The Undisputed Champion

Altria, formerly Philip Morris, is unquestionably the #1 company in the domestic tobacco industry. Its Marlboro brand of cigarettes accounted for an amazing 43.6% share of the U.S. market in 2012, up 0.6% from the prior year. It has been the #1 selling brand in the U.S. for over 35 years. Marlboro is a category-busting brand, with offerings in almost every segment of the market, including full-flavor, menthols, "light" and "ultra light" (although they can't be called that anymore), 72 and 100 millimeter, etc.

Along with other premium brands such as Parliament and Virginia Slims, and discount brands like Basic, Altria commands 50.3% of the U.S. cigarette market. Considering the next-closest firm, Reynolds, only carries 27% market share, Altria's dominance is clear.

The company also has a sizable smokeless tobacco division (just under 13% of sales), stemming from the 2009 purchase of UST. Similar to its dominance in cigarettes, Altria's Copenhagen and Skoal brands together accounted for 55.2% of U.S. chew sales last year, up from 54.8% in 2011. Reynolds, with its Grizzly and Kodiak holding 31.5% share, is a distant second. Smokeless is an attractive business. With much lower excise taxes and no settlement payments to the states, smokeless products carry immense (> 50%) operating margins. Furthermore, this is actually a growth business, with Copenhagen volume up almost 9% in the most recent quarter.

Altria isn't sitting still on the latest trends, either. The firm recently announced that it would be launching its first e-cig products (MarkTen) in August, challenging Lorillard (with blu) and several smaller manufacturers in the category.

Finally, Altria has a 27% stake in SABMiller, one of the world's largest brewers. This very attractive investment has routinely generated about 10% of Altria's pre-tax profits.

Against the Other MFI Tobacco Firms

In the previous article, we concluded firmly that Lorillard was a far better choice than Vector, for a variety of reasons. The same is true of Altria - far better operator, better competitive advantages, better balance sheet, etc. So the comparison comes down to which is a better buy: Lorillard or Altria?

By the numbers, we have two very similar firms here. Both Altria and Lorillard generate around 30% operating margins, convert 16% of sales to free cash flows, have similarly leveraged balance sheets, and carry dividend yields of 5%. Both have very strong and share-taking brands in Marlboro and Newport. Lorillard is actually generating modest revenue growth (3-4%) as menthols continue to account for higher percentages of cigarette sales, while Altria is basically treading water (flat revenues over the last 3 years). On the other hand, Lorillard does not compete in the attractive smokeless market, and although Lorillard does have significant share in e-cigs (40%), the "big boys" are coming to play very soon.

The last thing we have to compare is valuation. Lorillard is cheaper. Using the Magic Formula® earnings yield calculation, which accounts for cash and debt, Lorillard carries a 10.9% yield while Altria's is just 8.9%. However, this has been the norm - LO's 5-year average is 11.9% while MO's is about 10%! If investors do want one point of differentiation, Lorillard's payout of free cash flow towards the dividend is measurably lower at 71.5% vs. Altria's 92.3%.

Conclusion: Just Say No

We've done a lot of comparison here, but MagicDiligence believes that neither Lorillard nor Altria (and certainly not Vector Group) make particularly attractive investments right now. Just from above, we can see that both stocks are trending above their historical valuations at present. Additionally, a discounted free cash flow calculation gives me a fair value of $47 for Lorillard and $35 for Altria - both right around current prices. MFI investors should look elsewhere for opportunities.

Entering the 50 over 50 million screen:

Booz Allen Hamilton Holding Corp (BAH)
Dell, Inc. (DELL)
SAIC Inc (SAI)

Dropping out of the 50 over 50 million screen:

CF Industries Holdings Inc (CF)
Chemed Corp (CHE)
USANA Health Sciences Inc (USNA)

Entering the 50 over 1 billion screen:

Buckle Inc. (The) (BKE)
Altria Group Inc (MO)
Revlon Inc. (REV)

Dropping out of the 50 over 1 billion screen:

Gannett Co Inc. (GCI)
ManTech International Corp (MANT)
Select Comfort Corp (SCSS)

Entering the 30 over 3 billion screen:

Lockheed Martin Corp (LMT)
Altria Group Inc (MO)

Dropping out of the 30 over 3 billion screen:

Gannett Co Inc. (GCI)
Nu Skin Enterprises Inc. (NUS)

Today, there are two - Lorillard and Vector Group (VGR). Are either worth looking into as a potential investment? And if so, which of the two is better?

