5 Reasons to Believe in Tobacco Stocks

by Will Ashworth | June 23, 2014 11:00 am

5 Reasons to Believe in Tobacco Stocks

Tobacco stocks are smokin’ hot in 2014, up 14% year-to-date [1]through June 19. Doubling the pace of the S&P 500, tobacco stocks might be poised for growth for the first time in years. There are several reasons for this optimism, not the least of which are e-cigs, the devices meant to replace traditional cigarettes.

Cigarettes 185 5 Reasons to Believe in Tobacco Stocks[2]
Source: ©iStock.com/NickyBlade

But is it enough to keep the good times rolling?

I believe it is. Here are five reasons tobacco stocks will continue the momentum ride they’ve been on the past three months. The exact duration of this ride is heavily dependent on how two of these reasons play out over the next five years. If both deliver the goods (and that’s a big “if”), tobacco stocks would be one of the best long-term investments available.

Tobacco Stocks and E-Cigs

USA Today’s Matt Krantz recently was asked by a reader if e-cigs[3] will light up Altria (MO[4]) stock. While he didn’t specifically answer the question affirmatively, he did imply (via Patrick Hughes, an analyst with Height Analytics) that the Food and Drug Administration will oversee e-cigs and view them in a positive manner.

With e-cigarette sales of $1.5 billion in 2013[5] (Wells Fargo expects $24 billion by 2023) and all the major players marketing at least one brand nationwide, it’s only a matter of time before investors recognize that e-cigs are an extremely positive development for tobacco stocks. That’s especially true when you consider that, for the first time in year,s they’re able to advertise[6] without any restrictions. You can be sure they’ll spend large.

Tobacco Stocks and Marijuana

Big Tobacco might play coy about its intentions for marijuana but there’s no doubt the market is huge. According to a report[7] by Rand Corporation the amount of marijuana consumed in the U.S. between 2002 and 2010 increased by 40%, with consumers spending as much as $60 billion on the stuff in 2010 alone. When you consider that the combustible cigarette market[8] in 2013 is estimated at $85 billion, it stands to reason that e-cigs aren’t nearly as big an opportunity as marijuana is. Investors in tobacco stocks can’t ignore this reality.

InvestorPlace staff writer Robert Martin recently opined on the subject of marijuana stocks and the tobacco industry[9]. His conclusion: Big Tobacco will stay away from marijuana until the feds legalize it. Once marijuana legalization goes coast to coast, they’ll swoop in for the kill, taking out all the bit players[10] currently trying to benefit from the happenings in Colorado and Washington. Marijuana will be the long-term savior for tobacco stocks.

Tobacco Stocks and Dividend Yields

Four of the top five holdings in The Vice Fund (VICEX[11]) are tobacco stocks. Combined, their average dividend yield is 4.4%. With such a healthy dividend yield it’s no wonder that these four stocks represent 21.6% of the portfolio.

If you perform a stock screen looking for consumer goods companies with market caps greater than $300 million and currently paying a dividend yield of 4% or more, you’ll find that five of the nine stocks that make the cut are tobacco stocks. No other industry in the consumer goods sector pays better. If you can overlook the sins of an industry, you’ve got good financial reasons for owning tobacco stocks.

Tobacco Stocks and Free Cash Flow

Tobacco stocks are cash flow machines. After all, where do you think those dividends come from?

Altria, Reynolds American (RAI[12]), Lorillard (LO[13]) and Philip Morris International (PM[14]) generated $15.4 billion in free cash flow in 2013[15]. Out of that they paid $11.5 billion in dividends[16] and another $11.2 billion for share repurchases.

PM is the largest of the four tobacco stocks. It spent just $1.2 billion on capital expenditures in 2013, a fifth of the amount it allocated to stock buybacks. With rapidly declining sales in many of its mature markets, there’s minimal capital required to keep generating free cash flow. It’s a great business model that can only get better with any real success from either of the first two reasons.

Tobacco Stocks and China

Euromonitor released a research report[17] in late May suggesting that, by 2018, one out of every two cigarettes around the world will be smoked by someone from China. It’s one of three markets (Indonesia and Vietnam are the others) worldwide that aren’t experiencing declining cigarette sales.

In 2013, China’s cigarette sales topped $200 billion. It’s a huge market that currently is controlled by the state-owned China National Tobacco Corporation, which has a virtual monopoly in the Chinese market. Were the Chinese government to relax their stance even a little tobacco stocks like Philip Morris would benefit greatly. It’s a long shot, but you can’t discount the opportunity.

Tobacco Stocks Bottom Line

No other industry has captured as much attention as the cigarette business. You can be sure that e-cigs and marijuana are subjects that will continue to captivate investors, especially those interested in tobacco stocks.

There are plenty of reasons to believe in tobacco stocks. However, once marijuana is legalized federally, that list reduces itself to just one. Marijuana is a can’t-miss, given tobacco companies’ experience selling cigarettes.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.

Endnotes:
  1. 14% year-to-date : http://performance.morningstar.com/stock/performance-return.action?t=PM&region=usa&culture=en-US
  2. [Image]: http://investorplace.com/wp-content/uploads/2014/05/Cigarettes-185.jpg
  3. e-cigs: http://americasmarkets.usatoday.com/2014/06/20/ask-matt-will-e-cigs-light-up-altria-stock/
  4. MO: /stock-quotes/MO-stock-quote/
  5. e-cigarette sales of $1.5 billion in 2013: http://www.reuters.com/article/2014/05/30/us-usa-tobacco-ecigarettes-analysis-idUSKBN0EA0CF20140530
  6. advertise: http://www.businessweek.com/articles/2014-06-17/big-tobacco-keeps-pushing-into-e-cigarettes
  7. report: http://www.businessweek.com/printer/articles/208445-high-times-on-wall-street
  8. combustible cigarette market: http://www.newsobserver.com/2014/03/22/3721335/no-longer-blowing-smoke-e-cigarettes.html
  9. marijuana stocks and the tobacco industry: http://investorplace.com/2014/06/big-tobacco-marijuana-stocks-to-buy/#.U6RDEl652by
  10. bit players: http://investorplace.com/2014/04/medical-marijuana-stocks-mjna-phot/view-all/#.U6REll652bw
  11. VICEX: /stock-quotes/VICEX-stock-quote/
  12. RAI: /stock-quotes/RAI-stock-quote/
  13. LO: /stock-quotes/LO-stock-quote/
  14. PM: /stock-quotes/PM-stock-quote/
  15. free cash flow in 2013: http://financials.morningstar.com/ratios/r.html?t=MO&region=usa&culture=en-US
  16. $11.5 billion in dividends: http://financials.morningstar.com/cash-flow/cf.html?t=RAI
  17. research report: http://www.marketwatch.com/story/one-in-every-two-cigarettes-will-be-smoked-by-chinese-consumers-by-2018-2014-05-27-4173133

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