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. 


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.

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.

Investing in All Things Naughty

It’s so good to be bad—at least when it comes to investing.

Vice stocks are a corner of the market where many investors—and particularly professionals—are afraid to venture.  But this reluctance by many investors to embrace vice stocks is precisely what makes them such profitable investments (seeThe Price of Sin).  Because professional investors like to avoid being associated with merchants of death and peddlers of peccadillo, these companies tend to trade at discounts to the broader market and often pay substantial dividends.

Some areas of the vice world—in particular tobacco and firearms—have moats around their businesses that mafia dons or drug lords would envy.  Government regulation and a hostile legal regime make it almost impossible for new company to set up shop in these businesses.  The compliance costs would prevent them from ever getting off the ground…and the first lawsuit would bury them.

Today, we’re going to take a look at five high-profile vice stocks and evaluate their investment merits.

We’ll start with Diageo ($DEO), the London-based premium spirits giant.   Diageo just reported earnings growth of 28% year over year, helped along by rising U.S. booze consumption.

Most of the chatter today revolves around improving U.S. sales, but the real story is in emerging markets, where Diageo already gets 40% of its revenues and soon expects to get more than half.  Diageo sees “soft spots” in some of its key emerging markets, most notably in Brazil and China, but this is a short-term, cyclical cooling.  Diageo’s future lies in the developing world, and the long-term secular trend towards rising consumer incomes is here to stay.

Diageo is also a serial dividend raiser, boosting its dividend every year since 1999 (Note: dividends are paid in British pounds, and the gains can be masked when translated into dollars.)  Diageo raised its dividend by 9% this quarter and currently yields 2.6%.

Diageo’s core scotch whisky business has some of the best competitive moats I’ve seen.  Scotch isn’t even technically “scotch” until it been aged by 3 years, and you can’t command premium pricing until it has been aged by at least 12 years…if not 25.  Few would-be competitors have the patience or the bankroll to sink large sums of money today into a project that won’t be profitable for a decade or more. (SeeDiageo: The Ultimate 12- to 18-Year Investment”)

Diageo currently trades for 18 times earnings, making it a little on the pricey side.  This is a stock that should trade at a premium to the broader market and one that I expect to outperform the market over time.  But you might want drip into this one slowly or, better, wait for a pullback before making any large new purchases.

Next on the list is one of my very favorite long-term holdings, Dutch megabrewer Heineken ($HEINY).  Heineken, along with Anheuser-Busch InBev ($BUD) and SABMiller ($SBMRY), is a global enterprise with a portfolio of beer brands that covers every inhabited continent.

You might be surprised to see me this bullish on Big Beer.  After all, beer is a mature industry in the United States and Europe and growth—where there is growth at all—tends to be centered on smaller “micro brew” brands, not the big names you see advertised at the Super Bowl.

This is where Heineken’s geographic reach comes into play.  Heineken already gets about a quarter of its profits from Africa.  Think about this for a moment.  Africa is the least developed region of the world, and the last real “frontier” market of any size.  It also happens to be a rare pocket of growth in an otherwise moribund global economy and a region where incomes are still rising.

Topping it off, a disproportionate amount of alcohol consumed in Africa is of the homemade moonshine variety; in some countries the number is more than half.  As incomes rise, these drinkers will trade up to branded beer and spirits.

As Africa moves up the income ladder, the 25% of profits that Heineken already earns there will explode.  Consider Heineken a long-term investment in the rise of the African consumer.

Heineken is considerably cheaper than its Big Beer peers, trading for just 10 times trailing earnings and 1.7 times sales.  As a point of comparison, AB InBev trades for 20 times trailing earnings and at 3.6 times sales…and also lacks Heineken’s exposure to Africa.

No list of prominent vice stocks would be complete without mention of cigarettes.  Big Tobacco is a true pariah industry and the quintessential vice investment.  Unless prohibited for religious reasons—as is common with Islamic investment funds—many socially-responsible investors will give alcohol a free pass.  Not so with tobacco.

This is precisely why Big Tobacco has been such a profitable investment over the decades.  Because they have limited potential for growth and are largely forbidden to advertise, tobacco companies have huge piles of cash to distribute as dividends.  And because many investors shun the sector, the cheap valuations push the yield higher.  With dividends reinvested and compounded, Altria ($MO) is the most profitable company of the past half century, as Jeremy Siegel laid out in The Future for Investors.

Unfortunately, investors seem to have caught on, and much of what made Altria such a fantastic investment in years past no longer holds true.

At current prices, Altria yields 4.9% in dividends, which still makes it one of the biggest payers among large-cap American stocks.  But this is significantly cheaper than its five-year average of 6.5%, and it no longer trades at a discount to the broader market.  In fact, most Big Tobacco stocks trade at a slight premium to the market.

Tobacco stocks were fantastic investments for virtually the entire investing lifetime of anyone trading today.  But they were great investments precisely because they weren’t popular…and today, they are.

As compelling as the vice story is, Big Tobacco is best avoided at this time.

Next on the list is…ahem…”gentlemen’s club” operator Rick’s Cabaret International ($RICK).   The adult sphere is an interesting subset of the vice universe in that the economics are very different from the rest.  As I wrote earlier this year, adult media businesses like Playboy Enterprises have had a hard time competing with free and abundant competition on the internet and have had to change their business models.  Playboy is no longer a “publisher” but a brand management firm focused on selling its image and its bunny logo.  The jury is still out as to whether this transformation will be a monetary success.

Rick’s is a different animal altogether in that—as an operator of strip clubs—its economics are closer to those of nightclubs, bars, and restaurants.  Unlike booze and cigarette sales—which tend to hold up well during economic downturns—strip clubs are more sensitive to the health of the economy and to the permissiveness of corporate expense accounts.  That said, Rick’s revenues held up remarkably well throughout the lean years of 2008 and 2009 and have been growing steadily for the past several years.

Rick’s is also reasonably cheap at 10 times earnings and 0.8 times sales.  And the company is reportedly considering spinning off its clubs into a REIT, which, if successful, could give a nice jolt to the stock price.

Alas, Rick’s is not going to be investable for most people reading this.  Rick’s has a market cap of just $84 million and average trading volume of just 33,000 shares per day.  This is a tiny small-cap stock that few investors are going to be comfortable owning.  That said, the company does have some big-name institutional buyers, including CALPERS (California-Public Employees Retirement System) and Dimensional Fund Advisors.

And finally, we come to “merchant of death” Northrop Grumman ($NOC), a defense firm perhaps best known for its unmanned drones.

Of course, Northrop Grumman does more than just drones.  The company builds an array of defense systems and even offers logistical support and “cyber defense” systems.

I come across Northrop Grumman regularly, as it has popped up on the Magic Formula screen off and on for the past several years.  For those unfamiliar with it, the Magic Formula was a screen devised by hedge fund legend Joel Greenblatt to find highly-profitable companies trading at temporarily low valuations.  I’ve used the screen as a “fishing pond” for years and have found some real gems.

Northrop Grumman’s dependence on government contracts at a time when the government is broke and looking to downsize has dampened investor enthusiasm for the stock.  It trades for just 11 times earnings and 0.8 times sales.

Yet the company has managed to navigate a difficult political environment deftly and has kept its net income stable even while revenues have been slightly down.

Northrop Grumman recently hiked its dividend by 11% and has raised its dividend for 10 consecutive years.  The company also has ambitious plans to buy back about 25% of its outstanding shares by 2015, making Northrop Grumman a model of shareholder friendliness.  At current prices, the stock yields an attractive 2.7%.

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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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