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Time to Quit Big Tobacco Dividends

Riding the U.S. tobacco gravy train has been one of the most reliable ways for an investor to get rich over the past century. Wharton’s Jeremy Siegel reports that Altria (NYSE: MO ) , formerly Philip Morris, was the best performing stock in the S&P 500 from 1957 to 2003. I believe him: They’ve been some of my best buys on CAPS.

But all good things — or bad depending on your perspective — must eventually draw to a close. Such is the case with U.S. tobacco stocks today. I think we are at a crossroads and it’s finally time to call ’em quits.

Quit your tobacco dividend addiction
U.S. tobacco stocks have historically appealed to investors because of their dividend yields of 5% or more coupled with reliable dividend increases. But now there is reason to think those dividends are — or soon will be — under pressure, and simply aren’t worth the risk anymore.

For the first time in the last decade, Altria’s free cash flow could not cover its dividend payments last year. America’s largest domestic tobacco company paid out $2.96 billion in dividends while only generating $2.6 billion in free cash flow. The gap was made up by the issuance of equity and debt.

Now, I’m sure an observant reader will point out that 2010’s result was an aberration due to a one-time $945 million Internal Revenue Service payment and that Altria’s continuing profitability cannot be judged by it.

I totally get that (and good for you for knowing that), but even if we add back the IRS payment, the free cash flow yield is a paltry 6.3%. That provides a dangerously thin margin to be supporting a 5.7% dividend yieldReynolds American (NYSE:RAI ) is in a similar pickle, supporting its own dividend yield of 5.7% with a free cash flow yield of 3.6%. Lorillard(NYSE: LO ) has more headroom.

There are better alternatives
Besides, a 5.7% yield (what Altria and Reynolds both offer, and Lorillard 4.7%) simply doesn’t cut it anymore. I can get that from safer telcos like Verizon Communications (NYSE: VZ ) or AT&T (NYSE: T ) , which sell their own form of addictive product. And unlike big tobacco, those two companies have ample free cash flow yields (a whopping 16.6% for Verizon and 8.1% for AT&T) to cover their dividend yields of 5.4% and 5.7%, respectively, while funding future growth.

Another alternative is junk bonds. Don’t laugh. Altria, Reynolds, and Lorillard are practically junk bonds themselves, since they have a risky future, pay out most of their expected return, and have, dare I say, a finite lifetime. Junk bond ETFs like the SDPR Barclays Capital High Yield (NYSE: JNK ) offer yields of around 8%. And they’re more diversified to boot.

Last but not least, what about Coca-Cola (NYSE: KO ) or PepsiCo (NYSE: PEP ) ? They’re trading at nearly identical free cash flow ratios as the tobacco companies (4.9% and 4.8%, respectively), which I’ve argued matters more than dividend yields. Why would I buy a moribund Altria or Reynolds when I can buy a Coke or Pepsi at a similar valuation? Plus you still get a roughly equal payout when you factor in share buybacks.

A picture is worth a thousand words
But there is another reason to stay away from U.S. tobacco dividends. Starting in fall 2012, tobacco companies will have to start putting horrific pictures on every cigarette carton. While I personally doubt this will have an effect on pre-existing smokers, I do think this will discourage a great many kids from taking it up. And without new customers, big tobacco and their big dividends eventually bite the dust.

The Campaign for Tobacco-Free Kids — an interest group that lobbies against tobacco companies — has put together an informative factsheet detailing the effectiveness of pictorial labeling requirements in the 35 countries that already have them.

More than 90% of Canadian youths report that pictorial labels make smoking seem less attractive. When a second set of pictorial labels was introduced in Thailand in 2006, 53% of smokers said it made them think “a lot” about the health risks, and 44% of smokers said they were “a lot” more likely to quit over the next month. When Brazil introduced new picture warnings, 67% of smokers said it made them want to quit. When pictorial labels were introduced in Australia, the number of smokers who called the quit line doubled.

Just Say NO
Like their products, big tobacco’s stocks are just too expensive and just too dangerous. These companies pay out most everything in a dividend, retaining almost nothing for growth, and 4.7% to 5.7% just isn’t a high enough return given the risk. There are better alternatives for your money

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