3 Tobacco Stocks with Dividends that Won’t Quit

By Robert Coleman - February 8, 2012 | Tickers: MO, PM, RAI | 0 Comments

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The tobacco industry is one of the oldest in America, and the companies that have emerged as leaders in this industry have established a moat for themselves that can only be challenged by government intervention or radical cultural shifts. Whether or not you agree with the ethics of marketing tobacco, you have to admire the business models of these companies and the returns promised by owning a stake in them. By selling a product that is both popular across the globe and habit forming in nature (I know, terrible), the big, bad tobacco companies have created favorable positions for themselves in the market; and by offering dividends upwards of 4%, they have created favorable opportunities for investment.  

Altria Group (NYSE: MO), Reynolds American (NYSE: RAI), and Philip Morris International (NYSE: PM) are three of the biggest players in the industry, all with market caps over $23 billion. Many investors have raised concerns about the strong price performance of these companies, particularly Altria, in the face of lagging demand for cigarettes and the weaker earnings this deficiency brings; and indeed, the company is priced at 17 times earnings and 15 times book value with a current ratio of less than 1--not an ideal valuation. The current valuations of the tobacco giants are no reason to go cold turkey, however.

*Graphic courtesy of Centers for Disease Control and Protection

The first argument against them, the issue of declines in earnings, is based off the fact that tobacco use in America has been trending downwards for decades. But could this trend level off? Healthy People 2020, a group that provides national objectives based off historical benchmarks and progress, has set goals of 16% and 12% as the smoking rates for adults and youths respectively to be realized by the end of the decade. Fortunately for tobacco companies, the target adult rate is only marginally lower than the current rate, and the target youth rate appears unrealistic at best. This also doesn’t take into account the use of smokeless tobacco, which remains prevalent among adolescents and promises to be a continually strong source of revenue. What is more, two of these companies, Altria and Philip Morris, serve international markets and benefit from higher tobacco use in foreign countries relative to the U.S.

The next argument, the issue of overvaluation, can be defended in much the same way as the first: Altria, Philip Morris, and Reynolds have not lost any of their earning power. All three companies beat their earnings estimates in their most recent quarterly reports, displaying their ability to stay profitable against the tide of decreasing demand. Whether through raising cigarette prices or adapting marketing strategies to avoid legal complications, sound management will keep the cash coming in. As long as people keep smoking, tobacco companies will find a way to grow their earnings; Philip Morris International is projected to grow its EPS by over 12% over the next 3-5 years, and even Reynolds, which has the lowest projected earnings growth of the three, is projected to lift its EPS 6% over the same period.           

Concerns with the financial standings of tobacco companies have in turn raised concerns about the high dividends these companies pay. History would suggest otherwise, but even without considering the dividend consistency of these stocks, there is little reason to believe that yields should show a significant decline; players in the tobacco industry sell a habit-forming, internationally demanded, virtually recession-proof product with price-setting flexibility. If that is not enough encouragement, then consider how cultural changes will affect the demand for this product.

Though indisputable scientific evidence demonstrating the risks of tobacco use is now readily available, we live in an age that champions personal freedoms. Everyone in the developed world already knows that smoking can kill them, yet people still smoke, and thus will continue to smoke. One of the first things economists learn is that people don’t act rationally, and while this may be bad for economists, it’s great for tobacco stocks (and those who seek a share in these profits). In short, if we are looking for an industry with high dividends but without high volatility, we need look no further than America’s original cash crop.

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