Buying tobacco stocks is a polarizing topic among investors. Some refuse to invest in the sector because of moral objections or the belief that declining smoking rates will kill tobacco companies. Others love them, arguing these businesses efficiently protect their bottom line and dividends, making them ideal long-term income investments.
Let's look at three top companies in the sector -- Altria (NYSE:MO), Philip Morris International (NYSE:PM), and Reynolds American (NYSE:RAI) -- to understand the benefits and drawbacks of investing in Big Tobacco.
Altria, formerly known as Philip Morris USA, spun off its foreign operations as Philip Morris International in 2008. As a result, Altria now generates all of its revenue from the American market. Its flagship Marlboro brand has consistently been the most popular brand in the U.S., claiming over 40% of the market in 2014.
Although the smoking rate among U.S. adults has plunged from 42% in 1965 to 18% in 2012, Altria has protected its top and bottom lines by cutting costs and increasing prices to offset declining shipment volumes. That might seem like an unsustainable long-term plan, but the average price for a pack of cigarettes across all 50 states (including excise taxes) is just $5.51, compared to $12.14 per pack in Australia (which has a comparable smoking rate), suggesting that U.S. prices could have room to rise.
From 2008 to 2014 (excluding the PMI spinoff), Altria's cigarette shipment volume fell 26%, yet its annual revenue rose 27%. During those seven years, Altria's annual diluted earnings per share rose 73%. The company also boosted its dividend payout every year, with an average annual boost of nearly 9% over the past five years. Today, Altria pays a forward annual dividend yield of 4.1% -- more than double the S&P 500's average yield of 1.9%.
Altria has also invested in other businesses, including snuff, cigars, wine, e-cigarettes, and a stake in brewer SABMiller, to diversify its top line. Together, those businesses accounted for just 7% of its top line last year, but their weight could increase over the next few years.
Philip Morris International
Philip Morris International was originally spun off to capture higher sales from foreign markets with higher smoking rates, lower excise taxes, and looser regulations. Unfortunately, that strategy also exposed it to huge currency impacts.
The strong dollar has been crushing PMI's foreign earnings, which are reported in U.S. dollars. Last quarter, PMI's net revenue (excluding excise taxes) fell 4.4% year over year to $6.6 billion. Excluding the impact of a strong dollar and excise taxes, revenue would have actually risen 9.1%. Excluding currency impacts, revenue across all global regions rose, with the EMEA (Europe, Middle East, and Africa) and Latin America/Canada regions posting double-digit annual growth. But including currency impacts, only the Latin America/Canada region posted positive sales growth.
The company also competes against cheaper "gray market" brands in certain regions, including Europe, where economic turmoil has reduced discretionary income. Like Altria, PMI is expanding into other businesses, such as e-cigarettes, but those products still account for a sliver of its top line.
The good news is that PMI remains dedicated to boosting its dividend annually. Over the past five years, it raised its payout by an average of 12% per year. It currently pays a hefty forward annual dividend yield of 4.8%.
Reynolds American is the second-largest U.S.-only tobacco company after Altria. Last year, Reynolds American acquired Lorillard, the third-largest U.S. tobacco company at the time, to compete more effectively against Altria. After that acquisition, Reynolds American claimed over a third of the U.S. cigarette market. Its Newport, Camel, and Pall Mall brands were respectively the second, third, and fourth most popular brands in America in 2014, with a combined market share of 28%.
Reynolds American's core business strategy is similar to Altria's -- increase prices to offset falling shipment volumes while reducing expenses. From 2008 to 2014, Reynolds' total cigarette shipments fell 23%, but its annual revenue only slipped 4%. During that period, annual diluted earnings per share rose 20%. Reynolds also boosted its dividend annually, with an average yearly increase of more than 6% over the past five years, and currently pays a forward annual dividend yield of 3.5%.
Reynolds American also sells snuff, nicotine gum, and e-cigarettes, but they only account for a small part of its business. Reynolds nearly became the top e-cigarette maker in the world by acquiring Lorillard's blu e-Cigs, but the brand was sold to Britain's Imperial Tobacco Group to sidestep a possible antitrust probe.
I believe Altria is a more stable tobacco stock than PMI or Reynolds American. It owns a dominant brand, is shielded from foreign currency impacts, and has plenty of room to raise prices. However, Altria isn't a cheap or low-risk stock. Its trailing of P/E of 20.6 is merely comparable to the S&P 500's ratio of 20.7. Rising interest rates could reduce investor demand for high-yielding dividend stocks with higher P/Es such as Altria.
Leo Sun owns shares of Altria Group,. The Motley Fool has no position in any of the stocks mentioned. 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.