Why Altria Shares Are Rolling Over

Source: Thinkstock

Source: Thinkstock

Altria (NYSE:MO) is the largest tobacco producer in the United States. It owns the industry’s most valuable brand—Marlboro. The company’s stock has performed incredibly well for the first part of 2014—up 9 percent, which isn’t bad for a defensive company. But I think that this outperformance is about to change.

Before I discuss my reasoning behind this assertion, first I will explain why the stock has performed so well. There are two reasons for this. First, the company is relatively defensive and recession resistant. Investors have been rotating into these sorts of companies and as they have taken profits out of more economically sensitive stocks and growth stocks as quantitative easing comes to an end and as economic data comes in lighter than expected. Investors have also been drawn to dividend paying stocks as interest rates have come down and dividends become more attractive by comparison.

Second, the second and third largest tobacco companies in the U. S.—Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO)—have recently announced a merger. The reduction in competition makes life easier for all competitors, which means that Altria Group will spend less on advertising while gaining pricing power. Investors have bid up the entire sector because of this, and there is no doubt that Altria Group will benefit.

But this doesn’t change the underlying fact that Americans are smoking fewer cigarettes. This is fairly evident if you look at Altria Group’s second quarter earnings, which were released earlier this week. The company reported that its earnings per share rose slightly from $0.63/share to $0.64/share. But the company’s earnings were actually down slightly—about 0.3 percent. Furthermore, revenues fell by 0.8 percent.

This doesn’t look so bad, but the numbers would have been even worse if the company didn’t have pricing power and the flexibility to raise its prices. A daunting statistic for the company is that it reported a whopping 5 percent decline in cigarette volume year over year for the quarter.

So the scenario we have is one where the company is compensating for lost volume by raising prices, and it can do this for a while. This is especially true now that competition in the U. S. tobacco market has come down. But eventually the company’s price increases will lead to further volume declines, as addiction can only go so far in driving sales. In fact, statistics suggest that smokers on average tend to be less well educated than non-smokers and that they make less money, which means that the strain of rising prices is acutely felt by Altria Group’s consumers.

The company is fighting tooth and nail in order to stymie what is an inevitable decline in its business. It is pushing other products such as smokeless tobacco and e-cigarettes, although I think investors are overly optimistic in their belief that these products can save the industry. Perhaps the best thing the company has done recently is to diversify into alcohol given that wine revenues rose by nearly 9 percent year over year. But this hardly moves the needle.

Ultimately unless Altria Group and its peers can generate organic growth, or unless they simply start moving into other businesses they are in serious trouble. Altria Group doesn’t appear to be very expensive at 19 times earnings given how low interest rates are, but if the company’s cigarette volumes continue to decline we will eventually see a more meaningful decline in the company’s earnings power.

With this in mind, I think investors need to consider taking profits in Altria Group despite its apparent stability and attractive 4.6 percent dividend yield. Investors who insist on owning a tobacco company—and I do see the appeal given that cigarettes are addictive and given that they can be sold at incredible mark-ups—should consider Philip Morris (NYSE:PM), given its exposure to emerging markets where we see signs of growth. Furthermore, Philip Morris has come down in value given its weak earnings comparisons that have resulted from a strong dollar relative to international currencies. The company trades at about a 15 percent discount to Altria Group and yet it has the growth to support a higher valuation.

Disclosure: Ben Kramer-Miller has no position in the stocks mentioned in this article.

More From Wall St. Cheat Sheet: