Tag Archives | Big Tobacco

Will “Safer” Cigarettes Save Big Tobacco Stocks?

Philip Morris International (PM) recently announced plans for a $680 million factory in Italy to produce less-lethal cigarettes.

Notice I said “less-lethal” and not “nonlethal.” Unlike the popular new e-cigarettes, which produce a nicotine vapor mist, the Philip Morris variety will contain real tobacco to appeal to smokers who crave the taste of a real cigarette. Though unlike with traditional smokes, the tobacco is heated rather than burned.

So, is this a big deal? Might Philip Morris’ efforts stem the terminal decline of smoking in the developed world?

Maybe … but I’m not buying it.

We’ve seen this before. In fact, Jeff Middleswart wrote about this very topic in Behind the Numbers this week. Writing about Reynolds America (RAI), Middleswart noted that:

“In 2000, RJ Reynolds rolled out the Eclipse cigarette, which was designed to heat the tobacco rather than burn it. The result was much less smoke and in advertising it claimed that was less harmful than other cigarettes. Studies did not substantiate that and states started to sue over the claims. RAI just paid Vermont $14 million to settle these claims.”

Oops.

Throughout 2013, I made the argument that tobacco stocks no longer represented an attractive investment on a value basis. I maintain two long-term positions in PM stock and Altria (MO) in a dividend-focused portfolio, but I don’t recommend adding new money to those positions at current prices.

Big Tobacco isn’t disappearing any time soon. It’s still a wildly profitable business, and tobacco stocks are some of the most reliable dividend payers traded on the market today. But anyone expecting tobacco stocks to deliver market-beating returns going forward needs to take a step back and look at the numbers.

Thankfully, Middleswart has done the heavy lifting for us. Writing again about Reynolds American in his Jan. 9 issue, Middleswart commented that Reynolds traded at a 7.6% yield in September 2002 and at a P/E ratio of just 40% of the broad market.

And today? Reynolds yields 5.2% and sports a P/E that is 90% of the broad market, roughly in line with its peers.

If you’re buying Big Tobacco stocks at current prices, then you are implicitly assuming that one or both of the following must be true:

  1. U.S. stocks — which are already looking expensive based on the cyclically adjusted P/E ratio (CAPE) — will command a significantly higher valuation than they do today.
  2. Tobacco stocks will trade at a substantial premium to the broader market.

Do either of these scenarios seem likely to you?

Again, I’m not a permabear on tobacco stocks. At this right price, I love tobacco stocks as consistent dividend payers.

But that’s the key; the price needs to be right. Tobacco stocks should trade at a substantial discount to the broader market given that they are in terminal (albeit slow) decline.

But what about e-cigarettes? Might they offer a source of new growth for the battered industry?

Yes, and in fact, they already are. But the e-cig market is not big enough to replace declining sales of traditional cigarettes. As I wrote last year, the era of regulation-free e-cigs is quickly coming to an end, and in any event, e-cigarettes only account for about 1% of total tobacco sales.

If you insist in owning tobacco stocks, then PM stock and Altria are easily the “cleanest dirty shirts” of the lot. Philip Morris International’s emerging-market business has a much longer shelf life than those of the domestic sellers, and Altria owns nearly 30% of SAB Miller (SBMRY), the diversified global brewer.

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 market insights, global trends, and the best stocks and ETFs to profit from today’s exciting megatrends. This article first appeared on InvestorPlace.

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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.

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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.

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