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2 Tobacco Dividends to Buy and 1 to Avoid

Sean Williams
July 11, 2011

Investing in sin stocks is not for everyone, but they often provide unparalleled cash flow and remarkably high dividend yields to keep otherwise on-edge investors happy. While there are many sin sectors we could focus on, including alcohol, casinos, and firearm producers, I'd instead prefer to focus on the sector with arguably the biggest bull's-eye on it from both a legal and ideological perspective: the tobacco industry.

U.S. lawmakers are making it increasingly difficult for tobacco companies to sell their products. Numerous states have raised their tobacco tax rate over the past decade, while the FDA recently released a ruling requiring tobacco companies to affix large warning labels to their packages and advertisements by October 2012. In sum, the going has been tough for tobacco companies in the U.S., and it's likely to get tougher.

Thus it makes sense to look past the dividend paid by most tobacco companies and dig deeper to see whether you have a payout you can trust for the long term, or a high-yield smoke-and-mirrors candidate. While the tobacco sector doesn't offer a vast selection of choices, there are two clear-cut dividend standouts and one company that could burn you if you aren't careful.

Philip Morris International (NYSE: PM  ) -- trust it
What's the best way to avoid U.S. regulators? How about by avoiding the U.S. altogether!

Philip Morris International, the Altria (NYSE: MO  ) spinoff that began trading as a separate entity in 2008, conducts all of its business outside the U.S. This isn't to say that there aren't stringent smoking regulations outside of the United States. Australia is currently lobbying for tobacco companies' packaging to be changed to a plain olive color, while Canada has some of the toughest antismoking laws worldwide. Luckily for Philip Morris, the company has significant market share in many of its foreign markets, allowing it to weather any potential regulation storm.

Relative to Altria, or even rival Lorillard (NYSE: LO  ) , Philip Morris' dividend is the least impressive of the group. While Altria and Lorillard are yielding 5.7% and 4.7%, respectively, Philip Morris is paying out 3.7%. But unlike Altria and Lorillard, which are 100% tied to the U.S. and its many rules and regulations governing tobacco sales, Philip Morris offers investors a considerably greater long-term growth rate and a lower payout ratio. In short, the company has a greater chance at raising its dividend than does Altria, and it also will likely face fewer legal challenges. This appears to be one of the safest bets in a gamblers' sector.

Reynolds American (NYSE: RAI  ) -- trust it
Reynolds American is the second-largest domestic tobacco producer behind Altria and faces many of the same legal woes that Altria faces in the U.S. So why should you even consider investing domestically considering the argument for Philip Morris above? Reynolds American's healthy balance sheet and its burgeoning smokeless tobacco business are two reasons that come to mind.

Relative to Altria, Lorillard, and multinational rival British American Tobacco (AMEX: BTI  ) , Reynolds American has the safest balance of debt to equity. As long as the prospect of legal action remains in the forefront of investors' minds, having a clear-cut cash advantage is paramount in the tobacco sector. Altria and British American have debt-to-equity ratios of 222% and 108%, respectively, while Lorillard sports negative shareholder equity. With a debt-to-equity of just 62% and $3 billion in cash, Reynolds American's balance sheet looks stable.

The main driver behind Reynolds' future dividend growth will be its smokeless tobacco revenue, which currently accounts for 8% of its business. With companies like Star Scientific (Nasdaq: CIGX  ) still years away from making a dent in the industry, it's probably safe to assume that Reynolds American will continue to rake in healthy