In this article, I take a look at Phillip Morris (PM), Altria (MO), Lorillard (LO) and Reynolds American (RAI)—the tobacco products manufacturers.
My analysis of these companies is focused on the next 3 - 9 months. Typically, the farther into the future you look, the less accurate the predictions. So, I keep the time frame of my predictions or forecasts to the next 3 - 9 months. The technical term is an intermediate-term investor. From 9 months to roughly 2 years is a long-term investor, and 2+ years is a buy-and-hold investor.
The tobacco companies sell an inelastic product, which means that as the price increases, revenue should increase. However, as price increases, tobacco products become more income elastic, and people stop spending as much on tobacco products. Therefore, as the price of tobacco products continues to increase partly because of inflation and partly because of taxes, the revenue of the tobacco firms will decline. Clearly people have stopped smoking as much, particularly in the U.S., as the sin tax hits the pocketbook of the consumer. We could easily see an increase in the price of cigarettes as lawmakers in the U.S. struggle to bring down the deficit. Further, the cost of healthcare is incentive to increase the tax on cigarettes, as the smoking population increases federal healthcare expenditure.
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. Further, we'll examine the financial statements to evaluate the financial performance and position of the firms. Additionally, macro-economic indicators are provided at the end of the article. As part of investment analysis, one 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.
Typically, tobacco stocks perform well during periods of economic uncertainty. However, the trend is towards people not smoking or smoking less, which will adversely impact sales for tobacco manufacturers and should weigh on returns.
The investors who are long these companies probably will want to hold their investment no matter what this article says. Hopefully, you can keep an open mind. Investors without positions in these companies should wait for a correction. Short-term investors should be buying on dips, generally speaking. Aggressive investors should consider short selling.
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 -- Neutral or Sell
Company vs. Industry [TTM]
- Return on Assets: 9.36 vs. 3.80
- Return on Investment: 12.55 vs. 5.75
- Return on Equity: 23.31 vs. 21.18
(Data courtesy of Reuters)
Financial Performance and Position
Return on assets, investment and equity improved compared to the previous quarter. Also, the industry return on equity increased substantially compared to the prior reading. That said, the management team at Reynolds remains in the "thumbs up" category.
In the three months ending June 30, 2012, net sales declined 4 percent. Operating income increased 27 percent, as selling and general administrative expenses declined 33.4 percent. Additionally, net income increased 35.5 percent. Also, the dividend increased 11.3 percent. Investors welcome the sight of expense management, margin expansion and dividend increases.
The quality of earnings is important when evaluating a company. High quality earnings suggest the company isn't using accounting gimmicks to boost earnings. Reynolds' earnings aren't high quality, as settlements related to lawsuits contributed to negative operating cash flow. Additionally, Reynolds is paying dividends using cash it didn't generate from operating activity; that is unsustainable. The firm has about $1B in cash and pays out roughly $640M in dividends. Hopefully, they'll have to cut their dividend and the stock price will decline substantially.
In terms of the balance sheet, current assets declined 22.3 percent. The decline is attributable to a decline in the cash balance. Total current liabilities remained roughly the same. That means, the liquidity position worsened.
Equity investors face risks from the restrictive covenants of the term loan the firm entered. The loan is set to mature towards the end of the year. However, a breach of the covenants could result in financial penalties.
Tobacco Litigation
The company is facing litigation because it produces products that are harmful to consumers. That being what it is, according to management, the company wins most of the cases, and doesn't intend to settle any tobacco-related litigation claims. Also, Reynolds could face a materially adverse impact from litigation claims.
The Engle case in 2000, ended with a $145B punitive damages verdict in favor of the plaintiffs. However, the Florida Supreme Court reversed the award. The Engle case highlights the legal risks Reynolds faces.
As of June 30 2012, outstanding jury verdicts in favor of the Engle Progeny plaintiffs has been entered against RJR Tobacco in the amount of $243.4M. The Engle case could have a materially adverse impact on earnings and cash flow in a particular quarter or fiscal year.
