Yield, Value, And Safety Limited With 'Consumer Indiscretionary' Stocks

by: John D. Thomason

This is a continuation of the series of searching for stocks with the above listed attributes suitable for an income portfolio, this time focusing on companies which provide indulgences, which I have defined as "consumer indiscretionary" stocks. These are companies which offer products which are popular, but not very healthful, such as alcoholic beverages, carbonated beverages, snack foods, formula restaurants, and last, and also least, tobacco.

Similar to consumer staples, these stocks enjoy steady sales in good times and bad, and are thus somewhat recession-resistant. The group contains a number of well-known dividend payers, and several in this grouping could be considered for inclusion in a dividend portfolio. In this article I will present how I approached the task of evaluating the choices, and what I believe to be the best selections available at the moment.

Unfortunately, few of these stocks are available at attractive prices today, while there are several that should be avoided at current price levels, and there are others that should be avoided regardless of price levels. In investing, knowing what to avoid can often be as beneficial as knowing what to buy. Even if an investor disagrees with the recommendation to avoid a given stock, it can still be worthwhile to be aware of some of the shortcomings, as an incentive to keep a closer watch on the investment.

After reviewing the data, I have decided that there is a natural divide between the tobacco stocks and all of the others, such that they really are not comparable. Tobacco usage, as is well-known, is in a secular decline, and is only allowed to exist because of history, and the fact that tobacco taxes and the settlement terms of the landmark 1998 settlement provide significant income for the states.

The tobacco companies have taken a posture towards their businesses that, with apologies to the late coach George Allen, says "the future is now." While payouts are indeed high, these declining businesses have dim long-range prospects, high debt levels, unattractive valuations, and little to no value, other than as going concerns. The extension of the regulatory authority of the FDA over tobacco in 2009 has further increased the political risk of these firms.

As an example, one company, Lorillard (LO), would be catastrophically affected if the FDA were to limit or disallow menthol flavoring of cigarettes, which has been discussed. I'm not making any judgment here regarding tobacco usage. It is just that the facts as I see them preclude me from recommending any of these stocks as attractive, long-term investments.

Unlike tobacco, the other stocks reviewed are viable as long-term, ongoing businesses, and the major distinction between them is price. Some are available at decent, although not bargain, prices, while some are so extended, it is difficult to see them as attractive investments today. Accordingly, I have divided the complete set of stocks I started out with into two groups - non-tobacco stocks and tobacco stocks. Data will be presented separately for these two groups.

As was the case in my previous articles in this series, most of the data was obtained from the MSN Money website, which I refer to repeatedly as the "primary source website." I used the TD Ameritrade website available to me as an account holder for dividend data. The Morningstar ratings data came from morningstar.com, which provides basic data without charge, with registration. Other ratings data came from resources available to me as an account holder with E-Trade, TD Ameritrade, Schwab, and Fidelity.

I used the E-Trade scan feature to perform my initial scan. To begin the search, I scanned for companies in the Consumer Non-Cyclical sector, with the only qualifier being yield, which had to be at least 3%. Separately, I scanned for Services, Restaurants, again with a 3% yield requirement. I combined all the stocks identified to produce my final list of 14 stocks, 7 non-tobacco and 7 tobacco. The stocks are:

Non-Tobacco Stocks

  • Molson Coors Brewing (TAP) - Consumer Non-Cyclical, Beverages, Alcoholic.
  • Pepsico Inc (PEP) - Consumer Non-Cyclical, Beverages, Non-Alcoholic. Also Snack Foods.
  • Dr Pepper Snapple Group (DPS-OLD) - Consumer Non-Cyclical, Beverages, Non-Alcoholic.
  • Darden Restaurants (DRI) - Services, Restaurants.
  • Coca Cola Co (KO) - Consumer Non-Cyclical, Beverages, Non-Alcoholic.
  • McDonalds Corp (MCD) - Services, Restaurants.
  • Diageo P L C (DEO) - Consumer Non-Cyclical, Beverages, Alcoholic. DEO is an ADR, based in the United Kingdom.

Tobacco Stocks

  • Universal Corp (UVV) - Consumer Non-Cyclical, Tobacco. UVV is a tobacco leaf processor and wholesaler which sells to manufacturers of tobacco products.
  • Reynolds American (RAI) - Consumer Non-Cyclical, Tobacco.
  • Imperial Tobacco Group P L C (ITYBY) - Consumer Non-Cyclical, Tobacco. This as an ADR based in the United Kingdom.
  • British American Tobacco (BTI) - Consumer Non-Cyclical, Tobacco. BTI is also an ADR based in the United Kingdom.
  • Altria (MO) - Consumer Non-Cyclical, Tobacco. MO focuses solely on the U.S. market.
  • Philip Morris Intl (PM) - Consumer Non-Cyclical, Tobacco. PM was spun off from MO in 2008 to focus on non-U.S. markets.
  • Lorillard Inc - Consumer Non-Cyclical, Tobacco.

