Tobacco: You Either Love It or Hate It

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

The tobacco industry has been and continues to be at the center of many ethical arguments. No matter how you feel about these companies, there is something you can always be sure of: big tobacco can be relied upon to produce investor returns. This is true even now, with falling cigarette shipping volumes, increasing worldwide regulation, and changing tobacco habits.

<img src="/media/images/user_14485/tobacco-vs-sp_large.png" />

Tobacco performance vs. the S&P 500. Source: Google Finance

The four major US tobacco companies are Lorillard (NYSE: LO), Philip Morris USA (NYSE: PM), Altria Group (NYSE: MO) and Reynolds American (NYSE: RAI), and all of them have out-performed the S&P 500 over a ten year period. Even Philip Morris, which only started trading as a separate entity in 2008, has outperformed the established index.

But where to invest?

With the four major tobacco firms all providing significant investment returns, where do you invest your money right now? Which firm will give you the best returns for the future?

<table> <tbody> <tr> <td> <table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Forward P/E</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> <td> <p><strong>Dividend yield per share</strong></p> </td> <td> <p><strong>Dividend cover</strong></p> </td> <td> <p><strong>3yr Dividend growth</strong></p> </td> </tr> <tr> <td> <p>PM</p> </td> <td> <p>14.7</p> </td> <td> <p>1.73</p> </td> <td> <p>3.98%</p> </td> <td> <p>1.72</p> </td> <td> <p>25.90%</p> </td> </tr> <tr> <td> <p>MO</p> </td> <td> <p>13.28</p> </td> <td> <p>2.43</p> </td> <td> <p>5.59%</p> </td> <td> <p>1.30</p> </td> <td> <p>24.20%</p> </td> </tr> <tr> <td> <p>RAI</p> </td> <td> <p>13.31</p> </td> <td> <p>2.55</p> </td> <td> <p>5.70%</p> </td> <td> <p>1.20</p> </td> <td> <p>24.30%</p> </td> </tr> <tr> <td> <p>LO</p> </td> <td> <p>12.37</p> </td> <td> <p>1.55</p> </td> <td> <p>5.51%</p> </td> <td> <p>1.40</p> </td> <td> <p>35.40%</p> </td> </tr> </tbody> </table> </td> </tr> </tbody> </table>

 Data Source: Motley Fool CAPS

Currently, on a foreword P/E basis, Lorillard looks the cheapest. Lorillard is also the winner when it comes down to the PEG ratio. Reynolds American is currently the winner on yield. Philip Morris has the best dividend cover, with the dividend being covered 1.7 times, while Reynolds' high yield has the lowest coverage in the group. The winner for the best payout growth goes to Lorillard, which has produced a compounded dividend growth rate of 35.4% over 3 years, an average of 11.8% a year.

What about historic earnings growth?

<img src="/media/images/user_14485/5yr-eps_large.jpg" />

Data Source: Motley Fool CAPS

Both Philip Morris and Lorillard have provided the best earnings growth over the past 5 years. PM drives growth from price increases and expansion into developing markets, while Lorillard gets most of its growth from growing its share of the US cigarette market and similar price increases. Reynolds has had slow growth in its value brand but no growth in its premium brand. Altria’s market is in the US only, a market that is coming under pressure from legislation and value producers such as Lorillard. 

Earnings Quality

I believe the key for a good investment is to look at the quality of earning a firm produces. More importantly, what is the rate of net profitability the company produces? A high gross margin but low net profit can signify a very inefficient firm, which means it is not a good long term investment, in my opinion.

 

<img src="/media/images/user_14485/profit-margins_large.jpg" />

Data Source: Motley Fool CAPS

The profitability margins further highlight the strength of Philip Morris and Lorillard. However, PM has the more efficient business, with a net profit margin 2.4% above that of LO. Whilst Atria generates the highest gross margins, the net profit comes in significantly lower. Of all the firms, Reynolds American has the most inefficient business.

<img src="/media/images/user_14485/np-per-doller_large.jpg" />

Data Source: Motley Fool CAPS

Put simply, Reynolds American generates 16.5 cents per dollar of revenue, which is almost 40% less than Philip Morris.

So we can see that the best companies are Philip Morris and Lorillard. They are historically the most efficient and right now are trading on attractive growth multiples.

What about the future?

There are over 35 brands between these 4 tobacco companies alone. This can confuse both smoking and non-smoking investors alike! So here is a basic guide to tobacco products:

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Main brands</p> </td> <td> <p>Strengths</p> </td> <td> <p>Weaknesses</p> </td> <td> <p>Opportunities</p> </td> <td> <p>Threats</p> </td> </tr> <tr> <td> <p>PM</p> </td> <td> <p>Marlboro (outside US), L&M</p> </td> <td> <p>High margin, High quality, Strong brand loyalty. Global exposure</p> </td> <td> <p>High price Marlboro easy to undercut</p> </td> <td> <p>Developing market expansion</p> </td> <td> <p>Lower cost competitors products, Legislation, Black-market fakes</p> </td> </tr> <tr> <td> <p>MO</p> </td> <td> <p>Marlboro (inside US)</p> </td> <td> <p>High margin, High quality, Strong brand loyalty</p> </td> <td> <p>High price, No global exposure</p> </td> <td> <p>Lacking opportunities in US market, needs diversification</p> </td> <td> <p>Lower cost competitors products, Legislation, Black-market fakes</p> </td> </tr> <tr> <td> <p>RAI</p> </td> <td> <p>Camel, Pall Mall</p> </td> <td> <p>Value and intermediate quality brands, Global exposure</p> </td> <td> <p>Lowest margins</p> </td> <td> <p>Growing market share in value market, Developing market expansion</p> </td> <td> <p>Legislation, Black-market fakes (in higher margin brand)</p> </td> </tr> <tr> <td> <p>LO</p> </td> <td> <p>Newport, Maverick, Kent</p> </td> <td> <p>Strong brand loyalty, Many brands, Strong growth in value segment, High margins</p> </td> <td> <p>Lack of global exposure</p> </td> <td> <p>Currently holds 14% of US market, Room for expansion, Strong premium menthol brands.</p> </td> <td> <p>Legislation, Competition from larger firms, Lower cigarette volumes shipped in the US</p> </td> </tr> </tbody> </table>

Based on these facts I believe Philip Morris and Lorillard present the best opportunities for investors. Although both have their weaknesses, I would favor PM over LO. Philip Morris has significant scope for global growth even with higher-priced products. The high profit margin implies there is also room for improving returns for shareholders.


rupert12345 owns shares of Altria Group and Lorillard. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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