Safe, Undervalued Tobacco Stocks To Buy
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Although the Obama administration seems adamant on hiking dividend taxes up to164%, tobacco stocks still have room to rise. I am particularly optimistic about emerging market potential and the irrational discount to intrinsic value in some stocks. While it's always safe to broadly diversifying in the leading brands, if you want to outperform the broader market, you may be tempted to back the smaller players in this oligopolist industry. Is this the right decision?
With the most well known cigarette brand in the world, "Marlboro", in an industry known for sustainable streams of free cash flow, Altria and PMI both have attractive economic moats. The former specializes in domestic markets while the the latter operates in only international settings. Though smoking rates are declining in the United States, active share repurchasing programs will keep EPS up. PMI still narrowed its guidance range of $5.12 to $5.18 per share, which reflects FX headwinds and greater investments in marketing, particularly in Asia. And in the third quarter, PMI was slightly below expectations after consistent beats in the preceding four quarters. Altria has been more on and off.
PMI trades at a respective 16.5x and 14.2x past and forward earnings versus corresponding figures of 16x and 13x for Altria. The latter also offers a higher dividend yield at 5.7% (versus 4.1%) but is forecasted for slower 5-year annual EPS growth at 6.7% (versus 9.9%). This steeper growth curve for PMI is backed by the recent past in which the international marketer substantially outperformed its competitor.
And even though third quarter performance was short of expectations, PMI still is being overly hit by a tough comparable in the third quarter with organic cigarette volume growth of 4.4%. Moreover, Marlboro continued to gain share and now controls 18.4% of the European market. This is particularly impressive, since you would expect premium brands to be hit in a challenging environment. Despite a challenging comparison in Indonesia when 3Q11 growth registered at 22.5%, the company still posted a 13% volume growth in 3Q12.
In regard to the degree of defense offered in tobacco, one only need to look at Altria's third quarter earnings call to grasp management's aggressiveness on returning free cash flow to the shareholders. The dividend distribution was hiked 7.3% in 3Q12--the 46th hike in more than four decades. Meanwhile, $260 million in stock was repurchased, and the $1 billion buyback program was hiked by another $500 million. This will be supported by strong momentum: each of Altria's tobacco brands have increased retail share.
Don't Miss Out On Lorillard (NYSE: LO)
While Altria and PMI have the leading brand, Lorillard has room for penetration. At a respective 13.5x and 12.4x past and forward earnings, the cigarette producers is quite cheap. It also quite safe with a dividend yield of 5.5% and an annual EPS growth of 11% over the past 5 years. Operating margins have meanwhile risen to 28.9%, but the stock should be even closer to its 52-week low given that the last three quarters have been misses (average miss of 7.1%).
Assuming Lorillard meets growth expectations, 2016 EPS will come out to $11.67. At a multiple of 16x, this translates to a future stock value of $186.72. Discounting backwards by 7% yields a present value of $133.13. Though that is not an incredible margin of safety, it is large enough when complemented by the generous dividend yield. And UBS even has a $140 price target--the prevailing price is at a ~20% discount.
Lorillard's main opportunity comes from market share gains. It was able to increase retail share by 0.2 percentage points as Newport captured 12.1% of the market. Volume declines also did not fully offset the benefits derived from higher prices in the recent quarter. In general, the industry has struggled from weak volumes, so it's nice to see that the Newport marketer was able to absorb this headwind.
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