Is It Time to Ditch Big Tobacco?

While it doesn't exactly elicit warm, fuzzy feelings, the tobacco industry has historically been both remarkably profitable and highly stable. Offering products for which demand is relatively inelastic, tobacco companies have managed to stay largely insulated from downturns in the broader economy, while paying out juicy dividends to shareholders.

But increasing regulatory pressures by the FDA and a recent court decision in Australia threaten the industry's future. Are big tobacco's best years behind it?

Stability and profitability
There are no two ways around it. Tobacco companies have posted the best returns for investors over the last decade, adjusted for volatility. Risk-adjusted return for tobacco companies over the past decade was 3.6% better than the next best performer, Internet and catalog retailers.

They also tend to offer a high degree of stability. In the past five years, growth in cash flow from operations has been remarkably stable. Margins have held up well, too, with the industry posting a median gross margin of 45% in its latest fiscal years. And most important, tobacco firms have had a consistent track record of sharing their profitability with shareholders in the form of a median dividend yield of 5.1%.

All in all, the big tobacco companies tend to be tremendous cash-flow generators and stable dividend payers, and have delivered consistently even through tough economic times. But can their success continue?

Headwinds for big tobacco
Regulatory agencies like the FDA certainly don't hope so. The Tobacco Regulation Bill, signed into law in 2009, has given the FDA new powers to regulate tobacco products. Under the law, the agency has the authority to set guidelines and standards, as well as to ban certain ingredients in tobacco products.

High taxes and restrictions on public smoking are also taking hold across the country, further deterring smokers. As a result, the incentives to quit are greater than ever, especially in major metropolitan areas like New York, where a pack of smokes will run you more than 12 bucks.

New York City also led the way with the Smoke-Free Air Act in 2002, which prohibits smoking in offices, bars, and restaurants. And last year, the city also banned smoking in parks, beaches, and pedestrian plazas.

With all these crackdowns on smokers in the U.S., tobacco companies have turned elsewhere in their aggressive search for profits. International markets, especially those in Southeast Asia, are proving to be big tobacco's holy grail. With growing and younger populations, significantly less regulation, and a cultural acceptance of smoking, countries like Indonesia (home to the infamous two-pack-a-day toddler) and the Philippines have become a haven for major tobacco companies. Sales volumes have soared.

But the outcome of a recent court decision in Australia has now put even these markets at risk.

Australia approves cigarette-pack logo ban
The land down under recently approved anti-tobacco marketing laws that will ban logos on cigarette packages. Starting Dec. 1, cigarettes and other tobacco products have to be sold in plain olive-green packets bearing graphic images of smoking-related illnesses, such as mouth and lung cancer.

The decision came as a major blow to companies British American Tobacco (NYS: BTI) , Britain's Imperial Tobacco, Philip Morris, and Japan Tobacco, which challenged the ruling on the grounds that it impeded their intellectual property rights.

While Australia is a relatively small market, the decision does pose a major risk for big tobacco. If the law is adopted as a standard in major markets like Brazil, Russia, Indonesia, and the Philippines, it could potentially lead to significant declines in sales volumes.

Countries such as Britain, Canada, India, Norway, and New Zealand are said to be watching the impact of the ruling closely and may consider similar initiatives if results from Australia prove encouraging. Some are expecting profits for premium-priced cigarettes to take a hit, since companies will no longer be able to brand their packages.

Final thoughts
Does all this mean that big tobacco's best days are behind it? I doubt it. But it does mean that investors need to differentiate among big tobacco companies now more than ever. While cigarette volumes in the U.S. are likely to continue declining or stay flat, the future looks bright for companies with substantial exposure to higher-growth emerging markets.

This is a major reason why I like Philip Morris (NYS: PM) , a company that has tremendous brand power, a sustainable dividend yield, and massive international exposure (its products are sold in around 180 countries), especially to less-regulated Asian markets like Indonesia and the Philippines.

Among domestically focused players, my favorite is Lorillard (NYS: LO) , the name behind the ever-popular Newport brand of menthol cigarettes. I think the company has the best prospects for earnings and revenue growth in coming years, along with Philip Morris. While competitors Altria (NYS: MO) and Reynolds American (NYS: RAI) were quicker to move into alternative smokeless products like snuff and snus, Lorillard was the first to move into the e-cigarette market, which may prove to be highly lucrative going forward. The company believes e-cigarette sales will grow faster than other alternative smokeless products because the action of smoking that many users enjoy is very similar to traditional cigarettes.

Another reason I like Philip Morris and Lorillard is because these companies have a solid track record of dividend growth. If you're searching for other solid dividend payers but want to avoid the stigma of big tobacco, The Motley Fool has put together a special free report outlining nine top dividend-paying stocks. You can access your copy today at no cost! Just click here.

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Fool contributor Arjun Sreekumar does not own shares of any companies listed above. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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