Why You Should Include These Tobacco Companies in Your Portfolio

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

Although many believe that tobacco is a declining industry, there is still potential in emerging countries. Despite having some room left for growth, I am particularly interested in the substantial dividend yields that some tobacco companies like Altria (NYSE: MO), Lorillard (NYSE: LO), and Reynolds American (NYSE: RAI) offer. Let’s take a closer look at them in order to understand if they stand as good investment opportunities for the long-term.

I love you Philip Morris

Altria (formerly Philip Morris) offers the highest dividend yield (4.99%) among the firms in this article. However, it is also expected to deliver the weakest EPS growth over the next five years. So, trading at 16 times its earnings, very close to the industry average, is this stock a buy?

On the bright side, Altria is the largest tobacco company in the U.S., holding about half the market share. Its strong brand portfolio that includes Marlboro, Virginia Slims, and Parliament among others, adds to the addictive nature of its products and has provided the firm with strong pricing power and a wide moat. This has helped the firm generate good amount of free cash flow and high returns on capital, which has in turn allowed it to return value to shareholders through dividend payouts. These dividends have been increased in almost every one of the last 45 years.

On the downside, Altria sold out its international segment and the majority of its non-tobacco assets, limiting its operations to the declining U.S. tobacco industry. However, holding an established, moated business with above average margins, while paying out juicy dividends, I'd recommend buying and holding on to this stock.

Finally, it is important to highlight that Altria has been diversifying its risks in the U.S. by adapting to evolving consumer demands; particularly, its incursion in the smokeless tobacco industry should increasingly contribute to revenue in the years to come.

Premium brands for premium margins

Lorillard sits on the success of its premium cigarette segment. Actually, its main brand, Newport, holds about 40% of the premium cigarettes market share in the U.S. However, “with roughly 90% of its volume generated from the menthol category, and the threat of potential increased regulation from the U.S. Food and Drug Administration, the firm could be vulnerable to unfavorable regulatory developments.” (Morningstar)

In spite of this fact, analysts expect Lorillard to deliver the highest EPS annual growth rates over the next five years, averaging 10%. In addition, the firm has been yielding 4.87% in the form of dividends. Going forward, this percentage is expected to rise to 5.03%. This shareholder reward policy depends on the company's margin generation capabilities; mainly on account of the fact that most of its portfolio is composed of premium products, its operating margins are the highest in the industry.

Moreover, unlike most of its competitors, Lorillard holds over 30% of the market share in two growth segments within the industry: menthol and electronic cigarettes. So, offering compelling growth prospects and a company moated by the addictiveness of its products, while paying out a juicy dividend and trading at 14 times its earnings, at about a 13% discount to the industry average, I'd recommend buying and holding on to this stock.

Stay away from the mall

Reynolds American is the least attractive among these companies. Offering limited growth prospects while trading at 18 times its earnings, at about a 12% premium to the industry average, this does not look like a good investment. However, due to a dividend yield of 5%, some analysts have considered a buy recommendation.

In my opinion, Reynolds is a hold for now. Despite holding the second position in the U.S. tobacco market and 50% of the top ten brands,its valuation discourages me from buying this stock. In addition to the declining demand and increasing regulation and restrictions on smoking, the company faces strong competition from Altria, which has implemented an aggressive marketing campaign that has put considerable pressure on Reynolds’ margins and will most likely impact its main brands’ (Pall Mall and Camel) market shares. In addition, the firm holds one of the oldest customer demographics in the industry; this will further limit its growth in the years to come.

Nevertheless, I’d advocate on keeping a close eye on this firm since a drop in its stock price could open an attractive opportunity for dividend investors. Furthermore, Reynolds’ trend towards innovation, its strong positioning in the super-premium segment (through its Natural American Spirit brand) and its strong e-cigarette segment could provide more upside than expected.

Bottom line

Combining strong, moated, long-standing businesses with addictive product offerings and some opportunities for growth, Altria and Lorillard look like attractive investments for the long-term. However, what really drew my attention are their dividend yields. If you are looking for a secure investment that will continuously reward shareholders through regular dividend payouts, these companies are the way to go.

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Victor Selva has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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