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In this article I take a look at Phillip Morris (NYSE:PM), Altria (NYSE:MO), Lorillard (NYSE:LO), and Reynolds American (NYSE:RAI) - the tobacco products manufacturers that may offer investors upside potential that outweighs the risks.

To evaluate the common equity shares of these firms, we'll use the management effectiveness, book value-share, price-sales and price-book value ratios. Additionally, macro-economic indicators are provided at the end of the article. As part of investment analysis, analysts should consider both the company fundamentals and the macro-economic landscape. The macro-economic picture in the U.S. is deteriorating. In Europe, the economy is currently contracting.

European officials are working towards recapitalizing the banks in Spain. Also, European officials are investigating pro-economic growth policies that would reduce the sovereign risks the region is facing. Until pro-growth policies are implemented, and Spain's banks are recapitalized, sovereign risks remain.

Typically, tobacco stocks perform well during periods of economic uncertainty.

Rating System

Buy - Be long

Neutral - No position

Sell - Be short

The ratings, research and analysis in this article should be considered as a starting point for further research.

Reynolds American -- Sell

Company vs. Industry (TTM)

  • Return on Assets: 7.69 vs. 3.44
  • Return on Investment: 10.78 vs. 5.31
  • Return on Equity: 20.97 vs. 15.38

(Data courtesy of Reuters)

The quality of earnings is important when evaluating a company. High quality earnings suggests the company isn't using accounting gimmicks to boost earnings. Reynolds' earnings are high quality, which is bullish. Additionally, the firm generates enough cash from operating activities to cover financing activities and investing activities.

A bearish factor for consideration, the $3B in tobacco settlement accruals that will be paid over time. Given the $2.4B in cash and $270M earned in the first quarter of 2012, tobacco settlements represent material risk to the firm's valuation. Further, current liabilities exceeded current assets in the first quarter of 2012, according to the firm's financial statements.

Additionally, Reynolds has $306M remaining in payments to pension plans to make this year. I consider that a bearish factor as employer contributions to pension plans should weigh on earnings in the coming quarters.

Investment Thesis

Based on the management effectiveness ratios, management is effective compared with its industry peers. However, book value-share is declining.

That said, based on the valuation, investors should distribute shares of Reynolds. The macro-economic risks from potential fiscal consolidation in the US and European Union could cause valuations to decline. Some investors may want to protect long positions by buying put or selling call options.

(click images to enlarge)

Book value/share is decreasing; the decline in book value/share is bearish.

Shares are trading above their 2012 peak; additionally, the share price of Reynolds is near a major peak.

Price/sales is increasing and is near its 2012 peak; the firm may be overvalued on a price-sales basis. The increase in price-sales is mostly attributed to an increase in the price of common equity shares.

Price-book value is increasing and is near its 2012 peak; a decline in price-book value should occur in the coming months. The increase in price-book value is partly attributed to a decline in book value. The market may be saying that its likes the growth prospects of Reynolds.

Philip Morris -- Sell

Company vs. Industry

  • Return on Assets : 25.36 vs. 3.44
  • Return on Investment : 46.43 vs. 5.31
  • Return on Equity : 427.97 vs. 15.38

(Data courtesy of Reuters)

Compared with the end of the fourth quarter of 2011, the cash position increased. Accompanying the increase in cash was an increase in short-term borrowing.

Net revenue grew compared to the year-ago quarter as the excise tax on products increased.

The quarter ending March 31, 2011 was a quarter of high quality earnings while the 2012 quarter saw a decrease in the quality of earnings. That being said, cash from operating activity was enough to cover investing and financing activity in the first quarter of 2012.

Investment Thesis

Based on the management effectiveness ratios, management is effective compared with its industry peers. However, book value-share is declining.

That being said, based on the valuation, and the broader market, investors should distribute shares of Phillip Morris. The macro-economic risks from potential fiscal consolidation in the U.S. and European Union could cause valuations to decline. Some investors may want to protect long positions by buying put or selling call options.

Book value/share is declining; the decline in book value/share is bearish.

Shares are trading near their 2012 peak; a decline in share price may occur in the coming months.

Price/sales is increasing; however, the valuation metric is below its 2012 peak.

Price/book value is increasing and is near its 2012 peak; a decline in price/book value may occur in the coming months.

Lorillard -- Sell

Company vs. Industry

  • Return on Assets : 31.44 vs. 3.44
  • Return on Investment : 72.71 vs. 5.31
  • Return on Equity : -- vs. 15.38

(Data courtesy of Reuters)

Compared to the end of the fourth quarter of 2011, the cash position increased. Accompanying the increase in cash was an increase in inventory.

Net revenue declined compared to the year-ago quarter as cost of sales increased.

The quarter ending March 31, 2011 was a quarter of high quality earnings as was the 2012 quarter. That being said, cash from operating activity was enough to cover investing and financing activity in the first quarter of 2012 and 2011.

Investment Thesis

Based on the management effectiveness ratios, management is effective compared with its industry peers. However, book value-share is declining.

That being said, based on the valuation, and the broader market, investors should distribute shares of Lorillard. The macro-economic risks from potential fiscal consolidation in the U.S. and European Union could cause valuations to decline. Some investors may want to protect long positions by buying put or selling call options.

Book value/share is declining; the decline in book value/share is bearish.

Shares are trading near their 2012 peak; a decline in share price may occur in the coming months.

Price/sales is increasing; however, the valuation metric is well below its 2012 peak.

Price/book value is increasing and is near its 2012 peak; a decline in price/book value may occur in the coming months.

Altria -- Sell

Company vs. Industry

  • Return on Assets : 8.94 vs. 3.44
  • Return on Investment : 11.49 vs. 5.31
  • Return on Equity : 74.59 vs. 15.38

(Data courtesy of Reuters)

Compared with the end of the fourth quarter of 2011, the cash position increased. Accompanying the increase in cash was an increase in inventory.

Net revenue was flat compared with the year-ago quarter as was cost of sales.

The quarter ending March 31, 2011 was a quarter of high quality earnings as was the 2012 quarter. That being said, cash from operating activity was enough to cover investing and financing activity in the first quarter of 2012 and 2011.

Investment Thesis

Based on the management effectiveness ratios, management is effective compared with its industry peers. However, book value-share is declining.

That being said, based on the valuation, and the broader market, investors should distribute shares of Altria. The macro-economic risks from potential fiscal consolidation in the US and European Union could cause valuations to decline. Some investors may want to protect long positions by buying put or selling call options.

Book value/share is declining; the decline in book value/share is bearish.

Shares are trading near their 2012 peak; a decline in share price may occur in the coming months.

Price/sales is increasing; however, the valuation metric may decline in the coming months.

Price/book value is increasing and is near its 2012 peak; a decline in price/book value may occur in the coming months.

Macro Environment

ISM Non-manufacturing PMI is declining; the decline in non-manufacturing PMI is considered bearish. ISM non-manufacturing PMI should stabilize in the coming months.

The pace of job growth has slowed in recent months and may stabilize at low levels.

CB consumer confidence is increasing and may decline in the coming months. The Expectation Index and the Present Situation Index both declined, according to the latest report.

European Union services PMI is declining and should increase in the coming months.

European Union manufacturing PMI is declining and should increase in the coming months. A silver lining from the current release of the report is that the pace of decline in Italian manufacturing is slowing. Additionally, the depth of the contraction in manufacturing has yet to reach the depth of the contraction from the financial crisis in 2009.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 4 Overvalued Tobacco Stocks