Which Is The Best Tobacco Stock In The Industry?

Feb.28.14 | About: Philip Morris (PM)

Tobacco stocks have remained a preferred choice among dividend investors, as tobacco companies offer attractive dividends. Also, the tobacco industry has done well in expanding its earnings and dividend over the years. The industry has high margins and generates solid cash flows. However, in the recent past, tougher regulations, higher taxes, consumer health consciousness and the growing popularity of alternate tobacco have adversely affected the sales volume of the industry. As sales volume has been falling for the industry, tobacco companies are relying on price increases to expand their revenues and earnings. Also, as tobacco companies generate solid cash flows, share repurchases have remained an important measure to grow earnings.

Despite the pressure on the sales volume for tobacco companies, I still believe tobacco stocks remain an attractive investment option for dividend investors. Also, tobacco companies have the potential to increase earnings and dividends in the future. Moreover, share repurchases are likely to be important contributors towards earnings growth. Philip Morris (NYSE:PM), Lorillard (NYSE:LO), Altria (NYSE:MO) and Reynolds American (NYSE:RAI), all four leading tobacco companies, have posted healthy financial performances in recent years. The four companies offer solid dividends, backed by strong cash flows. Despite the fact that all four companies have posted healthy financial performance in recent years, PM remains my stock pick. PM has higher margins, solid cash flows, a diverse geographical revenues base and lower payout ratio; due to these reasons, PM is the best tobacco stock for me.

Sales Volume

As pointed out earlier, the tobacco industry has been facing sales volume decline in recent years due to tougher regulations and health concerns. Dropping sales volume remains a concern for the tobacco industry, which has been creating difficulties for companies to expand sales. In the last three years, the tobacco industry has experienced a sales volume decline of approximately 3.5%. PM, which I believe is the best tobacco stock, has outperformed the industry's sales volume in recent years. The table below shows the sales volume trend for companies, indicating that the sales volume for PM stays better than the industry average.

2011

2012

4Q2013

PM

1.7%

1.3%

-4%

LO

6.9%

-1.4%

-1.6%

MO

-4%

1%

-5.8%

RAI

-5.8%

-5.6%

-8.5%

Industry Average

-3.5%

-2.5%

-6%

Click to enlarge

Source: Companies Reports

Financial Performance

The tobacco companies have posted healthy financial performance in the last five years, evident by the sales, earnings and dividend growth rates, as shown below. LO has enjoyed the highest sales and earnings growth rate of 10% and 14%, respectively, in the last five years. RAI and LO achieved the highest dividend growth rates of 7% each. PM also enjoyed decent sales, earnings and dividend growth rates of 4.7%, 9.7% and 3.3%, respectively, in the last five years.

Source: Reuters

The tobacco industry has attractive margins, and companies are undertaking several measures, including cost controls and productivity improvement steps to maintain and further improve margins. PM has the highest gross, operating and net margins of 65%, 45% and 28%, respectively, among its peers.

Source: Companies Reports

Rich Shareholder Return Policies

The tobacco stocks have remained admired investment choices for dividend investors, as they offer high yields. The companies generate solid cash flows and have been sharing their successes through dividends and share repurchases. Dividends offered by the companies are sustainable, as they are backed by solid cash flows. PM has the strongest dividend coverage ratio of 1.55x and lowest dividend payout ratio of 68% among its peers. PM has a lower dividend yield of 4.7%, as compared to its competitors; however, PM can further increase its dividends by expanding its dividend payout ratio. I believe, despite the fact that the drop in the industry's sales volume remains a concern, dividends offered by the companies are safe.

PM

LO

MO

RAI

Dividend Yield

4.7%

5.1%

5.4%

5.5%

Payout Ratio

68%

69%

81%

79%

Dividend Coverage

1.55x

1.45x

1.15x

0.9x

Click to enlarge

Source: Yahoo Finance and Calculations

Conclusion

The above-mentioned tobacco companies have posted healthy financial performances in recent years and remain attractive investment options for dividend investors. However, I believe PM is the best tobacco stock, as sales volume trend, dividend coverage, margins and payout ratio for the company remain better than its competitors. Also, PM has a diverse international market exposure, which will provide earnings growth in the long term and portends well for the stock performance. LO also has delivered healthy financial performances, evident from its sales, earnings and dividend growth rates in the last five years, but I think the ongoing menthol review is a significant risk to its future performance.

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.