Altria (NYSE:MO ) is America's largest tobacco company selling the most popular cigarette brands such as Marlboro, Parliament, Virginia Slims, and Benson & Hedges. Conventional cigarettes form the lion's share of its sales at 85%. It also manufactures and sells chewing tobacco, cigars, and premium wines. Altria is touted as the prototypical recession resistant stock, and that was seen in the 2008-2009 crisis where earnings and revenues increased as the world fell apart.

Recent performance has been no less stellar with 5-year total returns making Altria look more like a technology stock.

With 49 years of consecutive dividend hikes, Altria has increased its dividends longer than many people using its products have lived. That is an extraordinary feat. One that makes dividend growth investors take notice.

In the most recent quarter, the company's cigarette volumes fell almost 5%. While the industry as a whole has been declining, Altria's decline was higher than average.

Altria still managed to boost its dividend this year, and thanks to buybacks and price increases, it will boost its earnings as well. Altria's buybacks have been legendary and actually exceed that of even our favourite stock.

Conventional cigarette sales continue to freefall.

Not really noticeable on the chart, but usage rates actually went up slightly during each of the last 3 recessions, which also explains why Altria is so recession-resistant. With sales moving lower each year, though, Altria has focused its strategy on what it considers its future.

Altria's IQOS (I Quit Original Smoking) is the key to its growth plans, and it believes that the experience so resembles the actual smoking experience without its health impacts that it has branded its strategy after it.

While IQOS products have started selling overseas and enjoy rapid growth in a few select markets, they have not yet been approved by the FDA. Altria calls the FDA process a tad less optimal than they would have liked.

Of course, this is the same company that long back insisted that cigarettes were safe because doctors smoked them. The studies done so far have had issues with according to an investigation by Reuters. Some select quotes from that article include,

Reuters also found irregularities during interviews with some of the principal investigators contracted to conduct the trials for the company. One principal investigator said he knew nothing about tobacco. Philip Morris (PM) had to jettison the experiment that investigator performed after it emerged he hadn't followed a basic procedure for obtaining informed consent from participants during clinical trials.

A second investigator submitted urine samples that exceeded what a human being is capable of, according to two former company employees, and then initially refused to acknowledge there was a problem. A third said he doesn't hold such company-sponsored clinical trials in high regard, describing them as "dirty" because their purpose is more commercial than scientific.

After reviewing Reuters' findings, Philip Morris said in a statement that "all studies were conducted by suitably qualified and trained Principal Investigators."

Reuters did not find any evidence that the outcome of the experiments presented by the company to the FDA was manipulated or falsified.

Altria wants the IQOS products to be labelled as having a lower risk of causing cancer/harm. Such a label would make it the mainstay product of those trying to quit and could potentially stabilize the total number of users of its products.

Kishor Lad, a clinical data manager at the company between 2012 and 2015, said to prove the product presents less risk of tobacco-related disease, the company would need to conduct large clinical trials over several years to show that people who used iQOS lived longer than people who smoked cigarettes.

Philip Morris said it disagrees. Under U.S. regulations, the company said, the FDA "does not require premarket epidemiological data as a condition of marketing authorization."

A key reason why we think PM and Altria's endeavor will fail miserably is that while there are 70 known carcinogens in cigarettes, there are close to 7,500 total compounds in cigarette smoke.

What is most interesting is that some of these ingredients were actually higher in IQOS than in regular cigarette smoke. In an article just published on August 27,

Findings PMI reported levels for only 40 of 93 harmful and potentially harmful constituents (HPHCs) on FDA's HPHC list in IQOS mainstream aerosol. All substances in PMI's list of 58 constituents (PMI-58) were lower in IQOS emissions compared with mainstream smoke of 3R4F reference cigarettes. However, levels of 56 other constituents, which are not included in the PMI-58 list or FDA's list of HPHCs, were higher in IQOS emissions; 22 were >200% higher and seven were >1000% higher than in 3R4F reference cigarette smoke. PMI's studies also show significantly lower systemic exposure to some HPHCs from use of IQOS compared with smoking combustible cigarettes. Conclusion PMI's data appear to support PMI's claim that IQOS reduces exposure to HPHCs. However, PMI's data also show significantly higher levels of several substances that are not recognised as HPHCs by the FDA in IQOS emissions compared with combustible cigarette smoke. The impact of these substances on the overall toxicity or harm of IQOS is not known.

