The U.S. tobacco industry has long been a favorite space for conservative income investors to find some of the best high dividend stocks.

The tobacco business is known for its stability thanks largely to the addictive nature of its products, which has given cigarette manufacturers significant pricing power and predictable, steadily growing cash flows over the decades – even despite increased taxes, restrictions on marketing, and a number of other challenges from the federal and state governments.

However, investors are worried that the tobacco industry’s best days could finally be behind it after the U.S. Food and Drug Administration (FDA) made a drastic announcement [last week].

As a result, Altria (MO) saw its stock price drop by nearly 20% before recovering for a 10% loss.

Let’s take a closer look at the surprising regulatory proposal that was announced to learn about its potential impact on Altria’s future and if the company’s dividend could be in danger, especially given the high payout ratios notorious in the tobacco industry.

Why did Altria’s Stock Drop?
Altria and several other major tobacco producers plunged after the FDA announced plans to explore lowering the nicotine allowed in cigarettes to non-addictive levels.

Such a move could accelerate the decline in smoking and reduce the pricing power long enjoyed by industry, chipping away at the core products that generate close to 90% of Altria’s total operating income today.

Even newer, lower-risk smoking alternative products such as electronic cigarettes and heated tobacco products could be affected.

The FDA stated that it will seek input on issues such as the role of flavors (including menthol) in tobacco products, for example.

Since Altria’s tobacco business operates solely in the U.S. and is largely focused on the premium end of the cigarette market with dominant brands such as Marlboro, it is more directly in the crosshairs of the FDA than its peers (Philip Morris’s stock was slightly up [after the announcement], for example).

Before writing off the company, there are a number of reasons why this news, while certainly serious, might not end up being as bad as investors fear.

Why the Market Might Have Overreacted
Tobacco companies have been busy adapting to the long-term decline in smoking rates for years, developing a number of reduced-risk products.

In fact, smokeless products accounted for roughly 13% of Altria’s adjusted operating income year-to-date.

While that is not a huge figure, Altria maintains over 50% retail share of the smokeless market and owns the number two e-vapor brand in the country, positioning it reasonably well to capitalize on a potential shift from smokeable to smokeless products over the coming years.

The company also has exclusive rights to sell IQOS heat sticks, a much less toxic product that heats tobacco instead of burning it, in the U.S., which could help it further offset a potential acceleration in falling cigarette volumes.

Philip Morris has spent billions of dollars developing IQOS, which has done very well in overseas markets. The FDA began its substantive science review of this modified risk tobacco product application for Altria in May.

These types of lower risk products could have much more favorable tax treatment than traditional cigarettes since they are less toxic, which might allow more profits to drop to the company’s bottom line.

The FDA supports the continued development of these products, noting that it seeks to strike “an appropriate balance between regulation and encouraging development of innovative tobacco products that may be less dangerous than cigarettes.”

The agency extended its deadline for manufacturers to submit reduced-risk tobacco product review applications for approval, for example.

If the market shifts faster in this direction thanks to new nicotine regulations, Altria’s large size, substantial cash flow, and extensive distribution systems could give it a major advantage over smaller rivals.

In addition to releasing less harmful tobacco products, the potential for widespread legalization of marijuana consumption, a market estimated to be worth between $40 billion and $50 billion, could provide another major opportunity for Altria to offset future regulatory pressures.

It’s also worth noting that the government has a lot to lose if its proposed regulations caused a significant amount of Americans to quickly stop smoking.

State and local tobacco tax revenue tops $17 billion annually, and legal settlements with tobacco companies have brought in billions of dollars more over the years.

Losing this money would create a large revenue hole to fill, so finding some sort of middle ground seems more likely. Perhaps that comes with taxing reduced-risk tobacco products more, but that only works if demand is strong enough.

There are a number of scientific challenges behind the FDA’s proposal, too. Objectively determining a nicotine level that is nonaddictive may not be easy, and it could be very challenging to manufacture cigarettes with lower nicotine levels.

There could be a number of unintended consequences to consider as well. For example, will determined smokers need to consume even more packs of cigarettes to achieve the same feeling of comfort if nicotine levels are lower? Could some sort of black market develop for traditional tobacco products, causing the government to miss out on significant revenue?

In other words, the only real certainty today is that there will be plenty of lobbying, political pushback, technical holdups, and debate over this proposed regulation.

It could be years before we have clarity on what the final regulation will look like and how it could affect Altria’s overall business.

Is Altria’s Dividend Still Safe?
The good news is that Altria’s dividend remains in great shape today. Our Dividend Safety Scores look at a company’s payout ratios, debt levels, free cash flow generation, and more to gauge how safe their dividends are.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

Investors can learn more about Dividend Safety Scores and view their real-time track record here.

Altria’s Dividend Safety Score of 98 indicates that it continues to have one of the safest payouts in the market. This is largely a function of the company’s consistent free cash flow generation and strong balance sheet.

The company’s safe dividend starts with its reasonable payout ratio, which is expected to be approximately 75% this year and somewhat below management’s 80% target.

While that would be relatively high and perhaps somewhat dangerous for many types of businesses, Altria’s cash flow is very stable because demand for cigarettes has historically been very inelastic.

In fact, Altria’s reported sales grew in fiscal years 2008 and 2009, the company recorded sturdy operating margins, and free cash flow generation was excellent.

That could change if nicotine levels are significantly reduced, no longer justifying the cost of a pack of cigarettes for consumers, but that seems very unlikely to happen anytime soon.

Management continues to expect annual earnings growth in the high single-digits as well, which is supportive of safe and growing dividends.

Altria’s dividend and business future are also protected by its balance sheet. The company maintains an A- investment-grade credit rating, which gives it plenty of flexibility to tap debt markets if it needs to invest heavily in smokeless products to stay relevant in the future.

Altria has raised its dividend for more than 45 consecutive years and will soon join the dividend kings list. I don’t expect today’s news to threaten the safety of its dividend anytime soon.

Closing Thoughts on Altria, the Tobacco Industry, and the FDA
Increased regulation usually isn’t good for a corporation’s profits, and that’s especially true when it is aimed at structurally eliminating the main reason why a core product offering is popular (the addictive nature of nicotine).

In a worst case scenario, today’s news is admittedly a big concern for U.S.-focused tobacco companies such as Altria.

However, many details are missing.

For example, we don’t scientifically know how low a “low” nicotine level is, what affect it will have on the number of cigarettes consumed, and how quickly demand for reduced-risk tobacco products could rise to offset any weakness.

Furthermore, the government seems unlikely to quickly part with an annual tax revenue source of nearly $20 billion without having some sort of replacement plan in place.

A spokesman for Imperial Brands, a tobacco manufacturer in the U.K., put it best when he said, “Until the eventual development of specific proposals, it’s too early to understand the practical implications.”

While Altria’s long-term growth outlook certainly became murkier today, making the stock’s 20.4 forward P/E ratio all the more uncomfortable, it could take years to figure out what this new regulatory proposal will actually look like, how significant it really is, and what net impact it will have on Altria’s bottom line (especially if demand for reduced-risk products accelerates, marijuana becomes legalized, taxes on smokeless products become more favorable, etc.).

Therefore, I would not be inclined to sell Altria on this news, even if I was a conservative income investor living on dividends in retirement.

Events like this are just another reminder of the importance of maintaining a well diversified dividend portfolio and giving companies plenty of time to respond and adapt to the ever-changing world around them.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends