If you own a conventional dividend company—let’s go with Colgate-Palmolive as an example—there are three techniques (buybacks, volume growth, and raised prices) to raise profits that principally flow from two sources (the volume growth and raised prices). In other words, if you sell toothpaste, the way you make higher profits is by increasing the amount of toothpaste you sell and/or raising the cost you charge your customers for each tube. If you do at least one of those successfully, you might also engage in a stock repurchase program that destroys some of the ownership units so that the remaining shares can lay a greater claim on profits.
In the case of tobacco stocks, you only have one tool in your arsenal: raising the price per pack of cigarettes. Selling more of the items is not an option, as smoking rates have been declining in the United States since the 1980s. In the case of Altria (which most famously sells the Marlboro brand, among others), volume shipments have been declining at a rate of 3.3% annually since 1983. The shareholder wealth that has been created over the past three decades has been the result of production diversification and the ability of tobacco companies to rise prices on the typical pack of cigarettes at a rate higher than what most investors thought the market would bear.
This over-reliance on price increases (rather than price increases + volume growth) is why the tobacco executives of yore made acquisitions for stable sources of revenue like the food giants. That’s why, up until the Kraft spinoff in 2008, a customer who went to the grocery store and bought Oreos and Kraft macaroni and cheese ended up sending profits to the treasury of the old Philip Morris. It was a strategy that recognized the eventual limitation of the tobacco industry, and it was a plan to avoid shareholder wipeout—tobacco executives acted intelligently on behalf of shareholders by planning a switch of sorts—the lucrative tobacco profits would be used to acquire food companies while the cigarette money was pouring in, and eventually, when tobacco profits started to decline, shareholders could switch to reliance on the food groups to take care of future growth and ensure adequate returns for shareholders.
As we now know, that’s not how the history worked out. RJ Reynolds got rid of Nabisco. Altria spun off Kraft, which then split itself in half from Mondelez. Activist shareholders correctly concluded that the price of the stock for food companies owned within a corporate shell of a tobacco company demands a lower market multiple, but they took that appropriate insight to conclude that unrelated businesses should be spun off from the parent tobacco companies. This created short-term profits in the form of a spiked price at the time the food companies were spun off, but it imperiled long-term shareholders because it made the remaining tobacco shareholders reliant on tobacco profits to drive the bulk of their returns (thus removing the safety valve that existed in the event that tobacco profits moved towards irreversible declines).
You would be correct to note that Altria today is still more diversified than just tobacco products. It is also smokeless tobacco products, has a 25-30% stake in SABMiller, and has some small winery operations that are so small they deserve nothing more than footnote status. However, it’s been the pulse of the times to spin off unrelated businesses. Look at Abbott Labs, spinning off Abbvie. Look at General Electric, letting go of Synchrony. Look at Conoco, spinning off Phillips 66. Kimberly-Clark, ITT, Fortune Brands, CBS, International Paper, Chesapeake Energy, National Oilwell Varco, Dover, Sears, Safeway, Murphy Oil, Marathon Oil, and Valero Energy are other companies that come to mind. I would fully expect that, at some point, Altria would either sell or spin off the SABMiller stake, in line with its 2008 decision to let go of Philip Morris International, and Kraft (which is now Kraft + Mondelez).
People often wonder what the worst-case scenario for tobacco investors would look like: the answer is something like this. Altria reaches a point where its brand of products can no longer raise cigarette prices at a rate that overcompensates for modest volume losses, and the long history of dividend hikes is forced to come to an end. Most likely, this would be accompanied by a strong drop in the share price.
Of course, current tobacco executives aren’t stupid. They maintain a 25% gap between the amount of profit that is retained and the amount that is paid out as dividends. From this gap, they repurchase some of their stock, meaning there are fewer owners that require dividend payments. This provides a boost of sorts: you get price increases in the pack of cigarettes plus the removal of 2-4% of the shareholders that would otherwise have a right to dividend payments, and this acts as a countervailing force against volume declines. Volume has been declining steadily at over 3% for three decades now, and that hasn’t prevented Altria from compounding at a 20.62% rate for three decades straight, turning a $10,000 investment into $3.5 million. With the exception of some tech companies, it’s the best investment you could’ve made in 1983. Nothing has historically compounded quite like it. But if you want to watch for warning signals, you should study the relationship that exists between Altria’s stock repurchases plus the added profits created by price increases, and then compare that figure against volume losses. A turn in that relationship is what would serve as the signal for permanent trouble.
*As an aside, that’s why I regard Philip Morris International as the ideal tobacco investment. They operate exclusively outside of the United States, and in some years, they report volume gains. Their business model does not yet possess the permanently downward sloping volume shipments that is characteristic of the American tobacco industry, and that’s what makes it more lucrative: Philip Morris International offers buybacks, price increases, and occasional volume growth as the components of its long-term wealth creation.
Originally posted 2014-09-30 12:03:04.