Some substances were increased as much as 20-fold, and one particular standout came in at 136-fold. Partial list is shown below.

A number of these substances, including several that were more than 50% higher in IQOS aerosol, belong to chemical classes that are known to have significant toxicity, such as α,β-unsaturated carbonyl compounds (eg, 2-cyclopentene-1,4-dione),24 1,2-dicarbonyl compounds (eg, cyclohexane, 1,2-dioxo-),25 furans (eg, 2 (5H)-furanone)26 and epoxides (eg, anhydro linalool oxide).27

One additional compound that was increased in IQOS heat sticks was Acenaphthene.

This was published in the highly reputable JAMA under the highly provocative title

The official response from Phillip Morris International was that acenaphthene is not part of the list of chemicals known to be harmful. However, being in the aromatic hydrocarbon group and lacking toxicity studies does make it something worth exploring. What impact could these substances in isolation or combination have at such higher levels is not something we can guess, but FDA will be hard-pressed to approve a slogan saying that IQOS has lower risk when 56 chemicals, many lacking toxicity studies were actually increased in IQOS kind of products. Even with reduction across a slew of harmful chemicals, one has to remember that we don't know exact levels at which some these chemicals max out their damage. A 50% reduction for example might not reduce the damage caused by some of these.

We don't believe that IQOS will succeed in being branded as less harmful than smoking cigarettes. We also believe that Altria is now reaching the tipping point where it will have a hard time compensating for volume declines. Shown below, we can see that Altria has dodged the impact of declining sales volumes through rather hefty price hikes that far exceeded inflation.

A thing to remember is that 1% percent drop in smoking population from 40% to 39% eroded 2.5% of revenues. The same 1% drop from 13% to 12% will erode 7.6% of revenues. Altria's conventional measures of increasing prices will have to work double time to make an impact on increasing revenues. Will it succeed? In our opinion, it will likely reach a point of persuading the remaining smokers into quitting even faster. Smoking has been shown to be moderately price sensitive, and various studies have shown a correlation between negative 0.4 and negative 0.8 between prices and smoking. As the remaining population quits, the price increases will be even higher versus the past, and this should likely create a final loop which removes this stock from aristocracy.

As we approach the home stretch into single-digit percentage smoking population, what we would watch out for is the next recession. As already described, we expect Altria to be aggressively raising prices, but we also expect the states which have large pension issues to deal with, to join in the fray in the next recession. We believe this will dwarf anything seen in the past, and while it will ultimately kill their golden goose, the US states will not hesitate to hit in even more taxes on this "sin stock".

We have not touched on e-cigarettes here. Those have come under increasing scrutiny recently with multiple calls for regulations. Should Altria dodge those regulation bullets and successfully continue increasing those sales, the dividend streak could be extended a bit. It is also possible that the percentage of population smoking stabilizes at a lower level. We still think that the next set of tax hikes will make it very expensive to be a smoker, but we cannot be sure that quit rates will increase.

At 15-16 times earnings, MO looks like the ultimate dividend stock with a 49-year hike streak. IQOS is being hailed as a growth story with potentially less harm than regular cigarettes. The secular decline though is reaching a tipping point in our opinion, and IQOS will not be allowed a "less harmful" label. We also think the risk of market share erosion is highly underestimated. With the continuously shrinking market, it remains probable that the remaining players no longer match Altria's massive price hikes to try and steal market share. We think the death knell for this stock will actually be the next recession, versus conventional wisdom of it emerging victorious at such times.

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