Altria: The Biggest Threat This Company Faces Is Rising Cost Of Capital

| About: Altria Group, (MO)
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Dividend investing has been one of the most successful and popular strategies over the last decade. Many traders have proclaimed buy and hold as dead, but patient investors willing to continuously buy and compound income and total returns in consumer staple stocks continue to outperform most indexes.

Tobacco stock have been some of the most popular and best performing dividend stocks in the market. Companies such as Philip Morris International (NYSE:PM), Altria (NYSE:MO), Lorillard (NYSE:LO), and Reynolds (NYSE:RAI), are all up over 30% in the last year. These stocks have also significantly outperformed the broader indexes over the last decade as well.


Altria is the largest U.S. tobacco company. The $69 billion dollar company has over 50% of the U.S. tobacco market, and the company gets over 75% of its revenues from cigarettes. Altria owns 25% of SAB Miller, the smokeless tobacco brands Skool and Copenhagen, and the wine brands St. Michelle and Columbia Crest. Altria also sells the John Middleton Cigar brand.

Smoking rates have been declining in the U.S. for the last several years at the rate of 2-4%, but Altria has continued to grow earnings per share by 8-10% with price increases, cost cutting, and market share gains at the lower end. The company also maintains a $1 billion dollar buyback.

Altria has had significant litigation settlements the last couple years, and the company's net income has been fairly flat even thought earnings have grown in the high single digit over the last couple years.

The biggest threat Altria faces over the next several years is not new regulation, increasing litigation, or declining smoking rates. It is the prospect of rising costs of capital. The company's buyback plan is obviously financed with pre-tax capital, but Altria has $14 billion in long-term debt, and the company was forced to recently repurchase $2 billion in bonds this past quarter, and to lower fiscal 2012 guidance by nearly 10%.

Altria's long-term cost of capital is around 6%, or 2 percentage points over the prime rate of the 30-year treasury, and the company was forced to borrow at high rates to finance the acquisition of US Tobacco because the buyout was timed during the financial collapse. If Interest rates rise several percentage points, the company will likely need to buy down debt, and the 80% payout ratio will limit management's ability to increase future dividends. Altria has raised the dividend by nearly 8% a year over the last five years, but the company's cost of capital is now higher than the dividend. Altria had to recently reduce the company's guidance from $2.17-2.23 to $2.01-2.08, and the company has raised the dividend by an average of 7% a year over the last several years despite the company's net income consistently being flat because of litigation settlements.

If interest rates rise by two percentage points, the company's long-term cost of capital will rise to over 8%, and the company will not be able to borrow to increase dividends. Altria's projected earnings growth over the next five years is 4-6%, and the company's payout ratio is 80% of adjusted earnings, but the company has consistently paid out over 100% of net income because of litigation settlements over the last three years. Altria will need to increasingly allocate capital to its nearly $14 billion in long-term debt if interest rates rise even minimally, and the company's payout ratio leaves minimal room for future dividend increases. Management's recent $2 billion buyback caused the company to reduce earnings guidance by 10%, and each $1 billion in debt the company buys will likely require a 3-5% earnings reduction.

Altria continues to use price increases and cost-saving programs to grow earnings in a declining market, but the company will face significant obstacles in the future. Altria recently completed a nearly $1 billion dollar cost-saving program, and new cost initiatives are supposed to be less than $250 million. The company has also raised prices and taken market share at the lower end over the last year, but the company's flagship brand Marlboro has seen little growth over the last year. If interest rates rise in the next several years and growth slows, the company will have difficulty raising dividends.

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.