According to RAI, they'll be paying less than $2.4B annually in 2012 and thereafter in the State Settlement Agreement. The State Settlement Agreement is materially adversely impacting results of operations and cash flow.
There is litigation galore. I don't think it'll be enough to force the firm into Chapter 7 or 11 bankruptcy. It'll be enough to damage their financial position. That being what it is, eventually the legislators will awaken to the fact that they make a product that kills people, and the legislators will do something about it. Expect on-going legal troubles.
Segment Data
Revenue from RJR tobacco declined compared to the year-ago quarter, while American Snuff and Santa Fe increased revenue. Reynolds did an excellent job of managing expenses in its operating segments. People aren't smoking as many Camel or Pall Mall cigarettes. Pall Mall cigarettes are awful, however, they burn slowly.
I consider the segment data to be bearish, since revenue declines mean the firm could be headed for poor financial performance.
Retirement Benefits
Additionally, Reynolds has $303M 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 valuation, investors should distribute shares of Reynolds. Investors are bidding the price of shares and valuations to irrational levels, and it is only a matter of time before there is no one left willing and able to buy. Some investors may want to protect long positions by buying put or selling call options.
Further, the long-term prospects of the tobacco companies are unfavorable as taxes, litigation and legislation negatively impact industry operating conditions. Also, the switch to electronic cigarettes should weigh on sales going forward.
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Book value-shares is declining: the decline in book value-share is considered bearish. The share price is diverging with book value-share.
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Shares of Reynolds are trading above the rising 50-day simple moving average. The trend is bullish, as Reynolds is in a secular bull market. The secular bull market should take valuations to irrational levels, which is what we are seeing.
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Price-sales is increasing as the firm continues to be overvalued.
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Price-book value is increasing as book value declines and price increases. Reynolds is overvalued on a price-book value basis.
Philip Morris -- Neutral or Sell
Company vs. Industry
- Return on Assets: 24.92 vs. 3.80
- Return on Investment: 47.64 vs. 5.75
- Return on Equity: 754.84 vs. 22.18
(Data courtesy of Reuters)
Financial Performance and Position
Compared with the end of the fourth quarter of 2011, the cash position increased and accounts receivable increased. Accompanying the increase in cash and accounts receivable was an increase in short-term borrowing. Further, current assets remained relatively flat as inventory decreased. We didn't see an improvement in the liquidity position of the firm, as short-term debt and the current portion of long-term debt are greater than the cash balance. There is also an equity deficit. In other words, the company has negative equity. PM's liabilities are greater than the firm's assets, as dividend payment and cash repurchases were larger than net earnings. The financial position of Phillip Morris is weak, and the dividend payment could prove to be unsustainable.
Net revenue grew compared to the year-ago quarter, as the excise tax on products increased. The company's financial performance is solid, as operating income and net income grew. Further, the dividend increased. However, comprehensive income attributable to Phillip Morris for the first six months of the year decreased compared to a year ago. The decline is mostly attributable to a loss from currency translation.
The six months ending June 30, 2012 was a period of high quality earnings. Capital expenditure increased, even as cash flow from operations decreased. Capital expenditure usually has a long-term positive impact on operating activity. Phillip Morris doesn't use much of its cash flow from operating activities in investing activities. Instead, the firm returns a large portion of its cash to its owners. That suggests the company is lacking in growth investment opportunities. Further, the firm is issuing debt to pay stockholders and buy back shares. That isn't sustainable, and it suggests the firm would do well to decrease the size of its dividend or share repurchase program.
Segment Data
The best performing segments are Eastern Europe, Middle East, Africa and Asia. That isn't surprising, as tobacco products are part of the culture in some of those areas. Although, that'll change as the populations become more educated, and future generations make the decision to not become addicted to nicotine. Overall, the firm is selling more cigarettes than it was last year.
Plenty of Litigation
There are several cases pending involving Phillip Morris. In addition, there is legislation pending that could materially adversely impact operating cash flow and earnings. Phillip Morris sells a product that kills people; I expect continued legal trouble. According to the firm's SEC filing:
Our business faces significant governmental action aimed at increasing regulatory requirements with the goal of preventing the use of tobacco products.
