Can ‘Safer’ Cigarettes Save Tobacco Stocks?

by Charles Sizemore | January 14, 2014 5:58 am

Can ‘Safer’ Cigarettes Save Tobacco Stocks?

Philip Morris International (PM[1]) recently announced plans for a $680 million factory in Italy to produce less-lethal cigarettes[2].

Notice I said “less-lethal” and not “nonlethal.” Unlike the popular new e-cigarettes, which produce a nicotine vapor mist, the Philip Morris variety will contain real tobacco to appeal to smokers who crave the taste of a real cigarette. Though unlike with traditional smokes, the tobacco is heated rather than burned.

So, is this a big deal? Might Philip Morris’ efforts stem the terminal decline of smoking in the developed world?

Maybe … but I’m not buying it.

We’ve seen this before. In fact, Jeff Middleswart wrote about this very topic in Behind the Numbers[3] this week. Writing about Reynolds America (RAI[4]), Middleswart noted that:

“In 2000, RJ Reynolds rolled out the Eclipse cigarette, which was designed to heat the tobacco rather than burn it. The result was much less smoke and in advertising it claimed that was less harmful than other cigarettes. Studies did not substantiate that and states started to sue over the claims. RAI just paid Vermont $14 million to settle these claims.”

Oops.

Throughout 2013, I made the argument[5] that tobacco stocks no longer represented an attractive investment on a value basis. I maintain two long-term positions in PM stock and Altria (MO[6]) in a dividend-focused portfolio, but I don’t recommend adding new money to those positions at current prices.

Big Tobacco isn’t disappearing any time soon. It’s still a wildly profitable business, and tobacco stocks are some of the most reliable dividend payers traded on the market today. But anyone expecting tobacco stocks to deliver market-beating returns going forward needs to take a step back and look at the numbers.

Thankfully, Middleswart has done the heavy lifting for us. Writing again about Reynolds American in his Jan. 9 issue, Middleswart commented that Reynolds traded at a 7.6% yield in September 2002 and at a P/E ratio of just 40% of the broad market.

And today? Reynolds yields 5.2% and sports a P/E that is 90% of the broad market, roughly in line with its peers.

If you’re buying Big Tobacco stocks at current prices, then you are implicitly assuming that one or both of the following must be true:

  1. U.S. stocks — which are already looking expensive based on the cyclically adjusted P/E ratio (CAPE) — will command a significantly higher valuation than they do today.
  2. Tobacco stocks will trade at a substantial premium to the broader market.

Do either of these scenarios seem likely to you?

Again, I’m not a permabear on tobacco stocks. At this right price, I love tobacco stocks as consistent dividend payers.

But that’s the key; the price needs to be right. Tobacco stocks should trade at a substantial discount to the broader market given that they are in terminal (albeit slow) decline.

But what about e-cigarettes? Might they offer a source of new growth for the battered industry?

Yes, and in fact, they already are. But the e-cig market is not big enough to replace declining sales of traditional cigarettes. As I wrote last year[7], the era of regulation-free e-cigs is quickly coming to an end, and in any event, e-cigarettes only account for about 1% of total tobacco sales.

If you insist in owning tobacco stocks, then PM stock and Altria are easily the “cleanest dirty shirts” of the lot. Philip Morris International’s emerging-market business has a much longer shelf life than those of the domestic sellers, and Altria owns nearly 30% of SAB Miller (SBMRY[8]), the diversified global brewer.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long PM and MO. Check out his new premium service, Macro Trend Investor[9], which includes a free copy of his e-book, The New Megatrend Investor: The Ultimate Buy-and-Hold Strategy That Will Make You Rich.

Endnotes:
  1. PM: http://studio-5.financialcontent.com/investplace/quote?Symbol=PM
  2. produce less-lethal cigarettes: http://www.bloomberg.com/news/2014-01-10/philip-morris-picks-italy-for-first-factory-for-new-cigarettes.html
  3. Behind the Numbers: http://www.behindthenumbers.com/
  4. RAI: http://studio-5.financialcontent.com/investplace/quote?Symbol=RAI
  5. made the argument: http://investorplace.com/2013/09/e-cigs-e-cigarettes-tobacco-stocks/#.UtBuEvRDuxI
  6. MO: http://studio-5.financialcontent.com/investplace/quote?Symbol=MO
  7. I wrote last year: http://investorplace.com/2013/09/e-cigs-e-cigarettes-tobacco-stocks/
  8. SBMRY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SBMRY
  9. new premium service, Macro Trend Investor: http://investorplace.com/order/?sid=SR8131

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