Home>Video>Peters' Favorite Long-Term Dividend Pick

Peters' Favorite Long-Term Dividend Pick

Sun, 27 Jul 2014

Planned consolidation should contribute to better pricing power in this shrinking industry, but one name stands out among the rest.

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Video Transcript

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. I'm here today with Josh Peters, editor of Morningstar DividendInvestor and also our director of equity-income strategy. We'll talk about some potential mergers in the tobacco industry, and what it could mean for dividend investors.

Josh, thanks for joining me.

Josh Peters: Good to be here.

Glaser: Let's start off with the news that Reynolds is looking to acquire Lorillard. What's the impetus behind this deal? Why do you think of the number-two and number-three players in the U.S. are trying to combine?

Peters: I think honestly it comes more out of addressing each firm's weaknesses as opposed to trying to capitalize on strengths. In Lorillard, actually you've got a very strong business, but their number-one product is menthol cigarettes sold under the Newport brand. The brand has been growing, gaining market share, and actually increasing volume somewhat over time which is really unusual as the whole industry shrinks 3% or 4% a year. Plus, they've got the pricing power that the industry has in general. It's been a phenomenal growth story as well as an income story, but the government could simply decide to ban menthol additives in cigarettes in which case, it's hard to see exactly what would be left that anybody would want to own at Lorillard.

In Reynolds' case, they have had a weaker market share trend relative to Altria, certainly, as well as Lorillard over time. A couple of their brands, Camel and Pall Mall, have done well, but it was really kind of hodgepodge. Reynolds was very much a product of multiple mergers itself, and in the aggregate they were losing share. So with this [potential merger], you are diversifying Lorillard away from that heavy dependence on menthol. You are getting this brand shuffle with many of Reynolds' current products being shuffled over to Imperial Tobacco--which is something people are almost barely aware of the fact that this is the fourth-largest company in the U.S. market--and creating what on the surface looks like a much stronger company with better market share trends going forward. Strategically it doesn't look like a bad deal.

Glaser: You don't own either of those names right now. Would you consider Reynolds-Lorillard combined? Is that something that would meet your standards?

Peters: Not yet. You have obviously a big deal premium that's being paid to Lorillard shareholders, and that's going to have to come out of Reynolds. They are going to have to execute this transaction. They are taking on a fair amount of debt. They are looking for a lot of cost savings. Now, maybe they will get them very quickly; maybe there could be some integration problems. In general, when you look at an industry and say it's consolidating--you've got the number-two and number-three players in this case, becoming just a single number two--that should benefit pricing for everybody. And certainly in this case, you don't look at the combined Reynolds and Lorillard and figure these guys are going to start throwing their weight around in a price war or something like that. No, they are going to have big dividends to pay certainly as well as debt service to meet. I think the point is that you are going to see pricing power actually strengthen, and you can benefit from that by owning Altria, which I've owned for a number of years here, without having sort of the elevated regulatory or financial or execution risk that you'll have with this combined Reynolds and Lorillard, if the government approves the merger as is.

Glaser: Looking at Altria, is that something that's trading anywhere close to an attractive valuation in a market with not a lot of values?

Peters: That's been a tough one for all the tobacco stocks. Even before we got into this merger mania between Reynolds and Lorillard, the industry was looking fairly expensive. Altria lately has been trading a couple of dollars above our fair value estimate. It's not unreasonable; I think it's a stock that's worth holding. I am continuing to hold it, and my recommendations are very straightforward that way. If I say, "hold it," it means I'm literally holding it, even if I wouldn't buy it at this price.

But the industry retains some fairly attractive characteristics, and this next wave of consolidation that might be under way, I think, supports the pricing power that is really unique. Even with a 3%-4% decline in industry volumes, you have companies that have been able to put up, mid- to  high-single-digit earnings-per-share growth and dividend increases, with price increases, cost cuts and share buybacks. This isn't an industry that's going to attract a lot of competition. It's very highly regulated, and it's declining. People don't rush in where business seems to be going away. But it's going away very, very, very, very slowly, and I think that that creates the opportunity to collect a lot of cash from these companies through their dividends over time.

Glaser: Are there any other names in the tobacco space you think could be interesting?

Peters: Well, so far we've just been talking about the domestic industry here in the United States, which has some really attractive qualities to it in terms of the competitive landscape. If you go into other markets, things tend to be more fragmented. But Philip Morris International's actually the one that is my favorite pick right now. In fact, I might say not just top pick in tobacco, but top pick in general. Certainly, I'm aware of and sympathetic to the ethical concerns that a lot of people have when investing in these areas. I respect that. I just let DividendInvestor subscribers make their own decisions.

But with Philip Morris right now, you get a global industry backdrop that's becoming more like the United States, both in that volumes perhaps are peaking and starting to move down, but the pricing power is still there. And I think you're going to see more consolidation around the world in tobacco; that's going to support the pricing power.

So longer term I think it's going to be easier for Philip Morris to grow its earnings 7%, 8%, 9% a year than it is for Altria to keep doing that, and yet the yields are very close, kind of in the mid-4% range. So, we think that Philip Morris is a couple of dollars undervalued. Yes, you have some foreign currency risk, but you've also got a great deal of diversification operating in dozens and dozens and dozens of countries with significant operations. It's probably my best long term buy of any industry right now.

Glaser: Well, Josh thanks for your thoughts today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching. 

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