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Strong Opportunities Abroad In The Tobacco Industry

The recent troubles of the tobacco industry revolving around lifestyle changes of US consumers en masse has led investors to avoid the sector with the belief that the industry is in a terminal decline. Tobacco companies trade at a valuation discount to the overall market despite the fact that many companies within the industry are very rich in cash flow and have histories of providing strong returns for shareholders. While Tobacco consumption in the United States may be declining, there is still very strong demand for tobacco products in emerging markets, particularly in Asia. Late last year I published an article titled, "3 Tobacco Stocks With Dividend Yields Of At Least 4% That Are Poised For Gains In 2013" which outlined Altria (NYSE:MO), Philip Morris International (NYSE:PM) and Lorillard (NYSE:LO) as strong stocks for 2013. For the most part, earnings multiples for these companies have expanded and especially given the extended nature of the US stock market, I have looked abroad for potential Tobacco investments for 2014.

Swedish Match AB (OTCPK:SWMAY)

Swedish Match is a leader in smokeless Tobacco products while also producing cigars and related lighting products and is based in Stockholm, Sweden. Shares of the company trade in Stockholm, Frankfurt and on the OTC market in the United States. At the end of 2012, approximately 56% of the company's sales were denominated in the Swedish Krona. Some investors are concerned about the company's rather large debt load, however given the company's strong cash flow from operations combined with a relatively manageable maturity schedule and easy credit environment, the company will likely not have trouble fulfilling these obligations. Smokeless Tobacco trends in the United States are encouraging and the country is becoming increasingly important to Swedish Match's bottom line. The company has strong growth potential outside of its traditional markets of the US and Scandinavia through its 50/50 joint venture with Philip Morris named SMPM International. Recently, the company has been hurt by heavy price competition in its smokeless products, where lower pricing has hurt margins. However, the company is poised to take advantage of strong trends in smokeless Tobacco outside of its home market in Sweden. Furthermore, the company has a very generous dividend policy, targeting a payout of 40-60% of EPS annually and currently sports a dividend yield of around 3.6%. The company is trading at around 14.3x TTM earnings. Swedish Match could benefit in 2014 from an easing of competitive pressures in Scandinavia for its smokeless products, which should stabilize margins and support the company's bottom line.

Japan Tobacco Inc. (OTCPK:JAPAF)

As one of Japan's largest corporations and employers, it is important for the overall health of the economy; this is a fact that is supported by the Japanese Government's large ownership of the company. Based in Tokyo, Japan, the company holds around a 60% market share on the domestic Tobacco market. I am very bullish on the Japanese economy over the long term given Prime Minister Shinzō Abe's reform plan dubbed Abenomics, which is aimed at structural reforms of the Japanese economy supported by monetary expansion to bring inflation and increased competitiveness to Japan. One of the main ways in which Japan Tobacco may be affected by these reforms would be the privatization of the Japanese Government's stake in the company. This has the potential to significantly alter the shareholder base of the company and creates the opportunity for significant change at the company to boost margins and profitability. Nevertheless, Japan Tobacco is a very strong company with tailwinds that should be beneficial to the bottom line for years to come. The company trades for around 15.5x TTM earnings while providing a dividend yield of around 2.7% to shareholders annually. Given the Bank of Japan's aggressive monetary expansion, I would make sure that foreign investors in Japan Tobacco are prepared for further weakness in the Japanese yen, as currency fluctuations can have large effects on performance of a given investment. Japan Tobacco shares will likely benefit over the long term from management's continued commitment to returning cash to shareholders in addition to an increase in the company's earnings.

Conclusion

While the global Tobacco industry is under pressure given the adverse health effects of Tobacco products combined with lifestyle changes, there is significant opportunity for investors in Swedish Match and Japan Tobacco as they are uniquely positioned to grow profitability despite industry headwinds.

Source: 2 Foreign Tobacco Stocks For 2014