Light Debt Load
The tobacco product manufacturer isn't carrying an excessive amount of debt. However, the debt burden could increase should Phillip Morris continue to pay dividends and repurchase shares at a pace it can't afford.
Investment Thesis
Shares of Phillip Morris are well into "bubble" land, and are being supported by the dividend junkies. The fundamentals of the business certainly do not justify the valuations. However, who cares about fundamentals when the firm pays a fat dividend that could be unsustainable? Obviously, this firm faces major risks from legislation, litigation and a shift towards a non-smoker population. The share price of Phillip Morris will take a nose dive once the dividend players realize the firm is overvalued and isn't the type of business investors should own from a long-term perspective. That said, short-term traders can profit from the irrational "crowd" and buy on dips and short-selling the bursting of bubble.
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Book value-share is negative. Usually people buy stocks below book value. However, in this case, investors are bidding up a firm that has a negative book value.
I apologize for the rest of the charts being missing. It seems Google Docs and myself believe the share price will tank, however, the share price is still rising. Further, price-book value is negative and the price-sales suggests the firm is overvalued.
Lorillard -- Neutral or Sell
Company vs. Industry [TTM]
- Return on Assets: 42.73 vs. 3.80
- Return on Investment: 78.55 vs. 5.75
- Return on Equity: -- vs. 22.18
(Data courtesy of Reuters)
Management is outperforming the industry based on the management effectiveness ratios.
Weak Financial Performance and Position
Compared to the end of the fourth quarter 2011, the cash position decreased. The cash position had increased at the end of the first quarter of 2012. Total current assets declined 22.7 percent from the fourth quarter of 2011 to the end of the second quarter 2012. The decline is mostly attributable to decline in cash, and partly offset by an increase in inventory and other current assets. Total assets declined 14.4 percent. The decline in total assets was smaller than the decline in total current assets as plant, property and equipment increased and goodwill and intangible assets increased. Lorillard has $747M in settlement costs. Total current liabilities declined 25.9 percent. The decline in total current liabilities was greater than the decline in total current assets; the firm's liquidity position improved. Long-term debt increased from $2.6B to $2.61B. Total liabilities declined 8.3 percent. The total shareholders' deficit increased to $1.57B from $1.51B.
While the financial position improved, as the liquidity and solvency position strengthened, total shareholders' deficit increased, there is a warning of a potential substantial decline in the value of Lorillard.
Net revenue increased 2.3 percent compared to the year-ago quarter. The increase follows a decline in the first quarter. Operating income declined $3M compared to the year-ago quarter. And net income declined $7M compared to the year-ago quarter. In other words, the firm did a poor job managing expenses.
The quarter ending March 31, 2011 was a quarter of high quality earnings as was the 2012 quarter. For the first six months of the year, earnings were poor quality. Earnings are poor quality because of the settlement costs involved with selling products that kill people. Further, cash from operations wasn't enough to cover investing and financing activities. In other words, the dividend and share repurchase program may not be sustainable. The firm has roughly $946M in cash, $747M in settlement costs and generates about $1B in net income. Additionally, there is litigation pending. The $1.1B per year in dividend payment and share repurchases is roughly all of the firm's yearly net income. Lorillard may discontinue its share repurchase program. That would help the share price decline.
Solid Acquisition
Lorillard acquired blu ecigs brand for $135M in cash. That was a good decision, as ecigs are a fast growing category. Although, research suggests some ecig brands contain carcinogens, it is unclear if blu ecigs contain carcinogens.
Plenty of Litigation
Lorillard is involved in 8,567 of legal cases, and the result of the cases should have an adverse material impact on the firm's earnings and operating cash flow.
Investment Thesis
The investment thesis is the same as for Phillip Morris and Reynolds.
Valuation
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Book value-share is declining as liabilities remain greater than assets.
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Shares of Lorillard are trading below the flattening 50-day simple moving average. Shares are being distributed, and the share price could decline in the coming months.
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Price-sales is generally rising, but has flattened out over the past six months.
