Why Philip Morris And Lorillard Are Smoking Hot Buys

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 |  Includes: LO, MCD, MO, PM, RAI
by: The Analyst Hub

Tobacco Companies like Philip Morris International (NYSE:PM), Altria Group Inc (NYSE:MO), Lorillard Tobacco Company (NYSE:LO) and Reynolds American Inc (NYSE:RAI) have provided investors good returns over the last couple of years through steady revenue growth, operating leverage and shareholder-friendly activities like dividends and share repurchases. Over the last 2 years, the shares of all these tobacco companies have rallied over more than 50%, and Philip Morris is clearly the winner with a 76% run up, owing to its unstoppable popularity in emerging markets.

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Source: Google Finance

These companies continue to draw investor's attention given an impressive dividend yield.

Company

Philip Morris

Altria Group

Lorillard

Reynolds

Dividend Yield

3.70%

4.60%

4.90%

5.10%

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Though Philip Morris has the lowest dividend yield among these companies, we favor Philip Morris, given its international exposure and a strong hold of its Marlboro brand in the global market. While the domestic companies are struggling with strict regulations and legal lawsuits, Philip Morris has an added advantage of growing in less regulated markets. Asia with more than 50% of the world's population represents a tremendous opportunity for the company (about 3.6 trillion cigarettes are consumed each year). Economic fundamentals in Asia are improving, and the expansive and growing population presents a huge potential customer base. We believe Asian countries like Indonesia, Philippines and China would prove to be "the engine of growth" for years to come.

  • Indonesia is one of Philip Morris' youngest Asian markets, with 27.3% of the population age 0-14 years and the country has widespread cultural acceptance of cigarette smoking, evidenced by a 32% smoking prevalence rate. Indonesia is currently Asia's second largest tobacco market after China and is expected to grow at a fast rate.
  • Philippines is another very lucrative market for Philip Morris due the company's nearly 93% market share. The company has various growth drivers in place like continued momentum in Marlboro in the Philippines' growing premium segment and further synergies to be realized from merger with Fortune Tobacco last year.
  • China is the largest cigarette market in the world, representing over 40% of the total global cigarettes consumed annually. PM's business in China is still relatively immaterial to its earnings as the sole manufacturer for the Chinese market is the state-owned China National Tobacco Corp. However, Philip Morris is the only international manufacturer that has a partnership with CNTC currently, which we think makes it the front runner for any future strategic partnerships. Thus, we believe that China could be the potential game changer and drive tremendous long term growth.

Philip Morris may appear to be a little expensive when compared to Altria, Lorillard, and Reynolds American. Even when we consider other consumer companies with similar yield profile and international exposure like McDonalds Corp (NYSE:MCD), it appears to be trading at a premium.

Company

PM

MO

LO

RAI

MCD

Forward P/E

15.92

14.46

13.65

14.49

14.88

2013 EPS

11.12%

7.69%

9.46%

6.75%

9.98%

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However, among these Philip Morris is the only company offering a double-digit EPS growth next year. Philip Morris' premium to McDonalds in justified as McDonald's has saturated global markets and therefore will have trouble growing in the future. Moreover, McDonald's is facing tough competition from its local and global peers and has underperformed the broader markets and peers, year to date.

As far as domestic tobacco peers are concerned, Philip Morris also offers better long-term growth prospects than they do, because cigarette consumption in U.S. is on the lower side (ranked 39th) and less than half when compared to Japan and many other countries in Central and Eastern Europe. Moreover, we believe Philip Morris' current valuation does not take into account the vast runway for growth in Asia. Thus, we believe the company is undervalued, and there is room for valuation upside.

Among the domestic tobacco companies, we believe Lorillard is the best bet, as it has the lowest valuation, yet it offers second highest dividend yield and best-in-class expected EPS growth in FY12 and FY13. The company also runs at better margins than Reynolds American and Altria.

Company

Profit Margin

Operating Margin

Lorillard

24.08%

44.52%

Altria Group

25.68%

42.23%

Reynolds American

16.81%

32.92%

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Lorillard has also diversified its portfolio by acquiring Blu Ecigs, a leading manufacturer and marketer of electronic cigarettes in April, and the company is also slowly increasing its global footprint to take advantage of increasing cigarette consumption in other international markets. Moreover, Lorillard's pipeline of new products is awaiting FDA's approval as substantially equivalent products (S/E's). Although there is lack of visibility in FDA's review process, but if the company is able to such approval anytime soon, the sales impact would provide a significant earnings upside. Thus, Lorillard provides a good investment opportunity in the domestic market and Philip Morris in the international circuit.

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

Business relationship disclosure: The article was co authored by Sandeep Gupta and Ashish Sharma. Both have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.