The Domestic Tobacco Industry

The manufacture and sale of cigarettes has historically been a great business, all else aside. Cigarettes are consumables, purchased over and over again, and their habit-forming properties have generated reliable sales and cash flows for producers, through good times and bad. Although volume growth in the U.S. died out over 30 years ago, "big tobacco" has been able to generate very good shareholder returns via price increases, product line extensions (particularly smokeless tobacco), and most importantly, voluptuous dividend payments and share buyback programs. In fact, from the 1950's through 2003, the single best-returning S&P 500 stock was that of Philip Morris, now Altria.

As in most consumer products, brand is the strongest competitive advantage here. Smokers are usually loyal to their brand, and it is difficult for non-established brands to get off the ground given the choking restrictions on marketing of smokes. This leads to another important factor - barriers to entry are immense. With a declining volume outlook, heavy regulation, and a very consolidated market (Altria, Reynolds, and Lorillard control 85% of the market), no new company in their right mind is going to enter the cigarette game.

All this said, the industry continues to face a lot of challenges. Volume declines have averaged about 3% a year, and fell 2.2% in 2012. This will likely continue, as more people become conscious of the health risks of smoking, increasing laws banning smoking in public places, much higher cigarette prices (due to both dramatically higher excise taxes and manufacturer pricing), and diminishing social acceptance of the habit.

Two other regulatory challenges remain over the industry. The Master Settlement Agreement (MSA) of 1998 was the final agreement from the litigation wars of the 1990's, requiring the 3 largest cigarette makers to make settlement payments to the states totaling over $9 billion a year. And in 2009, the Food and Drug Administration (FDA) was given the power to regulate the industry, and immediately raised concerns with its proposed "graphic image" warnings(since shelved) and threat to ban menthols.

Lorillard and Vector

Lorillard and Vector have quite different profiles, despite both being in the same business. Lorillard sits squarely in the "premium" segment of the market, with its flagship Newport brand the most popular menthol cigarette in the U.S. (almost 40% of the category, and 12% of overall cig sales). The company is the third largest cig maker, at just under 13% market share, and has actually been gaining market share as menthols became more popular - it held under 8% of the market 10 years ago. Lorillard is the only big tobacco firm to increase volume over the past 6 years, in the face of U.S. stick volumes declining over 20%. Finally, Lorillard is also forward looking, acquiring electronic cigarette maker Blu in 2012 and quickly ramping it up to a nearly $300 million run rate for 2013. While this would represent only 5% of sales, this is an important forward-looking market that is growing at 40% sequential (not year-over-year) rates, and one that Lorillard is establishing impressive 40% market share in.

Vector Group is a different story. The firm is strictly active in the value segment of the category, selling down-market brands such as USA, Pyramid, Grand Prix, Liggett, and Eve. Vector is the 4th largest cigarette maker, although with a tiny market share of 3.5%. The one thing the firm has is substantially lower payments under the MSA, which gives Vector an important cost advantage over the "big 3" who also compete on the discount shelf.

Let's make this simple - operationally, there is no question that Lorillard is a far better pick. Newport smokers are extremely loyal, menthol continues to grow as a percentage of the market, and the eCig business is a foothold to the future. Vector, on the other hand, has little brand loyalty and is getting squeezed on costs by excise taxes and on pricing by competition. In the most recent quarter, Lorillard's volumes fell just 2.3% while Vector suffered a 7.7% decline.

