Cigarette Companies That Are Best Positioned Against Their Peers

| About: Philip Morris (PM)

By Guan Wang

Some investors avoid investing in certain sectors, like the tobacco industry, because of uncertainty over what will happen with regard to external factors like regulation and consumer preferences. There is a theory that "sin stocks", like tobacco stocks, outperform the market because of loyal followings that are generally willing to pay a premium for the "sinful" product of their choosing and the relative oligarchy of companies in the industry thanks to high barriers of entry. In the case of tobacco, government regulations have certainly limited the growth in the tobacco industry, but, on the other hand, regulations have also elevated the barriers to entry into the industry. The risk could be worth it.

The most popular tobacco stock amongst the hedge funds we track is Philip Morris International (NYSE:PM). There were 39 hedge funds with this stock in their 13F portfolios at the end of last year. In total, they invested $2.4 billion in this $150 billion market cap stock. Tom Russo, whose Gardner Russo & Gardner had nearly $650 million invested in the stock at the end of 2011, was the most bullish of these money managers. Jim Simons' Renaissance Technologies also had $200+ million invested in this position at the end of the fourth quarter. Bill Miller, Cliff Asness, Joe DiMenna, and David Dreman are also in favor of Philip Morris.

So, why are so many bullish about Philip Morris?

For one, like most other tobacco stocks, Philip Morris pays an attractive dividend to its shareholders. Last year, the company raised its quarterly dividends by over 20% to $0.77 per share. Trading at slightly below $90 per share, Philip Morris has a current dividend yield of about 3.42%, versus 2% for a 10-year Treasury bond. Philip Morris has been increasing its dividend payments every year since 2008, when it spun off from Altria Group (NYSE:MO).

In addition to paying dividends, Philip Morris also benefits its shareholders by boosting its EPS through share repurchases. Over the past fiscal year, Philip Morris has bought back 80.5 million shares of its common stock, paying about $5.4 billion in the process - and the company plans to spend another $6 billion in share repurchases this year. Is Philip Morris likely to continue buying back shares and paying out dividends in the future? We think the answer is yes. It has a low payout ratio (around 60%), robust earnings growth, and high cash flow generation.

For the first quarter of 2012, Philip Morris' revenues increased by 9% compared with the same quarter last year, well outpacing its industry's average revenue growth rate of 1.3%. The strong growth in the company's revenues helped boosted its earnings. Philip Morris' net income increased by 13% to $2.16 billion while its EPS improved by about 18% in the first quarter this year. In fact, Philip Morris has demonstrated positive earnings growth over the past couple years. The company made $3.92 per share in 2010 and $4.84 per share in 2011. For the next few years, analysts expect Philip Morris' EPS to reach $5.29 per share in 2012 and $5.87 per share in 2013. The expected earnings growth rate is about 9-10% per year on the average.

Philip Morris also has a strong talent for generating cash flow. Over the past year, its cash flow from operations was $10.5 billion, up 11.6% from $9.4 billion in 2010. The healthy cash flow is what supports Philip Morris' dividend payments and share repurchases, but it also enables the company to capture certain expansion opportunities. For example, in February 2010, one of the affiliates of Philip Morris combined its business with Fortune Tobacco Corporation in the Philippines, in a venture that is sure to produce a range of cost-saving synergies. Additionally, Philip Morris is also planning to introduce its products in new markets, including China, India, Bangladesh and Vietnam. Currently the company has low penetration in these markets even though cigarette consumption there is quite high, together accounting for about 40% of international cigarette consumption. We think Philip Morris is well positioned to take advantages of the opportunities in these rapidly growing emerging markets.

Other major players in the tobacco industry include Altria Group, Lorillard Inc (NYSE:LO), and Reynolds American (NYSE:RAI). Philip Morris has a P/E ratio of 17.9, same as that of Reynolds, while Reynolds' expected earnings growth rate of 6% is lower than the 9-10% expected for Philip Morris. Also, Altria's P/E ratio of 19.5 is higher than that for Philip Morris and its growth expectation of 7% is lower.

Lorillard looks a bit more attractive. It has a P/E ratio of 16.7 and its earnings are expected to grow at 10.35% annually over the next couple of years. Though the company reported flat EPS for the first quarter this year, we believe it is ready for strong earnings growth in the year ahead. Hedge funds like Lorillard, too: Jim Simons' RenTech had $200+ million invested in the company at the end of the fourth quarter while Jean-Marie Eveillard's First Eagle Investment Management had a position in Lorillard valued at $271 million at the end of 2011.

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

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