Wow, how one earnings report can change the view of a sector when analysts seem to suddenly change their tune. Few sectors have experienced as strong and steady a move up as the consumer staple sector, with tobacco stocks leading the way.
Within the tobacco stock sector, the most popular stock to invest in for quite some time has been Altria (MO). Rising from just $20 a share a couple years ago, Altria's share price surpassed the $30 mark this past month, before pulling back nearly 12% over the past month. Interestingly enough, despite the strong multi-year performance of the tobacco stocks, equities in this sector have sold off pretty hard over the past as some companies like Altria have issued earnings reports that were not to the liking of analysts. Given this pullback in a number of tobacco companies after Altria's earnings report, I think it is worth reexamining this company's earnings report, and looking at what if any changes in outlook for the industry over the next couple years are warranted.
The main reason that most commentators and analysts have given for the recent pullback in Altria it the recent fourth-quarter earnings report. I must say, as someone who wrote in a fairly lengthy article nearly a year ago about how I did not think Altria was a particularly good investment, I think the analyst commentary and subsequent price action have been an overreaction. While I maintain that a number of smaller tobacco companies, like Lorillard (LO), have more upside than Altria, I think that investors who are looking for dividends over the next 2-3 years have little to concern themselves with.
The most glaringly negative commentary about Altria's earnings report came from Barron's, a respected publication that is also known to sometimes echo the thinking of many in the hedge fund industry. In a recent piece, written several days ago after Altria released earnings, Barron's author Sandra Ward seemed to come close to declaring the tobacco industry a dead zone for investors.
Ms. Ward started her article by citing a Morgan Stanley analyst who has not recommended any of the big three tobacco names in the U.S. for three years. She stated that he is shockingly not currently recommending them because of difficulties these companies face in operating in the U.S. Of course, during the past three years, U.S. tobacco stocks have paid dividends of roughly 5%-7% a year, and have appreciated between 40%-60% without including the dividend. Nonetheless, she cited this author to suggest that the operating environment for tobacco companies in the U.S. has mysteriously become more difficult over the past six months.
Her main points to back this argument up were that Altria's flagship brand is not growing its market share, fewer people are smoking cigarettes today, and, with cigarette prices now at nearly $6 a pack on average nationally, tobacco companies will have a harder time putting through future price increases. Now, call me crazy, but I think anyone with half a brain could have made all these arguments three or four years ago.
The reality is that Altria's quarter was very strong, and the strength of Altria's latest quarter came in a very difficult economic environment. Altria may sell an addictive product, but it still sells a premium product that is priced higher than that of many of competitors. Despite operating in what I agree is a difficult economic environment, Altria's numbers were very strong by any metric.
Now the numbers. Altria's flagship Marlboro brand finished the year with roughly 42% market share in the U.S., down .6% from last year. Altria's smokeless and chewing tobacco brand, which together make up about 8%-10% of the company's annual revenue, grew their market share by nearly 7%. Also, while the company did see a modest 4% decline in volumes that was more than offset by price increases, the fourth quarter saw no volume decline whatsoever, and the price increases more than offset the volume decline for the year.
Finally, with Altria's average selling point nationally for its premium Marlboro brand at $5.73, the product seems affordable and appealing to many of its traditionally blue collar and younger smokers. Altria's adjusted earnings for 2011 were actually $2.05 a share, compared with earnings of $1.87 for 2010. The company also guided above most analyst expectations to the $2.17-$2.13 a share range for 2012.
Now let's talk about this argument that the business environment has become more difficult for tobacco companies because of increasing taxes and regulation, as well as concerns over litigation. As an attorney, I follow major developments in the litigation process at both the state and federal level very closely. Looking at recent legal and regulatory developments, I don't see any changes in the legal environment for the tobacco industry over the past year that have been anything but positive for these companies. I'm also not quite sure why these old arguments are suddenly relevant now.
The Department of Justice's multi-decade federal lawsuit against the big three tobacco companies was thrown out nearly two years ago. The States have already settled with big tobacco and are issuing tobacco bonds going out 10 years. Under the Master settlement agreement, the four largest tobacco companies have agree to pay $206 billion to state governments over the course of the next 25 years. The payments are prorated to each company's respective market share and revenue. While this number sounds big, it means companies like Altria pay a couple billion a year to state governments, and have no worries about future lawsuits from state governments in the future.
Also, under the agreement, states like Michigan get nearly $4 from tobacco companies between state taxes and payments they receive under the master settlement agreement. It doesn't take a rocket scientist to figure out that under this agreement, state governments, many of which have already issued tobacco bonds going out 10 years, have no reason to do anything but maximize the revenue they can get from the tobacco industry by allowing these companies to continue to thrive.
Also, the final significant legal challenge that big tobacco faces, which is individuals bringing civil suits seeking large punitive damages, is no longer a big area of concern for the industry. Individuals bringing their own lawsuits, collectively known as the Engle cases, have been dealt a number of legal blows at the appellate level over the last year. While most of these cases were brought by single individuals, some of them obtained large punitive judgments against big tobacco for amounts up to several hundred million dollars. However, recent appellate level court decisions at the federal and state level have squashed many of these suits and made it much harder for new cases like this to be brought by plaintiffs in the future.
Not only have Altria and Reynolds recently gotten most of these large punitive judgment overturned at the appellate level over the last year, recent judicial decisions from the federal circuit court in Florida have made it much harder to bring cases like this in the future. The latest rulings in the Engle cases make it clear that juries cannot be instructed that tobacco companies engaged in fraudulent marketing strategies before the trial begins. This ruling makes it much more costly and difficult for individuals to research and prove their case. Unsurprisingly, since these latest pro-tobacco rulings, no new major lawsuits by individuals have been able to successfully obtain large jury awards.
So, what about regulation and taxes? Here again, I question the analyst's recent commentary. First, during the last several years the federal and state government have faced the biggest revenue challenges they have seen in decades. However, while the federal government and most states did increase the tobacco tax during this period, the tax increases were modest and have proven to be one-time actions. The federal excise tax was increased just 75 cents last year, and not at all this year. Also, most southern states passed small one-time tax increases. Most northern states, like New York, and Illinois, where cigarettes range from $8-$10 a pack, were forced to forgo increasing the state tobacco tax since their taxes were viewed as being at a point where future increases could actually decrease the total revenue these high-debt governments would likely receive.
So what really changed, and why did analysts and commentators suddenly become so negative on the tobacco industry? I think it is valuation. While these analysts claim they are trying to attack the unchanged and still strong fundamentals of an industry that still offers some of the best dividends in the market to investors, these commentators are really just making a valuation call. They think upside is limited. Here, I would agree with them. If you are investing in any of the big three U.S. tobacco companies and looking for more than a long-term return of 6%-8%, you likely will be disappointed. However, with treasuries yielding next to nothing, and stocks still involving significant risk, I'm guessing the 5%-7% yield most U.S. tobacco names continue to pay will remain appealing.