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4 Reasons To Buy, But There Is Still One Problem

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

Sometimes doing well in the stock market is less about finding a good company, and more about realizing that there might be someone better. A great example of this at work, is Reynolds American (NYSE: RAI) seems like a great opportunity until you realize this is not the only option in the tobacco industry. In fact, looking at the company’s recent earnings, investors could logically assume that Reynolds American's performance is good enough to warrant purchasing the shares, but there is one overriding problem that those same investors need to understand.

Even If You Don’t like the Industry…
Even if you have misgivings about the tobacco industry, it’s hard to ignore the significant yield and value available in many of these companies. It’s rare when you can find multiple stocks that each carry a high-yield, as well as positive earnings growth.

For instance, investors could choose domestic tobacco companies such as Reynolds American, Lorillard (NYSE: LO), and Altria (NYSE: MO), or they could choose the internationally focused Philip Morris (NYSE: PM) for their investment dollars. In each of these cases investors can expect a yield of between 3.7% and over 5%, combined with a growth rate of between 7% and 11%. If the stocks were overvalued, these numbers might not mean a lot, but with forward P/E ratios of between 14 and 16, each of these companies look reasonably priced.

In fact, one of the main attractions to Reynolds American is their class leading yield of 5.22%. While Lorillard comes close at 5.08%, and Altria pays 4.8%, investors looking for the best yield would likely pick Reynolds American.

More Than Just Marginally Better
A second reason investors might select Reynolds American over their competition would be the company’s class leading gross margin. In the last three months, Reynolds American reported a gross margin of over 63%. By comparison, both Lorillard and Altria generated margins of better than 45%, whereas Philip Morris reported a gross margin of just 27.5%.

In addition, Reynolds American has the lowest debt-to-equity ratio of their peers. In fact, the company’s debt to equity ratio of 0.98 is significantly better than Altria at 3.33. The fact is, both Lorillard and Philip Morris both have negative debt-to-equity ratios at the present time, and can’t compete in this way with Reynolds American.

Another positive aspect of Reynolds American’s recent performance was the company’s commitment to retiring shares over the last year. The company repurchased 4.17% of its diluted shares, which was just slightly behind Philip Morris’ retirement of 4.25% of their shares. Lorillard turned in a respectable performance in this area by retiring 3.3% of their diluted shares, but Altria fell somewhat behind the pack with a decline of just 1.5%.

There Is Just One Problem
If Reynolds American were the only selection available in the tobacco industry, this would be a very short post and investors could simply purchase the stock. However, given the company’s competitive position, it seems only fair to point out that there appears to be one superior option to Reynolds American at the present time.

I know many investors are huge fans of Altria, and given the company’s historical performance that’s understood. However, at this point the shares have the third lowest yield, the lowest expected growth rate, and the second highest P/E ratio. The fact that Altria has a much weaker balance sheet then Reynolds American, and also is retiring shares at a slower pace makes it difficult to recommend. For Motley Fool's take on Altria, please feel free to take the report below.

For growth investors, Philip Morris must look like an attractive option. There’s no question the company should outgrow its peers over the next several years, but it’s a little worrisome that the company’s overall cigarette volume was down in the current quarter. Given that international growth in cigarette sales was supposed to be the main attraction of this internationally focused company, if this growth doesn’t materialize investors could be disappointed.

This leaves Lorillard as the one option investors might consider over Reynolds American. On a point to point comparison, buying Lorillard stock gives investors a yield that is just slightly below Reynolds American, yet the company is expected to increase earnings at a rate almost 2% faster. When you include the fact that Lorillard sells for a P/E ratio that is less than Reynolds American, it seems as though you have a better value.

Though Lorillard has a lower gross margin and did not retire as many shares, the company does have revenue growth of 3.3% in the last quarter relative to a 2.6% decline at Reynolds American. In an industry suffering from volume declines, the importance of revenue growth cannot be overstated. Reynolds American looks like a good investment, but Lorillard looks just a bit better.

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.

Chad Henage 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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