Desperately Seeking Yield Through Equities Redux: Part 7 - Tobacco Stocks

Includes: AOI, LO, MO, PM, RAI, UVV
by: Philip Mause

This series brings up to date information presented in an earlier series in June-July of 2011. The first article in the new series dealt with BDCs; the second with agency mortgage REITs; the third with non-agency mortgage REITs; the fourth with telecom stocks; the fifth with equity REITs and the sixth with utility stocks. This article deals with tobacco stocks - stocks of companies which either manufacture cigarettes and other tobacco products or which are involved in the tobacco market.

This group - like the telecom and the utility stocks - is a "normal" group of companies in the sense that it is not governed by any special tax rules or requirements to distribute a percentage of earnings as dividends. Dividends are subject to normal dividend tax treatment. Unlike utilities and telecom stocks, this sector is not subject to rate regulation or regulatory approval of change of ownership or control. On the other hand, tobacco has become very much a "regulated" industry in the sense that all sorts of restrictions have been imposed on smoking in various locations and in the form of prohibitions upon the sale of products to minors. The industry has been under a complex settlement regime with state governments in which large payments are made to offset damages incurred due to health effects of tobacco.

For a variety of reasons, tobacco is viewed as a declining business - at least within the United States. From an investment point of view, this is a double edged sword. Growth is not likely but, on the other hand, companies in the industry face limited incursions from new entrants. The cigarette companies are trying a variety of strategies - smokeless tobacco and electronic cigarettes are two of these - with varying degrees of success. I think an investor must face the music here and recognize that long-term growth is going to be a very difficult challenge.

When I wrote the piece on tobacco stocks in the last series, it provoked a storm of controversy in the form of comments arguing the question of whether moral issues were involved in the decision whether or not to invest in these companies. I will not address that issue in this article. Frankly, I have enough trouble figuring out how to make money without having to make moral judgments in the context of investing. I have misgivings but I also think that it is difficult to go through the S&P 500 on this basis because similar arguments could be made about a number of other companies. It must be conceded that the industry has another double-edged sword in the form of the at least allegedly addictive nature of its products. Addictive products are certainly a good market to be in during a recession as they may be the very last consumer expenditure to be cut; on the other hand, the addictive nature of a product is bound to attract regulatory scrutiny.

I am providing the price and quarterly dividend as of the date of the original article (6/28/2011) and as of Thursday's close for Altria Group (NYSE:MO), Reynolds American (NYSE:RAI), Lorillard (NYSE:LO), Philip Morris International (NYSE:PM), Universal Corporation (NYSE:UVV) and Alliance One (NYSE:AOI). Prices are based on Yahoo Financial; dividend information is obtained from each corporation's website.

Price (6/28/11) Dividend (6/28/11) Price (3/14/13) Dividend (3/14/13)
MO $26.77 $.38 $33.80 $.44
RAI $37.22 $.53 $43.29 $.59
LO $37.06 $.433 $39.66 $.55
PM $65.92 $.64 $91.31 $.85
UVV $37.20 $.48 $58.01 $.50
AOI $3.09 ------ $4.03


The 2011 data for LO has been adjusted to account for a 3 for 1 split, which occurred earlier this year. Of the groups of stocks surveyed so far, this group seems to have had the most consistent dividend growth and price appreciation performance. The group tends to trade at relatively high PEs and to have relatively high pay out rations. Most of the companies are also repurchasing shares. This is definitely a group of stocks bought, at least largely, for dividend yield.

PM seems to be the star. PM sells exclusively or almost exclusively overseas - this is a product of the split up of MO several years ago. The overseas market contains at least some submarkets with considerably less anti-smoking regulation than we have here in the United States. I have often described PM as a "coward's way to bet against the dollar" because declines in the dollar's exchange rate against other currencies produce virtually automatic increases in PM's dollar-denominated earnings.

LO is periodically affected by concerns over menthol regulation. it is the most exposed to that kind of regulation through its popular Newport brand. There has been a long, ongoing debate about menthol and I do not anticipate any imminent regulatory action. MO has a long and solid history of rewarding investors but the MO that rewarded investors in the past included the international operations now spun off to PM and other businesses as well.

UVV and AOI are tobacco wholesalers and dealers and so are in a somewhat different business from the others. UVV sells at a lower PE than most of the cigarette companies and has moved up as it is paying down debt and piling up balance sheet cash. AOI sells at a very low PE of less than 6 times next year's projected earnings and has periodically been a favorite of some value investors. It has considerable debt but it also seems to have the earnings power to pay it off. It does not currently pay a dividend.

I have been a long-term holder of PM and have done very well. I think that there are always regulatory risks with this group and that it may make sense to wait for "regulatory squalls" and pick up stocks when they have been beaten down a bit.

Disclosure: I am long PM, MO. 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.