Here's Why the Best Is Yet to Come for Altria Group

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Shares of Altria (NYSE: MO) may have lost more than 13% of their value over the past year -- and fallen sharply over the past month as its latest earnings report missed analyst expectations on revenues -- but the best is yet to come for this tobacco giant.

A market dwindling away

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The maker of Marlboro cigarettes faces several challenges. The combustible cigarette market continues to decline, and states continue to make it more expensive to smoke by increasing excise taxes on cigarettes. California, for example, hiked taxes on cigarettes by $2 per pack last year, and because its Marlboro brand remains the leading cigarette in the state, with a 50% share, it feels the impact more than other brands.

The rising cost of smoking is leading cigarette users to trade down toward discount brands. Vector Group is a leading discount cigarette maker and, during its last quarterly report in November, said revenues were up nearly 10% for the first three quarters of 2017 thanks to higher sales volumes.

Altria has its own discount brands such as L&M and Basic, but they're not seeing as much customer uptake. In the latest period where Marlboro's shipment volumes fell 8.8%, Altria's discount brands were down more than 10%. For all of 2017, volumes for Marlboro and the discount brands were down comparably at 5.1% and 5.2%, respectively, but the tobacco company continues to see market share slip all across the board. Marlboro's share ended the year at 43%, down 0.7 percentage points, while its discount brands slipped 0.1 percentage point to 4.6%.

The declining cigarette market is no surprise; it's to the next generation of electronic cigarettes that everyone is really looking, and there Altria is seeing much better results.

The future of tobacco

Altria reported that full-year shipment volumes of what it calls its e-vapor MarkTen brand grew 60% for 2017, and that it has a 12.5% share of the market. While that trails considerably behind the Vuse brand from British American Tobacco's Reynolds American division at about 26%, and Juul Labs' JUUL device, which has quickly become the market leader with an over 40% share, there is still a lot of promise on the horizon.

As is well-known, Philip Morris International (NYSE: PM) is attempting to get FDA approval for its heated tobacco iQOS product both as a stand-alone product and one with a reduced-risk classification. While the latter designation seems furthest away since an FDA advisory panel recommended against approving the label, the regulatory agency has given lip service at least to allowing this next-gen device onto the market.

That bodes well for Altria then since the devices will be marketed under its Marlboro brand as Heat Sticks. The name recognition behind them and the significant acceptance by smokers in many of the markets they have been introduced suggests the iQOS could gain significant market share if and when they're released here.

Philip Morris has been ramping up its production capabilities and capacity in anticipation of marketing approval, with or without the reduced-risk label, and Altria can ride along on the coattails when that happens.

Entangling alliances

Philip Morris has committed itself to making every smoker worldwide give up cigarettes, and it wants them to switch to the iQOS. It has committed billions of dollars to the campaign despite resistance from anti-smoking activists. When it hits the U.S., the wave may be substantial enough to carry Altria higher.

The renewed cooperation between the two tobacco giants signals to many that there may be a merger of them in the near future. Philip Morris International was, of course, spun off from Altria several years ago to market its brands internationally while Altria handled the domestic market.

Many view a potential union of the two as a smart, strategic decision, particularly now that British American and Reynolds American have merged. Combining the two companies will allow it to more effectively compete in global markets.

Considering the naturally shrinking combustible cigarette market and the globally expanding smoking alternative market, there's good reason to believe the best is yet to come for Altria.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.