Lorillard is a Bad Deal for Reynolds American Investors

And then there were two.  Two of the three remaining American “Big Tobacco” companies announced today that they would be merging: Reynolds American (RAI) will be buying Lorillard (LO) for $27.4 billion, including debt assumed.

Reynolds and Lorillard combined have sales of $13.3 billion and a market cap of $55.3 billion as of yesterday’s prices, leaving Altria (MO), the maker of Marlboro and other iconic brands in the number one spot.  Altria has annual revenues of $17.7 billion and sports a market cap of $84.5 billion.  Breaking it out by market share, the new Reynolds will control about 42% of the U.S. cigarette market, Altria will control about 51%, and smaller and foreign brands will make up the rest.

I’ll be brutally frank here: I question the value of this merger.  Reynolds is paying a high price for what is, we should remember, a business in terminal decline.  As of yesterday’s close, Lorillard shares traded for 21 times earnings and at a dividend yield of only 3.8%—quite low by the standards of a tobacco company.

Let me be clear on something: I’m not necessarily opposed to buying stocks in industries that are in terminal decline.  Under the right set of conditions—barriers to new competitors, dominant market position, minimal need for new capital investment, ample cash flows for dividends and buybacks, etc.—stocks with shrinking businesses can be excellent investments.

But the key here is price.  An investment in a shrinking company only makes sense if it is priced at a deep discount to the broader market.  And Lorillard—as implausible as this is—trades at a slight premium to the S&P 500.

Forgetting price for a moment, the Lorillard deal also brings with it regulatory risk.  85% of Lorillard’s sales come from its menthol brands, and these have become a lightning rod in recent years.  The U.S. Food and Drug Administration has already banned most flavored cigarettes and reported last year that it believes menthol cigarettes contribute to youth smoking.

Reynolds is effectively making a $27.4 billion bet that the FDA will leave menthol cigarettes alone.  That seems reckless to me; it’s a bet with modest upside and potentially disastrous downside.

Is there a trade to make here?

Yes: Sell Reynolds if you own it and move on.

I’m not the biggest fan of tobacco stocks at current prices.  I have shares of Altria and Philip Morris International (PM) that I have owned for years as part of a dividend reinvestment strategy, but I haven’t invested any significant new money in these positions in years because I see better income options elsewhere, such as in REITs.

If you feel you must own tobacco stocks, then I would go with Altria or Philip Morris International.  While neither are fantastic bargains these days, neither have the potential regulatory time bomb that Reynolds does in its exposure to menthol.  At time of writing, MO and PM sport dividend yields of 4.5% and 4.1%, in line with RAI’s 4.3%.

This article first appeared on InvestorPlace.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 


Is the E-Cigarette Revolution Getting Stubbed Out?

Earlier this year, I asked if e-cigarettes would relight Big Tobacco’s prospects. My answer was an unequivocal “no.”

Rather than being a durable growth business for Altria (MO), Reynolds American (RAI) or Lorillard (LO), e-cigarettes seem to be yet another way to help people stop smoking—a trendier version of a nicotine patch or Nicorette gum, if you will. And because, as non-tobacco products, e-cigs were almost completely unregulated, they eroded another long-term competitive advantage for the existing players in the industry: high barriers to entry.

Outside of weapons, tobacco is probably the most regulated industry on the planet. An onerous regulatory regime favors large existing players with the size and political influence to navigate the red tape and has the effect of snuffing out smaller players and would-be upstarts. This is one of the reasons that, despite decades of punitive taxes and lawsuits and an ever-shrinking customer base, Big Tobacco is still wildly profitable. (In the special case of tobacco, the ban on advertising also give established brands with name recognition an insurmountable advantage over would-be upstarts.)

But in the wild-wild-west world of unregulated e-cigs, there are over 250 brands currently on the market and little or no restrictions on their sale or advertising. And in a shocking marketing failure for companies that are normally run like well-oiled machines, Big Tobacco largely botched the e-cig branding game.  As I wrote in June, Altria, the maker of the iconic Marlboro brand (among others) launched its new e-cig under the brand name Mark Ten.  Take a look at the brand’s website. There is no mention of Altria, Philip Morris, or Marlboro.

