Undervalued Dividend Growth Stock of the Week: Altria Group (MO)

I only own two small bags worth of personal items in my entire life.

All of my physical possessions can be carried onto an airplane.

To say that I’m not a fan of shopping would be an understatement.

Yet I do go shopping… every single day.

It’s just that the stock market is my store of choice.

That’s right.

While I shun the likes of, say, clothing stores, I’m delighted to peruse the stock market on a daily basis.

Whereas most stuff can create dependence while depreciating, that which I can buy from the stock market provides independence while slowly appreciating.

When I go shopping, high-quality dividend growth stocks are my merchandise of choice.

These are some of the best stocks in the world, representing equity in world-class enterprises that reliably pay increasing dividends to their shareholders.

You can see what I mean by taking a look at the Dividend Champions, Contenders, and Challengers list.

This list contains vital data on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Scanning that list will reveal some of the best businesses in the world.

That’s because it takes a special kind of business to be able to consistently rack up the ever-higher profit necessary to support an ever-higher dividend payment to shareholders.

I’ve been shopping for years, amassing a great collection of high-quality dividend growth stocks.

That collection is the FIRE Fund.

This is my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.

Indeed, I do live off of dividend income.

In fact, I was able to retire in my early 30s.

I share in my Early Retirement Blueprint exactly how I was able to achieve that.

As you might surmise, eschewing “traditional” shopping for the shopping I prescribe has been a big part of my success.

The merchandise I’ve been buying is worth a lot more than I paid.

And this has opened up financial freedom to me.

Now, it’s not just the right merchandise that matters.

Valuation is critical.

Price is what you pay. But value is what you get.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Abstaining from shopping at normal stores and buying normal merchandise, and instead shopping at the stock market and buying high-quality dividend growth stocks, sets you up to experience independence and appreciation over dependence and depreciation.

Of course, spotting undervaluation would require one to understand valuation in the first place.

The good news is, it’s not all that difficult.

My colleague Dave Van Knapp has made it even easier, via Lesson 11: Valuation.

Part of an overarching series of “lessons” designed to teach the A-Z of DGI, this lesson provides a valuation template that can be easily applied to almost any dividend growth stock out there.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Altria Group Inc. (MO)

Altria Group Inc. (MO) is one of the world’s largest tobacco companies. It is the largest cigarette manufacturer in the United States.

Founded in 1822, Altria is now a $77 billion (by market cap) tobacco giant that employs 6,000 people.

The company operates across the following subsidiaries: Philip Morris USA, U.S. Smokeless Tobacco, John Middleton Co, Helix Innovations, and Philip Morris Capital.

Altria also owns key equity investments that include a ~10% interest in Anheuser-Busch InBev (BUD), a 45% interest in Cronos Group Inc. (CRON), and a 35% interest in private e-cigarette maker JUUL Labs, Inc.

Despite attempts to diversify the business, US tobacco sales drive almost all of Altria’s revenue.

The company’s FY 2021 revenue breaks down across two primary product categories: Smokeable Products, 88%; Oral Tobacco Products, 10%.

Altria is most certainly not trying to be all things to all people.

They basically do one thing.

But they do it well.

That is exemplified through their flagship Marlboro brand.

Marlboro commands an estimated 40% share of the market.

Dominant.

In total, Altria controls just over 50% of the US cigarette market, making them the largest domestic player. They have no international cigarette sales.

To give you an idea of how important Marlboro is to the company, this single brand accounted for approximately 88% of the company’s total cigarette unit sales in 2021.

It’s important, at this juncture, to point out the painfully obvious.

The cigarette market is in secular decline.

There are less smokers today than there were 20 years ago, and we can be confident that there will be less smokers 20 years from now.

A shrinking customer pool isn’t great for long-term viability, let alone long-term growth.

All that said, if there’s any market with secular decline you’d want to be in, it’s probably this one.

Entrenched brands, limited competition, inelastic pricing properties, and an addictive nature of high-margin products end up creating a cash cow.

Put another way, if you’re going to do only one thing well, you could do worse than cigarettes.

Now, Altria’s management team has long been regarded as some of the best out there.

They see the writing on the wall, and it’s their fiduciary duty to ensure that the business remains an ongoing concern.

To that end, they’ve attempted to help “future-proof” the business by making moves into adjacencies like cannabis (through Cronos) and e-cigarettes (through JUUL) through equity investments.

These moves have, thus far, been disappointing, with Altria incurring major write-downs regarding its investments in both Cronos and JUUL.

