MO Money, MO Problems

Now, who's hot, who's not? Easy: the industry that sells flammable products and is widely regarded as the least moral stream of profitability, big tobacco.

If you're squeamish about investing in "sin stocks," that's fine. But before you leave, take one look at the following chart. A glimpse of the past three years reveals that tobacco stocks have handily outpaced the Dow Jones Industrial Average (INDEX: ^DJI  ) .

But you'd be silly to think that all this profitability doesn't come without some difficulty.

MO money, MO problems
The dividend kingpin of this group, Altria (NYSE: MO  ) , continues to catch heat. The company recently announced it will record a $119 million fourth-quarter charge related to two lawsuits. While the cases rack up a $62 million pre-tax charge, the related interest expense of $57 million almost doubles Altria's actual expense.

Altria's fat cash balance of more than $3 billion means it probably won't sweat over these charges. Considering the $1.17 billion profit it recorded in its third quarter, it has the pockets and cash flow to pay off charges like this well into the future. But as many of these barons realize, it's like the more money they come across, the more problems they see. So with money in the bank, and targets on their backs, industry cohorts such as Lorillard (NYSE: LO  ) , Reynolds American (NYSE: RAI  ) , and Vector Group (NYSE: VGR  ) can expect the lawsuits to keep rolling in.

While this ruling isn't exactly a performance anchor for Altria, it's indicative of the larger environment it faces. Big tobacco is between the unenviable rock, hard place, and harder place of litigation, taxes, and regulation. While it won an irregular victory at the hand of U.S. District Judge Richard Leon, that's hardly the sort of performance it can bank on. It continues to face pressure in Australia, where its packaging remains under fire.

On the lam
Sometimes a company just has to get out of Dodge to capture big profits. It's this reality that prompted the 2008 spin-off of Philip Morris International (NYSE: PM  ) from Altria. By focusing internationally with the Marlboro brand, while Altria focused domestically, Philip Morris was more insulated from U.S. litigation, regulation, and taxes. International markets are generally less hostile toward tobacco in these areas.

Best frenemies
Sometimes, though, the government and big tobacco are frenemies of sorts. That's because tobacco's practiced profit-making places it squarely in the sights of legislators looking to fill budget shortfalls or raise revenue.

And, oh, what revenue it brings in. In 2009, tobacco taxes racked up an impressive $17 billion for the U.S. government. While federal governments like to hike tobacco taxes -- 46 states and the District of Columbia have raised them more than 100 times since 2000 -- they need to be cautious. For instance, revenues have not gone up as quickly as taxes have been increased, suggesting that higher taxes put downward pressure on sales. This could also be exacerbated by a slowly declining smoking population in the U.S., meaning the cash cow of tobacco sales could wither up if government gets too greedy and raises taxes too much. It's for this same reason that I feel cash-strapped states are less likely to push through more smoking bans and restrictions at this time.

99 problems but a pick ain't one
Given the nature of tobacco companies, I've set my sights abroad. Philip Morris is arguably the best-positioned of the companies mentioned here. It consistently pays dividends topping 4%, has a conservative (for tobacco companies) payout ratio of 55%, and with a three-year dividend growth rate of 39.1%, it likes to give it back. Philip Morris' international presence removes it from many of the hostilities found in the U.S. market. With third-quarter revenue up 26% over last year, the company is demonstrating its international chops well.

There are other domestic options for those who like to play in domestic soil. If you want to get out of the game, flip, and go legit, there is always Star Scientific (Nasdaq: CIGX  ) . The smokeless tobacco company has seen weak performance lately but is a technological pioneer in its field. With smokeless tobacco products increasing sales as cigarette sales shrink, it could have a big upside. Granted, you don't get the fat dividend you get with traditional cigarette companies, but you also avoid the most destructive legislation and lawsuits, which traditionally miss smokeless products.

Earning an honest living
If you like the idea of these monster dividend yields but are uncertain about all the negative forces surrounding big tobacco, I invite you to check out The Motley Fool's special free report "Secure Your Future With 11 Rock-Solid Dividend Stocks." Thousands of investors looking to land consistent income have already requested it. It's free!

Austin Smith owns no shares of the companies mentioned here. The Motley Fool owns shares of Altria Group and Philip Morris International. Motley Fool newsletter services have recommended buying shares of Philip Morris International. Motley Fool newsletter services have recommended creating a bear put ladder position in 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.


Read/Post Comments (5) | Recommend This Article (5)

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 December 07, 2011, at 4:49 PM, sgt2lt wrote:

    I suspect that your readers are probably too old to catch any of your lyrical references (Notorious B.I.G, Jay-Z or Hugo), but I liked the "who's hot, who's not" intro...

  • Report this Comment On December 07, 2011, at 5:45 PM, xetn wrote:

    For what its worth, the charge that MO booked is based on the fact that they will probably contest the award. Their claim is that they signed the master agreement (along with the other majors) but the Oregon courts discounted that. To quote:

    “We believe that the Oregon Supreme Court misapplied the law and reached an erroneous result,” said Murray Garnick, Altria Client Services senior vice president and associate general counsel, speaking on behalf of Philip Morris USA. “As the lower court recognized, the state released its claims to any punitive damages when it signed the Master Settlement Agreement.”

    In 1998, the nation’s leading cigarette manufacturers signed the Master Settlement Agreement with 46 states, five U.S. territories and the District of Columbia. The Master Settlement Agreement was an historic agreement that imposed significant restrictions on a range of cigarette marketing activities and required the participating manufacturers to make billions of dollars of settlement payments to the states. In return, states including Oregon agreed to release claims “directly or indirectly based on, arising out of or in any way related, in whole or in part to” allegations of tobacco-related conduct.

    “This decision is grossly unfair and contrary to the language and spirit of the Master Settlement Agreement,” Garnick added.

  • Report this Comment On December 08, 2011, at 6:01 AM, tgparus wrote:

    PMI's profitability and pricing power are based on its international price-fixing cartel with BAT, IMT and JTI. see www.smokingate.com.

  • Report this Comment On December 13, 2011, at 6:37 PM, Mega wrote:

    "The smokeless tobacco company has seen weak performance lately but is a technological pioneer in its field."

    Lately? Performance has ALWAYS been weak.

    CIGX aren't technological pioneers, they're patent trolls and pseudoscience scam artists.

  • Report this Comment On December 14, 2011, at 3:22 PM, TMFBWItime wrote:

    @MegaShort

    I was referring to their stock price, which has fallen from their late May / early July highs.

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