Use Tobacco Companies to Put Cash in Your Pockets

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

Tobacco has had a spot high on the list of controversial industries over the years. This article is not to debate one view or the other. What cannot be debated is the fact that tobacco companies make their shareholders rich. The chart below shows how much the returns of tobacco stocks have dwarfed those of the S&P 500.

The chart includes a handful of the major tobacco players and how each has stacked up in relation to each other, as well as the S&P 500 in general over the years. The companies used in this chart are Altria Group (NYSE: MO), Philip Morris (NYSE: PM), Lorillard (NYSE: LO), and Reynolds American. We will examine some aspects of the tobacco industry that make it so lucrative, and then take a look at some of the best plays out there.

<img alt="" src="http://g.fool.com/editorial/images/52089/tobacco-returns_large.png" />

Source: Yahoo! Finance

Here is a quick snap shot of how they compare in key financial categories:

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Altria</strong></td> <td><strong>Lorillard</strong></td> <td><strong>Reynolds American</strong></td> <td><strong>Philip Morris International</strong></td> </tr> <tr> <td><strong>P/E</strong></td> <td>15.9X</td> <td><strong>13.8X</strong></td> <td>17.2X</td> <td>16.7%</td> </tr> <tr> <td><strong>Dividend Yield</strong></td> <td>5.13%</td> <td>5.00%</td> <td><strong>5.20%</strong></td> <td>3.70%</td> </tr> <tr> <td><strong>5 Year DGR (dividend growth)</strong></td> <td>14.3%</td> <td>* 17.3 (3yr)</td> <td><strong>17.8%</strong></td> <td> <p>*12.8 (3yr)</p> </td> </tr> <tr> <td><strong>Share Price</strong></td> <td>$34.34</td> <td>$42.84</td> <td>$46.28</td> <td>$86.63</td> </tr> </tbody> </table>

Nature of the product

Tobacco is a unique product compared to most things you can sell in the world. Tobacco is cheap (less so these days), and has been a consumable product longer than the United States has been a country. This has given tobacco companies decades to build up quite a strangle hold on the population through marketing and brand building. Look at any old commercial or movie and just about everyone is having a cigarette.

The most obvious yet powerful characteristic of tobacco is how addictive it is. While cigarette use has been on a slow decline for decades, there are still generations of smokers. All of these companies have loyal "fan bases" as most people who consume tobacco have a brand they favor over the others.

Pricing power

In the last 15 years or so, federal regulations regarding tobacco have really piled onto the industry providing some challenges to overcome. Smoking is slowly being banned in public places, taxes on cigarettes have skyrocketed, and the advertising ability of tobacco companies has been greatly hampered. Yet, the earnings of these companies continue to increase every year. How so? Pricing power.

Tobacco is a very inelastic product, which means that it can increase in price without having a significant effect on demand. Price increases have been primarily used to offset the decline in volume seen by tobacco companies (about a 3% decline a year). The inelastic nature of tobacco has enabled the tax hikes to have a minimal effect on tobacco earnings as well.

Dividends and stock buybacks

Tobacco is generally a very high-margin product as it is relatively cheap to produce and sells at a high premium. The table below shows the profitability of our four tobacco majors based off of the most recent financial reports.

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Altria</strong></td> <td><strong>Lorillard</strong></td> <td><strong>Reynolds American</strong></td> <td><strong>Philip Morris International</strong></td> </tr> <tr> <td><strong>Gross Margin</strong></td> <td>40.96%</td> <td>38.54%</td> <td><strong>51.28%</strong></td> <td>27.08%</td> </tr> <tr> <td><strong>Operating Margin</strong></td> <td>28.12%</td> <td>30.67%</td> <td><strong>31.68%</strong></td> <td>17.75%</td> </tr> <tr> <td><strong>Pretax Margin</strong></td> <td>27.57%</td> <td>28.39%</td> <td><strong>28.51%</strong></td> <td>16.62%</td> </tr> <tr> <td><strong>Net Profit Margin</strong></td> <td>17.85%</td> <td>18.04%</td> <td><strong>18.29%</strong></td> <td>11.73%</td> </tr> </tbody> </table>

