A Careful Look at UST and the Smokeless Tobacco Business (MO, BTI, UST)

UST, Inc. (NYSE: UST) is the leading producer of smokeless tobacco in the U.S. What defines smokeless tobacco? Basically any form of tobacco that you stick in your mouth but don’t have to light up. Specifically, think snuff (also known as “dip�?) and chewing tobacco (also known as "chew"). Brand names for UST’s products include the dual dip titans Copenhagen and Skoal, but also encompass Red Seal, Husky, Rooster and Bruton. Outside of smokeless tobacco, the company also produces wine and sparkling wine under the brands Chateau Ste. Michelle, Columbia Crest, Domaine Ste. Michelle, Villa Mt. Eden and Conn Creek – because what goes together better than a mouthful of smokeless tobacco and a glass of premium wine? But I digress…

Think that smokeless tobacco is no longer "in" Just step into one of the thousands of college frat houses across the country or take a trip to the U.S. Southeast and ask someone to point you in the direction of the nearest spit cup. You're sure to find some people that truly know the meaning of "fresh Cope." Sure, tobacco products are a declining market, but a very profitable market and there’s no reason not to take part in the piles of cash that UST is raking in. Moreover, with a lot of the messy legal action against the tobacco industry behind us, there will likely be less surprises from that end.

WHAT'S BEEN GOING ON

UST continues to truck along, bringing in nice profits through cost cutting strategies as revenue slowly declines. The company has been the subject of merger talks and could be an interesting acquisition for an Altria Group Inc. (MO), with over $6 billion cash on the books, or a British American Tobacco PLC (BTI), with over $3 billion in cash. Also, as I mentioned above, litigation, though not out of the question, seems to have quited down a bit.

GROWTH DRIVERS

Well in the tobacco industry, you’re really not going to find too much in the way of growth drivers. What you have is what you could almost call a legacy product with a very sticky customer base. In other words, you have a highly addictive substance that is being made obsolete through adequate education of the negative health effects that the product has. The fact is, though, that there are plenty of people that still use the product, and as there is a very inelastic demand (meaning that people don’t decrease usage by much when prices go up) among customers, the companies that are still selling tobacco can make some pretty decent profits doing it.

Just spitballing ideas here, my guess is that as these tobacco companies continue to accumulate cash on their books they'll eventually look to diversify themselves into other lines of business that don't have the (ahem) customer mortality rates. As they do this, it could be more appropriate to start talking about growth again.

VALUATION

Valuation is an interesting question here as this is a very slow growing company and there is little chance that there will be any major growth drivers in the future. The main way that you’re going to see earnings growth here is through continued cost cutting measures. That being said, the company is currently expected to grow around 7% per year over the next five years and the P/E on 2006 earnings is roughly 13.5x. This puts the PEG ratio at just under 2x, and well out of the range of what I would call a value play.

However, this is not a stock that I would own or suggest on the basis of growth and seeing a huge price run-up. Rather, this is a stable earner that could be a good spot in a longer term portfolio or just among a collection of "safe" stocks in a general portfolio. While the other tobacco companies could offer much the same thing, I think UST is very well positioned through its Skoal and Copenhagen brands, and trades at a P/E that’s a discount to the other tobacco stocks. Plus, the fact that it pays out a fat 5.6% dividend doesn’t hurt either.

TECHNICAL SIGNALS

As I wouldn’t suggest this stock as a trading engine, I don’t know that I’d put too much weight on the technical trends. I will say, though, that it looks like it could be a good buy at the levels that it’s at right now (after some significant declines in the last 12 months). Over the past few days it looks like it could be breaking out of a trading range it had been in for a while.

Personally, I own Altria as a play in the tobacco industry, but I think that UST is a nice company with strong brands and brand recognition. If I do decide to dump my Altria at some point, UST could very well make its way into my holdings.