Lorillard Inc. (LO), Reynolds American, Inc. (RAI): Can Tobacco Companies Sustain Their Growing Debt?

I am not ashamed to admit it–I think tobacco stocks are some of the best investments in the market. Without a doubt they have provided the best investor returns around. Even with increasing tobacco regulation all over the world, tobacco companies continue to outperform the rest of the market in terms of shareholder returns, profit margins, and sustainability.

However, in recent years a trend has been developing amongst tobacco companies. This trend involves buying back huge quantities of shares to strengthen earnings per share, as sales volumes fall, slowing down organic revenue growth.

For the most part the majority of these buybacks are funded through free cash flow, as tobacco companies have some of the best free cash flows on the market. That said, big tobacco is increasingly relying on debt to finance these buy-backs.

Net Debt

The increasing reliance on debt to fund buybacks can be seen most in Philip Morris’ and Lorillard’s debt position. Philip Morris has driven net debt up 300% since 2008, whilst Lorillard Inc. (NYSE:LO) has gone from a positive net cash position in 2008, to a net debt position of $1.4 billion in 2012.

Both Reynolds American and Altria have kept debt relatively stable over the past few years. However, since 2011, debt has risen 5% for Altria and 53% for Reynolds.

Constructed from the table above, this chart illustrates the worsening debt profile of the three companies. Lorillard Inc. (NYSE:LO) has swung from a net cash position into net debt, while PM has driven its net debt consistently higher!

On an individual basis, the debt profile of Philip Morris shows the company increasing both cash and long-term debt. Long-term debt is not rising as fast as net debt, indicating that the company has been relying on an increasing amount of shorter term financing over the past 2-3 years. However, over the same period, cash & equivalents have grown, but not enough to reduce net debt.

I have long thought that Reynolds American, Inc. (NYSE:RAI) was the most fiscally prudent of the four US tobacco companies. The company was working hard to reduce net debt until 2012, when it suddenly changed its course.

However, the company does still have a significant cash balance in relation to long-term debt, giving it one of the best looking balance sheets in the group.

Altria’s debt profile is one of the worst in the group, as I will explain further below.

The company’s long term debt has decreased over the past year, but at the same time so has cash – leaving the company with a worse net debt position. Altria has a relatively strong cash position, although not as large as that of Reynolds American, Inc. (NYSE:RAI), which to some extent offsets debt.

I have only managed to gather the complete set of data for Lorillard for 2011 and 2012.

This two year snapshot of Lorillard’s balance sheet does not provide much information, but it does show the company’s relatively large cash balance in relation to its net debt.

Debt Issuance/Reduction

This chart shows the debt movements across four companies. A negative figure is a reduction, while a positive figure is an increase in debt. Without a doubt, Philip Morris has issued the most debt over the five year period, followed closely by Altria, although Altria did slightly reduce its debt during 2012.

As I have already said, Lorillard has only started issuing debt in the past two years to supports the company’s dwindling cash balance. Reynolds’s has been reducing its debt from 2008-2011, but issued new debt in 2012, virtually wiping out all of its debt reduction activities.

Philip Morris has always issued debt and has not repaid any since 2008.

So, how sustainable is this debt?