Fire Behind the Smoke for These 5 Stocks

02/10/2012 10:15 am EST

Focus: STOCKS

Jim Trippon

Editor-in-Chief, China Stock Digest

Tobacco stocks may not be the most popular products in the eyes of many, but their stocks’ growth and dividend potential remains compelling for income investors, writes Jim Trippon of Dividend Genius.

No group of stocks is more stigmatized than tobacco stocks. With legitimate serious health concerns over cigarettes as an industry backdrop, tobacco stocks have been labeled sin stocks, so many investors shun them.

Others, however, who are open to the possibilities of investing in the group might be interested in taking a look at their fundamentals and stock performance, along with their dividends, for which they’re known. Although the sector has been subject to ongoing tighter regulations, rising taxes, and a lower percentage of the population in developed nations using its products, the industry has still somehow managed to thrive.

The Tobacco Business
The business is still capable of generating substantial revenues and cash flow, which of course eventually can translate to the bottom line with earnings.

Thus, for the tobacco companies that perform well in their business, there’s usually ample cash to pay out a generous dividend, often in the 4% to 6% range. This is incentive to draw investors into the sector.

A couple of the larger companies, notably Altria (MO) and British American Tobacco (BTI), generate annual revenue above the $20 billion mark. In the past several years, Altria has generated operating cash flows in the $2 billion to $4 billion range, while companies such as Lorillard (LO) and Reynolds American (RAI) produce more than $1 billion in operating cash flows.

The earnings from the large tobacco companies give us a window into the industry. Altria reported a 3.4% increase in its fourth-quarter revenue, to $6.1 billion, although net revenues for the full year 2011 declined to $23.8 billion, a 2.3% drop-off. Higher list prices for cigarettes partially offset lower sales volume.

For Reynolds American, its upcoming earnings report was expected to show $1.22 billion in revenue for the quarter, which would be a 1.9% gain from the year-ago quarter. For the full year, Reynolds was expected to report $8.58 billion, a slight increase of 0.4% from last year’s $8.55 billion. In the third quarter, both revenue and earnings were down slightly for Reynolds.

Altria, known for its Marlboro brand, has a $58 billion market cap, and currently yields a 5.7% dividend. This, along with its still-attractive cash generation and earnings makes it one of the leaders for the large names.

Philip Morris International (PM) has a $133 billion market cap and is a dominant global tobacco company, with a 4% current yield.

Reynolds currently yields 5.6%, while Lorillard’s payout gives it a 4.7% yield. British American, which has the second largest global market share, has seen its stock price bid up, so its current yield is down to 2.5%. As a group, these tobacco stocks are on a par on yield with other attractive dividend sectors, such as utilities and pharmaceutical stocks.

Some Further Cautions
There are some other some negatives with this group that show the impact of the health issues. Altria, for example, paid out $7 billion of its $23 billion in revenue in excise taxes. Further legislation and lawsuits are always a concern.

Going forward, revenue, earnings, and cash flow can be dented further by more than price increases due to higher taxes, as there is a diminishing pool of customers in the US. Roughly 20% of adults in the US smoke, whereas more than 50 years ago, nearly 80% did.

Although there are 1.3 billion smokers in the world today, some observers feel the number is expected to grow to 1.9 billion in the next ten or 15 years. This is due to world population increasing, as well as the long-term demographic shift of smoking moving from the developed to the undeveloped world.

Yet as most of the world’s governments either heavily regulate the industry or try to actively discourage it, while short-term tobacco is a relatively stable cash flow industry, other industry observers see a questionable long-term growth prognosis.

In addition to attractive dividends, tobacco stocks have performed well, both long and short term. Altria shares gained 17.8% in 2011, while Philip Morris rose 33.7%, and Lorillard shares rose nearly 50%.

Tobacco stocks trade at roughly a 13.5 P/E compared to the S&P 500, which trades at about 16 times earnings, so investors pay a premium right now for tobacco. Investors interested in the yields supported by strong cash flow should watch for better share prices.

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