Seeking Alpha
Profile| Send Message|
( followers)  

Earlier this month, the US Food and Drug Administration (FDA) delivered another blow to investors' favorite sin stocks: tobacco companies. As part of its anti-smoking campaign, the US FDA is going to start requiring tobacco companies to list the harmful ingredients in their products.

"The FDA wants the tobacco makers to report the quantity of 93 chemicals in their products. These include formaldehyde, nicotine, arsenic, cadmium, ammonia and carbon monoxide. Tobacco companies will also have to enlist quantities of 20 different ingredients that can cause cancer, lung disease and other health," reports Zacks. "The list of harmful products won't be available on the packages of the tobacco products. The FDA has decided that it will compile information for each product and make them available to the public by April 2013."

And, that is only the latest FDA requirement.

In June 2011, the FDA ruled that tobacco companies in the US had to include that all cigarette labels include a warning that covers the top 50% of a cigarette pack's front and back panels. The warning is to be a full-color "graphic design of a dead body, cancerous lungs and rotten teeth." The requirement was to start last October. While many in the States balked at the idea of the graphic warnings, Canada instituted a similar law in 2000. The country's smoking rate fell from 26% to 20%.

Obviously, these new FDA requirements are going to hurt cigarette sales - after all, that is their design. Further, implementing these changes will increase the cost of goods sold for many cigarette companies. In addition to design costs, the companies will have to pay more for ink. Many cigarette packs have just three flat colors, as in no color shading. Adding the full-color designs will mean adjusting their printing processes and increased ink costs.

Now, consider for a moment that the main reasons investors put their money in cigarette companies is because revenue is very consistent - people still buy cigarettes when the market is down and it's not like a pack-a-day smoker doubles his intake when money is good (at least not usually) - and dividends are high. If the FDA's anti-smoking campaign works as well as Canada's did, what will that mean for US cigarette companies?

In a word - diversification. They will need to diversify operations or face eventual extinction. As it stands, the US tobacco companies have already had to cut back. In October 2011, Altria (MO), the company behind market leader Marlboro, announced that it will have to cut its salaried work force by 15% as a result of declining cigarette sales across the country. Reynolds American (RAI), the company behind he Camel, Kool and American Spirit brands, is in roughly the same boat. According to a press release (pdf) dated March 14, the company will be cutting 10% of its workforce by the end of 2015.

In spite of cutting its workforce by a greater percentage than its rival Reynolds American, Altria is positioned much better. While the company only operates in the US - meaning that it does not have the advantage of geographic diversification and is entirely at the "mercy" (so to speak) of the FDA - it has something that rival Reynolds American does not - diversified operations.

Sure, Reynolds American has some diversification - it sells a smoking cessation product called Niconovum AB (the product is sold in Sweden under the name Zonnic) - but, Altria has something much better - wine. Specifically, Altria produces and sells the Chateau Ste. Michelle and Columbia Crest names, as well as distributes Antinori wines, Villa Maria Estate wines and Champagne Nicolas Feuillatte. The company also has an impressive portfolio of leveraged and direct finance leases in rail and surface transport, aircraft, electric power, real estate, and manufacturing.

Thanks to this difference, Altria returned 9.55% in the first quarter 2012, versus Reynolds American's 1.87%. Altria is also in a better position than Reynolds American when you look at the "tale of the tape". The two companies are priced similarly with regard to their future earnings - Altria has a forward P/E ratio of 13.15 while Reynolds American has a forward P/E ratio of 12.97. The pair also offer a similar dividend yield - At its current trade price of $31 a share, Altria's dividend yield is 5.20%, while Reynolds American recently traded at $41.50 a share, making its dividend yield 5.30%. But, the likeness virtually ends there.

Altria enjoys revenue growth of 5.0%, compared to its peers average of 1.0%. Reynolds American's revenue increased by just 0.1%. Altria also boasts a higher return on equity (75.89% compared to Reynolds American's 22.04%), a greater return on assets (11.05% vs Reynolds American's 9.78%), a better operating margin (39.55% vs Reynolds American's 30.52%), a higher profit margin (20.40% vs Reynolds American's 9.78%), a better current ratio (1.40 vs Reynolds American's 1.01) and a greater 5-year earnings growth estimate (8% per annum vs Reynolds American's 6%).

Rival Lorillard (LO), the company that makes Newport and Kent cigarettes, has greater earnings growth expectations (11.43% per annum over the next five years), a higher current ratio (1.73), greater revenue growth (10.20%), a better profit margin (25.07%), a higher operating margin (45.64%) and a better return on assets (40.29%). But, the company pays a lower dividend - 4.50% yield at its recent trade price of $136.50 - and it is priced higher with a forward P/E ratio of 13.82. Besides that, the company has the underdog brands, with just 14% of the market - a steadily decreasing market at that. Granted, Lorillard has been able to grow its market share and it has been on a rally lately, returning almost 16% in the first quarter 2012, but I am just not convinced that there is much to be made off a non-diversified company that makes a non-dominant brand in a shrinking market.

Despite long term threats from the FDA and other regulatory bodies, for my money, I recommend Altria. The company has great numbers and a strong portfolio. Combine that with a solid earnings growth estimate, high dividends and low pricing, and what's not to love?

Source: Altria: Why The FDA Can't Kill This Company