Investors Risk Chasing Yield Too Much In Tobacco Dividends (MO, T, RAI, LO, PM)

The continued rise in tobacco stocks is certainly cheered by tobacco stock investors who own the stocks for the high dividends.  The problem is that there seems to be a phantom premium now being built into tobacco stocks for new investors buying now.  It is starting to look and feel a lot like investors are in a classic “chasing yield” strategy right now.

Altria Group Inc. (NYSE: MO) has now hit a new adjusted high and shares have even crossed above the $30.00 threshold.  When we recently questioned how safe these tobacco dividends were earlier in December, Altria shares were around $28.65.  When we eliminated the tobacco sector from our 24/7 Wall St. 2012 Model Dividend Portfolio, the admission was that it might be a tad soon but that the share price was getting ahead of the underlying fundamentals.

Our take is that Altria would become very attractive again if it was to get closer to $25.00.  Admittedly, that might be closer to $26.50 now that investors have proven willing to invest in Altria above $30.00.  Altria’s 5.6% yield now compares to a dividend yield north of 6% for telecom giant AT&T Inc. (NYSE: T).

The tobacco sector is still a safe haven to hide in during market sell-offs, but the longer-term risk/reward is reaching above our parameters for investors with a 5-year or longer horizon.

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We have not added Reynolds American Inc. (NYSE: RAI) nor Lorillard Inc. (NYSE: LO) as replacement stocks for Altria in the Model Dividend Portfolio.  Again, if the share prices come back down then our interest may increase.  The good news is that Philip Morris International, Inc. (NYSE: PM) still has a safe dividend and it has plenty of income coverage to hike in the future.  The international tobacco play has “only” a 4.1% dividend yield and it has extreme currency risks.  The last hike was a large one from $0.64 to $0.77, and even if the company made the sale nominal jump to $0.90 per quarter it would be paying out less than 70% of its expected income per share.
 
Our belief is that the domestic tobacco market has too many headwinds in the future, but none of the threats are legal cases.  The biggest fear is that Joe Public has finally made a healthier move and more smokers are dropping out of the population.  Some die, but some quit. 

Over the last month we have read about price hikes being passed down to distributors.  After all, it isn’t really as if the stores can substitute out Joe Camel for the Marlborough man or vice versa.  Lorillard was shown to be passing on a $0.06 per pack hike, while a nickel hike was coming from Altria and Reynolds.  What if the government or distributors argue that there is price collusion happening?  Too many price hikes may eventually at some point drive away more smokers. States, cities, and counties keep turning to tobacco sales for higher taxes as well.

Investors should be at least concerned that the only way to grow earnings is by price hikes to keep juicing up the dividends.  Case volumes keep shrinking and operating costs and tobacco crop prices ultimately can only be cut so much.  There are only so many ways to diversify for growth as well.  Smokeless tobacco has been one push, and the non-tobacco “e-cigs” are another…

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We still maintain that the endless tobacco dividend hike game is yet entirely over.  At the current pace, we could easily see one more annual dividend hike or maybe even two.  Altria’s quarterly dividend went from $0.38 to $0.41, Reynolds went from $0.53 to $0.56, and Lorillard has now had four quarters of a $1.30 payout.  These dividends are now all under 6% because the share prices have risen enough.

When we eliminated tobacco from the 2012 Model Dividend Portfolio, we noted, “Our admission is a simple and humble one: we may be too early on this call.  You have been hearing about the death of the tobacco industry for years.” Tobacco is here today and will still be here tomorrow. 

The biggest fear for investors is that some time in the next year or two it could be the time that one of the tobacco giants says “We cannot afford to hike our dividend this year, but we hope to next year.”  If investors ever fear that to be the case, then that will mark the end of the tobacco run. 

Except for Lorillard, the stocks are above the consensus analyst price targets: Altria’s target is $29.00 with a share price above $30.00 and Reynolds American’s share price is $41.71 versus a target price of $40.75.

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JON C. OGG