Quit smoking, but invest in Camels

Tobacco stocks aren’t for everyone. They require a certain ethical flexibility, since you are profiting from the sad sight of addicted souls puffing away outside in the winter’s chill.

But if you’re like me, those concerns just don’t compare to the allure of outrageous corporate profits and growing dividends. Nik Modi, an analyst at UBS, likely agrees: He upgraded his recommendation on Reynolds American Inc. (RAI-N32.22-0.39-1.20%) – the maker of cigarette-store.biz/online/camel – to “buy” from “neutral.” He also boosted his target price on the stock to $38 (U.S.) from $33.

He is actually bullish on tobacco stocks in general, thanks to a stable pricing environment in cigarettes, growth in the “smokeless” cigarette category and high levels of cash distribution. But he believes that Reynolds stands out, even next to industry heavyweight Altria Group Inc. (MO-N24.08-0.08-0.33%), which I own.

The reason: Reynolds has suffered from earnings headwinds over the past three years, but with a few problems solved its earnings growth on a per-share basis should now outshine its peers.

“Reynolds has communicated roughly $60-million in cost savings opportunities through the end of 2012, but we believe there is at least the potential for further cost opportunities that could provide upside to margins and EPS growth rates,” Mr. Modi said in a note.

As well, the company’s cash distribution story is particularly compelling.

“Over the past three years, Reynolds has distributed roughly 77 per cent of its net income to shareholders through buybacks and dividends,” Mr. Modi said. “We believe that this will rise to 95 per cent over the next three years driven by improved free cash flow generation (from better fundamentals and less pension drag) and leverage ratios at the lower end of the company’s target. We expect Reynolds to begin share buybacks in mid 2011.”

By comparison, he expects Lorillard Inc. (LO-N76.51-0.56-0.73%) will return 84 per cent of its net income to shareholders over the next three years, while Altria will return 75 per cent. This is particularly important, given that Mr. Modi derives his price target to a large extent on expectations that Reynold’s dividend will yield 5.7 per cent. Currently, the shares yield 6 per cent.