The investment in JUUL has recently become even more disappointing after the US FDA announced that it had officially withdrawn authorization for JUUL products.

While a court appeal has temporarily allowed JUUL products to stay on shelves, this episode only serves as further evidence that Altria is, and will remain, heavily reliant on a market that is slowly dying.

On the other hand, these disappointments have pushed the stock’s valuation down to extremely low levels.

As a consequence of that, the stock’s yield has risen to sky-high levels.

Meantime, the company remains highly profitable, with good coverage of this very large dividend that continues to grow like clockwork.

Dividend Growth, Growth Rate, Payout Ratio and Yield

In point of fact, Altria has increased its dividend for 52 consecutive years.

That makes them a Dividend King, which refers to dividend growth stocks with 50 or more consecutive years of dividend increases.

More than five straight decades of ever-higher dividends shows an incredible amount of reliability.

The 10-year dividend growth rate is 8.4%.

That’s impressive, especially considering that Altria had already been increasing its dividend for more than 40 consecutive years a decade ago.

It’s easy to aggressively increase a dividend when a dividend is still young.

Not so easy to do that when you’re already decades into it.

However, it should be noted that more recent dividend increases have been in the low-single-digit range.

And that low-single-digit level would be my baseline expectation for future dividend growth over the long term.

On the flip side, the stock yields a jaw-dropping 8.5%.

To put that in perspective, that’s more than five times higher than the broader market’s yield.

It’s also 210 basis points higher than its own five-year average.

With an appropriate payout ratio of 74.1%, based on this fiscal year’s midpoint guidance for adjusted EPS, this big dividend looks protected.

The company has long maintained, and even targeted, this kind of payout ratio.

I see this as a compelling idea for income-oriented dividend growth investors, or investors looking to sprinkle higher yield into a portfolio.

I’d moderate my expectations regarding the size of future dividend raises, but you don’t necessarily need a lot of dividend growth when you’re starting off with an 8%+ yield.

Revenue and Earnings Growth

As compelling as the big dividend is, many of these dividend metrics are looking backward.

But investors are risking capital today for the rewards of tomorrow.

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later be instrumental when the time comes to estimate the stock’s intrinsic value.

I’ll first show you what this company has done over the last decade in terms of top-line and bottom-line growth.

And then I’ll uncover a professional prognostication for near-term profit growth.

Lining the proven past up against a future forecast in this way should give us a good idea as to where the business might be going from here.

Altria increased its revenue from $17.5 billion in FY 2012 to $21.1 billion in FY 2021.

That’s a compound annual growth rate of 2.1%.

That makes sense to me.

The fact that they can grow the top line at all when their core industry is in secular decline speaks to the strength of the business model.

Meanwhile, earnings per share grew from $2.06 to $4.61 (adjusted) over this period, which is a CAGR of 9.4%.

It’s important to note that I used adjusted EPS for FY 2021, as special items can distort GAAP earnings and result in an inaccurate view of the company’s earnings power.

A combination of margin expansion and share buybacks have helped to drive excess bottom-line growth.

Regarding the latter point, the outstanding share count is down by approximately 9% over the last decade.

Looking forward, CFRA believes that Altria will compound its EPS at an annual rate of 6% over the next three years.

This forecast seems reasonable.

Altria’s own Q1 FY 2022 quarterly report guided for 4% to 7% YOY growth in adjusted EPS for FY 2022.

CFRA is on the high end of that range, but I see nothing questionable here.

We already know that the industry is in secular decline.

This is underscored by a 7.5% decrease in domestic cigarette shipment volume for FY 2021.

But that doesn’t mean that Altria cannot grow, as they’ve proven out for years.

It all hinges around pricing power, which CFRA points out: “Although domestic cigarette sales volume will likely contract over the long term, MO has pricing power as the largest U.S. tobacco manufacturer and given the addictive nature of nicotine products. The tobacco industry boasts the strongest margins of any sub-industry in the Consumer Staples sector, and MO’s gross margin was 66.3% in 2021.”

That’s really what it comes down to.

It’s doing more with less, consistently.

All that said, I would expect Altria to only deliver low-single-digit dividend growth for the foreseeable future.

There’s simply not a lot of financial flexibility here to do otherwise, and there are still significant risks around certain areas of the business.

But when you’re locking in an 8.5% yield, you really don’t need much dividend growth in order to make sense of the investment.

