We have identified and analyzed the tobacco companies that are offering high dividend yields, have strong balance sheets, and have enough free cash flow to maintain their dividend payout ratios. With continuous growth in terms of high unit sales and net earnings, we believe that Philip Morris International, Inc (PM) is an attractive prospect, with its stock offering an attractive dividend yield of 3.5%.
Separately, Lorrilard Inc. (LO)'s stock has performed well in the recent past and has outperformed the market and competitors alike. The company's attractive dividend yield of 4.9%, which along with its high payout ratio and reasonable free cash flows, make it a valuable dividend stock to hold.
Also, despite Reynolds Amercian Inc.'s (RAI) revenues being downward trending, the company continues to be an attractive investment from a dividend standpoint (dividend yield of 5.5%). It has a good record of returning money to its shareholders in the form of dividends.
The largest tobacco company in the world by volume is China National Tobacco Co. Following extensive merger and acquisition activity in the 1990s and 2000s, the international markets are now dominated by five companies: Altria, British American Tobacco, Imperial Tobacco, Japan Tobacco and Philip Morris International.
Due to heavy regulations imposed on tobacco manufacturers and various high profile law suits, the Tobacco Industry in the U.S. has been adversely suffering and it is widely accepted that in the long term, these law suits will continue to strain the Tobacco Industry's financial performance.
The three main big players in the Tobacco Industry in the U.S. are Philip Morris, Reynolds American Inc., and Lorillard.
Key Industry Drivers:
Prices: Increased prices for tobacco products reduce consumption among adults, adversely impacting the industry.
Marketing: Funds invested in marketing by tobacco companies are crucial for their profitability. These funds go to licensed tobacco retailers so that they can put their products in the most visible locations. The chart shows the amount of funds invested by tobacco companies in marketing their products, an amount that is higher than the marketing expenditures for junk food and alcohol combined.
Risks: The Tobacco Industry is heavily taxed and various additional taxes have been proposed for the industry, but have yet to be enacted. Taxation has the potential to hit the company's profitability, however, despite the presence of existing regulations, the company has performed well.
Philip Morris International
Philip Morris International Inc., through its subsidiaries, is engaged in manufacturing and selling cigarettes and other tobacco products. Its portfolio of international and local brands include Marlboro, Merit, Parliament, Virginia Slims, L&M, Chesterfield, Bond Street, Lark, Muratti, Next, Philip Morris, and Red & White. PM sells its products in approximately 180 countries in the European Union, Eastern Europe, the Middle East, Africa, Asia, Latin America, and Canada.
Volume analysis: The company's cigarette shipment volume increased by almost 5% in 1Q2012 to 219 billion units, primarily due to growth in its Asian, African and Eastern Europe segments. The European Union segment slacked slightly because of a relatively low market share in the region. The Asian segment showed the most growth in terms of volume, with a 12% improvement in the first quarter. This increase was largely due to a higher market share in countries like Japan, Korea and Thailand. Overall, the total shipment volume from all segments was up almost 5% in the first quarter, with brands like Marlboro and Parliament outshining others. The company's other tobacco products, which include cigars, pipes and make-your-own cigarettes, also grew by an impressive 15% in volume.
Revenue analysis: Compared to 1Q2011, PM's overall net revenues from all segments increased by 9% in the first quarter to a total of almost $18 billion. However, this increase was largely offset by adverse currency movements, resulting in translation losses of almost $600 million. The Asian segment outperformed others in terms of revenues generated, showing an improvement of almost 21% in 1Q2012.
Analyzing the annual data reveals that the company's revenues have grown at almost 13%, which is higher than the increase in its cost of sales (increase of 11%) and a first quarterly increase of 6.4%.
Earnings Analysis And The Revisions: Net earnings increased by almost 13% in the first quarter to $242 million, with EPS up by 18% to $1.25. PM has revised its forecast for its 2012 earnings. It now expects EPS to be in the range of $5.20 to $5.30, up approximately 10% to 12% from 2011.
Balance Sheet: The company has a total debt of around $21 billion as of the most recent quarter, and a very high leverage ratio of 1,300%, which puts the company under immense pressure in terms of interest payments. However, it has a high interest coverage ratio of 13% compared to the industry average. All major credit rating agencies have a stable outlook for the company's debt. PM has a total of $2.5 billion in cash and other short term investments, which it plans to use for future share repurchase programs and dividend payments.
Upcoming Developments: The company has set a new share repurchase target of $18 billion, which is to be initiated from August this year. In the third quarter of 2011, PM's BOD approved a 20% increase in dividend payments to $0.77 per share, which are to be paid next month in July. Currently, the stock's dividend yield is an impressive 3.50%. With stable operations and free cash flows of $9 billion, the company's high dividend yield and plans to repurchase more shares are well supported.
Market Performance: PM has outperformed the market as well as its peers over a one year period as illustrated in the chart given below. The stock yielded 28%.
Valuation: The company is earning $5 per share and the year end estimate is $5.2. Applying a PE multiple of 17 to the estimated EPS of $5.2, we arrive at a target price of $88. Currently, the stock is trading around this level and we believe that this represents a fair valuation.
Recommendation: Based on our analysis, we believe that the company has performed well and it continues to see growth in its various segments in terms of high unit sales and net earnings. Moreover, the stock offers an attractive dividend yield and has announced its future plans for a share repurchase. All this is well backed by strong operations and sufficient sources of liquidity.
