Desperately Seeking Yield Through Equities: Part 7 - Tobacco Stocks

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

Tobacco stocks generally offer generous dividend yields and, like utility and telco stocks, are not pass-through entities and, thus, offer an investor an opportunity to take advantage of the tax advantageous treatment of corporate dividends. This sector has, of course, been under several "clouds" for a number of years. The potential for large awards in various kinds of litigation is worrisome.

This has been mitigated to a degree by the comprehensive settlement the industry reached with the states which presumably settled liability with the states and also set up a financial arrangement which gives the states a certain incentive to see the industry continue without the need for bankruptcy filings in response to huge damage awards. There are still other theories under which at least some of these companies could face ruinous litigation outcomes, but it appears that the danger has been mitigated.

More fundamentally, Americans are constantly made aware that smoking is dangerous and it appears to be forbidden in more and more settings. Near where I live, Montgomery County actually considered an ordinance making it illegal to smoke outdoors. This has all had the effect of depressing demand and, within the United States, smoking is a declining, but persistent, industry. In other parts of the world, there are fewer constraints on smoking, less publicity of its dangers, and still growing markets as more and more consumers can afford what has always been a rather expensive habit.

Paradoxically, the restrictions on advertising and promotional efforts probably enhanced profitability in the short run by reducing the industry's costs, making price competition difficult, and impeding entry of new competitors. Of course, in the long run, these restrictions have suppressed demand. It is unclear how effective the latest wave of anti-smoking public policy (requirements of pictures depicting tobacco induced illness) will be.

I am including a variety of companies in the industry. After the name of each company, I provide the stock symbol, Monday's closing price and the dividend yield.

  • Altria Group (NYSE:MO): ($26.77), (5.7%)
  • Reynolds American (NYSE:RAI): ($37.22), (5.7%)
  • Lorillard (NYSE:LO): ($111.19), (4.7%)
  • Philip Morris International (NYSE:PM): ($65.92), (3.9%)
  • Universal (NYSE:UVV): ($37.20)(5.1%)
  • Alliance One (NYSE:AOI): ($3.09), ( - )

Another name investors should be aware of is British American Tobacco (NYSEMKT:BTI). BTI also pays substantial dividends but I am generally not covering foreign companies in this series.

MO, RAI and LO are all in the cigarette business and are the leading companies in the American market. PM operates exclusively or virtually exclusively in the export market - it is the part of the old Philip Morris Company that sold to overseas markets and when the company was split up, MO got the domestic operations and PM got the overseas operations. PM probably has the best growth prospects of the group. It also offers investors a "coward's way to bet against the dollar" because all of its earnings are in foreign currencies but its financials are reported in dollars and, thus, it experiences a substantial earnings tailwind from a declining dollar.

UVV and AOI are really in a different business - tobacco wholesaling and curing. They buy tobacco from farmers and sell it to cigarette manufacturers. This is not a growth business and there is some concern that the manufacturers will try to bypass the wholesalers and deal directly with the farmers but this does not appear to have had a significant effect on their volume as yet. AOI is not really a dividend stock. For some reason, AOI is somewhat of a favorite of value investors. It has a lot of debt and if it can earn its way out of debt, it might trade up significantly.

Most of these companies have relatively high payout ratios. This is probably because they do not have much need for capex and also because they want to get money out of their own hands and into the pockets of shareholders so that it is not available to be lost in a monster tort verdict.

It is interesting that these companies generally trade at PE ratios that are relatively high - especially in comparison with the depressed PE ratios we have run into in mega tech. Is MO really facing better growth prospects and/or less risk in the future than Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), or Intel (NASDAQ:INTC)? I suspect valuations are heavily affected by dividends and that there is a kind of ceiling at 5-6% on dividend yields which prevents the stocks from declining.

There are generally lots of opportunities to buy these stocks in response to "event" reaction as the market digests the latest bad news about cigarette smoking or public policies aimed at its discouragement. At the current price levels, I believe that there are more favorable risk/reward opportunities to obtain yield elsewhere in the market, but as I generally have said, "at the right price...." almost anything can be a value investment.

Disclosure: I am long MO, PM, MSFT, INTC, CSCO.

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