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Are Coke and Pepsi the New Big Tobacco?

Earlier this year, I commented that semiconductor titan Intel (Nasdaq:$INTC) was my favorite tobacco stock.

I said this tongue-in-cheek, of course.  I am aware that Intel designs and manufactures microprocessors, not cigarettes.  But my point was simply that slow-growth (or even no-growth) investments, such as tobacco stocks, can be wildly profitable under the right conditions:

  1. There should be substantial barriers to entry for new competitors (what Warren Buffett likes to call “moats.”)
  2. The company should be financially healthy (strong balance sheet, manageable debt, etc.)
  3. Management should be committed to rewarding shareholders with rising cash dividends and, to a lesser extent, share repurchases.

But most importantly, even if all of these other conditions are met, the stock must be cheap.  Remember, if this is an industry in decline, you cannot pay top dollar for the stock and expect to have decent returns going forward.

Big Tobacco giants such as Altria (NYSE:$MO), Reynolds American (NYSE:$RAI) and Philip Morris International (NYSE:$PM) easily pass the first three conditions.  All benefit from the moats encircling the tobacco business (it would be all but impossible to start a new cigarette company today), all are financially healthy, and all solid dividend payers and growers.

Yet none is particularly cheap at the moment; all trade at a premium to the S&P 500’s earnings multiple.

Big Tobacco’s rich valuations these days are particularly noteworthy because tobacco is not just any run-or-the-mill no-growth industry.  It’s also a vice industry and perhaps, outside of firearms, the biggest of all social pariahs.

In many American cities, cigarette smoking is for all intents and purposes illegal.  Smoking in indoor public spaces like bars and restaurants is not allowed, and in the most aggressive cases (such as New York City) even smoking in outdoor public parks is prohibited.  But even where smoking is less persecuted, it’s not exactly welcome.

And this brings me to the crux of this article.  Princeton professor Harrison Hong and University of British Colombia professor Marcin Kacperczyk published an insightful paper in 2005 titled “The Price of Sin.”

The professors showed that social stigmas against investing in vice industries such as tobacco and firearms cause the stocks of companies in these industries to be depressed due to lack of institutional ownership.  No college endowment fund, foundation, or pension plan wants to be labeled a “merchant of death.”  As a result, vice stocks tend to be priced as perpetual value stocks and thus deliver market-beating returns over time.

So…by this rationale, wouldn’t Coca-Cola (NYSE:$KO) and Pepsico (NYSE:$PEP) be vice investments too?

New York Mayor Michael Bloomberg certainly seems to think so.  About the only thing he has fought as hard as tobacco is super-sized sodas.  His controversial ban on all sugary sodas larger than 20 ounces in NYC was tossed out in court, but he’s not throwing in the towel just yet.  His war against Coke and Pepsi will be a war of attrition.

And Bloomberg is not alone.  First Lady Michelle Obama has actively campaigned against soda consumption as part of her anti-child-obesity efforts. Calorie counts started appearing in menus a few years ago, and calls for assorted “fat taxes” have sprung up across various parts of the United States and Europe.  Japan—not normally a country associated with an obese population—started measuring the waist lines of its citizens in 2008 and requires diet changes for anyone deemed too fat.

How fat is “too fat”?  Try a 33.5-inch waist line for men and 35.4 inches for women.  I’m willing to bet that most of my readers would fall outside these bounds given that they are well below the American average.

Anti-tobacco laws did not spring up overnight.  It was a gradual process taking place over decades.  Smoking rates declined over time, driven more by changing attitudes than changing laws.

Is something similar happening to soft drinks?  Indeed it would appear so.  U.S. soda consumption fell in 2012 for the eighth consecutive year.  Even more foreboding, consumption per person is at the lowest levels since 1987.

Sales are still strong in emerging markets…for now.  But rising emerging-market incomes will only provide a temporary boost, if tobacco is any indication.  As incomes rise, so does health awareness.

But does any of this actually matter to Coke and Pepsi shareholders?  I made a strong case for slow-growth companies, and both Coke and Pepsi meet my first three criteria.  Both have enormous moats due to their branding power and global distribution (If you’re the investor of a new soft drink, you shouldn’t waste your time; Coke and Pepsi will bury you.) Both companies are financially healthy, and both have long histories of strong dividend growth.  On the dividend front, both Coke and Pepsi are proud members of the Dividend Achievers Index and major holdings of my favorite ETF: the Vanguard Dividend Appreciation ETF (NYSE:$VIG).

 Coke Pepsi

But what about price?  Coke and Pepsi have both seen price/earnings multiple contraction since the go-go days of the 1990s; for that matter, so has the entire U.S. stock market.

