Tobacco Stocks: It's Not Just About High Dividend Yield

By Sandeep Gupta - September 18, 2012 | Tickers: MO, LO, PM, RAI | 0 Comments

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Investors love Tobacco Companies and the main reason behind that is an impressive dividend yield. Lorillard (NYSE: LO), Altria (NYSE: MO) and Reynolds American (NYSE: RAI), all provide over 5% dividend yield. Philip Morris (NYSE: PM) lags behind the other three in this regard and provides a dividend yield of 3.5%. But does that really make Philip Morris stock less attractive? Well, successful dividend investors focus on more than just dividend yields.

The fraction (payout ratio) of the earnings that a company wishes to pay to shareholders makes up the dividend. A company having a high dividend yield might just be paying all its earnings to investors, while a zero dividend yield company may be investing its earnings to propel future growth. So, it is important to keep track of this metric (payout ratio) as well. Let’s study the dividend yield and payout ratio of the above mentioned tobacco companies.

Interestingly, Reynolds American provides the highest dividend but also has the highest payout ratio. Just on the basis of these metrics, Lorillard and Altria Group appear better investment options than Reynolds American, as both these companies provide comparable dividend yield at a lower payout ratio than Reynolds American. Moreover, we can see that Philip Morris’ low dividend yield is a result of a low payout ratio and there is nothing wrong in that as long as there is a visibility over the company’s long term growth. Philip Morris is well positioned in the global market with a strong hold of its Marlboro brand. Philip Morris has an added advantage of operating in international markets with greater cigarette consumption and thus, remains immune to the declining/stagnant cigarette consumption trends in the United States. In addition, the economic fundamentals in Asia have been strong and resilient, and the fast growing population in this region presents a huge long-term growth opportunity for the company.

Philip Morris provides highly visible free cash flow growth through strong pricing potential and relatively low exposure to input cost inflation. In a challenging economic climate the company has consistently hit their low double digit EPS target and returned substantial cash to shareholders. The following chart clearly reflects how Philip Morris has outperformed the S&P500 and its peers over the last five years.

I do not see Philip Morris stock as overvalued despite its strong run especially given the improvement in shareholder returns in the coming years. Let’s analyze the valuation multiple and future growth prospects for these tobacco companies.

Though, Philip Morris has the highest valuation among its peers, it also has the highest annual growth rate over the next 5 years. Altria Group and Reynolds American appear overvalued based on these metrics. However, Lorillard catches the eye as it is trading at a significant discount to Altria Group and Reynolds American, despite having better growth prospects.

The Bottom Line

I would suggest investors to avoid Reynolds American despite the “best-in-class” dividend yield. The company’s high dividend yield is merely a result a result of high payout ratio. Moreover, the company’s next 5 years growth rate (7.33%) doesn’t seem to support its multiple.

Lorillard offers a good investment opportunity at the current levels. Lorillard is trading at a discount to both Altria and Reynolds American, despite having a similar yield profile and better growth prospects.

Philip Morris is one stock I like the most due to its vast international presence and sustainable long-term growth. Though the company has the least dividend yield, but I will take that as low dividend yield is a result of low payout ratio and there is a good visibility over the company’s long term growth.

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