The unregulated free-for-all may be quickly coming to an end. The attorneys general for 37 states, Puerto Rico, Guam and the U.S. Virgin Islands have petitioned the U.S. Food and Drug Administration to regulate e-cigs as if they were tobacco products. Among their concerns are the attractiveness of e-cigs—some of which are fruit flavored like a hookah water pipe—to children and teenagers.  According to the Center for Disease Control, 1 in 10 high school students tried an e-cig in 2012.

And it’s not just American authorities.  On October 8, the European Parliament is expected to vote on a new tobacco directive that would treat e-cigs as a medicine and subject them to strict regulation.

We should have seen this coming. Call it an adaptation of Maslow’s Hammer: If all you have is a hammer, everything looks like a nail. After four decades of aggressively attacking tobacco smoking as a social ill, it its natural that regulators will clamp down on something that “looks like tobacco,” even if it is smokeless and likely no more harmful than my (admittedly excessive) coffee habit.

What does this mean for the industry?

Ironically, it’s modestly good news for Big Tobacco. Regulation should slow down the trend of smokers ditching their cigarettes for e-cigs. And within the e-cig universe, Big Tobacco will have a massive advantage over smaller upstarts. Altria knows a thing or two about navigating rough regulatory seas.  They can transfer that knowledge to their Mark Ten e-cig brand far more easily than a new upstart brand can learn it.

We need to keep a little perspective though. E-cigs still only make up about 1% of traditional cigarette sales, and cigarette sales continue to sink lower.  To the extent that tobacco is investable, it is a no-growth dividend and share buyback story. Tobacco is not—and never will be again—a growth story.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he was long MO. Click here to learn about his top 5 global investing trends and get your copy of “The Top 5 Million Dollar Trends of 2013.”  This article first appeared on InvestorPlace.

Should Tobacco Investors Fear the FDA?

The US Food and Drug Administration announces it is considering banning or strictly regulating menthol cigarettes…and the share prices of the companies that make and sell those menthol cigarettes take a tumble.  Haven’t we seen this movie before?

Midday Tuesday, the share prices of Altria ($MO), Reynolds American ($RAI) and Lorillard ($LO) were down by 2.8%, 1.9% and 4.1%, respectively, on the news that the FDA was considering stiffening the regulation on menthol-flavored cigarettes.  Apparently, despite decades of anti-smoking educational campaigns and prohibitively expensive taxation in many American cities, the flavored cigarettes encourage non-smokers to pick up the habit.  Who knew.

Lorillard took a bigger beating from the market than Altria or Reynolds American because menthol-flavored cigarettes make up a much bigger chunk of sales.  Newport—Lorilard’s premium menthol-flavored brand—is the top selling menthol brand and the second-largest-selling cigarette brand overall.

Should investors be concerned about this?

I wouldn’t worry too much about a menthol ban, per se.  We went through this same song and dance back in 2011.  The FDA made noise about banning or strictly regulating menthol cigarettes, which depressed Lorillard’s stock price—and created the conditions for one of the best trades of my career.  The FDA’s case—that menthol-flavored cigarettes taste better and thus encourage more people to smoke—is a weak one.  By the same logic a screwdriver should be illegal because the orange juice masks the taste of the vodka.  It’s hard to see something like this holding up in court.

But don’t mistake my downplaying of the risk of anti-menthol regulations for bullishness on tobacco stocks.  The last “menthol scare” created a fantastic investment opportunity in Lorillard shares because it made them fantastically cheap.  They traded for less than 12 times earnings and yielded nearly 7% in dividends.  Today, Lorillard changes hands at 15 times earnings and yield a much less impressive 4.7%.  Altria and Reynolds American sport earnings ratios that are considerably higher—and higher than the S&P 500 average—while also yielding about the same as Lorillard in dividends.

And while I believe this menthol scare will pass, there are other regulatory challenges that are likely to linger for a while—including the move to plain packaging.

I wrote last week that plain packaging laws attack Big Tobacco’s most valuable asset:  its companies’ brands.

Cigarettes in Australia now come in plain boxes with identical plain-type fonts on the front and grotesque pictures of cancerous death on the back; no logos or branding is allowed.  Aussie smokers have complained that their cigarettes now “taste different,” and early indications are that the rules are reducing cigarette consumption at the margin.  Most of the developed world is considering implementing similar plain-packaging rules.

Does this mean imminent death for Big Tobacco?  Of course not.  This is an industry that has survived decades of regulatory attacks and lawsuits and yet still goes about its business profitably.  But at the margin, plain packaging rules will erode the value of Big Tobacco’s business.

