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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. 


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It Just Keeps Getting Worse For Big Tobacco

The bad news just doesn’t stop for Big Tobacco.  The industry is no stranger to smoking bans, punitive taxation, and crippling lawsuits, particularly in the United States.  But life continues to get more difficult in much of the rest of the developed world too.  Let’s take a look at new developments coming out of the UK.

In June, the British Medical Association (“BMA”) voted in favor of banning cigarette sales to anyone born after 2000. The BMA is a doctors’ union, not an arm of the government, so its proposed ban has no legal teeth to it.  But this is the same BMA that successfully lobbied the British government to ban smoking in public places.  The UK’s Health Act of 2006, supported by the BMA, made smoking illegal in all government buildings, workplaces, and restaurants.

Whether the ban on British would-be future smokers passes or not, the handwriting is on the wall.  Western governments, saddled with unaffordable health costs, will not be letting up the pressure on Big Tobacco any time soon. And it’s starting to show up in earnings reports.  Last week, Philip Morris International (PM)  trimmed its earnings outlook for 2014, citing, among other factors, one of the most potentially devastating regulatory developments in decades: Australia’s plain packaging rules, which require all cigarettes, regardless of brand, to be sold in plain, white boxes with standardized font on one side…and a picture of a person dying of cancer on the other.

I wrote about Australia’s new rules a year ago (see “Judge Tobacco Stocks by Their Cover”), predicting that they would be very damaging to Big Tobacco’s branding power.  As I wrote then,

Longtime chain smokers light up for one very obvious reason: They are addicted to the nicotine. But for casual smokers — those who light up while drinking, for example — the experience matters, too.

I call it the “Rebel Without a Cause effect” … the devil-may-care image that goes along with smoking is part of what makes it pleasurable.

There is a certain appeal to Altria’s (MO) familiar Marlboro logo. But there is most certainly no romance in a plain white box with a picture of a diseased lung on the flip-side.

 Sure enough, Philip Morris CEO Andre Calantzopoulos noted that the rules were having an ill effect on Australian sales:  “With plain packaging, adult smokers do not quit more or smoke less. They do, however, appear to down-trade much more readily to lower price, lower margin brands and illicit products.”

The UK and Ireland are also seriously considering plain packaging laws, and several other countries are reported to at least be toying with the idea.

Even “vaping,” or the smoking of e-cigarettes, is under attack.  The U.S. Food and Drug Administration announced in April that it would be begin regulating electronic cigarettes.  And overseas, Britain’s equivalent of the FDA will begin regulating e-cigs as of 2016.  E-cigarettes—which are safer than traditional cigarettes because of the absence of carcinogenic tar—are actually illegal in Brazil, Norway and Singapore.

Remember, e-cigs were supposed to “relight” Big Tobacco as the transformative product that saved the industry from secular decline.  So much for that idea.

Where does Big Tobacco go from here?

I’m not predicting wholesale bankruptcy any time soon, and in fact, I still own shares of PM and  MO in a few dividend-focused portfolios I run. But I believe it’s important to be realistic here.  The industry’s ace in the hole—rising demand overseas to offset long-term decline in the developed world—is looking less and less reliable.  Even China—the world’s largest tobacco user by a wide margin—moved to ban indoor public smoking earlier this year.  It is only a matter of time before the regulatory vice is tightened further.

If you own tobacco stocks as part of a diversified dividend portfolio, I think it’s fine to continue holding your positions and to reinvest the dividends.  But I wouldn’t put significant new money into Big Tobacco any time soon, or at least not at today’s prices.  PM and MO trade for 16 and 19 times earnings, respectively, compared to an P/E of about 20 for the S&P 500.  Given the lousy growth prospects and the virtual guarantee of continued regulatory attacks, I would only recommend making new purchases of Big Tobacco stocks at much wider discounts to the market.

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. 

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The Great Whiskey Shortage: Who Benefits?

I have some truly distressing news to report: We’re drinking bourbon faster than distillers can make it.  Thus, unless demand abates or prices rise, we’re looking at a whiskey shortage.

As a whiskey lover, this saddens me.  But as an investor, it piques my curiosity.   Today, we’re going to take a look at how a whiskey shortage might affect distiller stocks.

Regrettably for those of us who like to live out the songs that Hank Williams Jr. wrote, there is no quick fix to the whiskey shortage.  Distillers can’t simply ramp up production to meet demand. In order to legally qualify as “straight bourbon,” whiskey has to be aged by at least two years, and higher end bourbons are often aged for a decade or more.  (For scotch, the aging is generally a lot longer; see “Diageo:  The Ultimate 12- to 18-Year Play.”)

