Friday's Top Upgrades (and Downgrades)

Analyst announces a pick, a pan, and a pass among tobacco stocks.

Jul 11, 2014 at 2:13PM

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense and which ones investors should act on. Today, we turn our attention to the tobacco industry, where professional asset manager Cowen & Co. has just announced one pick, one pan, and one pass. Without further ado, here they are:

Pick: Altria Group (NYSE:MO)
The world's best-known tobacco stock (even if we'll probably never get used to the new name), the company formerly known as Philip Morris, wins top marks from Cowen this morning -- an "outperform" rating and a $47 price target. But does Altria deserve the endorsement?

Probably not. Regulatory and litigation risks aside, Altria stock costs a heady 20 times earnings, which seems high for a company expected to post sub-8% growth rates over the next five years. Granted, the company boasts strong free cash flow and pays this out to its shareholders in the form of a hefty 4.5% dividend. But still, the growth rate just doesn't measure up to the P/E ratio that Altria carries.

What's more, even with Altria's dividend yield, the 9% growth in share price that Cowen is projecting over the course of the next year adds up to a total return of just 13.5% -- if this already overpriced stock can reach that high. That's not that much better than the long-term average return on a more diversified investment like the S&P 500. Long story short, I just don't see the attraction.

Pan: Lorillard (NYSE:LO)
This granddaddy of tobacco stocks (founded in 1760) scores low in Cowen's estimation. Cowen rated the stock an "underperform" today. But why does Cowen hate it?

Sure, priced at more than 21 times earnings today, Lorillard stock costs more than a share of Altria. Its 3.8% dividend yield is less generous, too. On the plus side, though, analysts see Lorillard growing its earnings at close to 11% annually over the next five years, a significantly speedier growth rate than Altria sports. Debt levels are modest here, at just $1.8 billion net of cash. And free cash flow is abundant, with the company generating $1.1 billion in cash profits over the past year (which is actually a bit more than Lorillard reported as its "net income" for the period).

Personally, I don't see the stock as a buy, any more than I do Altria. Lorillard's P/E ratio is too high, and its growth rate -- while three points better than Altria's -- is still too slow to justify this P/E. But this morning, Reynolds American said they are interested in owning Lorillard, and are in fact in the process of negotiating a merger.

The question now is how much of a merger premium Lorillard shareholders might expect to reap from such a transaction, if it goes through. Between the stock's already high price, though, and the fact that the merger-negotiation news has already driven Lorillard stock up 4% today, I'd expect further gains to be minimal.

Pass: Philip Morris International (NYSE:PM)
Cowen's final tobacco pick of the day, Philip Morris International, merits only a shrug of dismissal from the analyst -- and a "market perform" rating.

Priced at $85 and change today, Cowen sees Philip Morris International shares rising only 7% to hit $91 over the course of the next 12 months. And I agree with the analyst again on this one: Philip Morris International just doesn't look like an attractive investment.

Sure, priced at 16.5 times earnings, it's the cheapest stock of the three Cowen examined today. Its 4.1% dividend yield is attractive, too, placing right in between what Altria pays and what Lorillard shells out to its shareholders. But the stock sports the lowest growth rate of the three (less than 7%), and according to data from S&P Capital IQ, it's also the only one of these three stocks bearing the dubious honor of generating less free cash flow than it reports as "net earnings" on its income statement.

Neither of these being marks in Philip Morris International's favor, I'm going to take a cue from Cowen and pass on this stock as well.

Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.


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