Yet both sport current multiples well above the market average of 17, making them too expensive to be “tobacco stocks.”  (Of course, tobacco stocks are too expensive to be “tobacco stocks” too, so at least they have something in common.)

marlboro_manPricing here is complicated.  Coke has what is by most accounts the most valuable brand in the world, and Pepsi’s brands are also quite valuable.  It is the value of these brands that allows the stocks to trade at premiums to the market even while their core products are seeing weak demand.  But then, 20 years ago, I might have said the exact same thing about the branding power of the Marlboro Man.  Altria still has branding power relative to its Big Tobacco rivals, but this has to be viewed within the context of a shrinking industry.

In other words, I don’t expect Coke’s brand, as iconic as it is, to justify a premium valuation forever.

Bottom line: It would appear that Coke and Pepsi are slowly transitioning into vice stocks, though they are not quite there yet based on valuation.  Both stocks pay solid dividends and have a history of growing their dividends.  But at current prices, I wouldn’t expect either to outperform the market by a wide margin.

And on a final note, I’m going to be a proper Texan by enjoying a Dr. Pepper with my lunch.

Sizemore Capital is long VIG

 

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Investing in Oz

In the world of finance, “Investing in Oz” is usually taken to mean investing in Australia.  But with the recent interest in the 1939 classic movie The Wizard of Oz, the phrase has taken on a whole new meaning.

In 2013, Oz is back in a big way.  Walt Disney Pictures, a division of the Walt Disney Company (NYSE:$DIS), is set to release Oz the Great and Powerful early next month.  The movie—which had a $200 million budget—is a prequel to the original Wizard of Oz and tells the story of how the Wizard, played by James Franco, originally got to Oz.  The Wicked Witches of the East and West are, respectively, played by Rachel Weisz and Mila Kunis.

But the Disney production is not the only game in town.  Summertime Entertainment, which is privately held, is producing a $60 million animated telling of the Oz story with the working title Dorothy of Oz.

Dorothy

Dorothy Gale, voiced by Lea Michele

While the live-action Disney movie is getting more attention at the moment due to its imminent release, Dorothy of Oz may end up being the larger money maker.

The producers put together a cast that includes Glee star Lea Michele as Dorothy, Dan Aykroyd as the Scarecrow, Kelsey Grammer as the Tin Man and Jim Belushi as the Lion.

Smash’s Megan Hilty plays the China Princess, a new character not seen in the original Wizard of Oz, and Martin Short, Oliver Platt and Patrick Stewart also have prominent roles as new characters.  Much of the soundtrack is being recorded by singer-songwriter Bryan Adams.

Paying actors to voice an animated character is cheaper and more time efficient than paying them to stand in front of a camera.  But apart from having a production budget that is one fourth the size of Oz the Great and Powerful—and thus a much lower threshold for profitability—Dorothy of Oz could easily end up out-grossing its live-action rival.  Animated movies perform almost unbelievably well at the box office.

As NPR reported last year, there have been 70 computer-animated movies produced since the launch of Toy Story in 1995, and virtually all of them have grossed more than $100 million at the box office.  Animated films are also uniquely well suited for sequels, which often perform better than the originals.  And Dorothy, by the way, is the first of a three-part trilogy.

To throw out a few examples you might recognize, the Shrek franchise has taken in more than $3.5 billion, the Ice Age franchise $2.8 billion and the Toy Story and Madagascar franchises $1.9 billion each.

To put this in perspective, the entire Star Wars franchise, spanning six major movies over 35 years, has grossed only $4.3 billion.  The James Bond franchise, which has spanned 23 films over 50 years and six actors playing the starring role, has grossed $6.1 billion.

The children’s movie industry also has excellent demographics in front of it.  2007 was the largest birth year in U.S. history, even larger than the years of the post-World-War-II baby boom.  Those children born in 2007 are now 5-6 years old and finally old enough to sit through a movie.  They are also plenty old enough to nag their parents to take them.

But this is just the tip of the iceberg in the business of animation.  Though shrinking due to piracy and streaming services, DVD sales generally make up a large percentage of the total gross for a movie studio, and animated films tend to do particularly well in this area.  Revenues from DVD sales are often higher than revenues from the box office for animated movies.  Kids often re-watch their favorite movies multiple times per day, and a $15 DVD is often the cheapest babysitter a parent will find for their kids.

And this is nothing compared to merchandising.  If past animated films are any indication Dorothy of Oz has the potential to generate toy and merchandise revenues many multiples larger than its box office sales.

For example, five years after the 2006 release of Disney’s Cars, the movie had grossed $462 million at the box office.  But it had generated $8 billion in retail merchandise sales—seventeen times the amount it earned in ticket sales—and this was before interest in the franchise was rekindled by the sequel, Cars 2. New merchandise sales put the total well in excess of $10 billion…and counting.

