Can These Super Sin Stocks Make You Rich?

As of June 25, The Motley Fool's earnings quality score database displayed only a few S&P 500 Consumer Staples Sector "A"-ranked stocks. Here's (partially) how the dictionary defines the word staple:

  1. A principal raw material or commodity grown or produced in a region.
  2. A major item of trade in steady demand.
  3. A basic dietary item, such as flour, rice, or corn.

However, these five consumer staple stocks don't provide "basic dietary" items. Lorillard (NYSE: LO  ) , Reynolds American (NYSE: RAI  ) , Constellation Brands (NYSE: STZ  ) , Beam (NYSE: BEAM  ) , and Philip Morris International (NYSE: PM  ) are more commonly referred to as "sin" stocks and sell products that are far from essential to any diet.

Remember, though, that we're only reviewing their earnings quality and not passing judgment on their products.

Lorillard and Reynolds American are both "A"-ranked for earnings quality. Both companies make and sell cigarettes and tobacco products worldwide, so stockholders face a moral dilemma -- you support the tobacco industry and condone selling known cancer-causing products, but you get very healthy dividend yields of 5% ($6.20) from Lorillard and 5.7% ($2.36) from Reynolds, as well as some capital appreciation.

LO Shares Outstanding Chart

LO Shares Outstanding data by YCharts

Lorillard shows high operating and profit margins of 37% and 21%, respectively, and its operating cash flow margin stands at 25%. Nonetheless, company management has leveraged the balance sheet with more long-term debt. Stock has been repurchased but it has not helped earnings per share continue to rise. Lorillard also has a tangible book value of -$12.72, but is not at risk of going out of business anytime soon. Its farmers surely will continue to receive "transition" subsidy payments.

RAI Shares Outstanding Chart

RAI Shares Outstanding data by YCharts

By contrast, Reynolds shows a lower average profit margin of 16% but also lower long-term debt. Shares outstanding decreased and net income has been seesawing. The company's tangible book value is also negative, at -$8.01 per share. The stock has barely moved from January and is currently at $41.90. This stock is a relatively safe dividend play.

Anyone who has heard of the Marlboro Man knows Philip Morris, and Marlboro is just one of its many brands sold in 180 countries. Marlboro is one of the most recognized brands on earth, but Philip Morris is ranked "F" for earnings quality. Let's see why.

Philip Morris shows very high year-over-year operating and net profit margins of 46% and 29%, respectively. The trailing-12-month operating cash flow margin is very healthy at 32%, and revenue increased 10% to $7.448 billion. Net income and earnings per share increased 13% and 18%, respectively, year over year. The chart below exemplifies the artificial boost to earnings by float reduction.

PM Long Term Debt Chart

PM Long Term Debt data by YCharts

Despite its excellent cash flow metrics, Philip Morris gets an "F" ranking because days in inventory are very high at 273 days, actually down from 329 days last year. Are smokers buying stale cigarettes? Moreover, inventory as a percentage of revenue is at 98%, also very high, also down from last year's number of 122%. Lastly, it takes PM almost nine months to convert sales back to cash. The stock has risen only 6.87% since January to $83.99, and pays a 3.6% dividend, so total return equals 10.47% -- less than its P/E of 16.61 or its forward P/E of 14.48. The stock has risen ahead of itself and a pullback could be near.

Constellation Brands and Beam, both liquor and wine sellers, round out the group of sin stocks. However, Constellation is rated an "A" for earnings quality but Beam is rated an "F". Despite some disturbing inventory metrics, long-term debt is being paid down and extra cash is being used to decrease shares outstanding. Constellation doesn't pay a dividend. Its "A" rating is partly a function of its stock price, which has barely moved since January, up just 5.45% to $21.86. Recent news of mergers could make Constellation an interesting play.

Beam's revenue grew only 2% year over year, and its margins are lower and flatter than Constellation's. Operating and free cash flow were negative last quarter. Beam's receivables are improving, but days in inventory is 701 days -- great for the whiskey aging process but not for inventory turnover. Inventory as a percentage of revenue is 315%. Long-term debt is being paid down through issuance of more shares. Beam's shares have appreciated 19.46% since January; the stock is due for a pullback.

Foolish takeaway
You shouldn't judge a book by its cover, and neither should you judge these companies solely by what they sell. While their products may not be good for you, owning their stocks might be healthy for your portfolio. As always, Foolish readers should make their investment decisions based on earnings quality.

One of the great things about companies like Lorillard or Reynolds American is the great dividends they pay, but there are even better ones out there. You can read about them in our special free report:"Secure Your Future With 9 Rock-Solid Dividend Stocks." To see which dividends made the grade, click here now.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Beam. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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