Is The Tobacco Sector Up In Smoke?

Includes: BTI, PM, RAI
by: Drip Breakout


As a sector, tobacco is inherently consumer defensive and will not fade away quickly.

Although the sector is very high margin, recent tax, litigation expenses, and regulation threaten to erode big tobacco's lucrative trade.

Smoking has been on the decline in the U.S. for at least 30 years and this trend will likely persist in the face of an increased focus on health.

While worldwide consumption of tobacco is higher (at least in some countries) than in America, the future is uncertain regarding this trend.

I recently spoke with a colleague about the future of the tobacco industry both at home and abroad. As many analysts and health advocates alike accurately point out, U.S. tobacco consumption is at an historic low. This trend, as well as increasing costly litigation and government regulation, prompted "big tobacco" giant Philip Morris to spin-off its global operation into a separate company, Philip Morris International (NYSE: PM), leaving its domestic component rebranded as Altria (NYSE: MO).

Yet, despite current setbacks and the industry's ill effects on consumers, tobacco stocks proved very lucrative for long-term investors in the "sin stock" space. So given these variables, the question as (potential) investors is - where do we currently stand and what should be made from a money-making standpoint in respect to current industry trends? For the sake of this examination, let's discount Altria and focus on Philip Morris International and its prime global competitors.

Traditionally, income investors flocked in droves to tobacco seeking yield, and for good reason. The sector offered high yield, consistent payments, and solid income growth potential. However, like any stock these advantages were not entirely without risk. Much as in the past, tobacco companies were allowed to carry much more debt on their books than firms in other sectors due to high margins and an addictive product with a steady customer base.

However, this financial model has run into recent headwinds as a recent article in the Financial Times explains, Philip Morris has a debt addiction. In addition, "big tobacco" in recent years became the proverbial punching bag for a high tax / regulatory policy that runs the gamut in many countries - even outside the United States. Given the recent developments (in article) cited, Philip Morris International's dividend may be in trouble. Clearly, Philip Morris' recent debt woes should serve as a warning sign to the firm's competitors.

Second, tobacco companies, even in the face of stiff taxation and regulatory policies both at home and abroad, were able to offset economic adversity through regular price increases and increasingly "slick" marketing campaigns. Yet, arguably these long-term strategic efforts may be insufficient to overcome government efforts to increase public health and stamp out tobacco consumption.

So, let's go under the proverbial "hood" and take a brief look at some prominent key metrics. Currently, Philip Morris International's net margins weigh in at 27.3% (Source: Morningstar), British American Tobacco's (NYSE: BTI) at 25.6%, and Reynolds American (NYSE: RAI) at 19%. In terms of annualized (2013) total asset to total liabilities ratio, Philip Morris lists at 1.5, British American 1.2, and Reynolds at 1.5. Lastly, in terms of (quarterly) earnings growth, Philip Morris (-1.5%), British American (-1.3%), and Reynolds (-28.5%) possess regression, confirming a tell-tale sign of less volume and hence less consumption - not a positive sign.

Furthermore, particularly in the U.S. (but increasingly abroad) the threat of litigation looms large. Just recently, a jury awarded a widow punitive damages of $23.6 billion against R.J. Reynolds. And as a matter of record, high dollar judgments have become almost a matter of routine in the United States, hence a primary reason for the Philip Morris International spin-off-lawsuit abatement. However, it's only a matter of time before mass lawsuits pepper the international landscape as well - a considerable risk to investors.

Bottom Line

In summary, big tobacco, like any investment, carries its fair share of risks vs. rewards. The rewards include some of the highest margins of publicly traded companies, impressive regular payouts, and in some cases considerable economic moats. So, on the plus side many international firms offer the killer combo of growth and income potential. On the flip side, the perpetual threat of lawsuit, regulation, and high taxes must be counterbalanced with these perceived rewards. So in the end, investors need to approach potential investment with eyes wide open, think about a strategic holding, and keep up with the latest sector trends. Potential rewards are vast, but the risks may be greater.

Disclosure: The author is long PM, MO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.