As a business owner, selling products that have high profit margins along with strong brand awareness and an exceptionally loyal customer base is strongly desirable.

The cigarette industry fits this bill. While many investors are afraid of the implications of rising awareness surrounding the health effects of cigarettes, the industry’s decline is greatly exaggerated.

For instance, British American Tobacco estimates worldwide tobacco consumption to be declining at a -1.6% annual rate since 2010.

Cigarette Stock

Source: British American Tobacco Investor Presentation

Consumers are still purchasing ~3.4 trillion sticks of tobacco on an annual basis. Clearly, this industry still remains strong.

The American cigarette industry is highly concentrated in four large companies. These companies are:

This article will explore the investment prospects of these companies in detail.

Business Overview of Dominant Tobacco Stocks

Each of these cigarette companies are very large as measured by market capitalization:

  • MO: $132 billion
  • PM: $142 billion
  • RAI: $80 billion
  • BTI: $106 billion

While each is in the business of selling cigarettes, each of these companies have distinct characteristics that should be described before diving into further analysis.

Altria is the market leader in American cigarette sales. Before 2003, the company was known as Philip Morris but was renamed as Altria after some business restructuring (including the spinoff of Philip Morris International in 2008).

The company owns many well-recognized brands, including Marlboro, Skoal, Copenhagen, and Black & Mild. The company’s operations are broken down as follows:

  • Smokeable products (89% of revenue)
  • Smokeless products (8% of revenue)
  • Wine (3% of revenue)

They are the market leader in the US cigarette industry. In 2015, their flagship product Marlboro had more market share than the next 10 competitor products combined.

Cigarette Stock

Source: Altria Investor Relations

Philip Morris International was spun off from Altria in 2008 and is in charge of the production and distribution of Altria’s products outside of the United States. This includes the valuable Marlboro brand.

PM’s net income is well-diversified by geography. In fiscal 2015, the breakdown was as follows:

  • European Union: 32.6%
  • Eastern Europe, Middle East & Africa: 31.2%
  • Asia: 26.3%
  • Latin America & Canada: 9.9%

Reynolds American Inc. is the United States’ second largest manufacturer of cigarettes. Their brands include Winston, Camel, Salem, Pall Mall, Kool, Doral, Vantage and others.

Winston and Camel are the company’s flagship premium cigarette brands, while Doral is the company’s most popular discount brand.

RAI’s operations are divided into four segments for reporting purposes. The segments, along with 2015 fiscal revenues, are reported below.

  • RJR Tobacco: $8,634 million (80.9% of sales)
  • Santa Fe Natural Tobacco Company: $818 million (7.7% of sales)
  • American Snuff: $855 million (8.0% of sales)
  • All Other: $368 million (3.4% of sales)

RAI’s revenues are highly concentrated in their RJR Tobacco segments.

British American Tobacco PLC operates the largest vapour business outside of the United States, with headquarters in London, United Kingdom. The company holds dominant market share in many international markets.

Cigarette Stock

Source: British American Tobacco Investor Relations

BTI also owns 42% of RAI – giving them well-needed exposure to the US tobacco market.

BTI’s sales are broken down into four categories for reporting purposes. These categories (along with their 2015 revenues, reported in GBP) are listed below.

  • Asia Pacific: £3,874 million (26.3% of sales)
  • Americas: £3,340 million (22.7% of sales)
  • Western Europe: £4,030 (23.6% of sales)
  • Eastern Europe, Middle East, and Africa (EEMEA): £4,030 million (27.4% of sales)

American investors looking for exposure to British American Tobacco should purchase the company’s American Depository Receipt (ADR) that trades under the ticker BTI.

An ADR gives domestic investors the ability to gain exposure to international stocks. An overseas arm of a domestic bank holds shares of the underlying company, and issues the ADR in USD while converting all dividends accordingly.

Potential BTI-RAI Transaction

Before moving on to the analysis of these companies, it is necessary to mention a potential transaction between two of the companies in question.

I’m referring to the October 21 offer by BTI to purchase the 58% of RAI that is does not already own. The offer was worth $56.50 per share at the time of announcement – slightly above RAI’s current market price of ~$56.

The two companies have a tangled history. They collaborated on a joint venture in 2004 which resulted in BTI’s current partial ownership of RAI. There was a clause in the agreement of the two companies that restricted BTI from purchasing additional stock until 2014.

Clearly, it did not take long after this clause was terminated for the company to act.

The transaction is still pending, and BTI is expected to raise their bid in the near future.

Cigarette Stock Valuation

With the popular outlook on cigarette companies being quite negative, it would be understandable to see that many of the Big 4 trade at a valuation multiple below that of the S&P 500 Index.

This is indeed the case, with one exception:

Cigarette Stock

Source: Value Line

All of the Big 4 trade below the S&P 500’s current PE ratio of ~26 with the exception of RAI.

The trouble is that on a relative basis, these companies are all trading at a higher multiple than their historical average. This may be a detractor from future returns.

