In stormy times, tobacco stocks generally stand out thanks to their inherently defensive character. Recent monetary easing and indications from various central banks indicate that the low interest rate environment is likely to continue the coming years. This is likely to force investors to seek for high yield returns.
With unique defensive characteristics including robust earnings growth, high profitability and therefore strong operating cash flows, tobacco companies pay high and secure dividends and run share repurchase programs.
Growing Cigarette Volumes in Emerging Markets
The quantity sold in developed countries is therefore likely to contract by around 2 percent per annum over the next five years. In emerging markets, in contrast, sustained positive volume growth of 1 percent per annum is expected, driven by faster population growth and increasing disposable income for discretionary consumption, which supports the penetration of branded products. Cigarette companies with the highest emerging market exposure are therefore best positioned. While profitability looks below average in these regions at present, volume leverage should further boost margins over the longer-term.
[Click images to enlarge]
source: Credit Suisse
Strong Pricing Power
The tobacco industry benefits from a unique pricing power in comparison to other consumer goods industries for a number of reasons.
First, the global tobacco market is highly concentrated. Beyond the closed Chinese market, which in 2011 accounts for 40 percent of worldwide volumes, the global tobacco market is dominated by the five largest tobacco companies; Altria (MO), Imperial Tobacco (OTCQX:ITYBY), British American Tobacco (BTI), Japan Tobacco and Philip Morris International (PM).
source: Credit Suisse
Increased health consciousness and tightening regulations, such as public smoking bans and taxation in many countries, are the main limiting factors of cigarette volume growth in developed countries. The industry is also facing display bans and plain packaging. Of course, tobacco makers have strong arguments to discourage either their implementation or spread.
There is no evidence that plain packaging would reduce smoking, and it is likely to encourage illicit trade and reduce government tax revenue. Another risk is higher excise taxes. Most governments seem to have learned that frequent moderate tax increases are the optimal way to both boost government revenue and discourage smoking without risking a significant swift of consumption into the illicit trade. Frequent moderate tax increases give tobacco companies plenty of time to pass on prices without materially hurting volumes.
As a result of regulations, advertising bans and brand loyalty, major changes in this competitive landscape are unlikely in the years ahead, and price wars, like the one that occurred in Spain in June 2011, are unlikely to repeat. Second, demand for tobacco products is extremely price inelastic as already mentioned.
For example, listed price increases due to underlying product price or tax increases barely affect consumer behavior: on average a 10 percent increase in retail cigarette prices results in a volume contraction of around only 4 percent. High brand loyalty and lack of substitute products add to this.
The high price of cigarettes in relation to their relatively low production costs results in generally high profitability: The earnings before interest, taxes, depreciation and amortization (EBITDA) margin of the large tobacco companies in developed countries stands at almost 40 percent. Moreover, cost synergies stemming from the integration of acquisitions in recent years, further streamlining of production processes and price increases are likely to push margins even higher in the coming years.
This, along with tobacco companies' efficient working capital management, enables them to generate high operating cash flows. These, combined with very low capex requirements, lead to very high free cash flows which can be used to distribute to shareholders via high dividend payments and additional share buybacks.
British American Tobacco (BTI) and Philip Morris International (PM) are the best stocks to own if you want to profit from exposure to emerging markets and dividend yields above 4%. Both stocks are at a similar valuation in terms of P/E, and are expected to grow EPS at double digit rates in 2012 and 2013.
In one of my dividend articles I already mentioned both tobacco stocks. In this article I answered the question why are they interesting.