Smoke Your Worries Away With These Cigarette Stocks

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There are several ingredients to a good tobacco stocks: strong fundamentals (reward), consistent growth potential (reward), high dividend yields (safety), and low betas (safety). While the implementation of an up-to 164% tax hike on dividends would cause high-income stocks to decline ceteris paribus, there 3 other variables at play that could hold up--even increase--value. I recommend diversifying across most tobacco stocks while preferentially buying the company with the quickest growth rate--the stock that will likely be least impacted by any dividend tax hike.

Despite Q3 Softness, Phillip Morris (NYSE: PM) Is Still Defensive

In regard to the first variable, strong fundamentals, Phillip Morris is an industry leader. As a spin off from Altria, the company focuses on all markets outside of the United States and thus, supposedly, is less vulnerable to regulatory headwinds. And despite the company's leading market position, it managed to grow share in 2011 for the fourth consecutive time. Volumes and productivity have gone up concurrent to productivity improvements for a "best-of-both-worlds" story. This is incredible when you consider that PMI is ranked either #1 or #2 in the regions where it markets. Perhaps these excellent fundamentals are, collectively, the reason why multiples are quite high at around 17.5x earnings--above the historical 5-year average PE multiple 

However, third quarter results were fairly weak as marketing restrictions increased stringency across the world. Revenue of $7.9 billion fell well short of the $8.3 billion expectation as cigarette volume fell 1.3%. While this will erode the idea of PMI as the "premier" defensive tobacco stock, it is important to bear in mind that gross margins have all been on the rise. Accordingly, I don't see Phillip Morris losing its association as a safe stock any time soon.

As for the second variable, dividend, PMI is also quite strong with a 3.9% and growing yield. The company is also forecasted for solid annual EPS growth over the next 5 years at 9.9%. While this is not enough to make the stock undervalued, it's enough to hedge against a possible dividend tax hike. Finally, the company's large economic moat grants it limited volatility--approximately 15% less than the broader economy.

Riskier But More Undervalued Lorillard (NYSE: LO), A "Buy" Over Reynolds America (NYSE: RAI)

If you are looking for the highest returns, Lorillard may be your best. It trades at a respective 14x and 12.8x past and forward earnings with a dividend yield of 5.3% and a beta 0.4. Analysts forecast 8.7% annual EPS growth over the next 5 years, and this sets the bar low for outperformance. Gross margins stand at 36.3% and have been on the increase. By contrast, Reynolds trades at a respective 15.8x and 13.4x past and forward earnings with a dividend yield of 5.7% and a beta of 0.6. Analysts forecast just 6.2% annual EPS growth over the next 5 years, which may be too optimistic in light of just a 4.6% rate over the past 5 years. Lorillard has grown at a rate of 11%! There is little reason for analysts and the market to be so reserved on Lorillard's growth after the tobacco producer has achieved a superior return over the past 5 years.

In addition, Lorillard has improved both margins and volumes. While everyone talks about Phillip Morris and Reynolds as the top producers, Lorillard is right behind as the third largest domestic manufacturer and ownership of brand name Newport. Diluted EPS growth of 11% y-o-y also bested expectations. But perhaps most importantly, market share has continued to go up--albeit by just 0;.2% in this quarter.

While I would normally say that Reynolds is the safer pick due to its wider brand recognition and diversification, I believe that analysts have become overly bullish on growth. The recent $5 million settlement with Star Scientific for breaking a patent law sent the shares may have eliminated a major headwind (investors expected much more), but the fundamentals have floundered in recent months. Performance has been on and off with several misses over the last few quarters. I thus recommend avoiding the stock and go for the unexpected underdogs.

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