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Price-book value is less negative as the share price rose more than book value declined.
Altria -- Buy (reduced exposure)
Company vs. Industry
- Return on Assets: 12.42 vs. 3.80
- Return on Investment: 14.83 vs. 5.75
- Return on Equity: 99.10 vs. 22.18
(Data courtesy of Reuters)
Management is outperforming the industry based on the management effectiveness ratios.
Solid Financial Performance and Position
Compared with the end of the fourth quarter of 2011, the cash position decreased 53.2 percent. That followed an increase in the first quarter. Current assets declined 27.8 percent. The investment in SAB Miller increased 17.7 percent. Total assets declined 6.4 percent. Settlement charges declined 37.8 percent to $2.2B. Total current liabilities declined 20.4 percent. The firm became less liquid during the period. Total liabilities declined 9 percent. Altria became more solvent. Total shareholders' equity increased 16 percent.
Net revenue increased 9.6 percent compared to the year-ago quarter. That follows the first quarter reading of flat revenue growth. Operating income increased 45 percent compared to the year-ago quarter. The increased margins are attributable to a stable cost of sales combined with an increase in revenue. Net income increased 176 percent, as the provision for income tax declined in the second quarter. The dividend increased 7.9 percent. Comprehensive income increased 122 percent.
Earnings weren't high quality in the first six months of the year, as settlement charges and the deferred income tax benefit weighed on cash from operating activities. That compares with the high quality earnings of the first three months of the year. The firm generated cash from investing in the first six months of the year. However, the cash generated was not enough to cover dividend payments and share repurchases. As a result, the firm's cash balance decreased $1.7B during the period.
Segment Data
Altria mainly sells smokeable products, but its investment in SAB Miller helps to diversify its product portfolio. Earnings from SAB Miller are roughly double the earnings from smokeless products. Further, the firm is selling an increased amount of discount brand cigarettes and Black & Mild cigars as Marlboro sales decline.
Less Litigation
Altria is involved in substantially less litigation than its peers. It is involved in roughly 100 cases. However, Altria's settlement expense account is about three times larger than Lorillard's.
Investment Thesis
Altria has the best financial position and performance of the group. Even though I wouldn't consider the firm as a long-term investment, I think the financial performance and position is solid. I would reduce long exposure. At some point, shares of Altria are going to consolidate some of the gains. That consolidation could be a mild correction. However, it will depend on the fundamental conditions. I still see U.S. equities entering a bear market between 2012 and 2014. More aggressive investors can short sell shares of Altria, because the firm is overvalued. Short-term investors should still be looking to buy on dips.
Valuation
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Revenue-share is increasing: the increase is considered bullish.
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Book value-shares is starting to increase again: the increase is considered bullish.
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The price of Altria shares is increasing as shares trade above the rising 50-day simple moving average.
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The price-sales valuation metric suggests Altria is overvalued.
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The price-book value metric suggests Altria is overvalued.
Macro Environment
U.S. GDP Forecast
| Baseline | Alternative Baseline | Adverse | |
| 2012 | +2.3 | +1.8 | +1.8 |
| 2013 | -0.5 | -1.5 | +1.5 |
| 2014 | +2.4 | +1.6 | -0.5 |
In the baseline scenario, I see economic growth continuing through 2012 with a recession in 2013 and economic growth resuming in 2014. Under the alternative baseline scenario, economic growth this year is slower than the baseline scenario, and the recession in 2013 is deeper. In the adverse scenario, the recession occurs in 2014. Under the baseline and alternative baseline scenarios, U.S. equities are in a bear market during 2012 and/or 2013.
The economic growth model assumes fiscal consolidation occurs in the U.S. and/or the recession in Europe is deeper than currently forecasted. Also, we could see a spike in the price of oil on Iran risks.
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ISM non-manufacturing PMI is declining; the index is expected to continue to decline in the coming months.
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Non-farm employment change increased this month. The pace of job growth is expected to continue to slow.
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CB consumer confidence is starting to decline; the index is expected to decline in the coming months.
Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
