Why British American Tobacco plc And Imperial Tobacco Group PLC Could Be Considered A Safer Pick Than Lloyds Banking Group PLC

Traditionally, the tobacco sector has been a haven for those seeking reliable earnings and dividend growth. But more recently the effect of macroeconomic weakness on consumers’ wallets — combined with rising legislative action, from public smoking bans through to the introduction of plain packaging — has led to fevered speculation as to whether ‘big tobacco’ can be considered an attractive stock investment any more.

However, I believe that the industry is on the cusp of a strong recovery in 2015 and beyond, making the likes of British American Tobacco (LSE: BATS) and Imperial Tobacco Group (LSE: IMT) promising stock selections.

By comparison, I believe that banking goliath Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US) faces a much less secure future.

E-cigarettes to drive revenues skywards

The long-term outlook for the tobacco sector has improved markedly during the past 12 months as the potential of e-cigarettes has become apparent. The popularity of this new technology is expected to eclipse sales of regular tobacco products within the next 10 years, and both British American Tobacco and Imperial Tobacco have large exposure here through their Vype and blu labels respectively.

While this exciting new sub-sector has also faced growing calls for lawmakers to restrict the sale, marketing and usage of vaporisers, a number of studies this year has helped to ease the pressure. During the summer the Harvard School of Public Health failed to find that e-cigarettes necessarily lead to users taking up traditional products, and just last week the Cochrane Collaboration reported that the technology can help smokers quit or cut down their cigarette consumption by half.

And I do not believe that demand for regular cigarettes is dead and buried by any means, and expect sales in developing markets — responsible for the lion’s share of global off-take — to take off again once current cyclical troubles persist.

Combined with the fruits of significant restructuring at British American Tobacco and Imperial Tobacco, resulting in the closure of scores of local brands and an increased emphasis on revenue-driving labels, I believe that the earnings outlook remains strong for next year and beyond.

But Lloyds faces a more uncertain future

By comparison, banking heavyweight Lloyds still has to combat a multitude of headwinds as we enter the new year. Firstly, the extent of the legal penalties facing the firm is set to remain a mystery, particularly as the number of claims for the mis-selling of PPI and interest rate hedging products continues to climb higher. The firm had to hike provisions related to these issues alone by another £900m during July-September alone.

In addition, Lloyds — far and away the country’s biggest mortgage provider with a near-25% market share — faces the implications of a cooling housing market which has intensified in recent months. On top of this, the likes of Barclays, Royal Bank of Scotland and HSBC are all taking the hatchet to their mortgage rates in order to challenge Lloyds’ supremacy.

And as recent tests by the European Banking Authority (EBA) and Bank of England have revealed, Lloyds still has much work to undertake to bolster its weak capital position. The business scraped through the EBA’s minimum CET1 ratio target of 5.5% with a reading of 6.25%, while the Bank of England cautioned that Lloyds “remains susceptible to a severe economic downturn.”

Smoking dividends overshadow Lloyds’ own payout prospects

Indeed, I believe that Lloyds’ precarious capital ratio could put the kibosh on the firm’s plans to crank its dividend policy back into gear in the coming months. The company has been locked in discussions with the Prudential Regulatory Authority for months now concerning this issue but a decision is still to be made.

Even if Lloyds receives the green light, the company’s fragile balance sheet could see dividends fall short of expectations this year and next. A token dividend of 1.1p per share is pencilled in for 2014 by City analysts, and the bank is expected to ratchet the total payout to 2.9p in 2015, in turn yielding 3.8%.

But prospective dividends still lag those of British American Tobacco and Imperial Tobacco. The former is anticipated to lift shell out a final payment of 97.5p per share in 2014, driving the total payment to 145p and creating a yield in 2014 to 4.1%. And a full-year payout of 153.8p for 2015 creates a yield of 4.4%. Imperial Tobacco, meanwhile, is predicted to raise the dividend 10% to 141p for the year ending September 2015, in turn producing a chunky 4.9% yield.

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Royston Wild owns shares of Imperial Tobacco Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.