where price rises are necessary in order to offset falling volumes, Altria enjoys a stronger position than its industry peers. This pricing power could prove to be a positive catalyst on its earnings and dividend payments over the medium to long term.

Bond Yields

There is great debate among investors as to when the Federal Reserve will raise interest rates. However, the consensus estimate is for one interest rate rise in the next year. This could hurt the appeal of reliable income stocks such as Altria, since bonds will become more attractive compared to dividend stocks as a result of their increasing yields. Therefore, in the short run, Altria's share price could see reduced demand from investors, and it may subsequently underperform the wider index.

However, looking further ahead, the Federal Reserve is expected to raise rates to only 2.25% in 2020. In other words, monetary policy tightening is likely to be slow and steady, rather than fast. This could allow the appeal of lower-risk, higher-yielding shares such as Altria to remain high. That's especially the case if political risk increases over the medium term, or if challenges in Europe force the Federal Reserve to maintain a dovish stance for longer than is currently anticipated by the market. This could keep demand for Altria's shares high and positively catalyse its share price.

Reduced Risk Products

Altria's exposure to reduced risk products (RRPs) will boost its future dividends, in my view. That's because the company has signed an agreement with Philip Morris (NYSE:PM) to jointly invest in RRPs. This is in addition to a distribution agreement which sees Altria's MarkTen e-cigarettes marketed by Philip Morris abroad, while two of Philip Morris' heated tobacco products are distributed by Altria in the US.

The agreement allows Altria and Philip Morris to pool resources on the development of new RRPs. In my opinion, e-cigarettes are the latest in what could be a long line of RRPs, with the sector offering scope for innovation as consumers are unwilling/unable to give up nicotine products, but are seeking better long-term health outcomes from doing so. By pooling resources, Altria and Philip Morris reduce risk, and this allows them to invest in a wider range of products which could boost their earnings and dividend growth prospects over the long run.

Finances

Altria's dividends are very affordable right now, and this provides scope for the company to continue to increase moving forward. The company's payout ratio is 78%, which is slightly below its long-term target payout ratio of 80%. Further, it has identified $300 million in annualised cost savings which can be realised by the end of next year. This should improve its free cash flow and provide scope for a faster rate of increase in dividends over the short to medium term.

Outlook

Although Altria faces risks such as rising interest rates and increasing regulations, its outlook as an income stock remains bright. The strength of its Marlboro brand and the inelastic nature of demand for tobacco products should allow the company to pass on tax rises to the consumer without hurting sales significantly. The slow forecast rise in interest rates should also keep demand for resilient income stocks such as Altria high, especially with political risk being high. Further, potential in the RRPs space and improving finances should positively catalyse the company's dividend growth. When combined with its 4% yield, all of these factors make Altria a high-quality income play right now.

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.