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Dividends and Big Tobacco

The industry is facing some disruption, but core cigarette businesses continue to perform.

Philip Gorham: Love them or hate them, tobacco companies pay big dividends, but it's been a rough ride this year, with the stocks more volatile than they have been in the past. And with the industry facing some disruption, now's perhaps a good time to review the sustainability of those dividends. 

Disruption is coming from the emergence of new products, particularly vaping devices. In the U.S., the FDA is clamping down on the marketing of vaping products. And if the vaping category is impaired as a result of that, we would generally see that as a positive for most of the tobacco industry. It may be attracting a new consumer, but vaping is highly competitive, economic moats are almost nonexistent, and margins are much lower than those of cigarettes as a result.

So if the category goes away, the consumer that switched to vaping, and perhaps dual-users of both products, may go back to smoking cigarettes, which remains a highly profitable, multi-cash-generative business that should be able to support dividend growth. Cigarette consumption is, of course, in decline in most markets. So growth is dependent on the company's being able to offset volume declines with price increases. Most markets, we think still have headroom for multiyear price hikes, and we expect that, that pricing power to drive earnings growth in the low single-digit range for the next few years.

However, economic road bumps, tax increases, or marketing restrictions can all have a usually temporary impact on price elasticity. So we recommend one of the globally diverse manufacturers in order to mitigate that risk. Those global players are yielding roughly between 5.5% to 7% yields currently. Philip Morris International is probably the highest-quality business. It has the leading position in higher-margin heated tobacco, and it's yielding over 5%. British American Tobacco is similar in size. It's a bit more skewed to vaping than heated tobacco, but with a 7% yield, it also looks pretty good value.

The company with the highest dividend yield is the UK's Imperial Brands, which is yielding 11%, and that's on the back of recent double-digit dividend growth and a pullback in the stock. We think this is probably the lowest-quality business of the group--it generally has weaker market positions. But while dividend growth will slow significantly to the low single digits in the near term, that 11% yield can't be ignored and the stock looks significantly undervalued. 

So, while the headlines have certainly not been pretty, and there will be substitute product in some form going forward, the core cigarette businesses are chugging along reasonably well, and that should drive cash flow and growth for several years to come.

Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.