Making it worse, there is a shortage of barrels needed to age the whiskey, which isn’t likely to be resolved for another two years.  The barrel shortage—and the skyrocketing cost of barrels that has resulted—have led to a battle in neighboring Tennessee over the legal definition of Tennessee whiskey.

Under Tennessee law, “Tennessee whiskey” must, like bourbon, be aged in a new, charred oak barrel.  Diageo (DEO), the world’s largest spirits company and the owner of the George Dickel Tennessee whiskey brand, is agitating for a law change that would allow whiskey aged in used barrels to qualify.  Brown-Forman (BF-B), owner of the iconic Jack Daniels brand, views this as close to sacrilege and is lobbying for the definition to remain unchanged.

All of this is being fueled by the surge in popularity of a spirit that, up until very recently, was considered a drink for old men and backwoods rednecks.

My tastes in liquor have always been stodgy and old mannish.  I like a good bourbon or scotch, and I could never get into vodka cocktails when they were popular.  Unless you’re James Bond—or a Russian gangster—there’s just something a little emasculating about being seen in public drinking a clear, flavorless spirit.  And let’s face it, vodka doesn’t complement a cigar well.

I’m not sure I like the fact that bearded hipsters have embraced my drinks of choice.   But as an investor, I’m very interested in how the whiskey shortage looks to benefit the stocks of the major bourbon distillers.

Suntory Beverage & Food Limited

Let’s start with Suntory Beverage & Food Limited (STBFY),which recently completed its acquisition of Beam Inc., formerly the purest play on bourbon.  Beam was the owner of the eponymous Jim Beam brand, as well as the higher-end Maker’s Mark and Knob Creek  and the lower-end Old Crow. Suntory is Japan’s leading spirits company, though most Americans will be unfamiliar with its Japanese whisky brands, such as Yamazaki and Hakushu.

[Note for booze snobs: Japanese whisky—like Scotch and Canadian whisky—is correctly spelled “whisky.” American bourbon, Tennessee whiskey and Irish whiskey are correctly spelled “whiskey.”]

Suntory’s Beam sells more than bourbon—its brands include Canadian Club Canadian whiskey, Teacher’s scotch whisky, Sauza tequila, and Courvoisier cognac, among others—but the Beam empire was first and foremost a bourbon story.

A whiskey shortage should mean better pricing for Suntory’s bourbon brands.  But unfortunately, this means relatively little for Suntory stock.   The Beam acquisition, while accretive to earnings, is small relative to Suntory’s size.  Beam’s sales make up about 12% of the combined entity’s sales.

As a general rule, I love booze stocks as long-term investments.  But Suntory is one that I would recommend avoiding.  It relies too heavily on a declining Japanese market, and any stock in Japan is subject to massive macro risk (see “Stay away from Japanese Stocks.”)

Enjoy Suntory’s fine selection of American bourbons. But avoid Suntory stock.

Diageo PLC

Next up is one of my very favorite long-term holdings: British-based Diageo PLC, the largest and best diversified spirits group in the world.

Diageo recently began marketing its Bulleit Bourbon and Orphan Barrel brand, making it a strong competitor in the small-batch, high-end segment.   Going a little more mainstream, Diageo also markets its George Dickel Tennessee whiskey and its Crown Royal Canadian whisky, which—while distinctly not bourbon—compete with bourbon among drinkers of sweet North American whiskeys.

Diageo will enjoy fat margins on its new premium bourbons.  Of this I have little doubt.  Yet, as was the case with Suntory, I don’t see this having a big impact on Diageo stock.

Diageo is best known for its Scotch brands, and specifically Johnnie Walker.  And even while bourbon is enjoying an American renaissance, most whisky lovers outside of America prefer scotch.  North American sales for all of Diageo’s products make up only about a third of Diageo’s revenues, but emerging markets make up about half.

Bourbon can be found in trendy bars in the developing world.  But it is still very much a niche product outside of America, and Diageo’s primary focus is on strengthening its scotch brands in these markets.

So, while I love Diageo stock and continue to recommend it for long-term investors, I don’t see the bourbon whiskey shortage having much of an impact on it.


The best-positioned stock to take advantage of the whiskey shortage is Brown-Forman (BF-B), the maker of Jack Daniels Tennessee Whiskey, the most recognizable name in North American whiskeys.  Brown-Forman also markets Southern Comfort and a handful of other smaller brands.

