Tobacco Investment Is Good for the Long Run, and for Income

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When investors think of Philip Morris International (NYSE: PM), they probably think of a fast growing emerging market tobacco giant which has been paying a consistently growing dividend since it was spun off from Altria (NYSE: MO). Its dividend per share rose from $1.54 in 2008 to $3.24 in 2012. Recently, Philip Morris declared a quarterly dividend of $0.85, bringing the forward annualized dividend to $3.40 per share. Should investors consider Philip Morris at its current price? Let’s take a closer look.

EPS growth due to share buybacks

Since the beginning of the year, Philip Morris has gained close to 10%, lagging the S&P 500’s return of more than 13%. The mediocre performance for the past six months might be due to the decline in its first-quarter earnings results. In Q1 2013, while its revenue grew 2.8% year-over-year to more than $18.5 billion, its net income decreased 1.7%, from $2.16 billion in the first quarter last year to $2.12 billion in the first quarter this year. Reported operating income was down 0.4%, mainly because of the currency impact. Excluding the currency impact, operating income was actually up 3.1%.

Despite the decline in first-quarter net income, its EPS grew 2.4% to $1.28. The growth in the EPS was attributable to the share repurchase activities. In Q1 2013, Philip Morris spent around $1.5 billion to buy back 16.7 million shares, reducing the share count to nearly 1.65 billion. Looking forward, Philip Morris expected to generate around $5.55 to $5.65 EPS, including $300 million in one-year gross productivity and cost savings and $6 billion in share repurchase.

Weak balance sheet

What might worry investors is Philip Morris' weak balance sheet. As of March 2013, the company had negative equity of $4.3 billion, nearly $4 billion in cash, and as much as $25.6 billion in debt. Moreover, Philip Morris booked a high amount of goodwill and intangible assets, at nearly $13.4 billion. Consequently, the tangible book value of the company was much lower, at only $(17.7) billion. Philip Morris is trading at around $91.70 per share with a total market cap of around $150 billion. The market values Philip Morris at around 11.64 times its EV/EBITDA.

EV/EBITDA stands for Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization. This ratio takes into account the market value, cash, and debt level, in comparison with the cash flow generating ability of a company. The lower the ratio, the cheaper the stock.

Are Atria and British American Tobacco better buys?

Compared to its peers Altria and British American Tobacco (NYSEMKT: BTI), Philip Morris’ valuation stays in between. Its ex-parent, Altria, has a different playground with the main focus on the U.S. market. Altria is considered to have much slower potential growth due to the stricter tobacco regulations in the U.S. What makes Altria interesting is its 26.8% voting interest in SABMiller.

At the time of writing, SABMiller is worth more than $79 billion on the market, valuing Altria’s 26.8% interest at around $21.17 billion. Interestingly, the investment in SABMiller was booked at only $6.75 billion in Altria’s balance sheet as of March 2013. Altria is trading at around $35.60 per share with a total market cap of $71.30 billion. The market values Altria the cheapest at 10 times EV/EBITDA.

British American Tobacco is the most expensively valued tobacco company among the three. At $110 per share, it is worth around $105.4 billion on the market. The market values the company at 12.15 times its EV/EBITDA. The company derived around two-thirds of its revenue from emerging markets. Looking forward, the company will try to simplify the company’s transaction process including developing new lower cost suppliers without quality compromise, increasing production efficiencies, using “Lead Logistics Partners” to manage the third party logistic networks.

Moreover, British American Tobacco will reduce its SKU portfolio by 17%, with a 60 % reduction in cigarette paper grades and 23% reduction in blends. The move will certainly push up its operating margin, driving its bottom line higher.

My Foolish take

Among the three, British American Tobacco has the highest dividend yield at 5.20% while Altria ranks second with a 4.9% dividend yield. Philip Morris offers the lowest, but still a decent dividend yield of 3.7%. Income investors could consider tobacco companies for their portfolios with their juicy dividend yields. I like Philip Morris and British American Tobacco for their growing emerging market business. I also think Altria could be a decent buy because of its understated SABMiller stake.

Tobacco companies have been under siege in the U.S. for decades, as waves of litigation, regulation, and anti-smoking campaigns have given the industry a black eye. Yet Philip Morris International focuses on overseas markets, where business prospects generally look brighter. Investors have been happy with its stock's performance, but is Philip Morris still a buy? Find out in The Motley Fool's premium research report on the company, which includes in-depth analysis of its opportunities and challenges ahead. To claim your report just click here now.

Anh HOANG has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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