Reynolds Amercian Inc.
Reynolds American Inc. manufactures and sells cigarettes and other tobacco products in the United States. The company offers cigarettes under the brand names of Camel, Pallmall, Winston, Kool etc. It also provides smokeless tobacco products like moist snuff under GRIZZLY and KODIAK brand names, pasteurized tobacco under CAMEL Snus brand name; and milled tobacco under the brand name of CAMEL dissolvables.
Revenue analysis: RAI operates through three segments: RJR Tobacco, American Snuff and Santa Fe. RAI's largest segment is the RJR Tobacco, which is also the second largest tobacco company in the United States. RJR's revenues took a 6% dive in 1Q2012, largely due to lower cigarette volumes. The decline in sales is illustrated in the table below.
Moreover, RJR Tobacco lost some of its market share in the first quarter of the year in comparison to 4Q2011. Looking at the annual data, the company's revenues declined by almost 2%. However, its gross margins are stable at an impressive 47% YoY, higher than PM's 27%. RAI's operating income also took a dive in the first quarter, which was largely due to lower cigarette volume and a restructuring charge of $138 million.
Earnings Analysis: Despite the fact that the company's management has reaffirmed its earnings guidance for 2012, its EPS was $0.47, down almost 28% from the previous year's quarter. This decline was due to the restructuring charge it incurred during the quarter.
Balance Sheet : The company has $2.4 billion in cash and other short-term investments and a total debt of around $4 billion. Its leverage ratio is under control as compared to the debt to equity of PM. The company relies on the funds generated from its operations to meet its liquidity requirements, as well as proceeds from the issuance of debt securities.
Attractive Dividend Yield: RAI paid a quarterly cash dividend of $0.56 per share, which was paid in April 2012. Furthermore, according to an announcement made by RAI, the company's BOD has approved an increase in the quarterly dividend to $0.59 from the previous $0.56. RAI has an impressive dividend yield of 5.50%, higher than the yield of its major competitor, Philip Morris. The company has also consistently paid dividends in the past.
Source: Company website
Market Performance: The stock has underperformed the market as well as its major competitors over a period of one year, yielding -2%.
Recommendation: The current P/E ratio for RAI is 19x, at a premium to its industry average. Despite the fact that the company's revenues are downward trending and it has lost some of its market share, it continues to be an attractive investment from a dividend standpoint. It has historically returned money to its shareholders in the form of dividends. With limited upside, it can be a value stock for investors that prefer dividends.
Lorillard, Inc., through its subsidiaries, manufactures and sells cigarettes in the U.S. It markets approximately 43 product offerings under various brand names, including Newport, Kent, True, Maverick, and Old Gold. LO is headquartered in North Carolina.
Declining Unit Sales: LO's total domestic volumes declined in 1Q2012 compared to the first quarter of the previous year; however, this decline was in line with the industry.
Net sales for the company also declined in 1Q2012, down 0.6% from the three months ended March, 2011. This decrease was largely due to a low unit sales volume. On a yearly basis, LO's revenues have shown a quarterly revenue growth of 0.30% (YoY) versus -2.90% for its competitor, RAI. Gross margins for LO at 50% also stand out from its competitors.
The company reported a quarterly EPS of $1.7, not changing much from 1Q2011. Earnings have grown at an impressive compounded annual growth rate of almost 9% over a two-year period.
Balance Sheet: The company has almost $2 billion in cash and it invests in money market funds. LO's cash flow from operations declined in the first quarter, largely due to higher leaf tobacco purchases. The company's debt, relative to its peers, is manageable at almost $3 billion.
Risks: LO's credit ratings are lower than its peers (currently BBB by Fitch), largely due to its reliance on one major brand, Newport. Any deterioration in its performance in the future can affect the profitability of the entire company.
Dividend Yield: The stock has a dividend yield of 4.90% and a high payout ratio of almost 68%, which is more than its peers. The chart below shows the dividend history of the company.
Recommendation: LO's stock has performed well in the recent past and has outperformed the market as well as competitors like Vector Group Ltd. (VGR) and RAI. Shares are up 12% year to date as of June, 2012. The company is trading at a P/E ratio of 16x, at a slight premium to its five-year average. However, LO's attractive dividend yield along with its high payout ratio and reasonable free cash flows of $1 billion make it a valuable stock to hold. Therefore, we recommend a long position.
British American Tobacco PLC
British American Tobacco PLC operates through its subsidiaries and engages in the manufacture, distribution, and sale of tobacco and nicotine products. It offers cigarettes, cigars, smokeless snuff, roll-your-own cigarettes, and pipe tobacco products. The company has total cash of $3.5 billion and a high leverage ratio of 121%. Quarterly revenue growth is impressive at 5%, which ranks above most of its peers. BTI has a dividend yield of 5.80% with a high payout ratio of 76%. The high dividend yield is well supported by the company's free cash flows of $4.29 billion.
Altria Group Inc.
Altria Group, Inc., through its subsidiaries, engages in the manufacture and sale of cigarettes, smokeless products, and wine in the U.S. and abroad. It offers cigarettes under the Marlboro, Virginia Slims, Parliament, Benson & Hedges, Basic, and L&M brands. The company has total cash of around $4 billion and a very high debt to equity ratio of almost 370%. MO has a dividend yield of 4.90% and a high payout ratio of 96%, which is well supported by its operating cash flows and free cash flows of $3.40 billion and $5 billion, respectively.