Financial Position

Moving over to the balance sheet, this is the weakest spot of the entire enterprise.

There is no long-term debt/equity ratio, as Altria has negative shareholders’ equity.

Total long-term debt of approximately $27 billion is only moderately concerning against a market cap of $77 billion.

The interest coverage ratio, at over 4, is also only moderately concerning.

I’d prefer to see an interest coverage ratio of over 5, but I don’t see dire straits here.

Profitability is spectacular.

Over the last five years, the firm has averaged annual net margin of 28.5% and annual return on equity of 116.4%.

The balance sheet has juiced ROE, but margins have been outstanding and generally improving.

Although the core product suffers from secular decline, it’s still one of the most profitable consumer products you could possibly sell.

And the business is defended by durable competitive advantages that include brand recognition, pricing power, limited competition, inelastic pricing, scale, addictive products, and huge barriers to entry.

Of course, there are risks to consider.

Competition, regulation, and litigation are omnipresent risks in every industry.

Litigation has long been a huge concern in this industry, as evidenced by the Tobacco Master Settlement Agreement.

Regulation cuts both ways.

Regulation has effectively made it impossible for new entrants to come to market in the cigarette space, which creates rational pricing and additional pricing power among the firmly entrenched incumbents.

However, regulation has also definitely hurt Altria.

A prime example of this is the recent decision by the US FDA to withdraw authorization for JUUL products.

Now, JUUL wasn’t generating any real cash flow for Altria. And Altria has already written off most of the $12.8 billion they originally invested in JUUL.

But this disaster hurt the balance sheet and the company’s reputation, and it further concentrates them into traditional tobacco products.

Another example of regulatory risk revolves around menthol.

If the US FDA bans the use of menthol in cigarettes, this could have a material impact on Altria. The company generates an estimated 20% of its sales in the menthol category.

The encumbrance of the balance sheet limits flexibility.

And while continued drops in domestic cigarette shipment volumes is expected, any acceleration in secular decline will make it difficult for the business to keep up and offset that with pricing increases and alternative product sales.

I think these risks are serious, but the valuation looks to already be pricing in a ton of risk.

With the stock down 25% from its 52-week high, it’s about as cheap as I’ve ever seen it…

Stock Price Valuation

The stock is trading hands for a forward P/E ratio of 6.6, based on midpoint guidance for this fiscal year’s adjusted EPS.

That’s extremely low for any business in any market.

We can also see that the P/CF ratio is just 9.2.

That compares to its own five-year average of 14.3.

To be fair, this stock never really commands premium multiples.

That strikes me as prudent, and investors need to respect the risks.

But we’re well below even Altria’s typically undemanding standards here.

And the yield, as noted earlier, is significantly higher than its own recent historical average.

So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 2%.

That dividend growth rate is about as low as I’ll ever go, but I think Altria deserves it.

Their core product is experiencing secular decline.

If this were any other product, I don’t even see why it’d be investable.

But because Altria’s product has so many powerful economic features, a long-term investment case can actually be made in the face of a slow death.

That said, I’d curb my enthusiasm.

And I’d temper my expectations regarding the size of future dividend raises.

I seriously doubt that Altria will be able to deliver the lofty dividend increases of a bygone era, as volumes continue to decline and investments in adjacencies have been poor.

But this low-single-digit dividend growth hurdle is so low and easy to clear, that even Altria should be able to clear it.

The payout ratio isn’t dangerously high.

And the near-term forecast for EPS growth would easily allow for it.

I view my model as erring on the side of caution, with the risks weighing heavily.

The DDM analysis gives me a fair value of $45.90.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I think my model was ultra conservative, yet the stock still comes out looking cheap.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates MO as a 4-star stock, with a fair value estimate of $52.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates MO as a 3-star “HOLD”, with a 12-month target price of $45.00.

I ended up very close to where CFRA is at. Averaging the three numbers out gives us a final valuation of $47.63, which would indicate the stock is possibly 13% undervalued.

Bottom line: Altria Group Inc. (MO) is selling a product that has extremely powerful economic features. Their industry is in secular decline, but the business remains a cash cow that could be milked for many years to come. With a market-smashing 8.5% yield, inflation-beating dividend growth, a reasonable payout ratio, more than 50 consecutive years of dividend increases, and the potential that shares are 13% undervalued, this dividend growth stock is a compelling long-term investment idea for income-oriented dividend growth investors.

— Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

Note from D&I: How safe is MO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, MO’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.