4 High-Yielding Tobacco Stocks

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Includes: LO, MO, PM, RAI
by: Convex Strategies

If you don't mind investing in "sin" stocks, the tobacco industry is a wonderful place to be able to enjoy some stability, and strong income in the form of large, growing, consistent dividends.

American tobacco companies, however, have been dealing with the declining usage of their cigarettes. This is due to a harsh regulatory environment that includes exceptionally high taxes on cigarettes, to go along with smoking bans on locations where smoking used to be legal. On the contrary, cigarette usage in developing economies is growing at a rate of about 3.4% per year, though this is likely due to rapid population growth more than anything else.

The real trend however, is the increasing prevalence of smokeless tobacco. These brands include Altria's (NYSE:MO) Skoal and Snus brands, and Reynolds American's (NYSE:RAI) Grizzly and Kodiak brands. Snus has been a popular product among ex-cigarette smokers, as they appear to believe (60 Minutes Interview) that it is a healthier alternative to smoking, and the juices can be swallowed, opposed to having to spit into a cup as is common with brands like Skoal, Grizzly, and Kodiak.

Because spitting is not necessary, students, and even office workers can use the product without it being noticed. While Snus is not yet a big part of Altria's revenues, and is often met with some investor criticism, Snus use has clearly been growing; its usage can be seen in various locations during the day if you look for it.

Smokeless tobacco as a whole, which accounted for about 12% of Altria's income in 2010, is a market that has been soaring for the last several years. The unfortunate part, for the morally conscious of us, is that said growth is largely a result of teen use. Altria currently holds 55% of the smokeless tobacco market. Reynolds American produces its Camel Snus line, which provides solid profits for the company. Phillip Morris International (NYSE:PM) acquired Swedish Match South Africa last September, which gave them a Snus line and other snuff products to add to its portfolio.

Altria owns 50% of the conventional cigarette market, and RAI owns roughly 28%. Add in Lorrilard (NYSE:LO) and you have nearly the entire U.S. market. While many see heavy regulation as a negative, the upside to it is that due to restrictions on advertising, it's nearly impossible for new brands to penetrate the market. The brands we see today are almost certainly going to be here three decades from now.

Altria (MO)

At a Forward P/E of 12.33, Altria is trading at a slight discount to its competitors. The company provides a 6.30% dividend to investors, and despite the 7.89% increase from last year, the dividend has been cut 13.77% on average from 2006. Despite its market share and fantastic product lines, its dividend may be at risk if growth doesn't pick up significantly.

One source of growth has been its winery business, but it doesn't make up a large enough portion of earnings to offset declining cigarette usage. Based on free cash flow, its payout ratio is 111%; it is indebting itself further every quarter simply to sustain the dividend. Additionally, the near 300% debt to equity ratio is a bit shocking.

With $13.69 billion in debt, the company generates enough cash flow to pay that off every quarter. Unfortunately, Altria instead finds new lines of credit to pay shareholders, make capital investments etc., and debt perpetually increases. While Altria's shareholder returns have been nearly unmatched over the last five years, there may be more risk than meets the eye.

Phillip Morris International (PM)

Spun-off by Altria to enhance shareholder return, it is currently trading at a forward P/E of 13. Despite the growth in emerging markets, 37.6% of PM's revenues do come from the European Union, where cigarette usage is following a trajectory similar to the one back in the States. For now, China is a closed market; incredibly unfortunate considering the fact that it is the single largest cigarette and general tobacco market on Earth.

However, if someone is ever able to gain entrance, it would likely be Phillip Morris. Investors shouldn't buy the stock on speculation or hopes that will be able to penetrate the Chinese market; it's unlikely in the near or intermediate future. Though, if it is able to do so, it would have a massively transformation effect on the company, leading to wild earnings growth and share price increases.

The company pays a dividend of 3.90%, which lags most of its alternatives. However, the quarterly distribution has risen more than 40% since the company began trading by itself. Better yet, generating about $9 billion in free cash flow per year, its payout ratio based on FCF is a sustainable 68%. Additionally, debt decreased slightly from 2009 to 2010.

Reynolds American (RAI)

Out of all of these, Reynolds American has arguably the best smokeless tobacco line. Skoal and Grizzly are two of the highest sellers in the moist-snuff market, and its profit margins are typically around 50%. RAI pays an excellent 5.70% dividend, which grew 17% from last year and has grown more than 7% on average for the last five.

Based on FCF, its payout ratio is 81% - a reasonably sustainable rate. Its debt to equity is vastly different from MO and PM, at 55%. Additionally, it only has $3.72 billion in debt. RAI trades at 13.45 times forward earnings.

Lorillard (LO):

LO generates nearly all (90%) of its cigarette revenues from its Newport brand. The company pays a 4.73% dividend and is an aggressive buyer of its own stock. The payout ratio is around 65%. Despite the fact that the company has no equity (mostly due to large buybacks), it only has $1.78 billion in debt, compared to $1.15 billion in cash on hand. It also generates more than $1 billion every year in FCF, so it is in solid financial shape.

Conclusion:

While Altria may be the leader in terms of distributions, market share, and has a past of outstanding shareholder return, the stock appears to have more risk than most are seeing. The balance sheet, in short, is a mess, and it's going to be tough for them to maintain, let alone grow its dividends over the long term.

Phillip Morris, in terms of actual revenue and earnings growth, probably has the best business. Despite its European exposure, its revenues come from Asia, the Middle East, Africa, and other emerging areas of the world where population growth is rapid, and wealth has plenty of room to grow. Its financial position isn't great either, but its cash flow generation is unparalleled, and its payout ratio is realistic.

If smokeless tobacco continues its upward trajectory, Reynolds American is very well positioned. Its financials are relatively strong, and its dividend appears to be sustainable, even at its very generous levels. Finally, Lorillard is nearly a pure play on cigarettes, even more specifically Newports. LO was, however, able to grow earnings 10% last year, so it is managing effectively. It is a very active re-purchaser, and has low debt levels.

Phillip Morris is the best long term play, but it may lack the lofty dividend levels necessary for pure income investors. For those individuals, Reynolds American is an excellent, stable choice.

An interesting tactic is just to buy all four of the companies, and profit off of nearly every smoker in the entire world (except the Chinese, so far), while enjoying the benefits of diversification, defensive investing, and strong income.

Disclosure: I am long PM.