Can E-Cigarettes Relight Big Tobacco?

They could ... or they could speed up tobacco's long-term decline

   
Can E-Cigarettes Relight Big Tobacco?

Has Big Tobacco stumbled into a new growth market in electronic cigarettes?

Well, sort of.

Use of e-cigarettes — which produced a smokeless water vapor infused with nicotine — is expected to more than double in 2013, which might ordinarily be good news for the major tobacco giants. Altria (NYSE:MO), Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) are all active in the market or have concrete plans to be active.

But the increasing popularity of e-cigs has come at the expense of the smoky originals. By Morgan Stanley estimates, e-cigarettes replaced 600 million “stick equivalents” last year and will replace 1.5 billion in 2013. Varying estimates have e-cigarettes accounting for 0.5% to 1.5% of all cigarette sales.

Growth is not something we’ve come to expect from the tobacco industry. Yes, cigarette stocks have produced fantastic returns for investors in recent years, but these stock market returns have come even while unit cigarette sales have continued their drift lower. American cigarette sales fell by 6.2% last year to 289 billion sticks; as recently as 2001, the number was well more than 400 billion.

What does this mean for Big Tobacco and its investors?

The tobacco industry has been very effective at managing the economics of decline, much to the benefit of shareholders. Altria and Philip Morris International (NYSE:PM) were core holdings of the Sizemore Investment Letter for most of 2010 and 2011, and our readers enjoyed fantastic returns driven by the relentless search for yield by investors in the low-rate world of quantitative easing.

There is absolutely nothing wrong with investing in an industry in decline, so long as the right conditions are in place. As I wrote last week, those conditions are:

  1. There should be substantial barriers to entry for new competitors.
  2. The company should be financially healthy (i.e. strong balance sheet, low debt).
  3. Management should be committed to rewarding shareholders via dividend hikes and/or share repurchases.
  4. The stock price should be cheap relative to the broader market.

How do e-cigs affect these criteria?

To start, they erode those all-important barriers to entry. Outside of military armaments, Big Tobacco might be the most highly regulated industry on the planet. Though it sounds onerous, it’s actually quite good for the large existing players because it makes it virtually impossible for new upstarts to come in and undercut the established brands on price.

There is one big problem here. The legal regime is still being formed for e-cigarettes, and right now it is something of a free-for-all that doesn’t necessarily favor existing Big Tobacco. It varies from city to city or bar to bar, but e-cigs also are generally free of the indoor smoking restrictions that have helped to curtail tobacco use.

Would smokers be likely to pay a premium for an e-cigarette branded with the Marlboro label? Maybe. Maybe not. But I’m betting the answer is no.

Rather than being a durable growth business for Big Tobacco, e-cigarettes seem to be yet another way to help people stop smoking — a trendier version of a nicotine patch or Nicorette gum, if you will.

Patches and gum did not destroy the tobacco industry, and neither will e-cigarettes. But they might speed up its long-term decline. According to the Wall Street Journal, e-cigarettes might have been a major reason that cigarette sales declined by over 6% last year rather than the usual 3% to 4%.

But in the end, the only aspect that matters to tobacco investors is how much of this is factored into current prices. Remember, item No. 4 above — for an investment in an industry in decline to make sense, it has to be priced accordingly. And right now, Big Tobacco stocks actually trade at a slight premium to the broader S&P 500.

I could be wrong, of course. Rather than hasten the decline of traditional cigarettes, the e- variety might offer a real avenue for growth. But given how quickly the industry is shrinking, it is hard to see any growth of this front offsetting the declines in unit sales. And none of the above justifies a premium multiple.

If you’re looking for sustainable dividend growth at a reasonable price, Big Tobacco is not your best option at the moment. As I wrote earlier this year when I called semiconductor maker Intel (NASDAQ:INTC) my favorite “tobacco stock,” you’re a lot more likely to find value in Big Tech.

 Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management.  As of this writing, he was long INTC.  Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.


Article printed from InvestorPlace Media, http://investorplace.com/2013/04/can-e-cigarettes-relight-big-tobacco/.

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