Better Buy: Philip Morris International Inc. vs. Reynolds American, Inc.

By Brian Stoffel Markets Fool.com

It's a dying industry that peddles a product known to cause cancer and shorten your life. Yet even in the face of public education and stiff regulation, putting your money behind tobacco companies has been one of the best investments over the past four decades. Case in point: Philip Morris (NYSE: PM) -- through an investment in parent company Altria (NYSE: MO) -- and Reynolds American (NYSE: RAI) have returned 9,500% and 6,900% respectively, since January 2000 -- far outpacing the broader market.

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Image source: Getty Images

Does that mean these two companies are good investments moving forward? And if so, which one is the better bet? I can't answer that question definitively -- no one can -- but I can offer three different lenses through which to view the question.

Financial fortitude

Dividend investors, especially those in tobacco companies, love to see money being returned to them. The outsize payouts are, after all, why they invested their money in the first place.

But there's something to be said for keeping a healthy stash on cash on hand. When tough times hit -- whether because of government regulation, supply-chain issues, input prices, competition, or macroeconomic forces -- companies with cash have options. They can continue to pay their dividends, buy back shares, or perhaps even acquire rivals.

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Debt-heavy companies are in the opposite boat, forced to cut their dividend and struggle just to make ends meet.

Here's how Philip Morris and Reynolds stack up in terms of financial fortitude.

Company

Cash

Debt

Net Income

Free Cash Flow

Philip Morris

$9.4 billion

$27 billion

$6.5 billion

$6.7 billion

Reynolds

$1.9 billion

$12.7 billion

$5.5 billion

$1.0 billion

Data source: Yahoo! Finance

Keep in mind that Philip Morris is currently valued at roughly 75% bigger than Reynolds. Having said that, however, it's clear that Philip Morris is the stronger company.

While I'm not a fan of either's fundamentals on the balance sheet, Philip Morris has a better cash-to-debt ratio and has brought in far more free cash flow over the past year -- relative to its size -- than Reynolds. For its part, Reynolds' current balance sheet status is due largely to the acquisition of Lorrilard, which was a good move. But it also introduces a level of fragility to the company over the short to medium term.

Winner: Philip Morris

Sustainable competitive advantages

When I look back at the performance of my own portfolio, the companies that have done the best are those with the strongest sustainable competitive advantages. In investing circles, this is often called a "moat."

Within the tobacco field, your brand provides substantially your entire moat. Philip Morris owns some of the most popular global brands, including Marlboro and L&M. The company doesn't function inside the United States -- that's what Altria is for. Globally, it is the second-largest seller of cigarettes, with a 14.6% market share, according to Statista. The only organization with greater share is China National Tobacco Corporation, which benefits from functioning in the most populous country in the world, as well as being protected by the fact that it is state-owned.

Reynolds, on the other hand, functions almost exclusively in the United States. For the time being, that's a boon, as the company is unaffected by a stronger dollar. Over the long run, however, such fluctuations tend to smooth out. The real moat the company has is in the popularity of its Camel, Newport, and Pall Mall brands, as well as the most popular electronic cigarette on the market, Vuse. The company has a 34.6% market share domestically, second to Altria, which owns 51.4% of the market.

In the end, both of these companies have very strong moats surrounding their businesses. While owning Marlboro is a definite plus, it's hard to argue that one's moat is substantially greater than the other's.

Winner: tie.

Valuation

Finally, we have valuation. While this isn't an exact science, there are some straightforward metrics we can consult to give us an idea of how expensive each stock is.

Company

P/E

P/FCF

PEG Ratio

Dividend

FCF Payout Ratio

Philip Morris

22

21

2.6

4.6%

94%

Reynolds

26

80

2.2

3.3%

222%

Data sources: Yahoo! Finance, E*Trade.

On almost every measurement, Philip Morris is the better bet. However, as I mentioned, the acquisition of Lorillard over the past 12 months has substantially skewed the results for Reynolds. If we look to see how these companies are trading relative to their forward earnings, Philip Morris comes in at 19, while Reynolds clocks in at 22. In other words, Philip Morris still looks like the better deal.

While the strong dollar and a weaker euro are going to drag on Philip Morris over the medium term, and with both companies being similarly valued, I'm going to give the nod here to Philip Morris, as it offers a dividend that yields 40% more than Reynolds.

Winner: Philip Morris

Final call: Philip Morris

So there you have it, Philip Morris is the better bet. You wouldn't know it if you follow these stocks. Philip Morris has advanced just 26% -- including dividends -- over the past three years, while Reynolds has shot 160% higher. But I think that, given a slight edge in both financials and valuation, Philip Morris is the slightly better bet today.

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Brian Stoffel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.