Which Tobacco Company Should Growth Investors Buy?

Tobacco companies such as Altria Group  (NYSE: MO  ) , Reynolds American (NYSE: RAI  ) , and Lorillard (NYSE: LO  ) are well known for their defensive nature and robust dividend payouts. However, the tobacco market is changing. And as the number of smokers within the United States continues to fall, these companies are having to rethink their long-term growth strategies. For investors this poses a dilemma, as all three companies have different non-tobacco long-term growth plans.

For example, Lorillard is well known for its brand of Blu electronic cigarettes, or e-cigs. Reynolds has its own brand of e-cigs as well as a selection of NRTs, or nicotine-replacement therapies. And Altria has the most diversification of all three, with a near 30% share in SABMiller, the Ste. Michelle wine brand, NRT products, and a new e-cig product.

The question is, which company is best positioned for long-term non-tobacco growth?

Biggest first
Altria is the biggest of the trio, so it's a great company to start the review with. Altria's greatest trait is its holding in SABMiller. Indeed, it is well known that Altria owns a near 30% economic interest in SABMiller; although what investors often fail to realize is how profitable this holding has been for Altria over the past few years. In particular, Altria's holding in SABMiller is actually one of the fastest growing parts of the Altria group.

Since 2008 Altria's annual income from its share of SABMiller has jumped from $467 million to $991 million, as reported during 2013; that's a compounded annual growth rate of 16.2%. In comparison, Altria's income from smokeable products has grown at a compounded annual growth rate of 4.2%. If Altria's income from SABMiller continues to expand at 16.2% per year, income from the holding will begin to rival cigarettes as Altria's main income source within a decade.

What's more, considering the fact that Altria's initial investment in SABMiller was $6.5 billion, income of $991 million for fiscal 2013 indicates an annualized return on investment of 15.2% -- not bad.

Altria's other alcohol interests include ownership of the Ste. Michelle wine company, which contributed $609 million to the company's sales in fiscal 2013. Ste. Michelle's sales expanded 10% during the fourth quarter and 8.6% for full-year 2013.

Other non-tobacco products
Aside from the company's alcohol interests, Altria is also active in the NRT section of the market. Products include the company's Verve chewable nicotine product and Denmark, a type of gum containing tobacco.

And of course, Altria's newest non-tobacco initiative is the company's e-cig, rolled out under the MarkTen brand name; sales have exceeded initial expectations. Within just seven weeks, MarkTen achieved brand leadership, taking a market share of 48% of the trial market. Altria intends to leverage lessons learned from its initial roll out when it commences national distribution during the second quarter of this year.

Furthermore, Altria recently acquired Green Smoke, an e-vapor business, to boost its e-cig offering. Green Smoke has been manufacturing and marketing high-quality premium products since 2009, so it knows the market well. The acquisition will bolster Altria's already-strong e-cig development and sales teams; it will also expand Altria's product portfolio to address adult smokers' and vapor users' different product preferences.

Peers are lagging
While Altria has been able to use its size to support its diversification into non-tobacco markets, the company's peers have not been able to accomplish the same kind of varied expansion. Nevertheless, this does not mean that Reynolds and Lorillard lack exposure to non-tobacco markets. Reynolds' subsidiary Niconovum USA has entered its first lead market in the United States with Zonnic, a nicotine replacement therapy gum; another subsidiary, R.J. Reynolds Vapor, has introduced electronic cigarette Vuse, which currently has limited distribution.

Meanwhile, Lorillard was one of the first companies to nationally roll out an e-cig product throughout the US. However, it does appear that the company is struggling in this market after a good start. For example, looking through the respective earnings reports, we can see that Lorillard's e-cig gross margin has declined from 37% reported during the first quarter of this year to 32% in the second quarter and finally 24% in the third quarter.

What's more, Lorillard's operating income and margin from its e-cig segment, respectively, have declined from $7 million and 12% in the first quarter of this year to zero during the third quarter. That's right, Lorillard made no profit from its e-cig sales in the third quarter.

The reason for this? Well, the company rolled out a new, cheaper e-cig product and expanded its offering into an additional 127,000 stores, which damaged the margin. In addition, the company's marketing spend increased as it tried to beat competitors.

Foolish conclusion
Looking at the non-tobacco initiatives of both Reynolds and Lorillard, they do not seem to be the sort of initiatives that will ever grow to replace their tobacco income. Unfortunately, this implies that in the long term both Reynolds and Lorillard will suffer as the number of smokers continues to decline. Overall then, Altria looks to be the best company for tobacco investors seeking growth.

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