High Price Valuations Make Tobacco Stocks Unattractive

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Governments around the world are getting tougher and tougher on tobacco companies. Investors should demand low valuations for these industry headwinds. Oddly, many of the industry stocks trade at high price multiples: 

<table> <tbody> <tr> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Industry</strong></p> </td> <td> <p><strong>Country</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>P/S</strong></p> </td> <td> <p><strong>Div Yield</strong></p> </td> <td> <p><strong>Payout Ratio</strong></p> </td> </tr> <tr> <td> <p>AOI</p> </td> <td> <p>Alliance One International</p> </td> <td> <p>Tobacco</p> </td> <td> <p>USA</p> </td> <td> <p>32.9</p> </td> <td> <p>0.13</p> </td> <td> <p>NA</p> </td> <td> <p>NA</p> </td> </tr> <tr> <td> <p>BTI</p> </td> <td> <p>British American Tobacco</p> </td> <td> <p>Cigarettes</p> </td> <td> <p>UK</p> </td> <td> <p>20.59</p> </td> <td> <p>4.15</p> </td> <td> <p>4.0%</p> </td> <td> <p>0.81</p> </td> </tr> <tr> <td> <p>LO</p> </td> <td> <p>Lorillard</p> </td> <td> <p>Cigarettes</p> </td> <td> <p>USA</p> </td> <td> <p>14.51</p> </td> <td> <p>2.4</p> </td> <td> <p>5.1%</p> </td> <td> <p>0.71</p> </td> </tr> <tr> <td> <p>MO</p> </td> <td> <p>Altria Group</p> </td> <td> <p>Cigarettes</p> </td> <td> <p>USA</p> </td> <td> <p>17.61</p> </td> <td> <p>2.79</p> </td> <td> <p>5.2%</p> </td> <td> <p>0.87</p> </td> </tr> <tr> <td> <p>PM</p> </td> <td> <p>Philip Morris</p> </td> <td> <p>Cigarettes</p> </td> <td> <p>USA</p> </td> <td> <p>17.98</p> </td> <td> <p>1.96</p> </td> <td> <p>3.8%</p> </td> <td> <p>0.63</p> </td> </tr> <tr> <td> <p>RAI</p> </td> <td> <p>Reynolds American</p> </td> <td> <p>Cigarettes</p> </td> <td> <p>USA</p> </td> <td> <p>16.56</p> </td> <td> <p>2.94</p> </td> <td> <p>5.4%</p> </td> <td> <p>0.87</p> </td> </tr> <tr> <td> <p>UVV</p> </td> <td> <p><strong>Universal <span class="ticker" data-id="205986">(NYSE: <a href="http://caps.fool.com/Ticker/UVV.aspx">UVV</a>)</span></strong></p> </td> <td> <p>Tobacco</p> </td> <td> <p>USA</p> </td> <td> <p>9.14</p> </td> <td> <p>0.47</p> </td> <td> <p>4.0%</p> </td> <td> <p>0.32</p> </td> </tr> <tr> <td> <p>VGR</p> </td> <td> <p>Vector Group</p> </td> <td> <p>Cigarettes</p> </td> <td> <p>USA</p> </td> <td> <p>64.56</p> </td> <td> <p>1.28</p> </td> <td> <p>9.4%</p> </td> <td> <p>6.14</p> </td> </tr> </tbody> </table>

These generally pricey multiples make absolutely no sense in light of the stream of tightening government actions against these companies.

Tobacco Companies Forced to Say They Lied

The U.S. government routinely makes tobacco companies advertise how unhealthy their products are. Now the government is trying to get them to admit they fudged the truth.