I next ranked the companies in each group, best to worst, for each of the six evaluation criteria sets. These results are shown in six sets of tables following, with each set consisting of two tables, one for the non-tobacco stocks, and one for the tobacco stocks. A brief recap describing each evaluation criteria set is presented, followed by the two tables showing the results of applying that criteria to the two groups of companies. After all tables have been presented, conclusions and recommendations are presented.

Dividends (Tables 1A and 1B)

The first criterion set is all of the key metrics relating to dividends. In addition to the current yield, I reviewed the last five years of dividend history, and calculated the dividend growth experienced over the period. I also show, for informational purposes, the payout ratio and the ex-dividend date (month and year) of the last increase.

Click to enlarge.

Earnings and Revenue (Tables 2A and 2B)

The next criterion set is earnings and revenue, which is the foundation upon which dividends are based. If earnings and revenue are lacking, dividends cannot be sustained for long. I reviewed the operating cash flow vs. net income for the last five years and the last five quarters, to see if cash flow consistently exceeded net income, which would indicate high-quality earnings. The table indicates the number of periods, out of five possible, that cash flow exceeded net income. Thus, 5/5 is an ideal reading.

I also reviewed the ten year histories of revenue and net income, to get an idea as to the stability of revenue and earnings, and also debt. The ideal case would be steadily increasing revenues and net income, and flat or declining debt. Another data item shown is the consensus five-year earnings growth forecast estimates from analysts. Finally, when available, the S&P earnings quality rating is shown.

Debt (Tables 3A and 3B)

The data is presented for consideration by readers for each of the final 14 firms. Debt levels are reasonable for all of the non-tobacco firms. Debt levels are generally high for the tobacco firms, with some interesting numbers for a couple of these names. Debt ratios of leverage, debt to equity, and interest coverage were taken as shown from the primary source website.

Long-term debt percentage of total capitalization and stockholder's equity percentage of total capitalization were calculated from the most recent balance sheets available. I also included, for comparison purposes, the percentage of total capitalization represented by the total of all non-current liabilities, not just long-term debt.

Returns (Tables 4A and 4B)

Return on equity, return on assets, and return on capital, as taken from the primary source website, are shown.

Value (Tables 5A and 5B)

Valuation ratios of price to earnings, price to book value, price to sales, and price to cash flow are shown. Unfortunately, as per the article title, few of these stocks represent good values at current price levels. In fact, only one stock, Molson Coors , has valuation levels that would qualify the stock as a value stock. Some of the non-tobacco stocks are at extremely rich price levels, and just about all of the tobacco stocks are quite highly priced.

Ratings (Tables 6A and 6B)

I mainly relied upon my favored resources of S&P and Morningstar, plus I included Schwab's rating if available. Also shown is the analysts' composite rating, presented as a numerical average, which came from the primary data source website. The number of analysts included in the rating average is indicated.

Conclusions and recommendations:

As far as the non-tobacco stocks are concerned, one is attractively priced, three are reasonably priced, and three are so far extended in price that I could not recommend them, except upon a substantial pullback. I believe I made it clear in my opening paragraphs what my opinion is regarding the tobacco stocks, although even here there is some distinction. Two are not too far out of line, and could be considered for dividend income, while none of the others have enough merit to be considered for purchase, in my opinion.

I will list the firms in each group, and will offer a brief comment explaining the rationale for my opinion in each case.

Non-Tobacco Group

Molson Coors Brewing is the only stock reviewed that is available at a value price. The stock has seen demand plateau in recent periods, and margins are in danger of further erosion. Still, the company has strong brands, a reputation for controlling costs, an excellent dividend growth record, and a low payout ratio. I believe the dividend is safe, and will continue to grow, and that the current weakness is a buying opportunity. Recommended under $42.

PepsiCo Inc has been placing second, at best, to KO in the soft drink category, but is better diversified, in my opinion, with a significant portfolio of snack food brands. (Keep those darn Fritos away from me before I eat the entire bag!) PEP is not a bargain, but is at least in a reasonable price range. Recommend buy, at $65 tops, and better yet, in the $62 to $63 range.

