Tobacco Stocks Offer An Alternative to Bonds for Income Investors

Greetings Fools! If you're reading this, odds are you are interested in the tobacco business. Even if you have an objection to the use of tobacco in modern America, the fact of the matter is that companies like any company, offer potentially phenomenal value propositions.  As such, it would be a disservice to the Foolish community for me to not cover a company like Altria Group (NYSE: MO  ) , a company I believe fits the bill very well!

Company and competitor data
With a market capitalization of $72.8 billion, Altria's the second largest publicly traded tobacco company in the United States and the third largest in the world, sitting behind Philip Morris International (NYSE: PM  ) , and British American Tobacco (NYSEMKT: BTI  ) . However, it is distinct from these players in the respect that it yields an impressive 5.47% per year. To put it in perspective, look at the table below, which shows the yields of some of the big cigarette producers in the industry.

Looking at the yields of the five largest publicly traded tobacco companies, we see that Altria Group smokes the competition. Next in line is Reynolds American (NYSE: RAI  ) , followed by Lorillard (NYSE: LO  ) , the two smallest of the big five, and then Philip Morris and British American. This data alone points to the conclusion that Altria should appeal more to income-oriented investors than the others, but things aren't always so simple.

While the current yield of Altria is high relative to its peers, how healthy is the company's balance sheet and cash flows? For starters, I think it's important to point out that, while the company boasts an average five-year net profit margin of 23.5% and return on equity of 110.5%, it has a rather low current ratio over the time frame of 0.97 (though its current ratio now is about is 0.83). Seeing as how this ratio is below 1, it suggests that the company is fairly illiquid and paying off current liabilities could be a problem for it.

The company has a high five-year average long-term debt/equity ratio of 3.04. By itself, this is high and is strong evidence that the company is far from solvent. To make matters worse, this number has increased from 2.6 in 2008 to 3.62 in its most recent fiscal quarter, a rise of about 39.2%. In short, the high amount of debt the company has assumed is levering up its return on equity and profit margins, something that is normal in business, but not usually to this extreme degree.

However, not everything is as simple as it appears, as we will soon see!

Cash is king, baby!
Probably the best way to determine this is to take the company's free cash flow, less dividends paid to shareholders, divided by interest expense. The results are shown in the table below.

For starters, I should note that I excluded the ratio from 2008 in my analysis because it's an outlier. What created this outlier was the result of a large gain from discontinued operations combined with a very low interest expense for the year because of low debt levels.

According to the data in the table, the company has a very low free cash flow/interest expense ratio after taking into consideration the payment of dividends. If this were all, it would indicate that the company is in financial trouble. However, there is one tidbit of information that we cannot overlook: treasury stock.

Beware of treasury stock!
Treasury stock comes into existence when a company buys back its own shares, and instead of retiring them, holds them in its treasury. What this means is that the company is reserving the shares, either for distribution for equity compensation, or to sell them back to the public to raise capital. Right now, the treasury shares of Altria amount to about $25.9 billion, which is creating an artificially high ROE and an artificially low book value.  What this means is that the company always has the ability to sell the treasury stock for cash, pumping up its liquidity

Normally, a healthy company will issue debt to buy treasury stock when its cost of debt dips below its cost of equity. Whenever the trend reverses though, the company can utilize this vast hoard of equity to throw back into the market for growth purposes, or to pay back its debt if need be, essentially affording it the same status as very low-cost financing in an environment of rising interest rates.

Summary
Initially, it appears as though its dividend may be at risk should profitability falter. However, a further look into its treasury stock suggests that the company has a hoard of equity to use on debt repayments, meeting operating expenses, paying dividends, growth opportunities, etc. In the end, a look at multiple items in the balance sheet was needed to understand the soundness of the company's dividend, but the conclusion is that investors likely have nothing to worry about in either the short-term or intermediate term.

It is for this reason that Altria may very well be a valid alternative to Treasury bills and, possibly, other dividend stocks.  The underlying rationale is that it offers a yield that is much higher than even the current 30-year T-Bill's 3.625%, while affording investors with enough liquidity that they likely won't have to fear the company not having the ability to meet attractive distributions.  On top of this, there's always the nice upside of growth.  Talk about having your cake and eating it too!

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