The same domestic trend has been in place for years, with declining cigarette case volumes yet higher and higher dividends from the big tobacco companies. The latest Centers for Disease Control and Prevention (CDC) report shows yet another big drop in smoking among adults, with only 18% of adults being current smokers. The question we have asked is how long the real earnings growth can be sustained with a steady decline in smokers. The good news for you dividend chasers is that the rise of the e-cigarette market may have arrived just in the nick of time.

The CDC said that adult smoking rates were 24.7% in 1997, 20.9% in 2005 and 20.6% in 2009. Now it is 18.0% in 2012, versus a preliminary expectation of 18.9%. A steady decline has been seen in smoking rates, yet the dividends from Big Tobacco keep going up each year.

Altria Group Inc. (NYSE: MO) recently announced that its Nu Mark subsidiary is planning to enter the “e-vapor category” as it is introducing the MarkTen brand e-cigarettes into a lead market in Indiana this August. Unfortunately, this looks like too small of a launch for what is supposed to be the industry leader. Lorillard Inc. (NYSE: LO) has a solid position in e-cigarettes with the Blu e-cigarette, and Reynolds American Inc. (NYSE: RAI) has relaunched its Vuse brand e-cigarette.

We have opined before that the rise of the e-cigarette market actually may be a game-changer for the world of high-dividend payments from tobacco companies. Again, it boils down to declining case volumes of cigarette sales. If there are fewer and fewer smokers, and if those who do smoke manage to smoke even less than before, then the declines have to be watched very closely. The real trick boils down to how the large tobacco players can grow earnings ahead with flat or lower sales coming solely from price hikes.

Altria Group Inc. (NYSE: MO) currently has a $1.76 dividend annually for a 4.9% dividend yield, with consensus earnings estimates of $2.40 per share in 2013 and $2.57 per share in 2014. That is on expected sales growth of 0.6% to $14.7 billion in 2013 and 1.4% growth to $17.85 billion in 2014.

Reynolds American Inc. (NYSE: RAI) currently has a $2.52 annualized dividend that generates a 5.2% dividend yield. Its consensus earnings per share (EPS) estimates are $3.21 in 2013 and $3.40 in 2014, but sales are expected to be down by 0.4% to $8.27 billion in 2013, with a gain of only 1% to $8.35 billion in 2014.

Lorillard Inc. (NYSE: LO) pays out $2.20 on its annualized dividend for close to a 5.0% yield. The consensus estimates are $3.12 EPS for 2013 and $3.42 EPS for 2014, while sales are expected to grow 6% to $4.92 billion in 2013 and 4.3% to $5.14 billion in 2014. With the popularity of Blu e-cigarettes, is it a coincidence that Lorillard has the best expected sales growth?

The good news is that the sales peak driven by price hikes translating to higher earnings may not hurt dividend chasers this year. That trend may even surpass our fear that dividend growth could peak in 2014 or even 2015. It seems like the wild card may be the e-cigarette market, which may be the next growth phase of the market. There is an independent website showing e-cigarette reviews, so you can see which brands are most favored.

Before you panic based on declining smoking rates, let’s look at the stocks versus history and versus consensus analyst targets:

• Altria trades at about $36.15, against a 52-week range of $30.01 to $37.61. Its consensus price target is $37.33 and the highest price target is up around $45.00.
• Lorillard is at $44.85, against a 52-week trading range of $36.70 to $47.02. While the consensus analyst price target is $45.67, the highest price target is $50.00.
• Reynolds American trades around $49.10, with a 52-week range of $39.70 to $50.15. The consensus price target of $47.00 is now lower than the current share price, but the street-high target price is listed as $61.00.

So, how much upside should investors demand from a tobacco stock? Our take is that if there is not 10% expected upside then there is not enough reward versus the risk in a tobacco stock. We are not a universal voice, however, and that is why we showed the highest price targets from Wall Street analysts as well.

A faster decline in the domestic adult smoking population is meeting the same trend of declining case volumes. Cigarette companies can only raise prices so much before their addicts revolt, and now there is a new revenue source for smokers (and ex-smokers who still consume nicotine) in e-cigarettes. If the tobacco companies are going to keep managing to grow their dividends in the years ahead, it sure looks and feels like it will be the e-cigarette market that will make that possible.

Note: All consensus earnings and sales estimates and analyst price targets are from Thomson Reuters.

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