Can You Afford These 8 Tobacco Stocks?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Government crackdowns on tobacco are an inescapable international phenomenon. Developed nations, emerging markets, and developing markets are enforcing more stringent restrictions on tobacco companies. Legal wins for tobacco companies are the exception in today's regulatory environment, not the rule.

Stock investors should take the hint and expect that there will be regulatory headwinds for tobacco companies and their products. As a logical consequence, investors should demand low valuations. Unfortunately, the high valuations fail to compensate investors for these risks.

Sin Taxes to Increase in the Philippines

Filipino billionaire and partial owner of Philip Morris (NYSE: PM), Lucio Tan, has stated that the taxes being charged on cigarettes should be increased on a graduated scale so as to prevent the country's $2.1 billion tobacco industry from suffering huge losses all at once. This is an implicit acceptance that rising taxes on tobacco products are inevitable.

Michael Tan, son of the tycoon, noted that further increase in sin taxes will have a negative impact on prices. Apart from increase in prices, job losses, a decrease in demand, and tobacco smuggling are some of the possible consequences of a large tax hike. Tan, director of the largest tobacco venture in the Philippines said, "We would like a moderate, predictable increase that will give realistic revenues for the government…The tobacco industry should be treated in a more fair fashion, with a more equitable sharing of the tax burden."

The President of the Philippines is pushing Congress to pass a bill that will ensure that collection of annual revenues reaches at least 60.6 billion pesos ($1.47 billion). This target will be attained by increasing taxes on tobacco and alcohol. Most of the revenue collected will be directed to the health sector and infrastructural development. World Health Organization rates the Philippines as the fourth-lowest in pricing of cigarettes per pack globally.

Russia's Tobacco Crackdown

Russia's government has considered legislation that could increase the excise taxes on tobacco by 40% by 2014, and would limit the advertisement of tobacco products. This legislation has been proposed in an effort to curb the rapid population decrease in Russia. It follows Russia's eight-fold tax hikes on cigarettes. This regulatory risk has material impact on tobacco stocks because Russia is the second largest cigarette market (after China), according to the World Health Organization.

Big tobacco companies such as British American Tobacco (NYSEMKT: BTI)Japan Tobacco, and Philip Morris are fighting Russian regulation. These big tobacco companies dominate the Russian cigarette market. British American Tobacco commands 21% of the market, 26% is held by Philip Morris, and Japan Tobacco has 37% of the market.

Australian Tobacco Regulations

Russia is following in the footsteps of other governments which have ever-tighter tobacco product regulations. Australia now requires its tobacco products to place images of cancer victims and gangrenous limbs on cigarette packs. Its new government standards require health warnings and horrifying images to cover seventy five percent of the fronts of cigarette packs. New packages are required to display unsettling images including a skeletal man dying of lung cancer, an image of tongue cancer, or an infected foot. Additional warnings have to cover the sides of the packages and ninety percent of the back.

Health officials hope that the disgusting new cigarette packaging will dissuade more consumers from smoking. Tanya Plibersek, Australia's minister of health, said, "Young people are the ones most affected by the packaging and by the advertising, and no parent wants their kid to start smoking."

The remainder of the packaging which is not covered in cautionary warnings is required to be drab. According to the state law, any trademarks or product names have to be in Lucida Sans font and the background of the packaging must be a specified greenish-brown hue. State officials will enforce these rules.

Similar regulations will appear in other countries. World Health Organization Director-General Margaret Chan said, "With so many countries lined up to ride on Australia's coattails, what we hope to see is a domino effect for the good of public health." Other nations including the New Zealand, India, United Kingdom, Turkey, and Russia expressed interest in more severe plain packaging rules.

Tobacco is Discretionary, Too

Tobacco products are viewed either as additive or recreational. It's really hard to quit, but customers can and do reduce their consumption in hard times. The idea that Tobacco is a recession-proof industry is a faulty one.

Philip Morris' third quarter financial results show how an economic slowdown can drop tobacco product sales. Shipments of Philip Morris cigarettes to Argentina, Brazil, Colombia, Mexico and then Canada fell 4.9% in the third quarter. Worse yet, shipments to countries like Portugal, Spain, Italy, France and other European Union countries declined eight percent.

Philip Morris Chief Executive Officer Louis Camilleri said, "Despite the difficult comparisons in the third-quarter, we remain confident that the fundamentals of our business are solid as a whole, which is testament to our progress, especially in our Asia and EEMA Regions."

However, in contrast to these declining sales, Philip Morris has seen good business in Asian countries including Thailand, Indonesia, and Vietnam. Sales in these Asian countries made up for Japan's declining sales for a tiny 0.6% sales growth for all of Asia. Philip Morris shipments rose to the EEMA region (Middle East, Eastern Europe and Africa) rose 3%.

Lorillard's (NYSE: LO) reported net sales of $1.66 billion in the third quarter of 2012, compared to $1.62 billion in the third quarter of 2011, an increase of 2.4%. The increase resulted primarily from higher cigarette prices, offset partially by lower cigarette sales volume. Lorillard's blu eCigs added $14 million in net sales to the company's third quarter. 

Warning: Tobacco Stocks are Pricey

Taxes and regulatory pressures and will likely increase country by country. In order for investors to consider tobacco stocks, they should be much cheaper than other stocks.

This is not the case:

Ticker

Company

Industry

Country

P/E

P/S

Div Yield

Payout Ratio

(AOI)

Alliance One International

Tobacco

USA

30.9

0.12

NA

NA

 

British American Tobacco

Cigarettes

UK

20.07

4.04

4.13%

0.81

(LO)

Lorillard

Cigarettes

USA

14.53

2.4

5.11%

0.71

(MO)

Altria Group

Cigarettes

USA

17.11

2.72

5.36%

0.87

 

Philip Morris

Cigarettes

USA

17.74

1.94

3.83%

0.63

(RAI)

Reynolds American

Cigarettes

USA

16.12

2.86

5.54%

0.87

(UVV)

Universal

Tobacco

USA

8.88

0.46

4.12%

0.32

(VGR)

Vector Group

Cigarettes

USA

64.16

1.27

9.50%

6.14

When considering the trend of increasing government regulation, these stocks are not trading at low-enough valuations. Investors would be better served investing in the S&P 500 because its average price multiples are lower and its companies face less governmental risks.

Cigarette stocks also have unsustainably high dividend payout rates. These dividends will not last forever since payout ratios above 60% leave little room for earnings declines or reinvestment. Of these dividend-paying tobacco companies only Universal has a sustainable payout ratio. If earnings decline or if governments initiate new restrictions these payouts would be threatened.

Conclusion

Investors should avoid tobacco and cigarette stocks based purely on investing prudence. Price multiples in this industry do not reflect the regulatory headwinds they face. Many of these stocks could see downward revisions to their dividend policies.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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