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Tickers in this Article: MO, RAI, LO
Tobacco companies are often considered the quintessential sin sector, but they are also regarded as a defensive sector and a good place to hide during market downturns. In addition, cigarette makers are generally great dividend payers, offering not only consistency but payouts that are excellent in dollar terms. All those high points aside, tobacco is one of the most controversial industries in the U.S. To say that government regulators don't particularly like the tobacco industry is to be kind. One might even argue that if federal regulators had their way, the tobacco industry might disappear altogether. (For more on sin stocks, see A Prelude To Sinful Investing.)

And that government regulation isn't going anywhere anytime soon. In fact, it's expanding. In June, President Obama signed what may be the most stringent tobacco legislation in history. Not only will cigarette makers be required to feature bigger, bolder warning labels on their products, advertising to young people will be limited and highly scrutinized. The legislation even goes so far as to grant the Food and Drug Administration (FDA) with the power to monitor and regulate the ingredients used to make cigarettes.

With earnings season upon us, let's take a look at how a trio of big cigarette makers may fare under the watchful eyes of Wall Street and Uncle Sam.

The Big Three Cigarette Makers

  1. Altria (NYSE:MO)
    One-Year Price Target: $21.85
    Dividend Yield: 7.6%

  2. Lorillard (NYSE:LO)
    One-Year Price Target: $79.83
    Dividend Yield: 5.4%

  3. Reynolds American (NYSE:RAI)
    One-Year Price Target: $44.33
    Dividend Yield: 8.6%
King of the Hill
Altria is the holding company for Philip Morris and the largest U.S. cigarette maker. The company makes Marlboro, among dozens of other brands of smokes, but the global strength of Marlboro might be enough to sustain any company. In terms of brand recognition, Marlboro is on par with Coke and Mickey Mouse as brand icons. The company also nearly cornered the market on smokeless tobacco when it acquired UST last year.

In a world where dividend cuts have become all too frequent, Altria yields 7.6% and the payout in dollar terms isn't bad at $1.28. Certainly Altria faces some strong political headwinds that may make the stock more of a long-term investment.

Altria reported second-quarter profits that were up 9% over the same quarter last year. The company has $2.56 billion in free cash flow and trades at just 9.3 times forward earnings, making it an appealing value proposition.

The Strong Runner Up
Reynolds American, the maker of Camel and Winston among other brands, plays second fiddle to Altria in terms of market share, but that doesn't mean investors should overlook the stock. Not with a dividend yield of 8.6% that translates to an annual payout of $3.40 per share. However, just like Altria, Reynolds American faces a spate of legal issues and recently had to contend with an appellate court ruling that nailed the company for a 2007 Camel magazine ad. However, Reynolds did just report that its second-quarter profits surged 4% over 2008. Reynolds American is another tobacco stock trading at reasonable levels (just under nine times forward earnings) and it has $1.42 billion in free cash flow.

A One-Trick Pony
While Lorillard does make several brands of cigarettes, it gets the bulk of its sales from the menthol brand Newport. That's not such a bad thing, considering that Newport dominates the market for menthols. Lorillard's dividend yield of 5.4% is lower than those of its aforementioned rivals, but the payout is tidy at $3.68 a share. Lorillard could be a riskier play than its peers because the FDA is investigating claims that menthol cigarettes are unhealthier than other varieties and that category accounts for 90% of the company's sales.

The company reports second-quarter results on July 27 and analysts are expecting $1.42 a share in profits. Lorillard missed first-quarter estimates by 5.2%, but beat fourth-quarter 2008 estimates by almost 12%, so there's no obvious trend in terms of surprises like we see with Reynolds American. Lorillard trades at 13 times forward earnings, which is fair, but the stock may be the riskiest of the trio mentioned here.

Bottom Line: Addiction And Taxes
Two things are certain in the world of tobacco: People get addicted to the product and the government loves to tax tobacco. The excise tax on cigarettes rose from 39 cents a pack to $1.01 a pack earlier this year, and with the tens of billions of dollars in tax revenue the tobacco industry generates, the government won't be putting the sector out of business anytime soon. On the basis of less risk, stick with Altria and Reynolds American. (For ideas on how to invest without ignoring your morals, check out Go Green With Socially Responsible Investing.)

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