Checking the Numbers

A quick examination of the financials paints a similar story. Lorillard's debt-to-cash ratio at about 3:2 ($3.1 billion to $2 billion) is far better than Vector's stretched 2:1 ($880 million to $440 million). Lorillard's operating margins are 31% - Vector's, 15.4%. Free cash flow margins, maybe the most important number of all, are striking. Lorillard generates a very solid 17.5% of revenues as free cash flows, while Vector's figure is just over 5%. However you look at it, Lorillard runs a far better business.

Surprisingly, this even extends to valuation. When accounting for cash and debt, and backing out non-operating items (of which VGR has a ton), Lorillard is actually cheaper at an earnings yield of 11.1%, vs. 8.9%.

Vector Group does win one comparison that a lot of investors care deeply about - dividend yield. At a nearly 10% yield, VGR nearly doubles LO's 5%. However, for many years now that firm has paid out far more in dividends than it has generated in free cash flow. The dividend has been fueled by new debt - long-term debt has more than doubled over the past 5 years. On the other hand, Lorillard funds its dividend purely with free cash flow, although payout ratio is pretty high at over 70%.

Packing It Up

Clearly, Lorillard is easily the better pick of the two. But is it a good pick, period?

Assuming Lorillard continues its historical norms of 4-6% share buybacks, modest dividend increases, and generally steady revenues (from price hikes, share gains, and eCigs), I see Lorillard as worth about $47 per share. With the current share price in the low $43's, that's only about 15% margin-of-safety, not enough for me given the poor industry outlook and still-hairy regulatory environment. It is not a candidate for our Top Buys list at this time. I'd like to see Lorillard get into the mid-$30's before getting interested.

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

Entering the 50 over 50 million screen:

Blucora Inc (BCOR)
CA Inc (CA)
Dex Media Inc (DXM)
Spectrum Pharmaceuticals Inc (SPPI)
Weight Watchers International Inc. (WTW)

Dropping out of the 50 over 50 million screen:

Booz Allen Hamilton Holding Corp (BAH)
CF Industries Holdings Inc (CF)
Dice Holdings Inc (DHX)
Endo Pharmaceuticals Holdings Inc (ENDP)
Pitney Bowes Inc. (PBI)

Entering the 50 over 1 billion screen:

Revlon Inc. (REV)
Western Refining Inc (WNR)
Weight Watchers International Inc. (WTW)

Dropping out of the 50 over 1 billion screen:

j2 Global Communications Inc (JCOM)
Lockheed Martin Corp (LMT)
Nu Skin Enterprises Inc. (NUS)

Entering the 30 over 3 billion screen:

Pitney Bowes Inc. (PBI)
Western Refining Inc (WNR)

Dropping out of the 30 over 3 billion screen:

Joy Global Inc (JOY)
Lockheed Martin Corp (LMT)

Boom, Boom, Boom

Like it or not, firearms are woven tightly into American history and culture. The founding fathers found gun ownership so important that they protected it in the second amendment to the U.S. constitution. Some of the world's most famous guns and gunmakers, from the Colt Single Action to theRemington 870 to the M16, have come from America. At about 40% personal ownership and over 300 million guns, the U.S. easily has the most armed citizenship in the world.

Recently, the gun industry has enjoyed record demand, with 3 distinct gun "booms" in the U.S. over the past 5 years. The first came in 2008, when the election of Barack Obama sparked fears of increased gun control and even a potential repeal of the second amendment. The second was in 2012, when his re-election became apparent. And the third, ongoing to this day, came after the horrifying school shooting in Newtown, Connecticut, sparked new momentum for gun control laws.

The tangible evidence is staggering. Background checks are up a staggering 4-fold since 1999. Since 2007, Ruger has grown sales 243% while Smith & Wesson is up 127%. Both firms are running flat-out, struggling to produce enough guns to meet demand.

Without a doubt, it has been a good time to be a gun maker.

Dueling Stocks

So we know the industry conditions are good, but which of the two stocks is more attractive?

The companies themselves are very similar. Ruger makes essentially all of its dough from firearms, and although S&W is also a big maker of handcuffs, 96% of sales are from guns. Both firms compete mainly in pistols, revolvers, and rifles. Ruger doesn't compete in black powder guns or "modern sporting rifles", where S&W does with its Thompson Center and M&P Sport lines, respectively.

