The Dividend Investors' Guide: Part XXII - Tobacco Dividends That Smoke The Market

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

The tobacco industry provides some great dividend yields but, for the most part, it lacks much growth potential. There is one exception to this rule that I will enlighten you with in just a moment. But first, let us take a few words to examine some of the peculiarities of this industry. Most tobacco companies have negative free cash flow. Several, like many large corporations today, are buying back shares. But, unlike most companies, the tobacco companies often must borrow (increase debt) to buy back shares. Besides increasing debt, this activity also reduces shareholder equity since treasury stock is counted as a negative within the shareholders' equity section. This is one more reason I don't like to use the debt/equity ratio.

Normally, I would stay away from companies utilizing this practice, but there is some logic that applies in this instance. Since dividends are kept so high to prop up the stock prices of these mature industry participants, the cost associated with equity is very high. Also, unless equity shares are bought back by the company and retired, this expense is one of infinite duration. Now consider the much lower cost of debt in today's environment and the fact that the debt is also of defined duration. These companies are simply substituting a lower cost of capital for a higher cost of capital. It is not possible for a company to continue this practice beyond a certain point or its cost of borrowing will increase to the extent that debt becomes more expensive. Fortunately, these companies have very predictable sales, margins, and cash flows. Without this level of predictability I would definitely stay away, regardless of the yields.

One problem that I'd like to make readers aware of is that the search for higher yields by investors has driven prices of most companies in this industry to what I consider unreasonable and unjustifiable levels. Why pay more than 15 times expected future earnings for a five percent dividend and almost not earnings growth? Much of the recent growth in EPS has come from reductions in outstanding shares in many cases. What I do not like is when the substitution of debt for equity takes on proportions that push free cash flow negative. So, that is where I draw the line here.

There is growth to be cultivated by this industry but most of the players are not positioned properly to take full advantage of the potential. Only one has proven to me that it is capable of the industry leading growth for which I search.

Lorillard (LO) is one of only two companies in the industry that is growing significantly faster than the industry average. The company is the third largest tobacco company in the U.S. and is the first of the major industry players to make an entry into the electronic cigarette market with the purchase of Blu Ecigs. This remains a very small portion of overall sales but should have higher growth potential than the core business. It also appears that LO has been gaining market share against competing brands. The share price commands a lower multiple than its peers. This doesn't exactly make the company a bargain, but it is less pricey than most of the competition and has better total return potential to boot, in my opinion.

The one overhanging negative is the potential impact of an FDA decision that could brand menthol cigarettes as posing a greater health risk than non-menthol ones. But I really don't think that this is a big negative in the long term. I don't expect a ruling, even negative to make much of a dent in demand for menthol cigarettes. If I am wrong, it could be a disaster for LO because nearly 90 percent of sales come from menthol brand, Newport. But unless a ruling came with some form of restrictions, I really don't think it will matter to customers. The more likely scenario would entail requiring a stronger warning label on packaging. I like to include links to articles by other authors to provide readers with broader perspective. Consider this one about the ecigs and this one for more on the dividend. Let's look at the metrics.