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The stocks of the big three tobacco companies offer remarkably compelling yields. But those yields have spiked for the simple reason that tobacco stocks are as risky to your portfolio as tobacco is to your health. More than ever, the rough economy and stricter smoking laws are crimping cigarette demand and pushing customers toward cheaper brands.

I've questioned the durability of these tobacco dividends before, and I still can't countenance the risk inherent in these dividends, even as these companies remain committed to maintaining their payouts. Active investors may be able to benefit in the near term, but in general I believe long-term investors should stay away because of the legal and earnings risks facing these companies.

I've decided to focus on the following three stocks because they represent the largest pure-play tobacco stocks, controlling about three-quarters of the cigarette and chewing tobacco markets.

R.J. Reynolds ( RJR) slashed its 2003 profit forecast by more than half on April 25, citing price competition from discount brands. The maker of Camel and Doral cigarettes now expects to earn just over $3 a share this year, which compares unfavorably to its proposed dividend payout of $3.80.

Like its peers UST ( UST) and Altria ( MO), R.J. Reynolds looks inexpensive on just about every valuation metric. At Friday's close of $28.39, the yield of 13.4% is approaching an all-time high, and the balance sheet boasts $22.40 per share in cash.

On the other hand, cash and debt have been moving in the wrong direction. At the end of the most recent quarter, the $2.4 billion company said it had more than $3 billion in total debt (more than 40% of which will come due in the next two years). This will sap more than 60% of R.J. Reynolds' cash on hand, giving management less leeway to supplement operating earnings to finance the dividend.

Management has made some efforts to stop the bleeding, such as suspending its $1 billion buyback program authorized last February. But cost-cutting will do only so much, especially as I see the profit outlook getting worse before it gets better.

Altria is arguably the most financially sound company in the industry. I've combed through the company's notoriously detailed financial statements, which please even the most ardent transparency hound.

The company has beefed up its advertising spending recently to maintain its lion's share of the market. That dominance is made clear by the fact that despite four consecutive quarters of declining sales, the company paid out only 48% of its trailing 12-month earnings to shareholders.

But even at that pace, this 8.31% dividend looks dicey because Altria still controls just over 50% of Kraft Foods ( KFT), whose growth has also been sluggish and below expectations. With Kraft's sales more unpredictable than in past years and tobacco regulation coming under federal and state review, Altria is going to have to really cinch up its belt to keep its dividend at the level its investors have come to expect.

Like R.J. Reynolds, Altria has suspended its ($3 billion) buyback program until access to the commercial paper markets improves and the company's cost of borrowing comes down. Altria needs to conserve its $1.3 billion cash hoard in the event it needs to post bonds to cover situations like the Miles case in Illinois.

The Street currently expects Altria to earn $4.60 a share for the year, which would cover the $2.56 annual dividend (8.4% yield) almost twice. That's certainly safer than R.J. Reynolds, but Altria's guidance has been trending lower, and it bears noting that the company has generally trimmed its guidance within a couple weeks of R.J. Reynolds' warnings during the past year.

UST, parent company of U.S. Smokeless Tobacco, appears to be the weakest of the three top players in the industry. The company controls 74.3% of the smokeless tobacco market, but has been losing share in that core business area. Its total debt spiked to 74% of total assets at the end of the most recent quarter, and the company's balance sheet shows only $371 million of cash remaining and negative $1.52 billion of shareholder equity. Plus, UST has reported negative operating cash flow in each of the past two quarters.

The company's 6.4% yield may seem appealing, but that $2 annual payout will be difficult to afford without tapping its cash on hand.

UST's wine business represents about 12% of total revenue, but has shown very little growth lately. The division makes up even less of UST's operating income (3%), as margins on the business are lower than for tobacco.

In addition to facing the same litigation risk as the other major tobacco players, the company could also find itself fighting a new wave of legal issues over smokeless tobacco products, something that hasn't received much press yet. UST outlined two antitrust cases and one litigation case that may affect earnings in its recent quarterly release.
David Peltier is a research associate at TheStreet.com In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier welcomes your feedback.

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