Traditionally, tobacco companies have offered investors some of the best cash returns on the market. A combination of high dividend yields and huge stock buybacks have led to investors receiving returns that in some cases have amounted to more than 10% per annum, excluding share price appreciation.

Tobacco

Big tobacco under pressure

However, a worrying trend is now developing within the industry. Big tobacco is under pressure to consistently increase dividends and continue buybacks to boost earnings-per-share while income stagnates as tobacco sales fall. With stagnating cash flows, the only way tobacco has been able to increase buybacks and dividends has been with additional borrowing. Currently, this is sustainable as companies have been able to keep earnings constant by increasing the prices of their products to offset falling sales.

Nonetheless, these companies cannot continue to raise prices indefinitely forever, and the rapidly rising piles of debt need to be serviced and eventually paid off. For example, Philip Morris International Inc. (NYSE:PM) is currently in the position where the company’s debts (liabilities) now far exceed assets. The company’s book value per share is in fact now negative to the tune of -$3.4. What’s more, at the end of the second quarter, total debt had grown by 30 percent year-on-year.

Over the same period, quarterly EBITDA fell 8.6 percent, as a number of uncontrollable factors hit the company, such as falling sales volumes, currency fluctuations and higher excise taxes – these factors are unlikely to abate over the longer term.

Tobacco companies facing risks

These risks are not just limited to Philip Morris International Inc. (NYSE:PM); both Lorillard Inc. (NYSE:LO) and Reynolds American, Inc. (NYSE:RAI) are also borrowing heavily to bolster cash returns to shareholders. Unfortunately, this has put Lorillard in an extremely precarious position, as the company stands to lose more than 90 percent of its revenue if the FDA move to ban or regulate menthol tobacco products. Additionally, Lorillard’s shareholder equity is already negative, and stood at -$1.85 billion at the end of the second quarter. Moreover, Lorillard’s debt-to-asset ratio was 107 percent at the end of the second quarter- suddenly Lorillard’s defensive tobacco reputation starts to fall away and the company actually looks quite risky.

Reynolds American, Inc. (NYSE:RAI) is in a similar position, however, the company’s true fiscal position is hidden by $8 billion of goodwill on the balance sheet, hiding the true extent of the company’s debt binge. Excluding goodwill, Reynolds’ shareholder equity is -$3 billion, or -$5.5 per share, while Reynolds’ debt to tangible asset ratio stands at 75 percent.  Furthermore, Reynolds is also at risk from FDA regulations on menthol products. 30 percent of Reynolds’ revenue comes from sales of the company’s Camel Menthol brand and loosing these sales would put serious pressure on the company’s cash flows. What’s more, it is likely that a 30 percent cut in Reynolds’ revenue would send interest costs on debt, as a percentage of EBIT from 10% currently to around 20-25%, ultimately forcing the company to borrow more to maintain its shareholder returns.

Overall, rising debt, falling sales and contracting cash flows are all factors that are now making the historically defensive tobacco industry, look increasingly risky.