Two Tobacco Companies Worth Owning

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

The decline in number of smokers in the U.S hasn’t stopped leading tobacco companies to maintain their high profit margins. Furthermore, some companies such as Lorillard (NYSE: LO) were able to show growth in revenues as e-cigarette market continues to rise. Let’s take a closer look at two tobacco companies Lorillard and Reynolds American (NYSE: RAI) worth owning.

Year to date, shares of several leading tobacco companies including Lorillard and Reynolds American have slightly outperformed the stock markets: Shares of Lorillard rose by 17.7%; Reynolds’ shares increased by 21.2%. In comparison, the S&P500 index rose by 15.8%. Reynolds’s rise came despite the company’s drop in revenues: Net sales fell by 2.6% during the first quarter of 2013 (year over year). Moreover, the drop in sales was mainly due to the 8.7% decline in volume of cigarettes sold during the quarter. Altria Group (NYSE: MO) wasn’t any different as its revenues slipped by 2.1% in the first quarter.

On the other hand, Lorillard’s revenues rose by 3.3% during the quarter. The rise in sales was mainly due to the increase in E-cigarette sales. Lorillard’s decline in units sold wasn’t as steep as Reynolds’s.

E-cigarette

The rise of the e-cigarette is among the driving forces in these days for tobacco companies. Moreover, this business segment allows tobacco companies to spend funds on advertising this product, which is not banned from main advertising media as regular cigarettes are. During 2012, television ads of e-cigarette rose by nearly 18% (year-over-year). This trend is likely to persist in the coming years, which will allow tobacco companies to expand their business in this segment. One major player in this segment is Lorillard’s subsidiary, Blu eCigs. Lorillard’s revenues continue to sharply rise in this segment: In the first quarter of 2013, revenues of electronic cigarettes rose by more than 46% compared to the last quarter of 2012.

Electronic cigarettes sales still account for a minuscule amount of Lorillard’s total revenues, but this could change with the rise in the company’s spending on advertising. Further, this segment is less profitable than regular cigarettes. Therefore, as Lorillard expands its electronic cigarettes business, the company’s profit margin is likely to dwindle. Other tobacco companies are also entering this business segment: Reynolds Vapor, a subsidiary of Reynolds, is in the process of augmenting its Vuse distribution to compete with Lorillard on the electronic cigarettes market shares. The latest news is that Reynolds Vapor will reach retail outlets in Colorado. Altria is expected to come out with its e-cigarette brand in August.

Profit margin

Despite the drop in revenues, the profit margins of Lorillard and Reynolds rose during the past several quarters and reached by the first quarter of 2013, 35.5% and 47.1%, respectively. On the other hand, Altria’s profit margins dwindled to 25%. The high profits margins of these companies are likely to keep the dividend payments high.

Dividend and Buyback

The main advantage of leading tobacco companies is their high dividend payment. Lorillard’s current yearly dividend stands at $2.20 per share, which comes to an annual yield of 4.8%. Moreover, Lorillard recently announced the company has doubled its stock repurchase program to $1 billion. At the same time, the company announced it will raise $500 million in senior notes. This switch of stocks for debt will lower the company’s financial expenses considering the currently low interest rates. This move will also benefit shareholders.

Other leading tobacco companies also offer high dividend yields: Altria pays $1.76 per share per year, which comes to an annual yield of 4.8%, Reynolds offers a yearly dividend of $2.52 per share, which is an annual yield of 5%.

Valuation

Let’s also take a closer look at these companies’ enterprise value and their EV to EBIT ratio to get a better understanding of these companies’ valuation. The table below presents the summery of data of all three companies and the average tobacco industry.

<img alt="" src="http://g.fool.com/editorial/images/57119/tobacco-lor_large.jpg" />

This type of valuation accounts for differences in financial structure of these companies. The yearly EBIT is based on the past four quarters (ending in the first quarter of 2013). As seen, Lorillard’s EV to EBIT ratio is the lowest at 8.9, which is also lower than the industry average. On the other hand, Altria’s EV/EBIT is slightly higher than the industry average. Reynolds has the same EV/EBIT the industry has. These findings suggest, at face value, Lorillard’s current value is relatively low for the tobacco industry while Altria’s is slightly high.

Bottom line

Lorillard and Reynolds offer interesting investment opportunities and even though the demand for cigarettes continue to dwindle, the growing e-cigarette industry could slowly pull back up their revenues. Finally, these companies' current valuations, rise in profit margins and high dividend yields makes these tobacco companies still a viable investment.

Tax increases that took effect at the beginning of 2013 affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "How You Can Fight Back Against Higher Taxes," the Motley Fool's tax experts run through what to watch out for in doing your tax planning this year. With its concrete advice on how to cut taxes for decades to come, you won't want to miss out. Click here to get your copy today -- it's absolutely free.


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!

blog comments powered by Disqus