Altria (NYSE:MO) and Reynolds American (NYSE:RAI), the two biggest domestic tobacco companies in the U.S., have been sound investments recently thanks to their protection from currency fluctuations, lower gas prices boosting discretionary spending, and the overall strength of the U.S. economy.
As of this writing, shares of Altria and Reynolds have respectively rallied about 25% and 50% over the past 12 months, easily outperforming the S&P 500's 3% gain. After those big gains, investors might be wondering if either stock is still a worthy buy.
Third quarter earnings
During the third quarter, Altria's revenues rose 4.7% to $4.98 billion, exceeding estimates by $80 million. Adjusted earnings improved 8.7% to $0.75 per share, meeting expectations, while total cigarette shipments inched up 0.1%. Altria's total market share in U.S. cigarettes, mainly supported by Marlboro, rose from 50.9% in the prior year quarter to 51.3%.
Reynolds American's revenues surged 41.1% annually to $3.16 billion, which also topped expectations by $20 million. But most of that growth was attributed to Reynolds' acquisition of Lorillard, which closed in June. That acquisition also boosted Reynolds' adjusted EPS 17% to $0.55, which met expectations. Cigarette shipments surged 29.5%, fueled by the addition of Lorillard's Newport menthol cigarettes. Reynolds' brands, led by Newport, Camel, and Pall Mall, claimed 33.9% of the domestic market, up from 33.6% in the prior year quarter.
To diversify away from cigarettes and cigars, Altria expanded its portfolio into new categories like wine, e-cigarettes, and a 27% stake in brewer SABMiller, which together generated nearly 10% of its pre-excise tax revenue last quarter. Anheuser-Busch InBev's (NYSE:BUD) planned $104.2 billion takeover of SABMiller will give Altria a large stake in the beer company, but it's unclear if Altria will still directly report earnings from that stake after the deal closes. During the third quarter, Altria's earnings from SABMiller plunged 43% annually to $187 million, mainly due to overseas currency impacts.
Reynolds' strategy, as seen with its acquisition of Lorillard and the sale of the international rights to several brands to Japan Tobacco, is to double down on the domestic tobacco market to challenge Altria. However, Reynolds is also diversifying away from cigarettes with snuff, e-cigarettes, and nicotine gum, which also accounted for around 10% of its top line last quarter. Reynolds also dominates certain niche markets in America -- Newport is the leading menthol brand, Vuse is the top e-cigarette maker, and Natural American Spirit appeals to younger smokers with organic tobacco and additive-free blends.
Looking ahead, rebounding gas prices might cause domestic cigarette shipments to decline. If that happens, both companies will likely fall back on their old strategy of raising prices. While that strategy might seem unsustainable, investors should recall that cigarettes are still much cheaper in the U.S. than in other countries with comparable smoking rates, like the U.K. and Australia.
Dividends and buybacks
Many investors buy tobacco stocks for their rich dividends and big buybacks. Altria currently has a forward annual dividend yield of 3.7%, while Reynolds has a yield of 3%.
Altria spent 75% of its free cash flow on dividends and 14% on buybacks over the past 12 months. The company recently completed a $1 billion buyback program in the third quarter, then authorized a new $1 billion buyback program to be completed by the end of 2016. Reynolds only had a free cash flow of $99 million over the past 12 months due to the acquisition of Lorillard, but it still spent $1.4 billion on dividends and $4.6 billion on buybacks. As a result, Lorillard's long-term debt surged 266% annually to $17 billion last quarter, while Altria's long-term debt declined 6% annually to $12.9 billion.
Altria trades at 23 times earnings, making it pricier than Reynolds' P/E of 18 and the industry average of 19 for the tobacco industry. Altria also has a 5-year PEG ratio (based on Thomson Reuters' long-term earnings estimates) of 2.5, compared to Reynolds' PEG ratio of 1.7. A lower PEG ratio, especially one under 1, indicates that a stock is "undervalued". As slow growth companies, neither Altria nor Reynolds are expected to make that cut, but Reynolds is still the cheaper choice.
As an income investor, I like Altria's higher yield, more manageable cash flows, and habit of spending more of its cash on dividends instead of buybacks. But as a value investor, I prefer Reynolds' lower valuations. I personally own both stocks, but if I had to pick only one today, I would go with Reynolds' more diverse product portfolio and lower stock valuations.
Leo Sun owns shares of Altria Group, and Reynolds American,. 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.