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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.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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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

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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The Russian Smoking Ban: Will It Snuff Out Big Tobacco Profits?

Life hasn’t gotten any easier for Big Tobacco.  Last week, Russia became the latest country to impose major new restrictions on smoking in public places.  Starting in June, Russians will no longer be able to smoke in restaurants, and cigarette advertising will be banned.

I have my doubts as to how strictly the ban will be enforced, but the fact remains that one of the friendliest countries towards public smoking just got a lot chillier.  According to the Wall Street Journal, 44 million Russians smoke, and they collectively account for 9% of Philip Morris International’s (NYSE:$PM) profits.  Japan Tobacco and British American Tobacco (NYSE:$BTI) get 11% and 8% of their profits from Russia, respectively.

Russians will not quit smoking overnight in response to the ban. That didn’t happen in the United States, and it won’t happen in Russia.  It may be years before it makes a serious dent in consumption.  But it does blow a major hole in one of the bullish arguments supporting Philip Morris International: emerging markets will not be growth markets for tobacco forever.  As countries reach higher levels of development, the costs to the health system prompts a crackdown.

We saw the same in China.  In 2011, China banned smoking in restaurants, bars, and in several other enclosed public spaces, though it is still legal to smoke in offices. But there are now plans to ban smoking in virtually all public place, New York City style, by 2015.

Again, we’ll see how strictly it is enforced.  Though China has no qualms with crushing freedoms of expression or religion, the right to light up a cigarette is one they seem to let slip.

Latin America?  Same.  Brazil, Argentina, Chile, and Peru all have bans in most indoor areas, and enforcement is starting to be taken seriously.

India?  You guessed it.  As of 2008, smoking was banned in most public places, though enforcement has been a little touch and go.

By now, you should be getting the picture.  Though enforcement varies from country to country, there is really no such thing as a “tobacco friendly” country anymore.  Everywhere you look, the noose is getting tighter.

Sizemore Insights readers know that I have been a Big Tobacco fan for a long time.  They tend to be dividend-paying powerhouses with consistent returns.  And like other “vice investments,” they tend to be priced as perpetual value stocks, which has made them an outstanding performer in recent decades.

But I don’t advocate buying tobacco stocks at any price.  Tobacco stocks have been a great investment precisely because they were cheap and no one wanted them.  But you can’t make that argument today.  In fact, if anything they have become trendy.

Last month, I wrote that At Current Prices Tobacco is a No-Go, and I want to repeat that sentiment today.  Domestic Big Tobacco stocks such as Altria (NYSE:$MO) and Lorillard (NYSE:$LO) trade at a slight premium to the S&P 500 earnings multiple.  That simply should not be.  These are companies in terminal, albeit gentle, decline.

And Philip Morris International, the “growth stock” of the bunch, trades at a significant premium.  Philip Morris trades for 18 times trailing earnings and yields 3.7%.  That is simply not a high enough dividend yield to make this stock worthwhile given the better alternatives out there.  “Boring” tech stocks like Intel (Nasdaq:$INTC) and Microsoft (Nasdaq:$MSFT) both offer higher dividend yields, as do most midstream master limited partnerships.

If Big Tobacco has a substantial price correction, then I might be interested again.  But for now, I consider these stocks as toxic as the cigarettes they sell.

Disclosures: Sizemore Capital is long MSFT and INTC.

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

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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The Playboy Leveraged Buyout, Two Years Later

Almost exactly two years ago, I wrote a short piece on Hugh Hefner’s leveraged buyout of Playboy Enterprises and commented that the company was transitioning away from its adult media businesses and into licensing and brand management.  Essentially, founder Hugh Hefner wanted to turn his company into something like a Dolce and Gabbana, but with an edgier reputation.

It’s easy to understand Hefner’s motivation.  The internet had taken a wrecking ball to his business model.  Magazine and newspaper sales are in terminal decline. (Remember, men buy Playboy Magazine for the articles. Really.)   And it’s difficult to turn a profit in adult media given that you’re effectively competing with free.

hefPlayboy Enterprises definitely had the pieces in place.  The Playboy bunny is one of the most recognizable brand logos in the world, and the robe-wearing, pipe-smoking Hefner is a brand in of himself.  Long after the 86-year-old Hefner passes, his image will have marketability.  It’s crass, but it sells.

Incidentally, Hefner is grooming his 21-year-old son Cooper to wear the robe and carry the pipe after he is gone, becoming the public face of Playboy.  Given that the company already has professional management currently led by CEO Scott Flanders, it’s not entirely clear what the young Mr. Hefner’s role will be other than attending extravagant parties with beautiful young women on each arm.  I suppose it’s a hard job for a young, red-blooded American male, but someone has to do it.

All joking aside, the young Hefner’s role will be extraordinarily important if Playboy Enterprises is to have a future.  Because now more than ever, the company is selling a feeling rather than a product: the aspirational image of the modern bon vivant. Think about the “most interesting man in the world” commercials for Dos Equis beer.  This is the image they are going for.  If Cooper Hefner is to sell the lifestyle as effectively as his dad, he has a large robe to fill.

