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Back to Part XXI - Petroleum Producers Poised to Produce

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

The tobacco industry provides some great dividend yields but, for the most part, it lacks much growth potential. There is one exception to this rule that I will enlighten you with in just a moment. But first, let us take a few words to examine some of the peculiarities of this industry. Most tobacco companies have negative free cash flow. Several, like many large corporations today, are buying back shares. But, unlike most companies, the tobacco companies often must borrow (increase debt) to buy back shares. Besides increasing debt, this activity also reduces shareholder equity since treasury stock is counted as a negative within the shareholders' equity section. This is one more reason I don't like to use the debt/equity ratio.

Normally, I would stay away from companies utilizing this practice, but there is some logic that applies in this instance. Since dividends are kept so high to prop up the stock prices of these mature industry participants, the cost associated with equity is very high. Also, unless equity shares are bought back by the company and retired, this expense is one of infinite duration. Now consider the much lower cost of debt in today's environment and the fact that the debt is also of defined duration. These companies are simply substituting a lower cost of capital for a higher cost of capital. It is not possible for a company to continue this practice beyond a certain point or its cost of borrowing will increase to the extent that debt becomes more expensive. Fortunately, these companies have very predictable sales, margins, and cash flows. Without this level of predictability I would definitely stay away, regardless of the yields.

One problem that I'd like to make readers aware of is that the search for higher yields by investors has driven prices of most companies in this industry to what I consider unreasonable and unjustifiable levels. Why pay more than 15 times expected future earnings for a five percent dividend and almost not earnings growth? Much of the recent growth in EPS has come from reductions in outstanding shares in many cases. What I do not like is when the substitution of debt for equity takes on proportions that push free cash flow negative. So, that is where I draw the line here.

There is growth to be cultivated by this industry but most of the players are not positioned properly to take full advantage of the potential. Only one has proven to me that it is capable of the industry leading growth for which I search.

Lorillard (LO) is one of only two companies in the industry that is growing significantly faster than the industry average. The company is the third largest tobacco company in the U.S. and is the first of the major industry players to make an entry into the electronic cigarette market with the purchase of Blu Ecigs. This remains a very small portion of overall sales but should have higher growth potential than the core business. It also appears that LO has been gaining market share against competing brands. The share price commands a lower multiple than its peers. This doesn't exactly make the company a bargain, but it is less pricey than most of the competition and has better total return potential to boot, in my opinion.

The one overhanging negative is the potential impact of an FDA decision that could brand menthol cigarettes as posing a greater health risk than non-menthol ones. But I really don't think that this is a big negative in the long term. I don't expect a ruling, even negative to make much of a dent in demand for menthol cigarettes. If I am wrong, it could be a disaster for LO because nearly 90 percent of sales come from menthol brand, Newport. But unless a ruling came with some form of restrictions, I really don't think it will matter to customers. The more likely scenario would entail requiring a stronger warning label on packaging. I like to include links to articles by other authors to provide readers with broader perspective. Consider this one about the ecigs and this one for more on the dividend. Let's look at the metrics.

Metric

LO

Industry Average

Grade

Dividend Yield

5.0%

5.3%

Neutral

Debt-to-Capital Ratio

99.0%

40.9%

Fail

Payout Ratio

66.0%

62.0%

Neutral

5-Yr Average Annual Dividend Increase

41.4%

N/A

Pass

Free Cash Flow

$0.07

N/A

Pass

Net Profit Margin

17.0%

15.0%

Pass

5-Yr Average Annual Growth in EPS

9.8%

5.9%

Pass

Return on Total Capital

50.8%

25.0%

Pass

5-Yr Average Annual Growth in Revenue

17.8%

6.8%

Pass

S&P Credit Rating

BBB-

N/A

Pass

The company rates one fail, two neutral rankings and seven passes; on par with many companies that made the list. The fail is due to the debt level. I only allow it in this instance for two reasons: debt is less costly and in the long term the debt can be paid down using cash flow that would otherwise be used to buy back shares. My five-year price target for LO is $185 which works out to a compound average annual total return of almost 15 percent.

The only other major company in this industry that caught my eye was Phillip Morris (PM). PM is the former international unit of Altria (MO) which spun off PM shares to shareholders in 2008. PM has potential to expand its market share in emerging markets. The company is organized in regional-centric operation units. The organizational method allows the company to shift business expansion focus from one market within a region to another with minimal expense. The company is entering markets with very minimal regulation and management expects to begin offering next-generation products within three years that will provide an experience similar to smoking but with a lower risk compared to actual smoking. For some more perspective on PM from other authors please consider this article or this one. Let's look at the metrics.

Metric

PM

Industry Average

Grade

Dividend Yield

3.3%

5.3%

Fail

Debt-to-Capital Ratio

97.0%

40.9%

Fail

Payout Ratio

57.0%

62.0%

Pass

5-Yr Average Annual Dividend Increase

42.0%

N/A

Pass

Free Cash Flow

$0.27

N/A

Pass

Net Profit Margin

11.3%

15.0%

Neutral

5-Yr Average Annual Growth in EPS

13.5%

5.9%

Pass

Return on Total Capital

53.3%

25.0%

Pass

5-Yr Average Annual Growth in Revenue

11.7%

6.8%

Pass

S&P Credit Rating

A

N/A

Pass

Two fails, one neutral ranking and seven passes result in just enough to make the list. Again, I am overlooking the debt level here for the reason explained at the beginning of the article. The dividend yield is low for the industry, but since it is growing relatively quickly, I don't mind. I expect a shift to fewer share buy backs to continue the dividend increases at a rate similar to the growth in EPS. The share price is high in my opinion which will tend to depress total return expectation. I expect P/E contraction over the long term. My five-year price target is $105 which works out to an average annual total return of about 6 percent. I would wait for a pullback in the price to around $80 before taking a position. That would increase my expected total return to ten percent.

Altria has a couple of strikes against it that I couldn't tolerate: the company cut its dividend and it has negative free cash flow. British American Tobacco (BTI) and Reynolds American (RAI) have a significant level of negative free cash flow. I realize that the companies are using debt to buy back shares but taking free cash flow negative to do so is a negative for me. It is just a line I prefer management not to cross. Universal Corporation (UVV) is the largest leaf tobacco exporter/importer in the world. I don't like the company's position as the middleman. The recent drop in EPS in 2011 may be representative of the volatility I expect the company to deal with for the foreseeable future.

Disclosure:

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: The Dividend Investors' Guide: Part XXII - Tobacco Dividends That Smoke The Market