As the Fed aims to raise interest rates three times in 2017, this will have the natural effect of lowering the valuation multiple of stocks (including those of cigarette companies). This is due to the natural relationship between interest rates and stock market valuations.

However, the main takeaway here is that the companies can be ranked in order of valuation attractiveness. BTI appears to be the most attractively valued, followed by MO, PM, and RAI (which appears overvalued).

Comparing Dividend Yields

Each of these companies pays robust dividends to their shareholders. Consider the following:

  • Altria is a Dividend Achiever and has increased dividend payments in 47 of the past 50 years.
  • Philip Morris has increased its annual dividend payment every year since the 2008 spinoff and is on track to become a Dividend Achiever in 2018. If you include dividend increases of the parent company before the spinoff, then PM is already a Dividend Achiever.
  • Reynolds American is a Dividend Achiever, and has increased their dividend every year since 2000 with only a single exception (2005 where it remained flat from 2004)
  • BTI is the only security in this analysis without a lengthy history of dividend increases. This is because of the dividend’s exposure to the GBPUSD exchange rate (more on that later).

The Dividend Achievers are a group of companies that have raised dividends for at least 10 years in a row.

You can see the entire list of all 273 Dividend Achievers here.

As it sits right now, each of these cigarette companies pays an attractive dividend north of 3%.

Cigarette Stock

Source: Value Line

Ranking these stocks in order of yield alone would give the following list:

  1. PM
  2. BTI
  3. MO
  4. RAI

These cigarette companies pay the vast majority of their earnings as dividends to shareholders. Consider the following table:

 

Company YTD

Dividends

YTD Adj. EPS YTD Payout Ratio
Altria (MO) $1.74 $2.35 74%
Philip Morris (PM) $3.08 $3.38 91%
Reynolds American (RAI) $1.30 $1.69 77%
British American Tobacco (BTI) $4.36 $6.76 64%

Source: Fact Set, Company Investor Relations

PM maintains the highest payout ratio.

One thing to note about the dividend payments of British American Tobacco is that the company only pays a dividend twice a year, and the payments are irregular.

Rather than paying steady quarterly dividends like most American companies, BTI pays a large dividend in May (called the “Annual Dividend”) and a smaller dividend in October (called the “Half Year Dividend”).

Source: British American Tobacco Investor Relations

This dividend structure creates a lumpy payout stream that is undesirable for investors who desire steady, predictable income.

Another consideration for BTI investors is the effect of the GBP/USD exchange rate on the actual dividend paid to holders of the BTI ADR. Since the dividend must be translated from pound sterling to USD, the dividends fluctuate based on the exchange rate.

That’s why the dividend payments appear to be on the decline since 2014. Expressed in GBP, the dividends have actually been rising.

These two factors (semiannual payments and reliance on the GBDUSD spot rate) make BTI’s dividends less attractive than the other cigarette companies.

Growth Prospects for Big Tobacco Stock companies

Over the long run, each of these four companies has compounded earnings per share with varying degrees of success. Consider these companies’ results since 2008 (the year that PM was spunoff from MO):

Cigarette Stock

Source: Value Line

This table shows adjusted EPS as a line graph and growth as a bar graph.

Over the past eight years, these cigarette companies have grown EPS at the following CAGRs:

 

Company EPS CAGR since ‘08
Altria Group Inc. (MO) 7.0%
Philip Morris International Inc. (PM) 4.2%
Reynolds American Inc. (RAI) 2.3%
British American Tobacco PLC (BTI) 3.9%

MO has been the best performer on a backward-looking basis by quite a wide margin.

Looking forward, each of these companies has a slightly different strategy for driving growth.

Generally speaking, the cigarette industry is focused on the introduction of innovative products for the health-conscious consumer, and this is definitely a trend seen among these four companies.

Altria has been focusing on the development and distribution of their heated tobacco platform.

Developed in conjunction with PM, the product is called iQOS. It is a hybrid between analog and electronic cigarettes that uses legitimate tobacco refills, but heats them to produce a smokeless vapour rather than hazardous smoke.

Altria retains distribution rights within the U.S. while PM tackles sales on a global basis.

Cigarette Stock

Source: Altria Investor Relations

In terms of forecasting future earnings, management has been very transparent.

In their 2016 annual presentation to shareholders, Altria communicated a target of 7-9% annual growth in adjusted EPS and a 80% dividend payout ratio (recall their current payout ratio is 74%).

They also recently announced a $3 billion share repurchase program, expected to be completed in 2018. This will reduce the company’s shares outstanding by approximately 2% based on today’s market prices.

Future returns for MO shareholders are expected to be 10.6%-12.6% over the long run, consisting of:

  • 3.6% dividend yield
  • 5%-7% EPS growth
  • 2% share buybacks

This returns could be reduced by valuation contraction (MO currently trades for 21.6x earnings, higher than historical averages).

Philip Morris International has been targeting the health-conscious consumer with the introduction of PM’s Reduced Risk Product (RRP) portfolio.

