Tobacco: Why Sin Is Winning

By Jane Genova - February 17, 2012 | Tickers: MO, CZR, LO, RAI, SHW | 0 Comments

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There’s the investor who's convinced that sin stocks endure, always bouncing back from public opinion, regulatory, and litigation hits. Those range from sex to gambling to tobacco.

We know that isn't true. Industries whose core competence is sin can change and the existing dominant players disappear. Look at Playboy Enterprises, which has gone private.  Social mores loosened around sex, making the kinds of products and services Playboy offered less enticing.  A similar upheaval could happen in U.S. gaming. The action is shifting from Nevada and Atlantic City to Macau, Asia and maybe from casinos to the Internet. Many of those U.S. gambling stocks could plummet and never recover. Also, within that changing industry, there are individually weak members such as Caesars (NASDAQ: CZR). Its debt could do it in even before business-as-usual might implode.

So, it should astound us that the three major tobacco stocks persist as recommended investments. After all, the industry is mature. And, since the 1998 Master Tobacco Settlement Agreement (MTSA), the death of tobacco companies had been predicted.  Yet, Philip Morris, owned by Altria (NYSE: MO), Lorillard (NYSE: LO), and Reynolds American (NYSE: RAI) are currently the darlings of the market. On February 9^th, THE STREET had the headline “Cigarette Stocks Reach 52-Week Highs.” Why is this happening?  Here are some of the reasons.

One, the industry is dominated by a small number of companies.  Barriers to entry, especially because the business is highly regulated, are high. 

Two, there is the lack of alternatives. This kind of sin happens primarily by smoking cigarettes. Gambling can take so many forms, dating back to the old number runners in urban areas. Of course, in recessions, customers can trade down to the company's products with lower price points such as private label. However, it is difficult to quit consumption since, many sources contend, nicotine is addictive.

Three, the expected physical and emotional result is guaranteed.  Cigarettes are a multi-purpose substance.  There is zero failure rate on expectations. They restore the level of nicotine in one's system, calm nerves, enhance pleasure, and lift low feelings.  Research published in the JOURNAL OF THE AMERICAN MEDICAL ASSOCIATION in 2006 documents that a signficant number of the mentally ill benefit from how cigarettes alter mood. Not every casino guest leaves satisfied. 

Four, tobacco companies tend to be well managed. They have to be in such a tough regulatory environment.  Some might say this penance for the sin has been the salvation of the players. Part of the efficiency has come about through mergers and acquisitions. The companies tend to have good cost control which, documents Richard Gallagher of VALUE LINE, leads to wide profit margins.

They also excel in marketing.  For example, they have been pioneers in pursuing markets in developing economies, particularly in Asia.  They were ready for the emerging middle class which could  afford and come to crave U.S.products. Abroad and domestically, they balance their premier brands with their own private label offerings.  

Smart also is the sign of diversification.  Philip Morris is experimenting with other applications for tobacco.  It has purchased a 40 percent stake in Medicago, a Canadian biotechnology company developing an influenza vaccine from tobacco leaves. It's a stretch to think this way but developing and highlighting such health-related uses of tobacco could rebrand it.

In addition, the tobacco companies manage the stock price with frequent buy-backs.  In 2012, Philip Morris is repurchasing $6 billion or about 4 percent of the current market capitalization.

Five, they have a steep learning curve. On the public affairs front they have come to comply with public opinion, instead of refuting it.  You bet, they encourage youth not to start the habit.  After caving to the MTSA, they have adopted an aggressive position in litigation, fighting lawsuits all the way to the U.S. Supreme Court.  Recently, after less than an hour of deliberations the jury ruled for Reynolds and Philip Morris in Gollihue v. R.J. Reynolds Tobacco Co., 09- CV-10530, U.S. District Court, Middle District of Florida (Jacksonville). No, the tobacco industry is no longer an easy litigation target.  It was by this same never-surrender post-MTSA stance that the former lead paint companies such as Sherwin-Williams (NYSE: SHW) prevented possible bankruptcy from public nuisance state-level lawsuits. The only remaining lead paint one is in California.

Six, they focus on dividends, frequently increasing them.  Reynolds has the highest at 5.46 percent yield, then Lorillard at 5.1 percent, and Philip Morris at 4 percent. That puts tobacco in the class of dividend aristocrats, which gets the attention of some investors.

But threats still loom for the overall industry as well as each player. Sin, by its nature, invites reform, particularly by those seeking political advantage.  The U.S. as well as just about any other nation could introduce a kind of prohibition. Talk of that is surfacing again. This is an election year. Overseas in Bhutan a total ban has already happened.  Sure, if cigarettes become illegal in the U.S., the business will go underground. But investors in the three companies will be out of luck.  Also, all three face the possible ban on menthol cigarettes by the Food and Drug Administration. There are contentions that menthol carries more health risks than non-menthol and is often the gateway product for teenagers.  Lorillard, whose business is about 85 percent menthol, is the most vulnerable. 

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