Why Altria's Dividend Is Very Safe

| About: Altria Group, (MO)

Altria Group (NYSE:MO), the U.S. tobacco giant, recently announced that it was moving into previously uncharted territory with the launch of a tobacco-free nicotine product. The maker of Marlboro cigarettes is launching a non-dissolving nicotine disc in a lozenge shape called Verve. This represents the latest attempt by a major tobacco company to use smokeless products in the background of falling sales for traditional cigarettes.

Unlike the other smokeless products sold by Altria and its major U.S. competitor, Reynolds American (NYSE:RAI), Verve will not contain any tobacco but instead use nicotine extracted from tobacco. The company is betting that this will permit it to market the product with health warning labels that are less stringent than the labels used for products containing tobacco. There is no doubt that nicotine is addictive and is associated with health problems such as high blood pressure and diabetes but, crucially, there is no link to cancer. For instance, smokeless tobacco products such as chewing tobacco have to highlight the risk of cancer and gum disease and carry a warning that reads, "This is not a safe alternative to cigarettes".

Smokeless tobacco products amount to less than 10% of tobacco industry sales, but they have been growing at 7% annually, while the volume of cigarette sales has been contracting by roughly 4% per year. Altria already has a firm grip on over half the smokeless tobacco market with products such as Copenhagen and Skoal moist snuff, while Reynolds, which makes Camel cigarettes and Grizzly moist snuff, has about one third.

Meanwhile, Lorillard (NYSE:LO), which makes Newport cigarettes and is the third-largest U.S. tobacco company, announced last month that it was acquiring electronic cigarette company Blu ECigs. Electronic cigarettes are a fast growing niche and work by converting liquid containing nicotine into vapor. The health impact of long-term nicotine use is presently unknown.

Altria ended the first quarter of 2012 on a high note with earnings per share of $0.49, marking an 11% increase over the previous year's earnings per share of $0.44. With the targeted cost saving by the end of 2013, there should be a positive impact on the earnings per share. Estimates put earnings per share at $2.19 for 2012, up from $2.19 in 2011, while the target for 2013 is $2.35 per share. At $5.65 billion, revenues were well ahead of the consensus estimate of $4 billion.

Sales of smokeable products were flat at $3.5 billion, while smokeless products showed a 3% increase to $380 million. In light of dwindling sales, the company has embarked on a cost reduction program that is expected to save up to $400 million by the end of 2013. Share buybacks totaled $294 million in the first quarter, and will reach $1 billion for the current year. The company has sought to offset declining sales volumes with price increases, banking on the fact that few smokers stop smoking as a result of price increases.

Life is becoming increasingly difficult for tobacco companies as governments and reformers alike try to persuade smokers to quit. Reynolds American has already announced that it will implement a 10% cut in its workforce because of the shrinking demand for cigarettes. Higher taxes are playing their part in the dwindling demand, and the State of California recently passed legislation raising taxes on cigarettes by one dollar a pack to discourage smokers and to fund cancer research. They may also have to cope with a possible FDA ban on menthol.

Obviously, Altria's focus is to tweak its business model to cope with these problems by concentrating on smokeless products and diversifying. It also looks as if its problems with the IRS are almost behind it. It will be paying $450 million of the $500 million due in the second quarter of 2012. By the end of 2011, Altria had paid more than $1 billion towards tax payments for the years 1996 to 2003.

Verve's introduction may support Altria's product diversification efforts, as the company's research shows that up to 30% of smoking adults are looking for an alternative to traditional products containing tobacco.

The other source of comfort for Altria investors is the fact that it is the largest tobacco company in the U.S. market. Contrast this to Phillip Morris International (NYSE:PM), which derives almost 40% of its revenues from Europe and has suffered from the downturn on the continent.

Altria has wisely concentrated on new extensions of the Marlboro brand to keep its traditional tobacco product range diversified. Despite the fact that 80% of its revenues come from cigarettes, it has a useful diversified investment portfolio, with a 25% holding in the largest brewer in the world, SAB Miller. It also owns the St. Michelle Wine brand as well as the John Middleton cigar brand. In fact, Altria is probably the most diversified of the so-called "sin" stocks.

Unless you have moral qualms about investing in a company whose business is almost exclusively tobacco and alcohol, you should take a realistic stance towards investing in Altria. The dividend yield is close to 5%, which is sustainable because people are not going to stop smoking or drinking, even if they only switch to smokeless tobacco products. There is still room to compensate for decreases in volume by increasing prices and, because these are mature businesses, Altria needs modest amounts for capital expenditure and can afford to maintain a high payout ratio. I would certainly recommend Altria to income investors. And if you have an existing holding, you should consider buying at opportune moments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.