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.
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:
- Altria Group Inc. (MO)
- Philip Morris International Inc. (PM)
- Reynolds American Inc. (RAI)
- British American Tobacco PLC (BTI)
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.
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.
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:
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%.
Source: Value Line
Ranking these stocks in order of yield alone would give the following list:
These cigarette companies pay the vast majority of