Big Tobacco Strikes Out in Q2

Earnings season for Big Tobacco has come and gone once more and the results were generally mediocre. Has the industry lost its ability to grow? Not enough that it’s in danger of losing its top billing as a dividend darling.

Analyzing the quarterly earnings of the five biggest publicly traded tobacco companies, I’ll tell you what matters and what doesn’t from their reports.

My first look is at Philip Morris International (NYSE:PM). Several things dragged down its second quarter — the main ones being the currency effect and an EU region that saw volumes decline 10% year-over-year.

Despite the weakness in Europe, it managed to hang on to market share in the region thanks to the strength of its Marlboro brand. The company estimates that the strong British pound will reduce annual earnings in 2012 by at least 25 cents a share. Still, it expects earning of at least $5.10 a share.

And with its Russian, Indonesian and Asian businesses making huge market share inroads, there will be plenty of free cash flow in the coffers to pay its healthy dividend.

British American Tobacco (NYSE:BTI) experienced some of the same ups and downs in the first half of 2012. Its performance was more muted, though, with volume and revenues that were flat compared to 2% and 7% increases at Philip Morris.

However, its net profit increased by 3% in the first two quarters to $3 billion. Cigarette manufacturers are routinely raising prices to make up for dwindling volumes and emerging markets should also help take some of the sting out of Western Europe and the Americas.

Like Philip Morris, it’s been busy buying back 18 million shares in the first half. A combination of higher prices, emerging markets and share repurchases should keep its earnings per share growth from stalling which is good news for dividends.

At first glance Altria (NYSE:MO) appears to have hit a home run in comparison to its European counterparts. However, included in its first half numbers in 2011 was a $627 million charge related to a proposed settlement with the IRS over taxes on lease transactions carried out by its financial services subsidiary, Philip Morris Capital Corporation. As a result, revenues and income were $490 million and $137 million less respectively.

Add those back in and revenues and earnings for the tobacco-related businesses are relatively flat. Saving the day is its 27% interest in SABMiller (PINK:SBMRF), which saw equity earnings increase 116% year-over-year to $743 million. Without the big boost from the beer business, it too would have little to cheer about.

Interestingly, Reynolds American (NYSE:RAI) had a much worse first half in terms of volume, shipping 7% less product. Yet its premium brands weren’t affected nearly as much as its value brands, which is the opposite of what many of the other cigarette manufacturers have experienced. Perhaps that’s why it was still able to increase earnings 5% excluding one-time charges.

Like all the other tobacco companies, the largest part of its business is suffering major shipment reductions. Unfortunately for Reynolds it doesn’t have emerging markets to make up the difference. That could become a problem in the future.

Last up is Lorillard (NYSE:LO), primarily the manufacturer of menthol cigarettes. CEO Murray Kessler suggested that the price increase this year came in mid-June instead of July 1, resulting in a reduction of inventory by wholesalers in the second quarter instead of the third.

As a result, it expects to have strong third and fourth quarters. Lorillard’s shipment volumes decreased by 2% in the first six months of the year — 90 basis points lower than the domestic industry in its entirety. Combine that with a 5% increase in its adjusted earnings per share and a 10 basis point increase in its market share and its business seems fairly sound.

Shipment volumes in the cigarette business have been shrinking for some time, but it’s a red herring. The bigger problem is figuring out when smokers are going to say enough is enough and reject these now routine price increases and actually quit smoking.

With emerging markets still thirsting for cancer sticks and Americans seemingly getting unhealthier by the day, the end of the road is far in the distance. For this reason, you won’t find yourself a better dividend play, despite the mediocre performance.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

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