FDA's Recommendation - Choose The Safest Beneficiary

Includes: LO, MO, NRT, PM, RAI
by: Core Equity Research

The U.S. Food and Drug Administration (FDA) has been making continuous efforts to curtail tobacco smoking. As a part of the same effort, the FDA previously recommended over-the-counter Nicotine Replacement Therapy (NRT). Though over-the-counter NRTs have been on the market all these years, their usage was not recommended for more than 12 consecutive days. The FDA has modified this rule and has removed the restriction on the maximum continuous usage of NRTs. This recommendation is expected to boost the sales of NRTs, which will affect the tobacco giants that are working on alternatives for tobacco products.

There are a few tobacco giants who have already initiated their efforts for strengthening their niche in the NRT market. In this article, I will analyze their financial position to identify the best pick from the lot. As the sale of NRTs pick up, it will translate into profits for the companies that are aiming to bank on the upcoming opportunity. As an investor, it is the best opportunity to pick a safe, profitable bet from the big tobacco giants.

Tobacco companies have always been known for their high-dividend yields and good capital returns, and we will focus on the companies that have already taken their first step towards the profitable NRT segment.

A bit about NRT

Before moving forward with the analysis, let me provide a brief overview of Nicotine Replacement Therapy (NRT). NRTs come in the forms of gum, lozenge or patch. These products are considered an alternative to tobacco smoking as they mostly contain the nicotine extracted from tobacco. Like cigarettes, nicotine is addictive, but nicotine has not been linked with cancer yet. Hence, NRT is comparatively a safer alternative.

Giants on the move

The tobacco companies I have picked have taken initiatives to enter the NRT market. Reynolds American Inc. (NYSE:RAI) has developed the Zonnic gum. This tobacco giant kept its product different from other nicotine gums in the market and similar to cigarettes.

Altria Group Inc. (NYSE:MO) introduced Verve in May 2012, a non-dissolving, lozenge-shaped and mint-flavored nicotine disc. And who can forget Philip Morris (NYSE:PM)? The big daddy of the tobacco industry purchased the patent and global rights to a smokeless nicotine-delivery system developed by a Duke University researcher, Jed Rose. (I have not discussed Lorillard (NYSE:LO) due to its menthol issue, though it is not a bad stock for investment).

Tobacco companies' stocks are known for their impressive dividend yields and high dividend growth rates. The companies I have analyzed in this article have been growing their dividend yields.

5-Year Average Annual Dividend Growth

Overview of the giants

The average 5-year annual dividend growth rate of PM stands at 14.6%. Altria has an average dividend growth of 9.6%, whereas Reynolds has a 5-year dividend CAGR of 7.6%.

PM is the market leader of the tobacco industry that manufactures and markets the world's no. 1 brand: Marlboro. PM stock has gained more than 100% over the last 5 years. PM currently trades at $92.72 with a 1-year target price of $97.99. The current dividend yield of the giant is 3.7% and is trading close to its 52-week high. This giant is expected to post an earnings growth of 10.2% this year, compared to the industry's negative growth of 4.1%.

Reynolds is trading at $44.20, with a 1-year target price of $46. It has a current dividend yield of 5.3%. The company has been sharing its profits with the investors via share buybacks. The company has an ongoing share repurchase program of $2.5 billion, under which it repurchased $250 million worth of common stocks in 4Q12. RAI share repurchase spending stood at $1.1 billion in 2012.

After spinning off Philip Morris and Kraft, Altria strengthened its niche in the U.S. market and now rules over half of that market. The company has a stable growth and a low beta. The company's P/S and debt-to-equity ratios are above the industry averages, but this stock is as close to the "bullish no-brainer" as you can get. Altria is trading at $34.84, with a 1-year target price of $36.67. The company has a dividend yield of 5.1%.

Picking the favorably priced stock

Looking at the above table, it is clear that PM has outperformed its peers and the industry. The company has higher earnings growth estimates for the current year and for the coming years. Its PEG is the lowest amongst the players, i.e. its earnings growth is most favorably priced in the market.

PM's margins are better than RAI and MO and its EPS is the highest. Well, these are not the only reasons I prefer PM among the other players.

RAI and MO stock prices are highly correlated

Strange but true, Reynolds and Altria's stock prices have been moving in almost perfect synchronization in the stock market. I don't understand what investors have been doing, but the correlation between their daily stock price movement stands at 0.93 using 1 year's daily stock price data. That is a strong correlation. The similar stock price movements puzzled me. So I decided to check it for a longer time period. Rather than using the data for 1 year, I extended the data and opted for two years of daily stock prices. The correlation increased from 93% to 97.3%. This relation implies a lot of criticalities, which I will elaborate in my next note. But while concluding this one, I can surely say that investing in these two companies is not a smart move. The beta of both the companies is misleading. Every company's total risk comprises of the market risk and the company - specific risk, whereas RAI and MO both have a bit of each other's market risk. Somehow, investors are displaying similar preferences to both the companies. News initiating a sell on MO, may initiate the same sentiment on RAI. Due to this strange investor behavior, I have dropped RAI and MO from my 'stocks-to-pick' list and have declared PM as a buy and the safest beneficiary from the upcoming changes.

PM cannot be overlooked due to its strong fundamentals, market position as a top player, huge margins, amazing growth prospects and future sales boost that is expected to stem from NRT sales. Out of the companies that are making a move in the NRT market, PM is a great buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.