With the exception of those who are morally opposed to it, investors ought to seriously consider adding Big Tobacco to their portfolios. Speaking at a recent conference hosted by Morgan Stanley, Philip Morris International (PM 0.25%) CEO Andre Calantzopoulos expressed the following sentiment: "We enjoy the luxury of operating in a very attractive industry characterized by superior margins, strong pricing power, and strong cash flows."
Even Warren Buffett, a man known for focusing on managerial ability, concedes that a business' economic characteristics are more important than the quality of its management. Let's take a closer look at how Big Tobacco companies exhibit each of the economic attributes mentioned by Calantzopoulos. In addition to his company, I've included a discussion on Lorillard (LO +0.00%), Reynolds American (RAI +0.00%), and Altria Group (MO +0.07%), the three largest domestic cigarette makers.
Superior margins
If you compare them with stocks as a whole, Big Tobacco companies enjoy superior margins. According to Morningstar, the average net profit margin of the S&P 500 index was 9.3% for the first quarter of 2013. What's more, the average net profit margin of the S&P 500 since 1952 is 5.9%. As the following table shows, these sin stocks absolutely crush the S&P 500 when it comes to net profit margins.
| Lorillard |
Altria | Philip Morris International | Reynolds American | |
| Net Profit Margin (TTM): | 17.5% | 17.2% | 11.3% | 18.9% |
| Net Profit Margin (five-year average): |
17.8% | 20% | 11.2% |
14.3% |
Well, they all crush the S&P 500 with the exception of Philip Morris International. That company is more efficient at converting revenue into net income than the S&P 500, although by a relatively slim margin. The reason Philip Morris International has a lower margin than its peers is pretty straightforward. Although the company pays lower income taxes than its American counterparts, excise taxes devour a much larger portion of its revenue. A country typically levies excise taxes on products it considers harmful to society, things like gambling and cigarettes among others.
For the nine-month period ended on Sept. 30, Philip Morris International reported that 63.9% of its revenue went toward paying excise taxes. The corresponding figure for each of the domestic sin stocks is less than 33%. Philip Morris' most recent quarterly report revealed the impact a sudden, unpredictable decision from a foreign government can have on its operations when its shipments to the Philippines fell 26.8% year-over-year because of a massive increase in excise taxes. . The company expects the excise taxes it pays will continue to increase.
Strong pricing power
One of the most attractive traits of these sin stocks is resiliency. According to Lorillard, domestic shipments of cigarettes have contracted at a compound rate of 3.6% over the past decade. And international shipments of cigarettes are declining too, albeit at a slower rate. Philip Morris International estimates international shipments of cigarettes declined from 3.4 trillion units in 2008 to 3.2 trillion units in 2012. And yet, this big dip in demand hasn't translated into an equivalent drop in revenues for these companies.
Philip Morris revenue (quarterly) data by YCharts
In the past two months, all three domestic cigarette producers have instituted price hikes. The ability to raise prices in the face of adverse industry conditions is a very favorable economic characteristic for a business to have. That being said, if the amount of cigarettes being smoked on earth continues to contract at current rates, eventually the profitability of these companies will be negatively affected. Prices cannot be raised indefinitely. But for the time being, the strong pricing power of these sin stocks remains intact.
Strong cash flows
An incredibly juicy dividend is a sign of a company with prodigious cash-flow-generating powers. And the dividends of these four companies are indeed juicy. Only one member of the mighty Dow Jones has a larger yield than any of these sin stocks (that being AT&T with its 5.4% yield). The following table presents some dividend data on these four big tobacco companies.
| Lorillard | Altria | Philip Morris International | Reynolds American | |
| Dividend Yield: | 4.4% | 5% | 4.4% | 5.2% |
| Payout Ratio: | 68% | 70% | 65% | 85% |
| Dividend Increase since Q2 2008: | 77.4% | 65.5% | 104.3% | 46.5% |
Reynolds American is a perfect example of how the highest yield doesn't always equal the best dividend. In addition to having to highest payout ratio, Reynolds has paid out 50% more in dividends than it has generated in operating cash flow in the past nine months. That all adds up to a dividend that is seriously lacking in stability.
Philip Morris' dividend strikes me as especially attractive. Yes the company is tied with Lorillard for the lowest yield. But thanks partially to massive share buybacks, Philip Morris International has hiked its dividend at a much faster rate than any of the domestic cigarette sellers since it was formed.
Foolish final thoughts
Big Tobacco is an economically enticing business. Companies that sell cigarettes have above-average margins as well as strong pricing power and cash flows. In my opinion, Reynolds American and Lorillard seem like inferior investments compared with Philip Morris International and its former parent company.
Reynolds American has an incredibly unstable dividend. And an investment in Lorillard should at least be postponed until the FDA issues a soon-expected ruling on menthols, upon which the company is dangerously dependent.