Dr Pepper Snapple Group is a distant third in the soft drink market, and lacks the economies of scale and international exposure of the big two, KO and PEP. Debt is a bit high, probably related to the Snapple acquisition, but is declining. With a decent 3.5% yield, and valuation metrics close to being a value stock, one could do worse. Recommend cautiously in the $38 to $40 range.

Darden Restaurants is about the only restaurant stock, other than MCD, sporting a decent yield. DRI offers some of the most popular formula restaurant brands, and should continue to compete well in this super-competitive field. With a valuation approaching the value range, it is also a cautious buy recommendation, in the $45 to $50 range.

Coca-Cola Co is definitely the king of the soft drink category, made even more famous as a Warren Buffet holding. Unfortunately, it has been bid up so high that I doubt if Warren would be a buyer at today's price. A significant price drop back into the $60 range would justify another look.

McDonald's Corp is definitely in oxygen-deprived territory at the moment, although it has dropped below the century mark. While one can't argue too much with success, it is priced accordingly, which removes it from the value-investing list. A retreat back to the $80 range during a bona-fide market correction might require another look at MCD.

Diageo PLC has enjoyed an amazing run since the 2009 lows, and offers a stable of top brands unlikely to drop out of favor. Unfortunately, the stock price reflects the love, and DEO would have to decline considerably, say maybe a third or more, to be even remotely tempting. DEO is the most richly-priced stock of all those reviewed for this article.

Tobacco Group

Universal Corp at least has a respectable book value in relation to the stock price, and as a wholesaler, avoids some of the exposure to regulation and litigation. While UVV has better debt and valuation metrics than most of the other tobacco stocks, it is still a tobacco stock. Some time ago UVV declined markedly on fears that some of its major customers were looking elsewhere, as a cost-cutting move. While those fears did not materialize then, they could return. I believe UVV is possibly the best choice of this set of poor choices, which is about the best I can say. A yield over 5% might be enticing enough for some dividend seekers, which would require a fairly significant price drop.

Reynolds American is my best retail choice in this set of poor choices, with debt, valuation, and other metrics not too far out of line.

Imperial Tobacco Group P L C (ITYBY) actually has some decent metrics, and while I am speculating with this thought, as I haven't researched it, I would hope there is a little less hysteria over smoking in Britain than here. Still, with a yield under 4%, I can't make a case for this British tobacco stock.

British American Tobacco differs from ITYBY in one major respect - it is significantly more over-valued. The same comments as the preceding item apply to BTI.

Altria and Philip Morris Intl might as well be considered together, since they sprang from the same well-spring, and my thoughts apply equally to both. They have had a terrific run since 2008, when PM was spun off from MO, and investors who bought then, or just about any time since, excluding recent weeks, have done well, or even terrific. My view is this train has left the station. Based on all of the fundamentals, I could not consider these as viable selections at anywhere near current prices. If I owned them, I would cash out, taking advantage of the rich valuations, even as I admit they could remain richly valued for some time because of the dividends they offer.

Lorillard Inc has to be one of the scariest stocks I have ever considered. LO has no equity, with liabilities exceeding total capitalization. Although the stock has surprisingly strong recommendations from S&P and others, to me the risk of an adverse FDA ruling on menthol cigarettes is a Sword of Damocles hanging above the stock that trumps yield, ratings, and whatever else there might be to recommend it. The true risk might be minimal, maybe even non-existent, but the fact is, I don't know, and I don't have any way to find out. So all I can do is to stay away. I can find a utility or REIT that pays 4% to 5%, without any FDA concerns.

In summary, I can't get too excited about most of these stocks, other than in a negative way, in the case of some of the tobacco stocks. I do favor TAP and PEP, and I could consider DPS and DRI at or near current price levels. If a significant market decline should occur, KO, MCD, and even DEO could become much more enticing, at significantly lower prices.

I cannot recommend any of the tobacco stocks at current price levels. Certainly many of them would have been good choices a year or two ago, especially MO and PM, with high dividends and outstanding price appreciation. The question now is, what returns can investors buying in at today's prices expect? The Faustian bargain the states made with the tobacco companies likely ensures that the companies will continue on for a long time, and since the only value they have for investors is to be dividend payers, the dividends will probably continue on for a long time as well.

Still, as a value investor, buying a security that, based on valuation metrics, is over-valued, and that may be at or near a price peak, is not a desirable proposition, regardless of yield. When you add to the picture the reality that the sector is in a secular decline, that the firms have high debt levels and marginal book values in most cases, and all have litigation / regulatory risks, it's a no-brainer - avoid these, there are better places for one's long-term capital.

All data is as of the market close on April 5, 2012, which was when the data collection exercise was initiated in preparation for writing the article.

Disclosure: I am long PEP, TAP.