There is a global movement among the world's governments to crack down on cigarette smoking. Investors should not be distracted by a legal win in recent news for U.S. tobacco companies: governments around the world are proposing and passing tobacco regulations.
This interplay between societal health issues and individual rights leads to compromises that challenge the outlook for tobacco company profits. In light of this, investors should demand low valuations. Unfortunately, many of these stocks are trading at too high a valuation to compensate investors for these risks.
Tobacco is Discretionary, Too
Tobacco products are viewed as recreational by some and addictive by others. The truth is that some customers can curb their consumption in hard times. Thus, the idea that tobacco is an amazing recession-proof industry is faulty.
Philip Morris' (NYSE:PM) third quarter financial results demonstrated how tobacco products can be hit by an economic slowdown. Shipments of Philip Morris cigarettes to Argentina, Brazil, Colombia, Mexico and Canada fell 4.9% in the third quarter. Worse yet, shipments to European countries like Spain, Italy, France and Portugal declined eight percent.
Philip Morris CEO Louis Camilleri said, "Despite the difficult comparisons in the third-quarter, we remain confident that the fundamentals of our business are solid as a whole, which is testament to our progress, especially in our Asia and EEMA Regions."
However, in contrast to these declining sales, Philip Morris has seen strong growth in Asian countries like Indonesia, Thailand and Vietnam. Sales in these Asian countries overwhelmed Japan's declining sales for a slight 0.6% sales growth for Asia. The shipments of Philip Morris to the EEMA region (Middle East, Eastern Europe and Africa) rose 3%.
A Rare Win For U.S. Tobacco
A Washington-based U.S. Court of Appeals upheld a decision that frees tobacco companies from putting pictorial health warnings on cigarette packets provided by the Food and Drug Administration. The court's 2-1 decision found that the lower court ruling violated the freedom of speech of tobacco companies guaranteed by the first amendment.
The FDA asked for a full review against the decision given by a three-judge panel in favor of tobacco companies to block the mandate for showing the dangers of smoking. A statement made on behalf of the FDA said, "The first amendment does not need statistical proof of the extent to which the decline in smoking rates resulted 'directly' from the new health warnings."
Russia's Tobacco Crackdown
This U.S. decision in favor of cigarette companies is the exception, not the norm.
The Russian government has considered legislation that could ban smoking in public and advertisements of tobacco products, and would increase the excise taxes on tobacco by 40% between now and 2014. This legislation has been proposed in an effort to curb the rapid population decrease in Russia. It follows 8-fold tax hikes on cigarettes in the country. The passage of this bill and others like it in Russia would have a material impact on tobacco sales, because Russia is the second largest market for cigarettes behind China, according to the World Health Organization.
Big tobacco companies such as Japan Tobacco, Philip Morris and British American Tobacco (NYSEMKT:BTI) are fighting Russian regulation. These tobacco giants account for most of Russia's cigarette sales: Japan Tobacco has 37% of the market, 26% is held by Philip Morris, and 21% is held by British American Tobacco.
Australian Tobacco Regulations
Russia is following in the footsteps of other governments which have tighter regulations for tobacco products. Australia's tobacco products are now required to place images of cancer victims and gangrenous limbs on cigarette packs. The new government standards require images and health warnings covering seventy five percent of the front of cigarette packs. New packages are required to display unsettling images, including a skeletal man dying of lung cancer, an image of tongue cancer, or an infected foot. Additional warnings have to cover the sides of the packages and ninety percent of the back.
Health officials hope that the disgusting new cigarette packaging will dissuade more consumers from smoking. Australia's health minister, Tanya Plibersek said, "Young people are the ones most affected by the packaging and by the advertising, and no parent wants their kid to start smoking."
The remainder of the packaging, which is not covered in cautionary warnings, is required to be drab. According to state law, any trademarks or product names have to be in Lucida Sans font and the background of the packaging must be a specified greenish-brown hue. State officials will enforce these rules.
Similar regulations will appear in other countries. World Health Organization Director-General Margaret Chan said, "With so many countries lined up to ride on Australia's coattails, what we hope to see is a domino effect for the good of public health." Other nations including New Zealand, India, United Kingdom, Turkey, and Russia expressed interest in more severe plain packaging rules.
Warning: Tobacco Stocks are Pricey
Regulatory pressures and taxes will likely increase worldwide. As a result, cigarette and tobacco stocks should be much cheaper than other stocks in order for investors to consider them.
Yet, tobacco and cigarette companies are not cheap:
British American Tobacco
It also appears that cigarette companies are using unsustainably high dividend payout rates to keep investors hooked on yield. These dividends will not last forever since payout ratios above 60% leave little room for reinvestment or as a cushion for external shocks. If earnings decline or if governments initiate new restrictions, these payouts would be threatened. Only Universal has a sustainable payout ratio among all the listed dividend-paying tobacco companies. Comparatively, Universal is cheaper than these other stocks based on valuation. Universal is the only stock among this list that I recommend as an investment candidate.
Independent of personal conviction, investors should avoid tobacco and cigarette stocks based purely on investing prudence. Today's high to mid-range static valuations in this industry have not priced in the regulatory headwinds they face. Worse yet, many of these stocks are likely to see downward revisions to their dividend policies. Lowered dividends could be interpreted as a signal that management does not have confidence in firm operations, and can send share prices much lower.