Although investing in cigarette manufacturers entails some risk, it’s tough to argue with the industry’s profitability. As the field of competition has narrowed, gains in free cash flows have allowed tobacco manufacturers to be extremely generous with their dividends. –The Editors

Over the past few years Altria Group (NYSE: MO) has transformed itself into a lean, mean cash-generating machine. The firm divested most of its non-tobacco business and international operations, spinning off Kraft Foods (NYSE: KFT) in 2007 and Phillip Morris International (NYSE: PM) in 2008. It also acquired UST and John Middleton, whose product portfolios included the popular Black & Mild cigars and Copenhagen and Skoal smokeless tobacco.

Altria dominates the US tobacco business and has amassed a 52 percent market share. The company’s cigarettes and smokeless tobacco products are No. 1 in the US, and its cigars hold the No. 2 position. Its next closest competitor, Reynolds American (NYSE: RAI), holds just 29 percent of the market.

Altria’s recent moves saddled it with a bit more debt than its peers; current total liabilities stood at $30.7 billion as of the second quarter. The firm financed its acquisition of UST through a $4.3 billion bridge loan and $6.8 billion in loans of various maturities and interest rates. But the company generates ample cash flow to cover its debt and dividend. And because big tobacco is hardly a growth industry these days, the need for heavy capital expenditures is next to nil.

That leaves Altria free to distribute its profits to investors through dividends and stock buybacks.

The company recently bumped its quarterly distribution from 35 cents per share to 38 cents, bringing its total annual payout to $1.58. Based on the strength of Altria’s balance sheet, the new distribution appears secure; the payout ratio is just over 86 percent of free cash flow.

Litigation and government regulation are an ever-present risk in Altria’s line of business, but these hazards have diminished in recent years. Altria faces one class-action suit that hasn’t yet had its day in court, but existing settlements don’t require any significant payouts in the near term.

And regulations issued by the Food and Drug Administration (FDA) actually carry some hidden benefits.

The FDA’s crackdown on tobacco manufacturer’s ability to advertise their products has solidified Altria’s market dominance by preventing upstart competitors from effectively raising brand awareness.

There’s also talk of an FDA crackdown on promotional pricing, which could be a boon for Altria’s profitability; the firm wouldn’t have to discount its products to keep up with competitors. Given the popularity of the company’s Marlboro cigarettes, Altria will effectively be able to set cigarette prices. Already the firm’s price increases have exceeded volume declines by a better than 3-to-1 ratio.

In short, Altria’s dominance of all corners of the US tobacco market–and the pricing power that this position entails–should encourage share buybacks and provide ample support for the company’s dividend payouts.

Although investors shouldn’t expect Altria’s shares to generate significant capital gains in the coming years, a 6.7 percent dividend yield is a mouth-watering prospect.–Benjamin Shepherd

WHY TO BUY

ALTRIA GROUP (NYSE; MO, $23.11)

*Focus on core business has enhanced profitability

*Low overhead encourages generous dividends

*Leading market position reduces effects of competition