Is Tobacco Still a Viable Investment?

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Leading tobacco companies’ stocks have rallied in recent weeks. The recent adjustment to the Master Settlement Agreement with several states helped fuuel the rise. The adjustment gave these companies credit for their past settlement payments for the next five years. But beyond this latest news, are tobacco companies capable of growing sales? Are they still a viable investment? Let's examine these issues.

Revenue of Altria Group (NYSE: MO) slipped in the first quarter of 2013 by 2.1% (y-o-y). Despite the drop in revenue, its operating profitability sharply increased by 31%, which led to a sharp rise in its operating margin from 29% in Q1 2012 to nearly 39% in Q1 2013. The company continues to pay a high dividend, which reached a more than 4.80% annual yield. The rise in profitability could lead to a rise in dividend payments in the near future.

Altria maintained its high payout ratio that reached in the first quarter of 2013 nearly 63% – roughly the same as other leading tobacco companies’ payout ratio. In comparison, in the first quarter of 2013, Lorillard (NYSE: LO) had a payout ratio of 64%, the same as that of Reynolds American (NYSE: RAI). Both of these companies also have high dividend yields of 5.1% and 4.94%, respectively.

The rise in profit margin is mainly due to the adjustments made to the Master Settlement Agreement, in which leading U.S tobacco companies were credited for the payments they made between 2003 and 2012. In the first quarter of 2013, Altria cut its settlement payments by $483 million. Due to this revised settlement, the company revised upward by nearly 6% its projected EPS for 2013.

But the company continues to report a decline in sales volume: in the first quarter of 2013, its volume of Cigarettes sold fell by 5.2% (y-o-y). Despite the drop in sales, the company still augmented its market share that reached 50.5% as of Q1 2013.

Reynolds American’s net sales also fell during the first quarter of 2013 by 2.6% (y-o-y). But Reynolds, even more than Altria, augmented its operating profit by 82%. Thus, its operating margin spiked from 25% in Q1 2012 to 47% in Q1 2013 (opens pdf). Much like Altria, the sharp rise in the Reynolds’ operating profitability was stemmed from the credit it received in the Master Settlement Agreement that cut its state agreement payment by $204 million in the first quarter of 2013. Moreover, the company will be credited by approximately $1 billion over the next five years. This means, Reynolds’ operating profitability will remain high in the coming years.

So tobacco companies are more profitable and will remain so in the next few years. But will these companies be able to produce growth?

Reynolds’ volume of tobacco products sold fell in the recent quarter by 3.8% (y-o-y). The total domestic cigarette shipment volume declined in the first quarter of 2013 by 6.2%. So, Reynolds is outperforming the industry but is still showing a decline in sales. Reynolds also managed to augment its market share by 0.6 percentage points to reach 26.1%. But without growth in sales the company’s profits will eventually dwindle. Reynolds is trying to boost its sales by tapping into the E-cigarettes trend that is still small but growing. Altria is also expected to jump on this bandwagon this summer. This might eventually lead to a new source of revenue that could keep these companies’ growth in sales.

Much like the previously mentioned companies, Lorillard also reported a sharp rise in its operating profit from $392 million to $561 million – a 43% rise. This also means its operating profitability sharply increased from 25% in Q1 2012 to 35% in the first quarter of 2013. Lorillard reduced its state settlement pay by $164 million in the first quarter and projects to cut a total of $205 million in the next five years. Despite this achievement, eight states haven’t joined the settlement yet so this issue will keep looming over these tobacco companies in the coming months.

In the first quarter of 2013, Lorillard’s revenues from cigarettes decreased by 0.4% (y-o-y). Its fall in revenue was mostly due to the 2.3% drop in volume of cigarettes sold. The drop in net sales was offset by the rise in prices. The company also entered the Electronic cigarettes business. The company reports its market share is around 40% in Electronic cigarettes, but its revenues account for around 3% of its total net sales.

Bottom line

The recent settlements these tobacco companies had with several states helped these companies to expand their profit margins in the first quarter and are likely to persist in the coming years. These companies still face two problems: They need to deal with several other states and reach a settlement with them. The other problem is the ongoing drop in the volume of sales. Even if tobacco companies were to keep raising prices, it won’t keep their revenues from further dropping. Perhaps tapping into new markets such as E-cigarettes might lead these companies to new highs. Until then, these companies’ high profit margins and large dividend payments will keep investors in their corner. 

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.

Lior Cohen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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