By David Sterman
Investors tend to steer clear of any company or industry with limited growth prospects. But there is money to be made if the rest of the market looks to shun such investments. After all, these largely matured businesses don't need to invest much money to develop products and fuel new growth, so they can generate an outsized level of profits on their revenue streams.
That's why some investors love tobacco stocks. They're unloved by many, but they typically offer very juicy dividends, making them a favorite among income-oriented investors.
Friday morning, we were reminded just how profitable these companies are: Lorillard (NYSE: LO), which makes Newport cigarettes, announced that an already juicy dividend would be boosted +12.5%, and the company plans to buy back another $1 billion in stock. Let's take a deeper look to see if the sector should merit your investment dollars.
Final spurt of growth
Many of us (myself included) assumed that Big Tobacco is already in decline. Yet as the table below notes, the biggest industry players are still seeing a bit more revenue growth this year, thanks in part to rising demand for smokeless tobacco.
But 2011 may mark the long-awaited inflection point that finally sees industry sales turn down as municipal smoking restrictions become increasingly onerous, which means that current sales and cash flow trends may be as good as it gets for this industry. And that puts the relevant valuation metrics into a stark spotlight.
|Company Name (Ticker)||Recent Price||Net |
|Free Cash Flow||Dividend Yield||2010 P/E||2011 P/E||2010 Sales Growth|
|Reynolds American |
|Philip Morris Intl. (NYSE: PM)||$52.03||-$12.7B||$2.8B||4.4%||13.8||12.4||+9%|
It's nice to see that Lorillard plans to buy back $1 billion in stock. Trouble is, that looks like an overreach. The company generated just $355 million in free cash flow in 2009, so it would take nearly three years worth of free cash flow to cover that buyback without hurting the balance sheet. Moreover, Lorillard paid out $631 million in the form of dividends last year, which appears unsustainable in light of that free cash flow. The fact that management has actually boosted the dividend means they are willing to deplete cash to cover that payout.
For Lorillard, that's challenging enough, with just $6 million in net cash on the balance sheet (though it has $1.8 billion in gross cash). But for rivals Reynolds American, Altria and Philip Morris International, which have $2 billion, $11 billion and nearly $13 billion in net debt, respectively, any move to hike the dividend or buy back more stock would be foolhardy.
This brings us back to the question of whether investors should buy these stocks. They all are valued at around 10 to 11 times projected profits, which isn't exceptionally cheap when there are many companies trading with single-digit P/E ratios right now. And Big Tobacco's dividend yields, which stand at around 6%, are not as attractive as some fixed-income equities such as master limited partnerships (MLPs).
It's best to avoid this seemingly tempting investment opportunity. Juicy dividends are nice, and large stock buybacks are a plus, but there are too many negatives in this industry -- most notably eventually declining sales and profits, and too-high debt loads. Of these stocks, at least Philip Morris still has decent growth prospects thanks to its international exposure.
If you want low P/E stocks, you can find them among tech stocks like Dell (Nasdaq: DELL) and Seagate (NYSE: STX). If you want nice dividend yields, you can find them among the oil and gas distribution MLPs such as Enbridge Energy (NYSE: EEP), which currently yields 7.4%.