Are Altria Group, Reynolds American, and Lorillard's Dividends Becoming Too Risky?

Dividend investors have long sought refuge in tobacco stocks. Yields for Altria Group , Reynolds American , and Lorillard range from 3.8% to 4.7%, well above the S&P 500 index's 1.9% yield. However, the rise of discount cigarettes and ever-higher excise taxes could soon threaten Altria, Reynolds, and Lorillard's ability to continually raise their dividends unless buyers remain faithful to their premium brands. Are tobacco stocks still safe for dividend investors? Find out below.

Attractive yields
As most dividend investors know, Altria, Reynolds, and Lorillard offer some of the most attractive yields on the market. Altria sports a 4.7% yield, Reynolds yields 4.4%, and Lorillard's yield sits at 3.8%. Each of these companies returns more money to shareholders each year than some companies return in a decade.

For instance, in 2013, Altria reinvested $131 million in its business. In the same year, it paid $3.6 billion as dividends and spent $634 million to repurchase stock. The total amount sent back to shareholders -- $4.2 billion -- dwarfs the amount necessary to maintain operations. Reynolds and Lorillard, too, are more than willing to put cash in shareholders' pockets. In 2013, Reynolds spent $153 million on capital expenditures and returned more than $2.1 billion to shareholders. Lorillard reinvested only $62 million and returned more than $1.6 billion to shareholders. This is why tobacco stocks have long been favored by dividend investors.

A cloud of smoke hangs over tobacco stocks
Despite a history of generous dividends, some investors are concerned that Altria, Reynolds, and Lorillard will be unable to cope with regulators' push to stamp out smoking in America. States are raising excise taxes to ever-higher levels, causing more and more low-income smokers to be priced out of the market for premium cigarette brands.

Instead of buying Malboros, Camels, and Newports, low-income smokers are switching to discount brands like Altria's L&M and Basic. To illustrate consumers' shift to discount cigarettes, consider Altria's cigarette volume trajectory. Overall, Altria's cigarette volume declined 4.1% in 2013 compared to 2012. However, discount volumes increased 3.1%, while premium volumes decreased 4.7%. Likewise, while strong sales of Lorillard's Newport cigarettes kept the company's premium volume up, its premium Kent and True brands declined faster than its discount brands. These numbers indicate that consumers are shifting to discount cigarettes.

What's more, low-income smokers make up a significant part of the market. According to a 2008 Gallup poll, more than 30% of Americans making less than $24,000 smoke cigarettes, compared to the national average of 21%. The smoking rate declines as one's income increases. Moreover, a study of the New York smoking population found that low-income smokers spend more than 25% of their income on cigarettes. With low-income smokers accounting for an outsized share of the cigarette market -- and with their budgets already stretched to the limit as excise taxes increase -- the trend toward discount cigarettes will only grow stronger. This is a troubling trend for Altria, Reynolds, and Lorillard.

Pricing power to the rescue
Fortunately for dividend investors, it seems that smokers are addicted to more than just the nicotine. Altria, Reynolds, and Lorillard continue to display pricing power despite shrinking demand for their premium cigarettes, showing that brands still carry sway in the minds of many smokers. In addition to rolling back promotional pricing, Altria raised Parliament prices by $1.10 per carton and raised all other cartons by $0.60. Reynolds and Lorillard also followed suit, raising carton prices $0.60 per carton across their entire product portfolios. This amounts to a 0.9% price increase on the average Marlboro carton price, but the percentage increase varies widely state by state.

Moreover, all three companies will likely raise prices again this year; they usually increase prices 3% to 4% per year. Although Marlboro volumes declined 4.3% in 2013, 3% to 4% pricing growth is usually enough to offset volume declines. This shows that premium brands may be almost as addictive as the nicotine itself. As a result, investors need not worry that Altria, Reynolds, or Lorillard will slash their dividends any time soon.

Foolish takeaway
The U.S. cigarette market has been in decline for decades and will continue to decline. Premium cigarette volumes are threatened by discount brands and other substitutes. However, dividend investors should not flee these reliable dividend stocks just yet. Altria, Reynolds, and Lorillard continue to show an ability to raise prices nearly as quickly as volumes decline. As a result, these cash cows should be able to cover their dividends for many years to come.

Top dividend stocks for the next decade
Tobacco stocks pay juicy dividends. The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

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Ted Cooper 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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