At the risk of offending whiskey snobs, Tennessee whiskey and bourbon are almost identical products and both suffer from the same factors causing the shortage.  And with Beam now under the Suntory umbrella, Brown-Forman is the only stock that can be thought of as even close to a pure play.

Brown-Forman is a wildly profitable company owing to its branding power.  Its return on equity was an impressive 37.5% in the trailing 12 months, and its operating margins a fat 32.3%.

But its current valuation—it trades at 31 times earnings—makes me pause.  At that price, you are implicitly expecting one of two things to happen:

  1. The American whiskey boom continues unabated for years…and isn’t replaced by something new and trendy.
  2. Brown-Forman will be acquired by a larger competitor (think Diageo or Pernod-Ricard (PDRDY)).

The first assumption is one I’d be hesitant to make given the whims of fashion.  And the second is even less likely.  Brown-Forman is family controlled, and in the past the company has very adamant about preserving its independence.

If Brown-Forman had a nice correction, I would recommend snapping up its shares.  But while we’re waiting for that to happen, I might instead suggest enjoying a Jack on the rocks this evening to start your weekend right.

This post 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. Join Macro Trend Investor today and start profiting from the powerful megatrends that are cresting across the global economy—and get ahead of the next macro trend to build your wealth for years to come.  Just $1.00 grants you your all-access pass!

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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.”


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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Pour Beam Down the Drain and Pick Up Some Diageo Instead

In case you had any doubts, it’s official. Diageo (DEO), the world’s largest spirits maker, will not be buying Beam, Inc. (BEAM) for its bourbon portfolio.

CEO Ivan Menezes said this week that Diageo would be expanding its existing portfolio of whiskeys and launching new ones, and adding for emphasis that “we don’t need to” buy Beam.

I told you so.

Late last year, Diageo had recently lost its distribution deal with Jose Cuervo, leading to wild rumors that DEO would buy Beam for its tequila assets. Beam’s Sauza is the No. 2 global tequila brand by sales.

Apart from the obviously backward logic of buying a large bourbon distiller to get a relatively small tequila brand, Diageo would have a hard time swallowing an acquisition of Beam’s size. Beam has a market cap of $11 billion (Diageo’s is more than $80 billion), and after years of pricey purchases, DEO and its shareholders have acquisition fatigue.

Purists will point out that Diageo is still very weak in bourbon and that acquiring Beam — and its Jim Beam, Maker’s Mark and Knob Creek brands — would fill that gap. Diageo currently only has one bourbon brand, Bulleit, and it is a relatively small player.

All of this is true, but there are a couple points to keep in mind:

  1. Bourbon is a very small market outside of the United States.
  2. Most drinkers make litter distinction between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky.

Per the first issue: Yes, the United States is the single most important market to be in globally. That’s not changing anytime soon. But it’s also a mature market and one where demographics are not necessarily moving in the right direction. Younger drinkers tend to prefer vodka cocktails, not whiskey.

And in any event, DEO is focusing its expansion efforts in emerging markets, where it plans to get more than half of its revenues by 2015.

Diageo’s scotch brands, such as Johnnie Walker, tend to be far more popular overseas. Most emerging-market consumers have literally never heard of bourbon. Try ordering one in a bar in South America or the Middle East and observe the confused look on the bartender’s face.

This brings me to point No. 2.

There are plenty of aficionados out there who take the distinctions between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky seriously. In Kentucky, you might be required to give satisfaction in a duel for confusing bourbon with neighboring Tennessee whiskey. (I’m joking … Sort of. )

But all three whiskeys have a sweet flavor (as opposed to scotch’s smoky flavor) due to their use of corn as a major ingredient. And most drinkers are only vaguely aware that they are different products. I have no stats to confirm this, but anecdotal experience has shown me that 95% of the patrons in any bar in America wouldn’t know that Jack Daniel’s (a Tennessee whiskey), Jim Beam (a bourbon) and Crown Royal (a Canadian whisky) are different types of whiskey.

And on top of all that, Diageo is planning on expanding its bourbon offerings anyway.

This is a long way of saying that Diageo CEO Menezes is absolutely right.

Diageo doesn’t need Beam.

And that causes a little problem here. You see, Beam has had an elevated valuation for years in the belief that it would be acquired by Diageo or Pernod Ricard (PDRDY). Beam trades for nearly 30 times earnings, compared to 20 times for the larger and better diversified Diageo.

My advice? Pour BEAM down the drain and stock up on DEO.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DEO. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar, but also which stocks will deliver the highest returns. This series starts Nov. 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

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