How Long Can Dividends Keep Investors Interested in Tobacco?

With issues being raised about the tobacco industry's key growth driver, which is the best tobacco company to own?

Apr 12, 2014 at 7:30AM

The tobacco industry as a whole is a cash-flow-generating machine. The tobacco companies are paying out dividend yields that are well above other companies'. However, the question is, how long can tobacco companies continue paying out relatively high dividend yields with tobacco sales in decline? We're also seeing a number of issues being raised about e-cigarettes, which are supposed to be a key growth driver for the industry.

A bumpy road to growth
Many of the top tobacco companies are betting big on electronic cigarettes. Lorillard (NYSE:LO) owns the leading blu e-cig brand, while Reynolds American (NYSE:RAI) has been pushing its own brand, Vuse.

While e-cigarettes are expected to be one of the key drivers of the tobacco industry, there are a few issues. The public use of e-cigarettes is already banned in Brazil. A couple of cities in the U.S. are restricting the use of e-cigs in public places. And the FDA is looking to gain authority over e-cigarette regulation. This comes just as the CDC is seeing an uptick in poison-center calls due to exposure to the liquid nicotine in e-cigs. 

Why investors still love big tobacco
Lorillard and Reynolds American are two companies at the forefront of the industry, after news surfaced last month that Reynolds American had hired investment bank Lazard to help with analyzing the viability of buying Lorillard.

The merger would bring together two of the nation's largest tobacco companies. However, the immediate question is the antitrust hurdles. Worth noting is that Reynolds American and Lorillard's combined revenues would still be nearly 25% below that of the No. 1 U.S. tobacco company by sales, Altria

One of the main reasons investors continue to love tobacco companies is their high dividend yields. Thanks to solid free cash flow-generating abilities, Lorillard and Reynolds American pay dividend yields of 4.7% and 5.1%, respectively-- over double the S&P 500 average dividend yield. And each is generating annual free cash flow that's more than 5% of its market cap. That's a solid free cash flow yield.

More trouble on the horizon?
Besides the issues with e-cigs, another big overhang for Lorillard is the potential for further scrutiny for menthol cigarettes. Lorillard is the leader in menthol brand cigarettes, with its Newport brand. The FDA continues to push to restrict menthol cigarette sales, or possibly ban them altogether. This comes as menthol cigarettes are claimed to be more addictive. The European Parliament recently voted to ban menthol cigarettes by 2022.

On the other hand, Reynolds American might be in better shape. It has been introducing products that appeal to customers' changing demands. It has already launched a nicotine replacement product, called Zonnic Gum, which saves smokers from the harmful effects of tobacco. Reynolds American is also upping its smokeless offerings. This includes offering new mint favors for Camel brand snuff products, Camel SNUS.

The best bet on tobacco
With all that said, what might be one of the best plays in the tobacco industry is the international leader. Philip Morris International (NYSE:PM) owns nearly 16% of the international (excluding the U.S.) market share. It also pays an impressive dividend that yields 4.6%. Since it operates outside the U.S., it's not facing the same FDA scrutiny as other tobacco companies.

And with the leading international position in the cigarette market, Philip Morris is looking to boost its presence in unconventional cigarettes. Earlier this year, it entered into an agreement with Altria, where Altria will market two of Philip Morris' heated tobacco products in the U.S. And although it doesn't have a presence in the international e-cig market, it plans to enter it very soon.

Bottom line
While the tobacco industry is still a great place to find solid dividend yields, the recent issues should give investors a reason to have a closer look at their risks. While Philip Morris does have headwinds, they aren't quite as pronounced as the ones Lorillard and Reynolds American face. For investors still interested in gaining exposure to the tobacco industry, Philip Morris looks to be a great stock worth considering.

The 9-minute dividend strategy you need to know
One of the secrets that few finance professionals will openly admit is the fact that dividend stocks as a group handily outperform their non-dividend-paying brethren. The reasons for this are too numerous to list here, but you can rest assured that it’s true. However, knowing this is only half the battle. The other half is identifying which dividend stocks in particular are the best. With this in mind, our top income analyst put together a report outlining a simple 9-minutes-a-year dividend strategy that should be in every income investor’s toolkit. To learn more about this "tax-skipping" dividend trick, all you have to do is click here now.

Marshall Hargrave has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. 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.

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