One of the key elements I look for while selecting companies that can be added to a dividend portfolio is the staying power of their businesses.
Is the industry prone to disruption? Can a new-age competitor give these companies a run for their money? Will they be alive long after I am gone? These are the key questions that one needs to ask before selecting a company, and the tobacco industry does tick all of those boxes.
The top three players of the industry –Philip Morris International (PM, Financial), Altria Group (MO, Financial) and British American Tobacco PLC (BTI, Financial)Â – have a combined market cap of $405 billion. With operations around the world, these three companies had total revenue of $58.7 billion last year. So, effectively, the valuation of these companies is more than six times their sales. That might seem a bit expensive at first, but with operating margins for all three companies staying north of 30%, these are solid businesses that can withstand the test of time.
Global trends impacting revenues
Key Industry Trends from Global.tobaccofreekids.org
Philip Morris and British American Tobacco control all major markets except for China, where the state-run China National Tobacco Corporation controls the domestic market. The Chinese government is well known for protectionism, and there is hardly a chance for these two big players to fight on an even scale in this country, which means we can only imagine what they can do in the rest of the world.
Sales of all three companies have been moving sideways since 2008, and the reason can be directly attributed to the kind of markets where these companies are seeing growth.
Although retail volumes around the world have been growing since 2000, that growth has slowed down over the last five years. Low penetration in mature markets is one reason, but another major factor is that high-growth countries outside of core markets don’t offer such high returns. And that’s what we’re seeing in the sales graphs for all three players. That’s not something that I see changing over the next five to 10 years at least.
In terms of sales volumes, there was a mere 8% increase over the period between 2000 and 2014, which bears out that assumption. With anti-tobacco lobbies getting stronger in mature markets, it’s only APAC and MEA that have shown any kind of growth in this area.
Source: Huffington Post
But the fact remains that even though penetration is high in developed markets, the industry is still growing, albeit slowly. As such, emerging markets still have enough steam to keep revenues growing sideways for these tobacco majors.
Dividend yield
Source: Dividend.com
Source: Dividend.com
Source: Dividend.com
For a dividend investor, however, all three companies make attractive investments because of the 3% to 4%-plus yields. Though payout ratios are high, these are highly stable businesses with relatively low Capex because of their already-high penetration levels.
Capex for Philip Morris International is the highest among the three, coming in at about $1 billion. British American Tobacco spends in the range of $600 million to $800 million, and Altria’s Capex is under $200 million.
As you can see, their Capex to FCF is extremely low, which means that kind of payout ratio is sustainable in the long term.
Finances
British American Tobacco has zero LTD, making it the healthiest company in this group. Its total liabilities are a tad under $14 billion, and it has more than $2 billion cash. In terms of dividend growth, an operating income of $4.6 billion is another good sign of sustainability.
The other two companies are not far behind, with combined cash of $6.7 billion and LTD of around $38 billion. Philip Morris'Â debt has grown in the past five years, and declining sales have seen its operating margin contract as well. However, the balance sheets of both companies are still solid enough to allow it to keep growing its dividends for several years.
Note to investors
Market dynamics aren’t going to support aggressive sales growth for any of these companies. Their high penetration in mature countries and low returns in emerging, high-growth ones will make sure of that. In addition, there is also a lot of pressure at the school level through tobacco awareness and anti-smoking lobbies.
But to say that these businesses are weak would be a gross understatement. The risk with them is not about stunted dividend growth but more about sustainability over several decades. For the next five to 10 years they are safe and lucrative dividend plays, and that’s what dividend investors need to know.
You should be looking at these as you do utility companies – strong industry moat, sideways revenues gradually edging upward, solid cash flows and balance sheets and capable of growing dividends for at least the next decade.
The risks are obvious as well – more stringent regulation, few core market opportunities and relatively lower returns in new markets.
As an investor, you need to decide what’s more important for you – high growth or stability – because the two aren’t often found together. If you’re after the first, then look at a non-disruptable industry with low market penetration; if you want the second, these three tobacco giants can give you what you need.
Disclosure: I have no position in any of the stocks mentioned and no intention to initiate any position in the next 72 hours.
Start a free seven-day trial of Premium Membership to GuruFocus.
Also check out: (Free Trial)
