Dividends up in Smoke

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What once-popular addiction has been on the decline since 1981? Cigarette smoking. According to drugfree.org, in 1981 the US cigarette market peaked with 640 billion cigarettes sold. Results plummeted to 485 billion in 1993 and reached 378 billion in 2005. The Center for Disease and Drug Control's website stated that cigarette sales declined further to 293 billion in 2011.

Three companies dominate this market in decline, with Altria (NYSE: MO) owning 46.1% of the market in 2011, with Reynolds American (NYSE: RAI) at 24.9%, and Lorillard at 13.7%. Altria sells the very popular Marlboro brand, Reynolds sells Camel's, and Lorillard sells Newport's.

All three of these companies have nice big dividends, but how will they be able to keep paying out these dividends in the long term if cigarette sales keep falling?

The future
According to the CDC, a 10% increase in the price of cigarettes would result in a 3%-5% decrease in consumption. When Obama raised federal taxes on cigarettes in 2009 by $0.64, cigarette sales fell by 10%, according to the Campaign for Tobacco-Free Kids.

Now Obama is proposing a $0.94 tax increase on cigarette sales, which would cut sales by at least 10% again. This would cause significant downward pressure on these major cigarette-makers' profits and would hamper their attempts to increase profits in a world of declining volume through price increases.

While Obama may not get his wish entirely, taxes on cigarettes will be raised at some point in time, especially at the state level. States aggressively tax cigarette sales to raise revenue and decrease cigarette usage. A combination of further federal and state cigarette-tax increases will cause cigarette volumes to fall more.

So what can "Big Tobacco" do? Well, they can push through price increases, but only if wages are increasing enough that consumers will be able to afford to keep buying cigarettes at the same volume. They can also try to take market share away from each other, and they can lobby aggressively against tax increases. None of these fix the bigger trend at hand; they just prolong the inevitable.

Companies are turning to electronic cigarettes to find growth in the cigarette market. Advertising and promotions for e-cigs increased from $444.2 million in 2010 to $451.7 million in 2011.

Lorillard bought out Blu Ecig in 2012 for $135 million to get into the electronic- cigarette space. So far, Lorillard has seen its Blu Ecig revenue increase by nearly threefold this year as Blu takes 30% of the market. The electronic cigarette is seeing some explosive growth, with the market growing from $250 million-$500 million in 2012 to potentially $1 billion in 2013 .

The other "Big Tobacco" companies are also jumping into the e-cig market, with Altria just releasing its own e-cig under the brand name MarkTen in an attempt to get into this fast growing market. Reynolds is planning on launching a revamped version of its e-cig brand VUSE so smokers can get the "perfect puff." Competition is starting to heat up, so more money will be spent on marketing. This is especially true in the TV space because you can legally advertise e-cigs (unlike traditional cigarettes).

Reynolds is launching a TV ad campaign to promote its VUSE e-cig and it is starting out in Colorado in September. Lorillard is countering with a TV commercial staring Jenny McCarthy.

Advertising helps get the product out there and can boost sales in the e-cig market regardless of who is putting out the ad. Spending on TV advertising for e-cigs grew 17.9% in 2012 and is up 71.9% in print advertising in particular . It is hard to tell if e-cigs will ever be able to grow out of a niche market, but only time will tell.

While I have no doubt that the e-cig market will continue to grow, even if it reached $1 billion in annual sales, that pales in comparison to the $100 billion a year traditional-cigarette market. So e-cigs, even with the increased marketing campaigns and distribution, would have to grow enormously to compensate for the drop off in traditional cigarette demand. If cigarette sales keep falling like they have, even e-cig growth won't be enough to turn these companies' profits around.

But the huge dividend
The reason why investors own these companies is because of their huge dividends. Altria pays out a 5.6% dividend yield, Reynolds pays a 5.2% yield, and Lorillard pays a 5.1% yield. These are all twice the average of the S&P 500 yield and very appealing. The problem is how can all of these payouts last when the cigarette industry is on the decline in the U.S.?

In the near term, these companies will keep lobbying against tax increases and will push through price increases to keep profits growing. Ultimately, however, their profits will start falling hard as cigarette sales keep falling and they can no longer push through price increases. At some point, there will be a plateau in U.S. demand, but I don't want to ride that train downhill to get there. As the market keeps shrinking, margins will be compressed to save market share and the dividends will have to be cut as profits plummet.

Final thoughts
While the dividends look attractive, the long-term prospects of the cigarette industry in the US look bleak. Less and less people are picking up cigarettes and more people are quitting. Everyone knows cigarettes are very unhealthy, and the stigma around them is keeping younger consumers away. You can't keep paying out large dividends forever when your market is shrinking; eventually they will be cut and shareholders will get burned.

The article Dividends up in Smoke originally appeared on Fool.com.

Callum Turcan has no position in any stocks mentioned. 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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