Why Altria Group Inc Could Burn Investors

Altria Group has lit up impressive returns for investors in 2014. Year to date, the tobacco giant's shares are up 32%, not including dividends. This trounces the 11% return for the S&P 500 index. With gains like these, it might be hard to see a bear case for a stock that just keeps on going up. But below the surface, trouble is brewing for Altria. The company remains overwhelmingly reliant on its smokable products, particularly its flagship Marlboro cigarette brand, which is a dangerous proposition considering the gradual yet persistent decline in smoking here in the United States.

Unless the company comes up with a more significant plan to branch out into new product categories, trouble might be lurking for Altria shareholders.

Continued revenue decline a cause for concernIt's hardly a secret that the number of smokers in the United States is on the decline. Altria sustained a 3.5% drop in smoking volumes for its Philip Morris USA division over the first nine months of the year. Going forward, Altria management forecasts a 3%-4% long-term annual volume decline. With this in mind, it's not hard to see why the company's revenue is falling -- down 1% net of excise taxes through just the first three quarters of 2014.

Management is counting on price increases to offset this trend. Fortunately for the company, Altria's brand position allows it to boost prices at a rate similar to its volume declines. Of course, a product that is addictive to its users helps greatly in that regard. But a business model that relieson price increases to make up for a dwindling group of customers does not seem sustainable.

What also seems unsustainable is Altria's reliance on cost cuts to drive earnings growth. Altria's adjusted earnings, which strip out one-time items such as litigation expenses, are up 5.5% year over year in the first nine months of 2014. With revenue declining, Altria has resorted to significant expense reductions and a $1 billion share buyback program to help produce earnings growth. But, again, a company can't cut its way to profitability forever. At some point, revenue will have to grow. However, it's hard to see how Altria will accomplish this.

Those bullish on Altria typically say the company's diversified business will provide revenue growth to offset the decline in smoking. It's true that Altria manages a slew of businesses outside cigarettes, including chewing tobacco brands Copenhagen and Skoal, as well as a wine business and a large stake in SABMiller. But these businesses, even when considered collectively, still account for too small a portion of Altria's overall revenue to have a meaningful impact. Altria's smokeable products represent 90% of its total revenue.

Will e-vapor products come to Altria's rescue?Altria needs a new catalyst to fuel growth. One very promising opportunity could come in the form of e-cigarettes. E-cigs and other vapor products are the first true growth category for the tobacco industry in a long time. Indeed, Altria estimates that sales of e-vapor products in the United States reached $1.3 billion last year. As of June 2014, sales had already clocked in at $1.8 billion, a very impressive number. Because of this, Altria has high hopes for its MarkTen product.

Altria tried out its MarkTen products in Indiana and Arizona in 2013, thenrolled out the brand nationally after achievingsatisfactory results in the two states. Through the end of last quarter, MarkTen was ranked in the top three e-vapor brands in the western U.S. by retail market share. This quarter, Altria plans to complete its national expansion to the eastern half of the country.

While the e-vapor category is exciting, this battle is far from over. The market is extremely fractured, with dozens of competitors releasing new products. Altria might indeed carve out a leadership position, considering its manufacturing and distribution capabilities, but if it flops in this area, it's hard to see how it can keep producing enough revenue growth to offset the continued decline in smoking. Without revenue growth, earnings growth based on share buybacks and cost cuts aren't a viable long-term solution.

The article Why Altria Group Inc Could Burn Investors originally appeared on Fool.com.

Bob Ciura owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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