These types of profits enable tobacco companies to grow their dividends at consistent rates above inflation. The lowest growth percentage of the four companies is Philip Morris (shown in the table at the top, and it is no slouch at over 12%). The massive amounts of cash these companies produce ensures that the dividend hikes will keep on coming. The immense margins of tobacco products also allow tobacco companies to buyback massive amounts of shares from the market. This cycle of cash flow has helped the earnings per share of tobacco majors grow every year in the face of declines in cigarette sales volumes.

Now that we have investigated the business model of these companies, let us take a look at them one at a time to check out whether they deserve a spot in your portfolio.

 Best of breed brand power

Altria is the domestic maker of Marlboro cigarettes, the number-one cigarette brand in the world. Altria has raised its dividend to shareholders annually the last 44 years running. Over the last 10 years, the dividend has grown at 11.4%! Its leading brand Marlboro has about a 43% market share of cigarette consumption in the US. The company has bought back $3.6 billion in stock over the last four years, and it's planning to buyback another $300 million of stock by the end of this year.

This will help drive earnings per share growth. To drive revenue growth moving forward, the company is looking to expand its smokeless tobacco and wine lines. Altria is also in the beginning phases of experimenting with its first electronic cigarette line. Given these moves to spur growth, combined with the company's aggressive share-buyback programs, Altria should be able to continue to provide returns inline with past performance in the near- to medium-term future.

Domestic up and comer

Lorillard is a domestic cigarette maker in the United States. Its most well-known brand is Newport Cigarettes, the number-one menthol cigarette in the United States. The company's Newport brand has risen in popularity in recent years and is slowly taking bits of market share from Altria and Reynolds American. However in spite of this, Lorillard trades at the lowest P/E of all the companies discussed.

This could be due to whispers of the government looking to restrict or ban menthol cigarettes in the US. This would be devastating to Lorillard should this fear ever come true. But - there is opportunity in the risk of this situation. Lorillard is currently nicely priced and is the best value of all the major cigarette makers, and its dividend-growth rate over the last three years is an impressive 17.8%. It has focused on the new electronic cigarette trend for growth and its brand "blu" is the leading electronic cigarette brand in the US. The potential rise of electronic cigarettes could be a large tailwind to Lorillard down the road.

Overall best in show"

Philip Morris International resulted from a spin off from Altria (then Philip Morris) in 2008. It sells the Marlboro brand across the world and is the number-one tobacco company in the world. It benefits from the "brand" power of Marlboro but operates in emerging markets among other places where the restrictions are more relaxed in comparison with the US market.

Philip Morris is aggressively buying back stock to drive earnings-per-share growth, but it also is seeing growth in markets such as Africa, Algeria, and Vietnam. Also if Philip Morris were to ever penetrate the government-controlled Chinese market, that would open up opportunity in the number-one market in the world. China accounts for roughly one-third of the entire world's cigarette consumption! Emerging markets will continue to provide Philip Morris with organic revenue growth for the foreseeable future.

Bottom line

Warren Buffett once said: "I'll tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. It's addictive. And there's a fantastic brand loyalty."

This quote pretty much sums it up. Tobacco companies have been rewarding shareholders for decades through massive dividends and share buybacks. Although some challenges have surfaced in recent years, the business model of tobacco is so strong that there is no reason to believe you can't continue to profit from this industry for the foreseeable future. 

Altria has been the best-performing stock of the past 50 years, but as the number of smokers in the U.S. continues to steadily decline, is Altria still a buy today? To find out whether everyone’s love-to-hate dividend stock is a savvy investment choice or a hazard to your portfolio, simply click here now for access to The Motley Fool's premium research report on the company.


Justin Pope owns shares of Philip Morris International. 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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