Don't be distracted by a recent legal win in the U.S. for tobacco companies: governments around the world are proposing and passing tobacco regulations. In light of this, tobacco companies face global regulatory risks. Unfortunately, their high valuations fail to compensate investors for these risks.
A Tobacco Win in the U.S.
A Washington-based U.S. Court of Appeals upheld a decision that frees tobacco companies from putting pictorial health warnings on cigarette packets provided by the Food and Drug Administration. The court's 2-1 decision stated that the lower court ruling violated the freedom of speech of tobacco companies as per the First Amendment of U.S. Constitution.
The U.S. FDA has asked for a full review against the decision given by three-judge panel in the favor of tobacco companies to block the mandate for showing the dangers of smoking. The government failed to give enough data that how these warnings would cut the smoking rates.
According to FDA "The First Amendment does not need statistical proof of the extent to which the decline in smoking rates resulted 'directly' from the new health warnings."
In 2011, R.J. Reynolds (NYSE:RAI), Liggett Group, Commonwealth Brands and other tobacco players in the country filed a suit against FDA for violation of First Amendment, by the mandate passed under the Family Smoking Prevention and Control Act for cigarette packages.
Tobacco Crackdown: From Russia with Love
This U.S. decision in favor of cigarette companies is the exception, not the norm.
In Russia, the government could pass a bill that bans smoking in public, advertisements of tobacco products, and would increase the excise taxes on tobacco by 40% between now and 2014. This legislation has been proposed in an effort to curb the rapid population decrease in Russia. Since World Health Organization ranks Russia as the second largest market for cigarettes behind China, the passage of the bill will largely affect the sales volume of tobacco companies.
Tobacco companies such as the British American Tobacco (NYSEMKT:BTI) and Philip Morris (NYSE:PM) are lobbying against this bill. Philip Morris is the largest tobacco company in the world, while British American Tobacco is the largest in Europe. Japan Tobacco has the most market share in Asia. These giants make up the majority cigarette sales in Russia: Japan Tobacco has 37% of the market, 26% is held by Phil Morris, and 21% is held by British American Tobacco.
The taxes on cigarettes have been raised 8-fold and there are plans for further increases in the future.
Tobacco Regulations Down Under
Russia is following in the footsteps of other governments which have tighter and still-tightening regulations for tobacco products. Australia's tobacco products are now required to place images of cancer victims and gangrenous limbs on cigarette packs. To comply with new government standards, there must be images and health warnings covering seventy five percent of the front of cigarette packs. New packages will display disgusting images including tongue cancer, a skeletal man dying of lung cancer, or an infected foot. Additional warnings have to cover the sides of the packages and ninety per cent of the back.
Government officials hope that the new packaging will curtail the recruitment of young people as smokers. Australia's health minister Tanya Plibersek said, "Young people are the ones most affected by the packaging and by the advertising, and no parent wants their kid to start smoking."
Health officials are hopeful that distasteful new cigarette packaging will dissuade more consumers from smoking in general. After most of the packaging is not covered in cautionary warnings, the remainder is required to be drab. According to the state law, the background of the packaging must be a specific greenish-brown hue and any trademarks or product names have to be in Lucida Sans font. State officials will lookout for violations of these rules.
These regulations will be mimicked elsewhere. Margaret Chan, the World Health director-general said, "With so many countries lined up to ride on Australia's coattails, what we hope to see is a domino effect for the good of public health." Countries including the United Kingdom, Turkey, New Zealand, India, and Russia expressed interest in more severe plain packaging rules.
Warning: Tobacco Stocks are Pricey
Regulatory pressures and taxes could continue to increase worldwide. Thus, cigarette and tobacco stocks should be much, much cheaper than other stocks.
Yet, somehow cigarette and tobacco companies are not cheap:
British American Tobacco
Tobacco Products, Other
None of these stocks are trading at low-enough valuations given the macro picture of stifling government regulation. Intel has a much lower price-to-earnings ratio of roughly 9, for example. McDonald's, another dividend-paying stock has a lower valuations that some of these cigarette companies. Some of these firms have negative accounting values for equity, which is worse considering how such firms have historically underperformed firms with positive book equity.
Why are cigarette stocks and tobacco stocks trading at these multiples? It appears that cigarette companies are using by unsustainably high dividend payout rates to keep investors hooked. The dividends of these dividend and tobacco companies will not last forever since payout ratios above 60% don't leave enough margin for error if earnings decline or if governments initiate new restrictions on your products. Only one dividend-paying tobacco company, Universal, has a sustainable payout ratio.
Investors should steer clear of tobacco and cigarette stocks regardless of personal conviction based purely on investing prudence. The high to mid-range static valuations in this industry do not reflect the regulatory headwinds they face. Many of these firms have dividend policies which are not sustainable and any downward revisions to dividend policy could be interpreted as a signal that management does not have confidence in firm operations.