Altria Group (NYSE: MO) faces pressure from the Justice Department to confess its intentions to mislead the public about the health risks of smoking. Its brand, Phillip Morris USA, is one of those accused to have formulated underrated descriptions of the detrimental effects of cigarettes. Altria has not provided any details but stated that it is studying the ruling made by U.S. District Judge Gladys Kessler. The ruling requires tobacco companies to issue statements, which admit they purposely manipulated American consumers, before they begin with any warning of the associated diseases of cigarette smoking. These should be incorporated in tobacco companies’ advertisements, whether in mass media or online media. According to Kessler, “This court has heeded its mandate to fashion corrective statements that are purely factual and uncontroversial and are directed at preventing and restraining the defendants from deceiving the American public in the future.” However, no deadline was imposed to comply with such ruling.

Reynolds American (NYSE: RAI) communicated that the company is currently evaluating its actions in response to the ruling. Reynolds in 2006, together with Altria and Lorillard (NYSE: LO), was found to have collaborated with the others mentioned to undermine the hazards posed by smoking.

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

International Governmental Pressures

Many other governments are restricting tobacco use through marketing regulations, laws restricting smoking, and taxes. These are real challenges to tobacco companies, and they come from both developed and developing nations.

The Philippines is boosting a sin tax for tobacco products. Michael 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 would target annual revenues of at least 60.6 billion pesos ($1.47 billion). This tax revenue will come from increased taxes on tobacco and alcohol. Most of the funds raised will be used in the health sector and for infrastructure spending. In terms of cigarette prices, The World Health Organization ranks the Philippines as the fourth cheapest country.

Russia’s government has also considered legislation to curb tobacco use. This legislation would increase taxes on tobacco by 40% by 2014, and would limit the advertisement of tobacco products. In Russia, the rapid population decrease has been a source of motivation for tobacco regulation and taxation. Russia has already implemented eight-fold tax hikes on cigarettes. Russian regulation is important to tobacco stocks because Russia is second only to China as the largest cigarette market, according to the World Health Organization.

Another country that is part of this trend is Australia. This country now requires disgusting images of gangrenous limbs or disturbing photos of cancer victims on cigarette packs. Australia’s new standards require these unsettling images to cover 75% of the front covers of cigarette packs. Unsettling images include a skeletal man dying of lung cancer, an infected foot, or an image of tongue cancer. As for the rest of the pack, warnings have to cover the sides and ninety percent of the back.

Health officials anticipate that disgusting new cigarette packaging will dissuade consumers—particularly children—from smoking. Australia’s minister of health Tanya Plibersek 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 not covered in government-mandated images and 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 probably appear in other countries. Margaret Chan,  Director-General of the World Health Organization 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 United Kingdom, Russia, Turkey, India, and New Zealand expressed interest in more severe plain packaging rules.

Tobacco is Discretionary, Too

Aside from government crackdowns, there is old-fashioned market risk that cigarette companies bear. As it turns out, they are somewhat discretionary and get cut by consumers in economic downturns.

This flies in the face of conventional wisdom about tobacco products, which are often viewed as addictive. Though it’s really hard to quit, customers do reduce their consumption in recession. Tobacco is not a recession-proof industry.

Philip Morris’s (NYSE: PM) third quarter results illustrate how an economic slowdown can impact tobacco revenues. Shipments of Philip Morris cigarettes to Mexico, Colombia, Argentina, Brazil, and Canada fell 4.9% in the third quarter. Even worse, shipments to European countries including Spain, Portugal, France, Italy, and other European Union countries declined 8%.

Warning: Tobacco Stocks are Expensive Based On Valuation

These stocks are not trading at low-enough price multiples in light of how they face a global trend of higher regulation, taxes, and product bans. Investors would be better off investing in an S&P 500 index fund because its average price multiples are lower and its companies face less regulatory challenges.

It should also be noted that tobacco stocks also have high dividend payout rates that are unsustainable. These dividends will probably need to be curbed since payout ratios above 60% leave little room for reinvestment or earnings declines. New government restrictions, taxes, or earnings declines would threaten these dividends. The only dividend-paying tobacco company on this list with a sustainable payout ratio is Universal. 

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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