Buy the Right Pack of Tobacco Stocks
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Faced with a series of political risks, tobacco is oddly trading at a premium compared to the S&P 500. Even still, tobacco stocks will continue to offer great stability, income support, and, all in all, strong returns. To invest for maximum returns, however, investors should look for producers that are positioned away from risks. With the secular trends strong abroad and demand holding steady domestically, producers have considerable room for penetration that could offset the political headwinds.
At a respective 18.2x and 15.9x past and forward earnings, Philip Morris may look to be fairly expensive. However, it is best as a defensive stock given its focus on international markets, its 3.7% dividend yield, and the stock's low beta of 0.85. The main headwinds tobacco investors have to face, ironically, have nothing to do with the business at all. Rather, they are strictly political.
First, there's the Obama administration's proposed 164% dividend tax hike. Given that the majority of shareholders are institutional and large, the market will react to the need to pay 39.6% of the distribution back in taxes. Capital gains will be taxed at a lower rate and thus attract more institutional investors into stocks that are reinvesting earnings (ie. away from tobacco producers).
Second, there's the fact that the Department of Justice recently appealed to a federal court over rehearing a FDA case to require tobacco companies to place (frankly) gruesome health warnings on packages. I actually do not see this as too big of risk, given that 46 million Americans continue to smoke despite greater education efforts by health organizations. Moreover, Philip Morris is not exposed to this headwind at all, since it does not operate in domestic markets.
The best way to hedge against these headwinds are to buy (1) Philip Morris due to its pure international exposure and (2) high-growth tobacco producers that are less susceptible to an investor exit for greater dividend taxes. In this case, Lorillard is an ideal stock to back. It offers a dividend yield of 5.3% but is forecasted for 11% annual EPS growth over the next 5 years - 360 bps greater than what is expected for Philip Morris. Moreover, it should be noted that Lorillard grew at a slightly greater rate during the period surrounding the recession. Accordingly, it may be able to yet again beat analyst expectations and offset any uncertainty from a dividend tax hike.
At a respective 14.3x and 12.4x past and forward earnings, Lorillard also trades at an unreasonably low discount compared to competitors. Assuming it meets expectations, 2016 EPS will come out $12.86. At a 16x multiple, this translates to a future stock value of $205.76. Discounting backwards by 8% yields a present value figure of $140, which is at a meaningful margin of safety to the current market cap.
Reynolds American (NYSE: RAI): Avoid Like The Plague
In my view, Reynolds is the stock to avoid in the market right now. It trades at 17x forward earnings, offers a 5.5% dividend yield, and is only forecasted for 7.3% annual EPS growth over the next five years. I do not see it creating enough value to increase multiples, and benefits accruing from the growth potential will be offset by the Obama administration's tax hike.
Unlike Philip Morris, Reynolds lacks the recognition to be the go-to cigarette brand. And unlike Lorillard, it lacks the high growth potential. This puts Reynolds in a bit of a pickle, especially since performance has been less than stable. A miss in 2Q 2011, 3Q 2011, and 1Q 2012 compared to strong peer results have put a damper on investor expectations. Given this softness, it is odd that the firm trades at a premium to its historical 5-year average PE multiple of 14.6x.
One must also bear in mind that free cash flow of $1.2 billion has been flat from 2Q 2011 to 2Q 2012 on a TTM-basis. Accordingly, I recommend holding out and buying more recognizable and/or faster growing brands.
TakeoverAnalyst 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.If you have questions about this post or the Fool’s blog network, click here for information.