Given the number of Lightning McQueen and Mater toys rolling around my house and the closet full of Cars-themed shirts and jackets in my three-year-old son’s room, I feel as though I have spent that much singlehandedly.  And most American parents and grandparents feel my pain.  (We didn’t stop with Cars, by the way. After Cars, my son discovered Toy Story.  We now own at least four Buzz Lightyear action figures, among many, many others…)

The Cars franchise was wildly successful, and not every animated movie can be expected to generate those kinds of returns.  As a case in point, consider the 2007 hit Ratatouille.  Though it was popular at the box office, kids weren’t exactly lining up to buy rat dolls after watching it.

Still, The Wizard of Oz is not Ratatouille. Including its original books, it’s been an American cultural icon for over a century, and its characters are highly marketable.  Dorothy stands to profit handsomely from this.  You don’t need to look behind the curtain to see the potential for a boom in all things Oz.

Note: To watch a preview of the movie and to get an early look at the virtual world planned, go to dorothyofoz.com.

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Sizemore on CNBC Asia: “Microsoft will Crush Google”

Watch me discuss Microsoft’s (Nasdaq:$MSFT) prospects and its potential financial lifeline to Dell Inc. (Nasdaq:DELL) with CNBC’s  Bernie Lo.



If you cannot view the embedded media player, see “Microsoft to Crush Google.”

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My Favorite Tobacco Stock is…Intel?

Yes, you read that correctly.  My favorite “tobacco stock” is Intel Corp (Nasdaq:$INTC).

Lest you think I’ve lost my mind, I am aware that Intel does not sell or market cigarettes or other tobacco products. Intel is the world’s premier designer and manufacturer of computer processors.

But while Intel is not a tobacco company, it most certainly is a tobacco stock, or at least it shares many of their characteristics.

This requires a little explaining.  If you’ve read some of my past posts, you are probably familiar with my reasons for liking tobacco stocks over the long haul, even if I recommend avoiding them at current prices (see The Price of Sin and Time to Stop Bogarting Cigarette Stocks).  Because of the social stigma associated with vice investments like tobacco, alcohol and firearms, many institutional investors shun them, either by choice or by socially-responsible investment mandate.  This causes sin stocks to be priced as perpetual value stocks, with the low valuations and fat dividends that this entails.

Well, I admit, in this particular respect Intel has nothing in common with tobacco stocks (even if it is priced like one at the moment).  It’s hard to find a scale by which Intel would be considered socially irresponsible. But let’s take a look at some of the other characteristics that make tobacco stocks—and Intel—interesting.

Tobacco companies have gargantuan barriers to new competition—what Warren Buffett might call an unassailable moat.   Given the legal and political risk and the size and scale needed to deal with both, it would be next to impossible to start a new tobacco company now.  You would need infinitely deep pockets and decades’ worth of political connections. As a result, Big Tobacco has become an entrenched oligopoly in which a handful of players—such as Altria (NYSE: $MO), Reynolds American (NYSE:$RAI) and Lorillard (NYSE:$LO)—completely dominate.

But even if you could start a new tobacco company, why would you?  It’s not exactly a business with a bright future.  In the developed world, tobacco is a business in steady but terminal decline.

This brings me back to Intel.  I’m actually in the minority among investors at the moment in that I see a bright future for Intel.  No, they haven’t figured out mobile yet, but they will.  As mobile devices become more and more sophisticated, they will need the power than only Intel can provide.  And there is also the server business, which accounts for roughly a quarter of Intel’s revenues.  Ironically, while Intel has yet to really break into mobile, its server business has benefitted handsomely as the mobile revolution has created greater demand for cloud services.

Yet this is not how the market views Intel right now.  No, Intel is a company resigned to gentle decline, as its core PC market inevitably shrinks.  From the way Intel bears talk, PC users are disappearing from polite company faster than smokers, forced to type on their physical keyboards in alleys behind buildings or in doorways.

For the sake of argument, let’s assume they’re right.  Intel would still be a buy at current prices.

As the Big Tobacco has proven for decades, companies in declining industries can make excellent investments under the right conditions.  If you have a dominant market position (think back to Warren Buffett’s “moats”), a conservative balance sheet, and have ample cash flow for share repurchases and dividends, you can do quite well by your investors even in a shrinking market. It’s worked for Big Tobacco investors, and it will work for Intel investors as well.

At just 9 times earnings, Intel is priced significantly cheaper than any major tobacco stock, and its dividend is competitive at 4.3%.  I might add that Intel’s dividend has risen by over 40% in the past two years and that its dividend still only accounts for 37% of (depressed) earnings.

Buy Intel and reinvest your dividends.  If I am right, Intel will regain its place among America’s most reputable growth stocks.  But even if I’m wrong, Intel is positioned to offer “tobacco like” returns for the foreseeable future.

Note: The “Intel is a tobacco stock” concept was conceived during a podcast interview with InvestorPlace Editor Jeff Reeves in which we each discussed our picks in the 10 Best Stocks of 2013 contest.  Jeff’s choice was Intel; mine was German luxury carmaker Daimler (OTC:DDAIF).

Disclosures: Sizemore Capital is long INTC and DDAIF

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