From a quality standpoint, there is a clear winner - Ruger. While both have enjoyed the boom, Ruger has operated better. We already quoted growth figures, where Ruger has double the revenue growth since 2007. During that period, Ruger has successfully gotten in front of the trends, a notable one being lightweight compact revolvers, something Smith & Wesson was behind the curve on. Ruger has a better balance sheet, with $46 million in cash and zero debt, vs. $62 million cash / $44 million debt for S&W. Ruger's operating margins have been in the 16-23% range during the boom, while S&W's have been about half that. Return on invested capital for Ruger has averaged 63%; for Smith & Wesson, 19%. S&W also went through a debacle of buying security supply company Universal Safety Response in 2009, only to turn around and divest it in 2011! Clearly, Ruger has been a better operator.

From a value standpoint, though, the opposite is true. Smith & Wesson is a much cheaper stock, with a 9.3 P/E ratio and a 19% pre-tax earnings yield, vs. 13.0 and 12.6% for Ruger, respectively. New management at S&W is making real progress in operations, posting a 20.7% operating margin in the past 12 months, only a few points behind Ruger's 23%. One point in Ruger's favor is the dividend - that company pays a substantial 3.8% yield, compared to no dividend for Smith & Wesson.

Pull the Trigger?

If someone held a gun to my head and told me to pick one of the two for investment, my choice would be Smith & Wesson, at least at current prices. Ruger may be the better company, but S&W is the better investment. A cheap valuation is the best determinant of investment success, and SWHC is considerably cheaper. Also, S&W has the longer history (160 years) and better known brands, no small advantages in a market where the collector is a major factor. Finally, S&W simply has more room to improve, and new management is already getting the company back on track and catching up to Ruger's operating standard.

All this said, I'm still not convinced that current gun demand is sustainable over the long term. In coming up with valuations for these stocks, it is prudent to scale back to 2010-11 volumes when estimating future cash flows. Doing this, I come up with a target around $12 for S&W, and about $49 for Ruger, further supporting the case for Smith & Wesson. In any case, a 25% margin-of-safety on SWHC is a bit tight for what seems like a market in a bubble. Neither of these gun stocks looks interesting enough to enter our Top Buys list right now.

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

Entering the 50 over 50 million screen:

CF Industries Holdings Inc (CF)
Enzon Pharmaceuticals Inc (ENZN)
Express Inc (EXPR)
PetMed Express Inc (PETS)
Sturm Ruger & Co Inc. (RGR)
Smith & Wesson Holding Corp (SWHC)

Dropping out of the 50 over 50 million screen:

Auxilium Pharmaceuticals Inc (AUXL)
ClearOne Inc (CLRO)
Digimarc Corp (DMRC)
GT Advanced Technologies (GTAT)
SuperMedia Inc (SPMD)
Vonage Holdings Corp (VG)

Entering the 50 over 1 billion screen:

General Dynamics Corp (GD)
KLA-Tencor, Inc. (KLAC)
Meredith Corp (MDP)
Myriad Genetics Inc (MYGN)
NETGEAR Inc (NTGR)
Spirit Airlines Inc (SAVE)

Dropping out of the 50 over 1 billion screen:

C&J Energy Services Inc (CJES)
CVR Energy Inc (CVI)
Dun & Bradstreet Corp (The) (DNB)
Foster Wheeler Ltd (FWLT)
Western Refining Inc (WNR)
Weight Watchers International Inc. (WTW)

Entering the 30 over 3 billion screen:

Broadridge Financial Solutions Inc (BR)
General Dynamics Corp (GD)
KLA-Tencor, Inc. (KLAC)
Nu Skin Enterprises Inc. (NUS)

Dropping out of the 30 over 3 billion screen:

CVR Energy Inc (CVI)
Dun & Bradstreet Corp (The) (DNB)
Pitney Bowes Inc. (PBI)
Western Refining Inc (WNR)