A Good Tobacco Company to Buy

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

Altria once again didn’t disappoint its investors by posting 3Q 2012 EPS of $0.58, in line with the consensus estimates. This consistent performance by the company makes it a continuous fourth quarter in which the company has done well without failing on the estimates. Its strategy of promotional discounting has worked favorably for the company as it has been welcomed and liked by almost everyone, except its two competitors Reynolds and Lorillard. Both these companies have conceded that increasing pricing pressure from Altria has forced them to reduce their pricing as well in the recent quarter.  Let’s have a look at the operating margins & dividend payout ratio of these companies.

<table> <tbody> <tr> <td> <p><span>Company Name</span></p> </td> <td> <p><span>Operating Margin (Last 12 Months)</span></p> </td> <td> <p><span>Dividend Payout Ratio</span></p> </td> </tr> <tr> <td> <p><strong><span>Altria Group </span></strong><span><span class="ticker" data-id="204556">(NYSE: <a href="http://caps.fool.com/Ticker/MO.aspx">MO</a>)</span><span></span></span></p> </td> <td> <p><span>42.41%</span></p> </td> <td> <p><span>92.00%</span></p> </td> </tr> <tr> <td> <p><strong><span>Lorillard </span></strong><span><span class="ticker" data-id="210627">(NYSE: <a href="http://caps.fool.com/Ticker/LO.aspx">LO</a>)</span><span></span></span></p> </td> <td> <p><span>44.62%</span></p> </td> <td> <p><span>71.00%</span></p> </td> </tr> <tr> <td> <p><strong><span>Reynolds American </span></strong><span><span class="ticker" data-id="205182">(NYSE: <a href="http://caps.fool.com/Ticker/RAI.aspx">RAI</a>)</span><span></span></span></p> </td> <td> <p><span>33.69%</span></p> </td> <td> <p><span>87.00%</span></p> </td> </tr> </tbody> </table>

Source: Yahoo! Finance

Although Lorillard may have higher operating margins, increasing pressure from Altria can force Lorillard to further reduce its pricing. On the other hand, Reynolds has significantly lower operating margin compared to its other two peers.

Also, as the tobacco industry is moving on to a maturing stage, each company's dividend yield becomes an important factor for investors.  Although all the three companies have a good dividend payout ratio, I feel Altria is a winner in this front. Here is an overview of its growth driver which I feel should drive its share price upward.

In 3Q 2012 Altria reported revenue from its core smoking products growing ~2.1% year over year, reaching $5.6 billion. Altria is continuously gaining in the cigarette market share from last three quarters. It gained ~120BPS of market share in 3Q 2012, backed by a strong performance by its Marlboro and L&M brands.

Marlboro has seen various new launches under its brand name, including Marlboro Black and Marlboro Eighty-Three in the recent past. With the help of these launches Marlboro gained ~100bps market share in 3Q 2012. Altria increased average prices of Marlboro by ~1% in this year, as compared to the average level of ~3% in 2011. Given its market share, I think the company should now increase its prices in the coming quarter, which will improve its profitability. 

Additionally, Altria’s focus on innovation will further provide it with an edge against its peers. It recently announced the launch of Marlboro NXT in USA, which gives two flavors in one cigarette by squishing a menthol capsule. With this launch the company would be better equipped to compete with Reynolds American’s segment leading brand Camel Crush. This is particularly important as young adult smokers are now shifting to different flavored cigarettes.

Coming to the smokeless segment, it saw a solid volume growth of 6% year over year. I expect this trend to continue because of secular shift to low risk smokeless products as compared to cigarettes. Furthermore, its partnership with Okona A/S to develop non-combustible nicotine should help the company in launching new products in future.

Furthermore, Altria’s cost reduction plan which was started in 2006 and further expanded in 2011 is again becoming a positive catalyst for the company.  This cost saving plan is expected to bring savings of $400 million annually by the end of 2013. This will help the company to maintain its margins in the difficult macro environment when tobacco products are seeing increased taxes and the increasing awareness about health concerns among the consumers.

Additionally, the company recently announced share repurchase of ~$500 million, thus extending its current share repurchase of $1 billion in 2013. This will lift its share price again in the future. Combining its strong growth potential with its forward P/E ratio of 13.28, I feel the company is currently trading at a cheaper level than competitors, and should provide good returns for investors. I would recommend buying this stock.

ShwetaDubey has no positions in the stocks mentioned above. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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