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Altria Group Inc (MO), Lorillard Inc. (LO): Is Tobacco Still a Viable Investment?

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Altria Group Inc (NYSE:MO)Leading tobacco companies’ stocks have rallied in recent weeks. The recent adjustment to the Master Settlement Agreement with several states helped fuuel the rise. The adjustment gave these companies credit for their past settlement payments for the next five years. But beyond this latest news, are tobacco companies capable of growing sales? Are they still a viable investment? Let’s examine these issues.

Revenue of Altria Group Inc (NYSE:MO) slipped in the first quarter of 2013 by 2.1% (y-o-y). Despite the drop in revenue, its operating profitability sharply increased by 31%, which led to a sharp rise in its operating margin from 29% in Q1 2012 to nearly 39% in Q1 2013. The company continues to pay a high dividend, which reached a more than 4.80% annual yield. The rise in profitability could lead to a rise in dividend payments in the near future.

Altria Group Inc (NYSE:MO) maintained its high payout ratio that reached in the first quarter of 2013 nearly 63% – roughly the same as other leading tobacco companies’ payout ratio. In comparison, in the first quarter of 2013, Lorillard Inc. (NYSE:LO) had a payout ratio of 64%, the same as that of Reynolds American, Inc. (NYSE:RAI). Both of these companies also have high dividend yields of 5.1% and 4.94%, respectively.

The rise in profit margin is mainly due to the adjustments made to the Master Settlement Agreement, in which leading U.S tobacco companies were credited for the payments they made between 2003 and 2012. In the first quarter of 2013, Altria Group Inc (NYSE:MO) cut its settlement payments by $483 million. Due to this revised settlement, the company revised upward by nearly 6% its projected EPS for 2013.

But the company continues to report a decline in sales volume: in the first quarter of 2013, its volume of Cigarettes sold fell by 5.2% (y-o-y). Despite the drop in sales, the company still augmented its market share that reached 50.5% as of Q1 2013.

Reynolds American, Inc. (NYSE:RAI)’s net sales also fell during the first quarter of 2013 by 2.6% (y-o-y). But Reynolds, even more than Altria Group Inc (NYSE:MO), augmented its operating profit by 82%. Thus, its operating margin spiked from 25% in Q1 2012 to 47% in Q1 2013 (opens pdf). Much like Altria Group Inc (NYSE:MO), the sharp rise in the Reynolds’ operating profitability was stemmed from the credit it received in the Master Settlement Agreement that cut its state agreement payment by $204 million in the first quarter of 2013. Moreover, the company will be credited by approximately $1 billion over the next five years. This means, Reynolds American, Inc. (NYSE:RAI)’ operating profitability will remain high in the coming years.

So tobacco companies are more profitable and will remain so in the next few years. But will these companies be able to produce growth?

Reynolds’ volume of tobacco products sold fell in the recent quarter by 3.8% (y-o-y). The total domestic cigarette shipment volume declined in the first quarter of 2013 by 6.2%. So, Reynolds is outperforming the industry but is still showing a decline in sales. Reynolds also managed to augment its market share by 0.6 percentage points to reach 26.1%. But without growth in sales the company’s profits will eventually dwindle. Reynolds is trying to boost its sales by tapping into the E-cigarettes trend that is still small but growing. Altria Group Inc (NYSE:MO) is also expected to jump on this bandwagon this summer. This might eventually lead to a new source of revenue that could keep these companies’ growth in sales.

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