Tobacco companies can help reignite your portfolio

Occasionally, the market gives investors the chance to buy great cash-flow-generating companies at prices significantly below their intrinsic value. We think one of those opportunities now exists for investors who do not mind holding firms that manufacture a harmful product. Facing challenges on multiple fronts, tobacco stocks have been dragged down with the market decline, despite the stability of their cash flows even during the recession. We believe there is now a compelling case for buying Altria, which we think has the most to gain from regulation under the Food and Drug Administration, and Philip Morris International, whose strong product portfolio and pricing power should position it well for long-term growth.

Favourable operating environment
The tobacco industry is conducive to wide economic moats. The market is fairly concentrated, with a small number of large players benefiting from significant economies of scale and generating high returns on invested capital. The addictive nature of tobacco products and strong brand loyalty have led to relatively stable market shares and have made it very difficult for smaller players and new entrants to replicate those scale advantages. New entrants would need to build manufacturing and distribution capabilities, and in the United States they are required to set cash aside for product liability damages, either by signing up to the Master Settlement Agreement or by putting aside cash in an escrow account. This has acted as a deterrent to new entrants in recent years.

Furthermore, manufacturers are the big winners in the tobacco industry. With few substitutes to tobacco products, a fragmented farming industry, and an oligopolistic structure, manufacturers claim the lion's share of the aftertax retail dollar.

Stern challenges
Despite operating in a favourable industry structure, selling an addictive product, and having the ability to generate strong free cash flows, tobacco companies have seen their stocks dragged down by the market in recent months. There are several reasons for this. The federal excise tax on cigarettes was increased April 1 from $0.39 to $1.01 per pack. Manufacturers have passed on the entire increase to customers by raising prices, and this could accelerate the decline in cigarette consumption this year. Given the industry's experience following the implementation of the MSA in 1998, and our estimate of demand elasticity, we forecast that cigarette consumption will decline 6%-7% over the next year.

Another head wind is regulation, as Congress has passed a bill giving the FDA regulatory control over the tobacco industry. In the short term, we do not expect this to have much of an effect, because the FDA will need time to build its new tobacco unit. In the long term, we think the bill may stabilize market shares through marketing controls, which should be a net positive for Altria but damaging to its competitors; this should solidify Altria's market dominance. Lorillard has the most to lose from FDA regulation, in our opinion. A panel will be set up to investigate claims that menthol cigarettes are more harmful than nonmenthol cigarettes. We think a menthol ban is highly unlikely, but with more than 90% of Lorillard's revenue generated in the menthol category, such a measure would be catastrophic for the firm.

We think the worst-case scenario for the industry under FDA regulation would be a reduction in the amount of nicotine, the addictive component of cigarettes, being forced upon manufacturers. However, it is likely that industry stakeholders would pressure the FDA not to implement such a measure. Just as smokers are addicted to tobacco companies' products, governments are addicted to the tax revenue the products generate. We estimate that total excise tax and MSA payments will be well in excess of $40 billion in 2009, or around 1% of all local, state, and federal taxes collected, and around two thirds of all excise tax receipts. In the case of the MSA payments to states, the states have in many cases already securitized that revenue and therefore are heavily reliant on the payments being made.

The risk of litigation still lingers over the domestic tobacco industry, although it has subsided significantly in the past few years. We expect financial penalties to arise periodically, but we think damages will be manageable.

How to play the tobacco industry
We think the downward pressure on tobacco stocks over the past 18 months has presented investors with an opportunity to buy the industry leaders. We think Altria has the widest moat in the industry, with a vast distribution network and collection of strong brands. In addition to Marlboro, Altria has the leading discount brand, Basic, so it should be well positioned to benefit from both short-term trading down and long-term trading up. Altria owns the two leading smokeless brands, Skoal and Copenhagen, which is helping it to migrate quitting smokers onto other tobacco products. At 11 times the firm's trailing-12-month earnings and a dividend yield of almost 8%, the stock is trading at levels not seen since the height of litigation risk earlier this decade. We expect the dividend to be maintained and to grow in the low-single-digit range over the next five years.

Although we think Lorillard's Newport is a very strong brand, the firm's exposure to the menthol category is a concern to us, given the threat hanging over that sector. We expect Reynolds American to underperform the industry because it has an older core customer demographic and we expect it to discontinue some of its peripheral brands.

Emerging economies such as Eastern Europe, Africa, and parts of Asia still offer growth opportunities. Smoking in those regions is rising, driven by growing populations and weak restrictions on smoking. The World Health Organization estimates that even if the proportion of the global population that are smokers declines 1% a year, there will still be 1.5 billion smokers by 2050, up from 1.3 billion today. Furthermore, some of the least penetrated international markets are those where populations are growing fastest, smoking restrictions are weakest, and the infrastructure has significant room for improvement. Litigation risk is lower in many overseas markets than it is in the United States because class-action lawsuits are less popular, and the process of bringing cases to court is often more expensive and cumbersome. In addition, there has been a long-term trend of trading up in emerging markets. This has created a positive mix effect for those companies with the strongest premium brands.

We think the best way to exploit the growth opportunities in international tobacco markets is with an investment in the industry leader, Philip Morris. The firm owns Marlboro in international markets, the only true global brand, and its product portfolio is skewed toward the premium category. While that may cause some short-term headaches as smokers trade down during the recession, it should position the firm for solid long-term growth. Philip Morris has a strong presence in emerging economies, and it is the price leader in most of its core markets. The company has joint ventures with Swedish Match in Europe and China National Tobacco in China, putting it in the pole position to exploit any lifting of government regulations in either of those regions, although we think it may take some time for those opportunities to emerge. We recommend investing at or below our $37.10 Consider Buying price.

We rate British American Tobacco similarly to Philip Morris: Both have wide economic moats, both have only a medium uncertainty rating, and their dividend yields are also closely matched, BAT at 4.5% and Philip Morris at 4.9%.