So, how is the company’s transformation going?

Actually, not that bad.  Since taking control of the company in 2009, Flanders has cut the payroll by 75% and sold off some its older media businesses.  Revenues are down from $240 million in 2009 to just $135 million in 2012.  But profits have nearly doubled, from $19.3 million to $38.9 million (measured as adjusted EBITDA).

Playboy is distancing itself from what most people would consider pornography, ditching its video business and offering media without nudity.  The Wall Street Journal calls it Less Smut, More Money. The company even has an iPhone app and a SiriusXM radio station.  And of course, there was the popular E! series The Girls Next Door.

The company is hoping to go public again in 2014, but it’s going to have a hard time getting there.  Licensing only accounted for $62 million of its $135 million in revenues last year, and the magazine continues to lose money.  The company is in violation of its loan covenants and may get downgraded by Standard & Poor’s.  And Playboy Enterprises’ ability to grow and go further mainstream will be limited by its toxic association with pornography and by the general cloud of sleaze surrounding its image.

And if the company does go public again, institutional investors will not exactly be lining up to buy shares.  If tobacco, alcohol and gaming stocks are difficult to own in the age of political correctness, then imagine having to justify a social pariah like Playboy to the trustees of a pension plan, foundation, or university endowment.

I wrote last year that Not All Sin Stocks are Created Equal, and Playboy Enterprises is a perfect case in point.  Its brands have value, but its core businesses have no moats.  If the company is successful in cleaning up its sleazy image and builds its licensing revenue streams high enough to compensate for a failing print media business, then the company might have a future.  Whether that future is enough to sustain the lifestyle created by Mr. Hefner is another story.

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Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Whiskey and Beer Still Better Long-Term Bets than Wine

Constellation Brands (NYSE:$STZ), the world’s largest publically-trading winery, took an absolute beating yesterday when the U.S. Department of Justice torpedoed the Grupo Modelo (OTC:$GPMCF)Anheuser-Busch InBev (NYSE:$BUD) merger on anti-competitive grounds.

Kruk: Switched to whiskey.

Kruk: Switched to whiskey.

Given the wide variety of alcoholic beverage choices, the government’s move seems a little absurd.  Yes, roughly 80% of all beer drunk in the United States is sold by just four mega-brewers.  But I hardly see this as being risky or detrimental to the wellbeing of American consumers.  It reminds me of a (perhaps apocryphal) quote from the baseball player John Kruk.  When told by his doctor that he needed to stop drinking so much beer, Kruk smiled and said he would switch to whiskey.

If beer became too expensive due to monopolistic pricing, U.S. consumers might do the same.

But whatever you think of the government’s decision, Constellation was the biggest loser here.  Under the planned merger, Constellation would have had exclusive distribution and marketing rights for Corona and Modelo’s other beer brands in the United States (Anheuser-Busch InBev would have acted as the supplier).

Constellation needed this.  As I wrote in July of last year when the deal was initially announced, Whiskey and Beer are Better Long-Term Bets than Wine.

While wine is more popular than ever among American drinkers, it’s not the best business to be in at the mass-market level.  Think about it.  Off the top of your head, how many beer brands can you name?  A dozen or more without even having to strain?

Now…how many wine labels can you name?

Unless you are a true connoisseur, you would have a hard time naming more than one or two.  Outside of the elite Château Lafite Rothschilds of the world, the vast majority of wines have very little in the way of name recognition.

As I wrote in July,“Outside of, say, Coca-Cola (NYSE: $KO), beer and spirits are probably the most recognizable and valuable brand names in existence.  Not surprisingly, premium beer and spirits businesses tend to enjoy high margins and high returns on equity relative to their peers. [As a case in point, Diageo (NYSE:$DEO) enjoys a return on equity roughly double that of Constellation.]

“Wine is a different story.  The attractiveness of a given vineyard varies from year to year, and few have national or international brand awareness.  Wine connoisseurs know their favorite vintages, but there is little brand loyalty at the mass-market level.  For a company of Constellation’s size, wine is a much harder business to operate.”

After yesterday’s 17% drubbing, Constellation trades for 15 times earnings and 2 times sales.  This is not expensive by today’s market standards, but it’s far from cheap.

Constellation Brands (NYSE:STZ)

Constellation Brands (NYSE:STZ)

Before the Modelo-Bud merger was announced last summer, Constellation was a $20 stock.  The merger announcement caused the stock to nearly double in the six months that followed.  So without Modelo, is Constellation a $20 stock again?

Probably not.  But without Modelo, it’s certainly not a $40 stock either.

I would recommend avoiding Constellation for now.   In the world of booze stocks, there are better values out there.  My favorite today?  Dutch megabrewer Heineken (OTC:$HEINY).

At 20 times earnings, Heineken is far from cheap.  But it’s one of the best options today for getting exposure to the rise of the emerging market consumer, and particularly the rise of the up-and-coming African middle class.

Disclosures: Sizemore Capital is long HEINY.

SUBSCRIBE to Sizemore Insights via e-mail today.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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