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Tobacco stocks have recently been popular among income-seeking investors, as they offer high dividend yields, have robust growth potential, and have attractive margins. The tobacco industry has mainly been relying on price increases, cost savings and share repurchases to fuel its earnings growth, as the sales volume of traditional cigarettes is on a decline. The sales volume for the tobacco industry is on a decline due to strict regulations and health concerns.

I will discuss and compare four tobacco companies in this article, including Philip Morris (PM), Altria (MO), Reynolds American (RAI) and Lorillard (LO). All of these four companies have delivered healthy financial performance recently, and analysts have projected decent earnings growth rates for them. Below, I have compared the recent financial performance, volume growth trends, dividends and expected growth rates of the aforementioned companies.

PM remains my top pick as the best investment option among the four companies, due to the following reasons:

  • Impressive last three years' average sales growth rate of 7.6%, and EPS growth rate 17%
  • Geographically diverse revenue base.
  • Attractive margins in comparison to its peers.
  • Decent sales volume growth trend.
  • Decent dividend yield of 4.05%, backed by solid dividend coverage of 1.7x
  • Low dividend payout ratio of 65%
  • Robust next five-year growth projection of 10.10% per annum

Financial Performance
All four companies mentioned above have registered healthy financial performances recently, as they were able to grow their EPS and dividends at attractive rates. LO and PM were the two companies that were able to enjoy high average sales growths of 8% and 7.6%, respectively, for the last three years. LO increased its dividends at a rate of 17% per annum in the last three years; the highest among its peers. PM enjoyed the highest EPS growth rate of 17% per annum in the last three years. The table displays the sales, EPS and dividend growth rates for the companies in the last three years.

PM

MO

RAI

LO

Sales

7.6%

1.5%

0%

8%

EPS

17%

10%

11%

13.5%

Dividends

13%

9%

10%

17%

Source: Reuters.com

The tobacco industry has historically maintained healthy margins. Also, the aforementioned companies have aggressively been working on productivity improvement initiatives to further strengthen their margins, and fuel future earnings growths. PM is at the lead amongst its peers, with the highest gross margin of 66%. PM also has high operating and net margins of 43% and 28%, respectively, in comparison to RAI and LO. The following chart shows the margin comparison between the companies.
(click to enlarge)
Source: Companies Reports

Sales Volume Growth
Lately, lessening sales volume has been an ongoing concern for tobacco companies due to tougher regulations and health concerns. Sales volumes for the tobacco industry were down 4% in the recent second quarter. PM has been able to consistently outperform the industry sales volume since 2010. The following table shows the volume growth trend since 2010.

2010

2011

2012

Q22013

PM

4.2%

1.7%

1.3%

-3.9%

MO

-5.3%

-4%

1%

-6.7%

RAI

-

-5.8%

-5.6%

-6%

LO

5%

6.9%

-1.4%

-1.7%

Industry Average

-3.8%

-3.5%

-2.5%

-4%

Source: Company Reports

Dividends and Cash Flow
The listed tobacco companies have been sharing their successes with shareholders through attractive dividend yields. Dividends offered remain important stock price drivers for the aforementioned companies. MO offers the highest dividend yield of 5.6%, followed by RAI, which offers a dividend yield of 5.3%. I believe the dividends offered by the companies are safe, as they have satisfactory dividend coverage ratios, as shown below in the table.

PM has the lowest albeit decent dividend yield of 4.05%, which is backed by its strong cash flows. Also, PM has the lowest payout ratio of 65%, and a solid dividend coverage ratio of 1.70x. I think PM's lowest dividend yield of 4.05% should not be a concern for investors, as it also has the lowest payout ratio of 65%, which provides PM with a potential to increase its dividends by expanding its payout ratio.

PM

MO

RAI

LO

Annual Dividend/ Share

$3.40

$1.92

$2.52

$2.20

Payout Ratio

65%

80%

87%

66%

Dividend Yield

4.05%

5.6%

5.3%

5%

Dividend Coverage (=Free Cash Flow/Dividends)

1.70x

1x

1.2x

1.3x

Source: Companies Reports and Reuters

Conclusion
The tobacco industry on the whole has posted healthy financial results as of late. However, I believe PM is the best tobacco stock in the industry, as the company has a better volume growth trend as compared to the industry and enjoys a diverse geographical revenue base. Also, PM has higher margins in comparison to RAI and LO. Moreover, analysts are projecting a robust next five year growth rate of 10.10%, in contrast to its peers' average of 9.5%.

PM

MO

RAI

LO

Average

Next Five Year Growth Rate est.

10.10%

7.8%

7.7%

12.5%

9.50%

Source: Yahoo finance

Source: Which Is The Best Tobacco Stock In The Industry?