Altria Group (MO) is widely viewed as a company that pays a highly sustainable dividend. The company itself touts its dividend credentials, saying at its Investor Day this past March, “We have increased our dividend for more than half a century, with 57 increases over the past 53 years.” The company has a strong position in a non-cyclical industry and produces hefty free cash flow, adding to its image as a rock-solid, high-yield dividend producer. But is this an accurate view?
Investors have their doubts. The dividend yield on Altria’s shares is 8.5%, the highest in the S&P 500 excluding two oil and gas pipeline stocks. It is well above the 6.7% yield of beleaguered Verizon (VZ) and the 5.7% yield of litigation-burdened 3M (MMM), two of the other highest-yielding stocks in the S&P500. Altria’s elevated yield suggests that the market is pricing in a dividend cut of perhaps 25% or more. Comparisons with other yields are enlightening: S&P 500 dividend yield (1.6%), 10-year Treasury yield (3.3%) and high-yield bonds (8.5%).
Looking deeper, what are the reasons for the doubts?
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One is that while Atria generates impressive free cash flow – $8.0 billion last year – it pays out most of it as dividends ($6.6 billion last year). This leaves little surplus cash flow. And, in each of the past two years, the company has over-spent its remaining cash flow on share repurchases, including about $1.9 billion on buybacks last year and $1.7 billion in 2021.
Adding further pressure, the company has publicly committed to raising its dividend by “mid-single digits” every year through 2028. At a 5% pace, the $6.6 billion in dividends will increase 34% to over $8.8 billion by 2028, adding $2.2 billion to the annual dividend burden. Some investors anticipate that share buybacks will reduce the share base and hence the dividend. But, even if the company uses the equivalent of all of its $1.4 billion in 2022 surplus cash flow to buy back shares, it could only repurchase about 1.8% of its shares each year. With dividends per share rising at a 5% pace, buybacks can’t keep up.
Another reason is that the key to the size and stability of Altria’s free cash flow is the revenue of its Smokable Products (cigarettes) segment. This segment produces 90% of the total company revenues. Yet, the number of smokers is declining by a steady 2.5% every year, creating a clear secular headwind that likely won’t abate. And, smokers are consuming fewer cigarettes, as industry volumes, or “sticks,” are declining at a 5% or more pace. In 2022, for example, industry volumes fell 8%, even after numerous favorable adjustments. Making matters even more challenging, Altria is losing market share in this shrinking market. In 2022, Altria’s Smokable Products sales volume slid nearly 10%.
Complicating its efforts to stanch its volume losses is its pricing strategy. To offset the enduring volume headwind, Altria’s preferred solution is to raise prices. In past years, this has been an effective approach to stabilizing its revenues. Last year, for example, Altria raised its Smokable Products prices by 9%, helping produce nearly flat (-1.7%) segment sales. To meet its aggressive Investor Day earnings and dividend growth goals, our model shows that the company must continue to increase its prices at a 9% pace every year for the next six years.
However, this price-increase strategy may be reaching its limit. Ever-higher prices for Altria’s marquee Marlboro premium brand (responsible for 90% of Altria’s stick volume) are outpacing price increases for competitors’ discount brands. Today, Marlboro’s price premium above discount brands is considered to be the widest in years. Smokers’ migration to lower price-point brands is exacerbated by rising inflation and a slowing economy that squeezes consumers’ spending power. This wide and expanding price gap is a major driver behind Altria’s market share losses. How much share is Altria losing? Last year, its 47.9% market share was 0.8 share points below its 2021 share. And, this loss continues a trend in place since at least 2017 when it had a larger, 50.8% market share.
Market share loss is a reputational problem for the company’s leadership. At its recent Investor Day, the company clearly stated its goal to “maintain our leadership position in the U.S. tobacco space over time.” But, given its steady share losses and strong likelihood of more losses, a key question is: how long will the company tolerate market share losses?
A growing risk is that the company does a repeat of “Marlboro Friday” – the April 2, 1993, announcement of a 20% cut in its cigarette prices to fend off cheaper competition. The shares fell 26% that day. We estimate that a 20% price cut today, partly offset by a rebound in volumes, would reduce revenues by nearly $4 billion. Most of this revenue decline would flow directly to free cash flow, likely producing a sizeable deficit that would directly threaten the dividend.
The company eventually will face this dilemma: deciding which is a higher priority – market share or dividend growth?
This dilemma completely ignores Altria’s plans to expand more aggressively into the promising market for “innovative smokefree tobacco products.” Altria had essentially zero such revenues at the start of this year as it is transitioning from its disastrous Juul initiative (purchased for $12.8 billion under prior company leadership but which is now essentially worthless) into NJOY, a company it acquired earlier this year for $2.7 billion. Altria promises $2 billion in innovative smokefree tobacco product revenues by 2028. Funding the internal development costs and acquisition costs would divert critical cash flow from dividend coverage.
Also, Altria plans to “effectively compete” in international and non-nicotine products. Like the innovative smokefree tobacco initiatives, these additional ambitions would further drain free cash flow. Competition in the U.S. is already heating up as a newly emboldened Philip Morris International (powered up by its recent acquisition of Swedish Match and its already-successful IQOS monopoly) presses more aggressively into the domestic market.
The company’s strategic streamlining through divestitures in recent years has raised cash, helping fund its dividend, buybacks and acquisitions. Its $13 billion stake in Anheuser-Busch InBev (BUD), along with sizeable tax offsets, offers a sizeable pool of cash to help bridge future shortfalls. But, Altria can’t rely on these non-recurring sources forever, and investors know this.
All-in, Altria investors need to assume that the company can thread a very narrow needle. We have our doubts and suggest that investors avoid the high dividend yield bait.
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