The FDA Presents Another Great Buying Opportunity

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

All the major tobacco companies saw a nice pullback last week as renewed concerns surfaced surrounding the FDA and menthol cigarettes, with my personal favorite, Lorillard (NYSE: LO), down over 5.5%.

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Fellow contributor Robert Ciura notes that he would avoid both Reynolds American (NYSE: RAI) and Lorillard due to their exposure to the methanol brands, where Lorillard has the key menthol brand Newport, and Reynolds sells Salem. cigarettes.

However, I think this could be a solid buying opportunity for investors looking to get into a stable, high-dividend paying industry. There was a similar scare back in 2011 when an advisory committee at the FDA ruled that the removal of menthol from the tobacco marketplace would benefit public health greatly.  

Even as tobacco companies have been forced to disclose the various dangers of their products, they've survived the onslaught of anti-smoking campaigns, seen taxes on their products move higher and higher, and had their products disallowed in various public places, yet people continue to smoke. 
U.S. sales leader

The dominant force in the U.S. tobacco market is, and has been for some time, Altria (NYSE: MO).  Revenue is expected to be up 1% in 2013, thanks to mid-single-digit volume growth in the smokeless-tobacco segment. 

Meanwhile, revenue is expected to be up 3% in 2014. Altria has a robust product portfolio, which includes Marlboro, Virginia Slims, Copenhagen, Skoal, Chateau Ste. Michelle and Columbia Crest.

The move to more smokeless products should not only help drive revenue higher, but also  boost margins. Last quarter, gross profit was up 2.4% year-over-year thanks to a lower cost of sales. The smokeable-products category saw operating income rise 1.5% last quarter, while the smokeless-products segment's operating income was up 12.5%. 
Altrai's smokeless tobacco brands, Copenhagen and Skoal, continue to gain market share. From 2008 to 2012, Copenhagen and Skoal together saw their market share rise from 47.5% to 50.6%.
Revenue growth and expansions 
Reynolds expects to see revenue grow slightly in 2013 and 2014. The company is looking to embrace the increase in smokeless tobacco volumes, expecting to see increased volume in its American Snuff segment.
Reynolds is also expanding its tobacco brands by offering new mint flavors for the Camel brand. Reynolds also offers a super premium brand, Natural American Spirit. The tobacco company recently announced 2Q EPS of $0.84, compared to $0.79 last year. However, cigarette shipments did fall 6% last quarter, and market share fell from 26.3% to 26%. Even still, worth noting is that its Pall Mall and Camel brands' market share was up 0.9 percentage points to 17.6%.
Lorillard also recently posted strong 2Q EPS results. EPS came in at $0.81 versus $0.73 for the same period last year. Lorillard continues to grow market share nicely. Back in 2012, Lorillard's market share increased 0.3 share points to 14.4%.
Meanwhile, Lorillard launched a variation of non-menthol products in late 2010 to help expand beyond the Newport Menthol brand. Lorillard is also turning to e-cigarettes. The company acquired blu eCigs, which contributed $61 million to sales 2012. During 1Q 2013, Lorillard expanded the blu eCigs distribution to more than 80,000 retail outlets and captured over 40% of the e-cig retail market share.

Bottom line

As I mentioned before, Lorillard is the best investment on a number of fronts. This includes valuation, volatility and dividend. Up until mid-2011, the three tobacco companies actually traded inline with each other, and since the FDA overhang, Lorillard has been trading below the industry.
The FDA scare arose back in 2011, where the tobacco industry has been resilient through the years, showing remarkable innovative powers and I don't think that will change anytime soon. 
All three tobacco companies have been diversifying their revenue streams and expanding their portfolios. The beauty about the tobacco industry is that its products are highly addictive, providing for stable revenue. This industry has grown revenue over the years despite a 3% annualized decline in cigarette consumption over the past decade. Growth in e-cigarettes could be the next big growth avenue for these stocks.
All in all, it's not that I don't like Altria or even Reynolds, I just like Lorillard better given its valuation. Altria and Reynolds both trade with PEG ratios of 2, while Lorillard's is at 1.1. 

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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