Cigarette Stock

Source: Philip Morris International Investor Relations

These innovative products have experienced rapid growth. For instance, consider the growth of just the iQOS product in Japan (one of PM’s largest markets).

Cigarette Stock

Source: Philip Morris International Investor Relations

PM is expecting full-year EPS for fiscal 2016 to be 10.5%-11.5% higher than the year previous. Over the long run, I believe it is reasonable to expect this company to grow earnings at a rate of 4%-6% (lower than their sister company MO due to less retained earnings).

This is largely due to their international market leadership in the Marlboro brand. Due to advertising restrictions in the tobacco industry, Marlboro’s brand recognition is extremely valuable.

PM cancelled their share repurchase program in 2015 due to currency headwinds. The company preferred to focus on bolstering cash reserves and ensuring the future safety of their dividend payments.

So share buybacks will not be a driver of growth for this company.

Over the long run, returns for PM shareholders are expected to be in the range of 8.5%-10.5%, consisting of:

  • 4%-6% EPS growth
  • 4.5% dividend yield

These expected returns could be effected by two factors. First, earnings multiple contraction (PM currently trades at 22.9 times earnings, below the stock market average but above historical averages for this stock).

Secondly, the current strength of the US dollar makes PM’s international sales less valuable when swapped back to USD. As I’ve mentioned, these currency headwinds were the driving factor behind PM cancelling their share repurchase program.

Currency has also been effecting PM’s revenue, with fiscal 2015 revenues dropping $4.7 billion from currency alone.

As the USD returns to a more normalized level, this will provide a tailwind for PM’s earnings.

Reynolds American is taking a two-pronged approach to driving future business growth. First, the company is focusing on increasing market share in regions where their products remain under-represented.

Cigarette Stock

Source: Reynolds American Investor Relations

Secondly, Reynolds is focusing on product innovation. This includes electronic cigarettes, lozenges, and chewing gum.

RAI’s Vuse Solo electronic cigarette currently has market leadership over key competitors.

Cigarette Stock

Source: Reynolds American Investor Relations

The company also produces the Zonnic line of chewing gum and lozenges designed primarily as a stop smoking aid. These products have been positively received by consumers who are focused on tobacco harm reduction.

Further, RAI’s Core product lineup of “heat not burn” cigarettes appeal to this same harm reduction consumer base. This product is very similar to PM and MO’s iQOS.

Cigarette Stock

Source: Reynolds American Investor Presentation

Altogether, this diversified product base should be supportive of future business growth.

Reynolds is also still realizing synergies from their 2014 acquisition of Lorillard Inc.

In fiscal 2016, RAI increased their targeted dividend payout ratio to 80%. They also announced a new share repurchase program for $2 billion expected to be completed by 2018. This buyback will reduce their shares outstanding by ~2.5% based on today’s stock price.

Shareholders of RAI can expect maximum total returns of 8.8%-11.8%.

  • 3%-6% EPS Growth
  • 3.3% Dividend Yield
  • 2.5% Share Buybacks

However, these are maximum expected total returns. With a PE ratio above 29, RAI is overvalued compared to the rest of their peer group and the aggregate stock market.

There is a high probability that multiple contraction will be a detractor from returns moving forward.

British American has been focused on (you guessed it) reducing the harm potential of its portfolio. The company now offers a full line of cigarette and derivatives for the health-conscious consumer.

Cigarette Stock

Source: British American Tobacco Investor Relations

As mentioned earlier, BTI has also placed a bid to acquire the remainder of RAI. This could potentially be a driver of near-term growth for the company if the acquisition is made at the right price.

Total returns for BTI are expected to be in the range of 5.9%-9.9%, consisting of:

  • 2-6% EPS growth
  • 3.9% dividend yield

Objectively speaking, it is more difficult to project total returns for BTI. This is because an investor is predicting not only the success of the underlying business, but also the GBPUSD exchange rate.

This is reflected in the wider range of expected returns for this company.

Final Thoughts on The Best Cigarette Stock Investment

Overall, the cigarette industry benefits from many favorable economics that benefit investors. They benefit from economies of scale, streamlined manufacturing and distribution processes, and an inelastic demand curve (companies can raise prices without dramatically effecting consumer demand).

Of the Big 4, I believe two companies stand out as the strongest dividend investments. These are MO and PM.

Altria has market leadership in the domestic cigarette industry with their dominant Marlboro brand. They also have the best track record of compounding EPS since the spinoff of Philip Morris International.

Pairing an investment in MO with an investment in PM allows investors to profit from the Marlboro brand not just in the United States but worldwide.

Both of the companies have high dividend yields, reasonable valuations, and sustainable payout ratios. As a result, they both have above-average ranks using the 8 Rules of Dividend Investing, and should provide adequate risk-adjusted returns moving forward.

With that said, all of the 4 large tobacco stocks today are trading for valuation multiples above their historical averages.  Patient investors should wait until a price dip to initiate or add to a position in MO and/or PM.

Article by The Financial Canadian, Sure Dividend