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Published: August 23, 2010
Investors tend to steer clear of any company or industry with
limited growth prospects. But there is money to be made if the
rest of the market looks to shun such investments. After all,
these largely matured businesses don't need to invest much money
to develop products and fuel new growth, so they can generate an
outsized level of profits on their revenue streams.
That's why some investors love tobacco stocks. They're unloved
by many, but they typically offer very juicy dividends, making
them a favorite among income-oriented investors.
Friday morning, we were reminded just how profitable these
companies are: Lorillard (NYSE: LO), which makes Newport
cigarettes, announced that an already juicy
dividend would be boosted +12.5%, and the company plans to
buy back another $1 billion in stock. Let's take a deeper look
to see if the sector should merit your investment dollars.
Final spurt of growth
Many of us (myself included) assumed that Big Tobacco is already
in decline. Yet as the table below notes, the biggest industry
players are still seeing a bit more revenue growth this year,
thanks in part to rising demand for smokeless tobacco.
But 2011 may mark the long-awaited inflection point that finally
sees industry sales turn down as municipal smoking restrictions
become increasingly onerous, which means that current sales and
cash flow trends may be as good as it gets for this
industry. And that puts the relevant valuation metrics into a
stark spotlight.
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It's nice to see that Lorillard plans to buy back $1 billion in
stock. Trouble is, that looks like an overreach. The company
generated just $355 million in free cash flow in 2009, so it
would take nearly three years worth of free cash flow to cover
that buyback without hurting the balance sheet. Moreover,
Lorillard paid out $631 million in the form of dividends last
year, which appears unsustainable in light of that
free cash flow. The fact that management has actually
boosted the dividend means they are willing to deplete cash to
cover that payout.
For Lorillard, that's challenging enough, with just $6
million in net cash on the balance sheet (though it has $1.8
billion in gross cash). But for rivals Reynolds American
(NYSE: RAI), Altria (NYSE: MO) and Philip Morris
International (NYSE: PM), which have $2 billion, $11 billion
and nearly $13 billion in net debt, respectively, any move to
hike the dividend or buy back more stock would be foolhardy.
This brings us back to the question of whether investors should
buy these stocks. They all are valued at around 10 to 11 times
projected profits, which isn't exceptionally cheap when there
are many companies trading with single-digit
P/E ratios right now. And Big Tobacco's dividend yields,
which stand at around 6%, are not as attractive as some
fixed-income equities such as
master limited partnerships (MLPs), the virtues of which my
colleague Carla Pasternak and others have extolled. [Read:
One of the Best Dividend Payers Ever Just Got Better].
Action to Take --> It's best
to avoid this seemingly tempting investment opportunity. Juicy
dividends are nice, and large stock buybacks are a plus, but
there are too many negatives in this industry -- most notably
eventually declining sales and profits, and too-high debt loads.
Of these stocks, at least Philip Morris still has decent growth
prospects thanks to its international exposure.
If you want low P/E stocks, you can find them among tech stocks
like Dell (Nasdaq: DELL) and Seagate (NYSE: STX).
[Read:
3 Beaten-down Tech Stocks Set for a Rebound] If you want
nice dividend yields, you can find them among the oil and gas
distribution MLPs such as Enbridge Energy (NYSE: EEP),
which currently yields 7.4%.
-- David Sterman
Staff Writer
StreetAuthority |
