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Summary

  • When discussing the tobacco industry, investors generally focus on Altria, Lorillard, Philip Morris, and Reynolds American.
  • Philip Morris sells internationally, while the other three companies are focused on the United States.
  • There are significant differences between domestic and international tobacco. As a result of these differences, the international companies may deserve to trade at a premium to their domestic counterparts.

The discussion of tobacco stocks tends to focus on Philip Morris (NYSE:PM), Altria (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard (NYSE:LO). These four companies are typically compared side by side despite there being fundamental differences in their business models. These comparisons cause some to reach an erroneous conclusion about Philip Morris's value relative to its peers. As most reading this are aware, Philip Morris sells exclusively outside of the United States, while the other three companies mentioned sell primarily or exclusively in the United States. Tobacco usage in the US has been declining for years, while worldwide tobacco consumption continues to rise. Since Philip Morris operates in a more desirable market, an argument could be made for it deserving a premium valuation relative to its domestic counterparts.

Comparative Valuations

Philip Morris

Altria

Lorillard

Reynolds

P/E

15.7

16.6

16.9

17.1

Estimated 5 Year Earnings Growth

7.4%

7.2%

10.5%

5.9%

Dividend Yield

4.43%

5.00%

4.24%

4.78%

PEGY

1.33

1.36

1.15

1.60

Using data from Morningstar, I created the above table to compare the four companies. On a P/E basis, Philip Morris, Altria, Lorillard and Reynolds American have relatively similar valuations. Companies are valued on more than their earnings for the past twelve months, so this is only a starting point. Earnings growth is an essential part to determining what a company is truly worth. Earnings growth is also the category where there is the largest difference between the tobacco companies. These four companies are expected to grow their earnings between 5.9% and 10.5% per year over the next five years. Lorillard has the highest growth estimates at 10.5% and Reynolds has the lowest at 5.9%. Altria and Philip Morris are expected to grow at 7.2% and 7.4%, respectively. Tobacco companies are often favored by income investors who value their dividend payments. When examining dividend yields, the results are again quite similar. These companies have established reputations for consistent dividend payments that increase over time. Finally, by dividing the P/E by the sum of the earnings growth and dividend yield, investors can see the dividend adjusted PEG, or PEGY, of each company. A PEGY of under 1.00 generally indicates an undervalued company. Primarily due to its lower growth estimates, Reynolds lags behind the other companies when using the PEGY ratio. When compared side by side, these companies seem relatively similar.

Since all these companies have considerable amounts of debt, investors should also consider whether they are able to meet their obligations. Looking at a company's bond ratings will give an investor a clearer picture as to whether or not the company can repay their debt. This article will be using Morningstar's bond ratings. Morningstar rates Altria's debt as BBB. Lorillard and Reynolds also have a BBB rating. Philip Morris has a slightly higher A- rating. According to Morningstar, a BBB rating indicates a moderate default risk. The A rating signifies a low default risk. While all firms will probably repay their obligations, Philip Morris presents the lowest default risk. All four of the commonly discussed tobacco companies also have similarly rated bond issues.

International vs Domestic Tobacco

The purported similarities between Philip Morris and the domestic tobacco companies quickly fade away when looking at their respective operating environments. Tobacco consumption is on the rise worldwide, but it has been declining for many years in the United States. While Philip Morris may not have the highest five year earnings growth estimate, its long term growth prospects seem promising when compared to domestic tobacco companies. The smoking rate in the United States has been declining for decades. According to the Centers for Disease Control and Prevention, 18.1% of Americans were smokers in 2012. For comparative purposes, over 40% of Americans smoked in the 1960s. Even after accounting for increases in the US population since the 1960s, there has been a dramatic decrease in the number of Americans who smoke. However, in many developing nations, the number of smokers is growing. Over the past three decades in China, despite the smoking rate declining from 30% to 24%, the number of smokers has increased by almost 100 Million. This increase can be explained by population growth. Many other populous countries are also seeing an increase in the number of smokers despite a lower smoking rate. Globally, the number of cigarettes smoked annually has increased 26% in the past three decades. Should this increase in consumption continue, international tobacco companies will greatly benefit. All else being equal, it's easier to grow earnings in an expanding market than a shrinking one. For that reason, Philip Morris has attractive long term growth prospects.

Regulatory risks are also far greater in the United States than other countries. It's no secret that the United States has adopted strict anti-smoking laws when compared to the developing world. Since the United States is effectively the only market for Altria, Lorillard, and Reynolds, new legislation could have a dramatic impact on their business. E-Cigarettes, once seen as the savior of domestic tobacco companies, have also been subject to recent regulation. Initially, e-Cigarettes could be smoked anywhere. However, they have recently been targeted by the same smoking bans that affect conventional cigarettes. Furthermore, in the past year, the FDA has been scrutinizing menthol cigarettes. While it is unlikely, should the FDA remove menthol cigarettes from the marketplace, it would take away a tremendous portion of Lorillard's sales. This action would be devastating to Lorillard and also have a significant impact on other domestic tobacco companies. For regulations to effect Philip Morris in a similarly devastating manner, it would require collaborative action by the legislative or regulatory bodies of many different countries. Obviously, that is far less likely to occur. Laws in the United States have not been friendly to tobacco companies, to say the least.

However, not all the differences are positive for Philip Morris and other international tobacco companies. For instance, Philip Morris is exposed to currency risk while domestic tobacco companies are not. However, it should be noted that this is not a major issue when compared to other problems facing tobacco companies. I would wager that if tobacco executives were given the choice of declining market size or currency risks, the choice of the latter option would be unanimous. Currently, exchange rates have been causing losses for Philip Morris. However, currency impact can work both ways and headwinds can quickly turn into tailwinds. Since Philip Morris conducts business in dozens of countries, they are impacted by the strength of the dollar relative other world currencies. The exchange losses imply that the dollar has been strengthening relative to the currencies Philip Morris receives in the course of its operations. Should the dollar weaken, Philip Morris will see its earnings boosted. Currency fluctuations are the main risk to Philip Morris that domestic tobacco companies do not face.

Conclusion

Despite comparable valuations, many differences exist between these four tobacco companies. Philip Morris is subject to a different set of rules, regulations, and market conditions than its domestic counterparts. While they face currency headwinds, they are subject to far less regulation and they operate in an environment where the number of smokers is expanding. Investors should consider requiring a larger margin of safety from domestic tobacco sellers. In the case of tobacco companies, similar valuations may not represent similar value.

Source: Big Differences In Big Tobacco