Are Tobacco Dividends Still Safe Beyond 2012 and 2013? (MO, RAI, LO, PM)

24/7 Wall St. has just released its 2012 Model Dividend Portfolio for investors.  While we have many names we have featured as buys in our income and defensive stock sectors, this is the first time in quite some time that we have eliminated tobacco stocks from the mix.  They are still safe sectors to hide in during market sell-offs, but the risk/reward is reaching above our parameters for the investors with a 5-year or longer horizon. 

The move takes of Altria Group Inc. (NYSE: MO) from the mix, and frankly we are not even adding Reynolds American Inc. (NYSE: RAI) nor Lorillard Inc. (NYSE: LO) currently.  The moves would easily be remedied if these share prices correct, but our belief is that the domestic tobacco market has too many headwinds in the future.  The good news is that none of them are legal.  It is a healthier move as more smokers are dropping out of the population, either by death or by the more preferable method of realizing that continuing to smoke will cause death.

Dow Jones gave some figures that show pricing power this morning, but some could perhaps argue that this is the industry banding together.  Lorillard was shown to be passing on a $0.06 per pack hike, while a nickel hike was coming from Altria and Reynolds.  Frankly, this price hike in our belief is only going to drive away that many more smokers even if it is just a marginal hike.  That hike, and then  some, will be passed on to Joe Public.  States, cities, and counties keep turning to tobacco sales for higher taxes as well.

Price hikes are now the only way that tobacco companies can grow earnings and cash flow enough to allow for higher dividends and continued share buybacks.  Case volumes keep shrinking and costs ultimately can only be cut so much.  We also still wonder about the risks of the nasty labels, even if that now appears to not be as large of an issue ahead right now. 

So, our take is not that the dividend game is yet entirely over.  At the current pace, we could see one more dividend hike. Maybe 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%.

We do not see a jeopardy of these being in the defensive stock category for traders, but the stock prices have just risen too far for us to recommend these for long-term dividend investors.  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. 

Still, what happens the year that one of the tobacco giants says “We cannot afford to hike our dividend this year, but we hope to next year.”  That will be the end. These tobacco stocks, except for Lorillard, are just too close to their consensus price targets as well.

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.

Lastly, we are not full of panic here.  If Altria came back closer to $25.00 or if Reynolds reach back down to $35.00 or so, the we would not hesitate a reconsideration.  We have just seen these shares rise and rise and the yield opportunities are better elsewhere.

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JON C. OGG