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2 Tobacco Dividends to Buy and 1 to Avoid

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Investing in sin stocks is not for everyone, but they often provide unparalleled cash flow and remarkably high dividend yields to keep otherwise on-edge investors happy. While there are many sin sectors we could focus on, including alcohol, casinos, and firearm producers, I'd instead prefer to focus on the sector with arguably the biggest bull's-eye on it from both a legal and ideological perspective: the tobacco industry.

U.S. lawmakers are making it increasingly difficult for tobacco companies to sell their products. Numerous states have raised their tobacco tax rate over the past decade, while the FDA recently released a ruling requiring tobacco companies to affix large warning labels to their packages and advertisements by October 2012. In sum, the going has been tough for tobacco companies in the U.S., and it's likely to get tougher.

Thus it makes sense to look past the dividend paid by most tobacco companies and dig deeper to see whether you have a payout you can trust for the long term, or a high-yield smoke-and-mirrors candidate. While the tobacco sector doesn't offer a vast selection of choices, there are two clear-cut dividend standouts and one company that could burn you if you aren't careful.

Philip Morris International (NYSE: PM  ) -- trust it
What's the best way to avoid U.S. regulators? How about by avoiding the U.S. altogether!

Philip Morris International, the Altria (NYSE: MO  ) spinoff that began trading as a separate entity in 2008, conducts all of its business outside the U.S. This isn't to say that there aren't stringent smoking regulations outside of the United States. Australia is currently lobbying for tobacco companies' packaging to be changed to a plain olive color, while Canada has some of the toughest antismoking laws worldwide. Luckily for Philip Morris, the company has significant market share in many of its foreign markets, allowing it to weather any potential regulation storm.

Relative to Altria, or even rival Lorillard (NYSE: LO  ) , Philip Morris' dividend is the least impressive of the group. While Altria and Lorillard are yielding 5.7% and 4.7%, respectively, Philip Morris is paying out 3.7%. But unlike Altria and Lorillard, which are 100% tied to the U.S. and its many rules and regulations governing tobacco sales, Philip Morris offers investors a considerably greater long-term growth rate and a lower payout ratio. In short, the company has a greater chance at raising its dividend than does Altria, and it also will likely face fewer legal challenges. This appears to be one of the safest bets in a gamblers' sector.

Reynolds American (NYSE: RAI  ) -- trust it
Reynolds American is the second-largest domestic tobacco producer behind Altria and faces many of the same legal woes that Altria faces in the U.S. So why should you even consider investing domestically considering the argument for Philip Morris above? Reynolds American's healthy balance sheet and its burgeoning smokeless tobacco business are two reasons that come to mind.

Relative to Altria, Lorillard, and multinational rival British American Tobacco (AMEX: BTI  ) , Reynolds American has the safest balance of debt to equity. As long as the prospect of legal action remains in the forefront of investors' minds, having a clear-cut cash advantage is paramount in the tobacco sector. Altria and British American have debt-to-equity ratios of 222% and 108%, respectively, while Lorillard sports negative shareholder equity. With a debt-to-equity of just 62% and $3 billion in cash, Reynolds American's balance sheet looks stable.

The main driver behind Reynolds' future dividend growth will be its smokeless tobacco revenue, which currently accounts for 8% of its business. With companies like Star Scientific (Nasdaq: CIGX  ) still years away from making a dent in the industry, it's probably safe to assume that Reynolds American will continue to rake in healthy margins as legislators push for safer tobacco alternatives.

Reynolds American's dividend growth rate over the past decade is a blistering 11.3% and based on its current yield of 5.6%, it looks poised to motor higher over the coming years.

Vector Group (NYSE: VGR  ) -- avoid it
Whereas many of the above names have momentum in their favor, Vector Group -- the company behind the Liggett, Grand Prix, Eve, Pyramid, and USA brand names -- is heading in the opposite direction.

Like Altria, Lorillard, and Reynolds American, Vector Group operates solely within the United States. But Vector is much, much smaller. With a market cap of only $1.3 billion and just over $340 million in cash on its balance sheet, Vector is considerably more vulnerable to lawsuits than its counterparts. In recent years, Vector has seen its earnings per share fall, while shareholders have witnessed a sharp rise in debt, from $156 million in 2006 to more than $530 million by the end of 2010.

Possibly the most disturbing factor about Vector Group is that the company has recently had to issue debt to finance its 9% dividend payout. The company earned just $0.81 per share on a trailing-12-month basis, but has paid out $1.56 in dividends during that time. Vector's payout ratio currently sits at an unsustainable 193%. Between the company's declining shareholder equity, its soaring payout ratio, and its widening debt load, I definitely can't recommend anything other than avoiding this company.

Foolish roundup
Tobacco dividends come with inherent regulatory risk, but if you're prudent in your research, you can potentially uncover some smoking hot deals. Just be careful not to become enamored solely with current yields in this sector, as it could be a quick path to getting burned.

Are you willing to invest in tobacco stocks given the legislative oversight they face worldwide? Share your thoughts in the comments section below and consider adding Philip Morris International, Reynolds American and Vector Group to your watchlist to keep up on the latest news in the tobacco sector.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong The Motley Fool owns shares of Philip Morris International and Altria Group. Motley Fool newsletter services have recommended buying shares of Philip Morris International, and writing puts on Lorillard. 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 that never inhaled.

Read/Post Comments (3) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 12, 2011, at 3:03 AM, mm5525 wrote:

    PM's dividend may be lower than others in the industry, but they do raise it consistently just as MO did pre spinoff. If you look at PM since 2008, the dividend is raised every year by a minimum of $0.04, and last October it was raised by $0.06. Given PM's raising of its guidance a few months ago by $0.10 to $0.20 EPS and given PM's dividend payout ratio of 60% of EPS, it seems relatively safe to assume PM will raise by around another $0.06 this October. Nice to read this article on the very day my PM dividend was paid, by the way! Good article, Mr. Williams.

  • Report this Comment On July 12, 2011, at 9:52 AM, Rasse76 wrote:

    I am an owned of PM, Altria and BAT. Have had all of them in my portfolio for a few years (approx 5) and must say I am very happy with them. Would be interesting to hear some comments on US tobacco vs European (are there such?) and/or Asian publicly noted tobacco companies.

  • Report this Comment On July 14, 2011, at 12:30 PM, jigar34 wrote:

    If I am not mistaken, roughly 40% of RAI is owned by British American Tobacco (BTI).

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