Tobacco stocks have had a great run over the past decade, beating the market on a total return basis by a wide margin.   But that outperformance was made possible by their cheap valuations and astronomically high dividend yields, and these conditions are not in place today.   If you want to buy Big Tobacco for its still higher-than-average dividend payouts, be my guest.  But be realistic and don’t expect the same kind of outperformance going forward.

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Can E-Cigarettes Relight Big Tobacco?

Has Big Tobacco stumbled into a new growth market in electronic cigarettes?

Well, sort of.  Use of e-cigarettes—which produced a smokeless water vapor infused with nicotine—is expected to more than double in 2013, which might ordinarily be good news for the major tobacco giants. Altria (NYSE:$MO), Reynolds American (NYSE:$RAI) and Lorillard (NYSE:$LO) are all active in the market or have concrete plans to be active. 

But the increasing popularity of e-cigs has come at the expense of the smoky originals.  By Morgan Stanley estimates, e-cigarettes replaced 600 million “stick equivalents” last year and will replace 1.5 billion in 2013.  Varying estimates have e-cigarettes accounting for 0.5% to 1.5% of all cigarette sales.

Growth is not something we’ve come to expect from the tobacco industry.  Yes, cigarette stocks have produced fantastic returns for investors in recent years, but these stock market returns have come even while unit cigarette sales have continued their drift lower.  American cigarette sales fell by 6.2% last year to 289 billion sticks; as recently as 2001, the number was well over 400 billion.

What does this mean for Big Tobacco and its investors?

The tobacco industry has been very effective at managing the economics of decline, much to the benefit of shareholders.  Altria and Philip Morris International (NYSE:$PM) were core holding of the Sizemore Investment Letter for most of 2010 and 2011, and our readers enjoyed fantastic returns driven by the relentless search for yield by investors in the low-rate world of quantitative easing.

There is absolutely nothing wrong with investing in an industry in decline, so long as the right conditions are in place.  As I wrote last week (see Are Coke and Pepsi the New Big Tobacco?), those conditions are:

  1. There should be substantial barriers to entry for new competitors.
  2. The company should be financially healthy (i.e. strong balance sheet, low debt).
  3. Management should be committed to rewarding shareholders via dividend hikes and/or share repurchases.
  4. The stock price should be cheap relative to the broader market.

How do e-cigs affect these criteria?  To start, they erode those all-important barriers to entry.

Outside of military armaments, Big Tobacco might be the most highly-regulated industry on the planet.  Though it sounds onerous, it’s actually quite good for the large existing players because it makes it virtually impossible for new upstarts to come in and undercut the established brands on price.

There is one big problem here.  The legal regime is still being formed for e-cigarettes, and right now it is something of a free-for-all that doesn’t necessarily favor existing Big Tobacco.  It varies from city to city or bar to bar, but e-cigs are also generally free of the indoor smoking restrictions that have helped to curtail tobacco use.

Would smokers be likely to pay a premium for an e-cigarette branded with the Marlboro label?  Maybe.  Maybe not.  But I’m betting the answer is no.

Rather than being a durable growth business for Big Tobacco, e-cigarettes seem to be yet another way to help people stop smoking—a trendier version of a nicotine patch or Nicorette gum, if you will.

Patches and gum did not destroy the tobacco industry, and neither will e-cigarettes.  But they may speed up its long-term decline.  According to the Wall Street Journal, e-cigarettes might have been a major reason that cigarette sales declined by over 6% last year rather than the usual 3-4%.

But in the end, the only aspect that matters to tobacco investors is how much of this is factored into current prices.  Remember, item #4 above—for an investment in an industry in decline to make sense, it has to be priced accordingly.  And right now, Big Tobacco stocks actually trade at a slight premium to the broader S&P 500.

I could be wrong, of course.  Rather than hasten the decline of traditional cigarettes, the e- variety may offer a real avenue for growth.  But given how quickly the industry is shrinking, it is hard to see any growth of this front offsetting the declines in unit sales.   And none of the above justifies a premium multiple.

If you’re looking for sustainable dividend growth at a reasonable price, Big Tobacco is not your best option at the moment.  As I wrote earlier this year when I called semiconductor maker Intel (Nasdaq:$INTC) my favorite “tobacco stock,” you’re a lot more likely to find value in Big Tech.

Sizemore Capital is long INTC.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

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