Tobacco: Bad for Your Health, Good for Your Portfolio.

Summary:

The story of the two major American tobacco companies (RAI and MO) is relatively simple. They are an addictive product with highly inelastic demand. This fact creates steady earnings and great dividend yields at current prices. In my opinion, this is the best reason to own these two stocks either on their own or to provide balance for riskier portfolio positions. Currently, RAI has a slightly higher dividend yield at 8.53% vs 7.60% for MO. Given the uncertain economic times, owning a solid non-cyclical stock that will return cash quickly should prove beneficial.

Company Overview:

RAI is the number 2 manufacturer of both cigarettes and smokeless tobacco products in the United States. The number 1 manufacturer is Altria Group. In the cigarette market, RAI's premiere brands are Camel, Winston, Kool and Pall Mall which are produced by RJR Tobacco. In the smokeless tobacco market, the company's premiere brands are Grizzly and Kodiak which are made by its subsidiary Conwood. It has also recently introduced a line of Camel branded smokeless tobacco products which it plans to expand going forward.

Key Competitors:

MO (Altria) - Number 1 player in the industry. Owns the Marlboro brand in America.

LO (Lorillard) - Owns Newport brand.

Many smaller brands, notably deep-discount brands which have pricing power because they are not a party to the master settlement agreement (MSA). Without going to the nitty gritty this agreement is a multi-billion dollar legal settlement that raises production cost for the major manufacturers.

Industry Drivers:

Most obviously the tobacco industry is driven by the number of smokers. Secondarily, this number is driven by a number of factors, most notably legislative action to tax tobacco products thus driving up the price and a persistent and intense public health/awareness push to encourage people to quit smoking. Although this leads to a long term decline in total number of smokers, the overall inelasticity of demand ensures that this decline is gradual and that the tobacco companies can effectively raise prices to counteract the demand that is lost. As such the long term outlook, barring any drastic legislative actions (raising taxes by $100/pack or an outright ban) is for a long slow decline of the industry.

In my opinion it is unlikely that new product offerings or marketing efforts will be enough to counteract the scenario.

Key Assumptions:

1. Tobacco use will decline gradually over time.
2. No major new legal action.
3. Inelastic demand pattern holds.
4. Legislative action (including recent federal tax hikes) will not have large detrimental impact.
5. Beta from Google and MSN is accurate (.64) .
6. For the record Yahoo Beta is .55.

Valuation: DCF ~ $44

Opinion/Analysis:

Dividends. Dividends? Dividends! That pretty much sums up why I put RAI in my portfolio.

Despite the fact that the long term outlook for tobacco is one of persistent long term decline as the effects of public health campaigns continues to take its toll on demand, I believe the industry has quite a bit of life left in it for an investor seeking predictable cash flows. In my view, this predictability and steadiness of the returns, along with RAI’s goal of returning 75% of operating income to shareholders makes this stock and excellent play in a market that lacks clear direction.

Its non-cyclical nature and inelastic demand ensure continuing profitability on a long proven business model. I believe this will continue to hold true despite many of the negative factors hammering consumer demand such as huge and continually increasing unemployment. The only major threats I see for the tobacco companies are the possibility of another round of big legal attacks (as opposed to the constant, expected and most importantly priced-in lawsuits they currently face) or some drastic legislation from the new administration.

Disclosure: Long RAI and MO in my stock portfolio on kaChing (41% return over the past year). The portfolio is publicly available for anyone to view and/or follow.

Comments

[fortypercent:]

awesome.
41% in one year on the entire portfolio. a year like that when the market was being dissolved is awesome. if my entire holdings increase in value that much i will sell all and retire my career. i would then sit home in a bath robe and power etrade all day.

May 30 05:26 PM

[fortypercent:]

i think i can, i think i can

May 30 05:27 PM

[fortypercent:]

i've got a good position LO. they need to move their products overseas.

May 30 05:28 PM

[The Geoffster:]

I quit smoking 28 years ago. That anyone still smokes baffles me, but they're everywhere. Have you looked outside of any office building lately? I'm also heavy into MCD but I wouldn't eat there. I just wish they'd legalize recreational drugs so I could make money investing in that vice as well.

May 30 10:38 PM

[YoYoMama:]

Sorry, at some point you have to live what you believe. I cannot support companies who were accomplices to the deaths of people I love, or run companies I don't respect. So although I love dividends, I will not buy any tobacco, gambling, firearms or alcohol stocks. I don't own MCD, and I won't own Wal-Mart either.

Call me a prude if you will, but there are just too many other choices to feel good about to buy a stock you might feel iffy about.

May 31 08:15 AM

[fxmaven:]

I would welcome more regulation for tobacco in the US. This way advertising budgets could be cut to zero and the difference paid out as dividends or invested in stock buybacks. Also MO is an industry leader slashing costs and raising prices to benefit shareholders. Selling off the New York HQ as relocating to VA to cut costs and realize the real estate gain was a brilliant move.

May 31 08:34 AM

[oscar13:]

Very good article, I have owned Mo, and Rai for a few years, and the dividends are consistent. Dividendmachine is correct in his assessment

May 31 08:38 AM

[mbkelly75:]

My wife smokes and I do not. As tobacco costs rise, she has cut down on her smoking, but can not seem to quit. We solved the expense part of the problem by purchasing enough tobacco stocks that the dividends are paying for her habit with money left over for re-investment so our dividends continue to increase. It worked for us! LOL!!

May 31 10:50 AM

[whisperonth...:]

mbkelly75, as a smoker I agree with you. And I did the same thing with oil trusts. Because I like to drive, I have enough dividends coming in from the oil trusts that they cover all the taxes I might have to pay on them plus all my gasoline, oil change, and general maintenance costs I might have. All the extra goes back in. Yeah, play the game so you get what you need, what you want, and some left over for the kids to inherit.

May 31 01:23 PM

[longandshort:]

I believe the whole processed food industry will be in the same boat as the tobacco industry, in that lawsuits and govt taxation will follow for "health" reasons, its just the tobacco industry is making money too easily and quickly right now and is an easy target. I still think MO is an amazingly run company.
....Looong MO!

May 31 11:49 PM