Top Stocks to Buy in Tobacco

By Markets Fool.com

Tobacco stocks are often considered slow-growth investments which are owned for income instead of price appreciation. Some long-term investors might also avoid these stocks, believing that declining smoking rates will eventually crush their core businesses.

Continue Reading Below

Image source: Pixabay.

However, many tobacco stocks have outperformed the S&P 500 over the past year due to the popularity of high-yielding dividend stocks in a low interest rate environment. Meanwhile, the profitability of many tobacco companies improved as they used higher prices, cost cutting measures, and buybacks to offset weaker sales. Therefore, investors should be familiar with three of the top names in the industry -- Altria (NYSE: MO), Philip Morris International (NYSE: PM), andReynolds American (NYSE: RAI).

Altria

Altria, formerly known as Philip Morris Companies, sells Marlboro, Virginia Slims, L&M, and numerous other tobacco brands. Marlboro controlled44% of the U.S. cigarette market last quarter, making Altria its largest domestic tobacco company with a 51.4% share.

Back in 2008, Altria spun off its international business as Philip Morris International. Altria focused on cutting costs, dealing with lawsuits, and raising prices to maximize profits from its shrinking market of American smokers. Meanwhile, PMI expanded abroad into higher growth markets.

Continue Reading Below

Between fiscal 2009 and 2015, Altria's annual revenue grew just8%, but its EPS surged 73% due to price hikes, layoffs, and buybacks. To diversify its top line, Altria expanded into cigars, snuff, wine, and e-cigarettes. Altria also holds a stake in brewery SABMiller, which was recently acquired by Anheuser Busch InBev (NYSE: BUD). That merger gave Altria two seats on AB InBev's board of directors and about $3 billion inpre-tax cash.

Altria will likely return most of that cash to its shareholders via dividends and buybacks. It currently pays a forward yield of 4%, which is supported by a payout ratio of 87%. It's raised that dividend every year since spinning off PMI.

Philip Morris International

After splitting with Altria, PMI enjoyed five years of robust growth. Its annual revenue rose 26% between fiscal 2008 and 2013, and its EPS grew58%. However, its growth then stagnated due to macro challenges in troubled areas like Latin America, regulatory disputes in countries like Uruguay and Thailand, and the impact of a strong dollar. Between fiscal 2013 and 2015, PMI's annual revenue fell 8% and its earnings declined 16%.

Image source: Pixabay.

Those challenges made PMI a riskier play than Altria, which seemed well-supported by low domestic fuel prices and its lack of exposure to foreign currencies. However, PMI's challenges look less brutal if we exclude the impact of the strong dollar.

Over the past nine months, revenue fromthree out of four of PMI's geographic regions declined annually. But on a constant currency basis, revenues rose by the single digits across all four regions. So if the dollar weakens, PMI's growth would improve significantly. Like Altria, PMI is a reliable income play -- it pays a forward yield of 4.8% and has hiked its dividend every year since splitting with Altria. However, its payout ratio of 98% suggests that it has much less room for future increases.

Reynolds American

Reynolds American, the second largest tobacco company in America, sells Camel, Newport, Pall Mall, Natural American Spirit, and other brands of cigarettes. Reynolds' brands controlled 34.6% of the U.S. cigarette market last quarter. British American Tobacco, which owns 42% of Reynolds, recently offered to acquirethe entire company for $47 billion, but the offer (which valued Reynolds at $56.50 per share) was rejected for being too low.

Reynolds' main strength is that it controls several niche markets. The Newport brand, which it gained by acquiring Lorillard last year, madeReynolds the top vendor of menthol cigarettes in America. Its Vuse e-cigarettes remain the most popular retail e-cig brand in the country, and its Natural American Spirit cigarettes appeal to younger smokers with their "additive free" products.

Like Altria, Reynolds is well-insulated from foreign currency woes and benefits from low fuel prices. It also uses the same strategy of raising prices, cutting costs, and buying back stock to offset weaker sales growth. Between fiscal 2008 and 2014 (the last full year before the Lorillard acquisition), Reynolds' annual revenue fell 4%, but its earnings rose 20%. Reynolds pays a forward yield of 3.4%, which is comfortably supported by its 44% payout ratio.

The key takeaway

Tobacco stocks are solid income investments, but investors should mind their valuations relative to the industry average of 21. Altria's P/E of 24 is already higher than that average, while PMI's P/E of 21 merely matches it. Reynolds' trailing P/E of 14 looks cheaper due to the Lorillard acquisition, but it still trades at 21 times forward earnings.

Looking ahead, higher interest rates could bring these stocks down and offer more attractive entry points with higher yields -- so investors shouldn't rush in to start new positions in these tobacco stocks just yet.

10 stocks we like better than Philip Morris International
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now and Philip Morris International wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of November 7, 2016

Leo Sun owns shares of Reynolds American. The Motley Fool owns shares of and recommends Anheuser-Busch InBev NV. 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.