Which Is The Best Tobacco Stock In The Industry?

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 |  Includes: LO, MO, PM, RAI
by: Equity Watch

Tobacco companies have delivered a solid financial performance in recent years, despite the fact that volumes of traditional cigarettes are on the decline. Tobacco companies have enjoyed healthy increases in EPS in recent time and have attractive margins. Also, tobacco companies have maintained their shareholder-friendly return policies; sharing successes through high dividend yields and by undertaking share repurchases. As tobacco companies offer high dividend yields, tobacco stocks have remained a popular choice for dividend-seeking investors.

In recent years, tobacco companies have been facing tougher regulations and changes in consumer preferences due to health concerns that have led to a decline in volumes of traditional cigarettes. However, to offset the impact of declining cigarette volumes, companies are working towards less harmful tobacco products, including e-cigarettes, and by taking measures to improve cost structures. Also, companies have been aggressively undertaking share repurchases to fuel bottom line growth.

Four leading tobacco companies, including Philip Morris (NYSE:PM), Altria (NYSE:MO), Lorillard (NYSE:LO) and Reynolds American (NYSE:RAI) have posted impressive financial results in recent years. However, I believe PM remains the best tobacco stock among the four companies. The reasons I believe PM is the best tobacco stock among all four stocks mentioned above are that PM has experienced healthy sales and EPS growth rates of 8% and 17%, respectively, in the last three years. Also, PM has maintained healthy volumes in recent times (excluding the recent third quarter), and have attractive gross and net margins in comparison to its peers in the industry. Moreover, PM has a solid cash flow and the lowest payout ratio in contrast to its peers. Another important factor, because of which I believe PM is the best tobacco stock, is its diverse geographical revenue base, which remains its key growth driver.

Financial Performance

Tobacco companies have delivered healthy financial performances in recent times, evident through their recent sales, earnings and dividend growth rates (as shown in the table below). Among the four tobacco companies, PM and LO have enjoyed the highest sales growths of approximately 8% in the last three years. PM experienced the highest EPS growth rate of 17% and LO enjoyed the highest dividend growth rate of 17%, in the last three years. The following table displays sales, EPS and dividend growth rates for the four tobacco companies in the last three years.

PM

MO

LO

RAI

Sales

8%

1.5%

8%

(0.5%)

EPS

17%

10%

13%

11%

Dividend

13%

9%

17%

10%

Click to enlarge

Source: Reuters

Attractive margins is another attractive financial metric for tobacco companies. Tobacco companies have continuously increased and sustained their margins in recent times. To fuel earnings growth rates, the companies are taking measures to reduce costs and improve productivity. PM, the pick of the tobacco stocks, has the highest gross and net margins of 67% and 28%, respectively, in contrast to its peers. The chart below shows margins comparison among the four tobacco companies.

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(Click to enlarge)

Source: Company Reports and Calculations

Cash Flows and Dividends

As mentioned above, tobacco companies have rich shareholder-return policies. Share repurchases and dividends have remained key stock price drivers for the companies in recent years. Dividends offered by the tobacco companies are safe and sustainable, as they are backed by their healthy dividend coverage ratios, shown below. MO has the highest dividend yield of 5.2% among its peers. PM has solid cash flows, evident by its highest dividend coverage ratio of 1.8x. PM has a low dividend yield of 4.4%, in contrast to MO's and RAI's dividend yields of 5.2% and 5%; however, PM has the lowest dividend payout ratio of 64% as well, which indicates that the company can increase its dividends by boosting its dividend payout ratio.

PM

MO

LO

RAI

Dividend Coverage = (Free Cash Flow/Dividends)

1.8x

1.1x

1.3x

1.3x

Annual Dividend per Share

$3.76

$1.92

$2.2

$2.52

Dividend Yield

4.4%

5.2%

4.2%

5%

Payout Ratio

64%

70%

68%

85%

Click to enlarge

Source: Yahoo Finance, Companies Reports and Calculations

Sales Volume Trend

Sales volume decline of traditional cigarettes has remained a headwind for the tobacco industry. The sales volume for the industry has been adversely affected by growing health concerns and tougher regulations. In the last three years, sales volume for the tobacco industry has contracted by more than 3% on average. Excluding the recent third quarter's results, PM has continuously outperformed the industry's sales volume in the last three years, as shown in the table below, which is why I believe it is the pick of the tobacco stocks.

2010

2011

2012

3Q2013

PM

4.2%

1.7%

1.3%

-5.7%

MO

-5.3%

-4%

1%

-3.5%

LO

5%

6.9%

-1.4%

0%

RAI

-

-5.8%

-5.6%

-4.3%

Industry Average

-3.8%

-3.5%

-2.5%

-4%

Click to enlarge

Source: Companies Reports

Conclusion

All four tobacco companies mentioned above have delivered solid financial performances in recent years; however, PM remains the pick of the stocks and the best tobacco stock among others, due to its solid sales and EPS growth rates, attractive margins, diverse geographical revenue base and solid cash flows. Also, analysts have estimated a healthy next five years growth rate of more than 10% for PM, which is higher than the growth rate estimates of MO and RAI of 8% and 7%, respectively.

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(Click to enlarge)

Source: Yahoo Finance

Following are the links to my recent articles on the four tobacco companies:

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.