Money From Smoke Vs. Smoking The Money

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

Let us imagine a regular 25 year old man who smokes a pack of cigarettes a day. If he were to live in New York City, he would spend around $10 daily for a pack of Marlboro Reds. This equates to $3,650 dollars per year. If he'd then decided to stop smoking for only one year out of his 71 years of existence -the average life expectancy of a heavy smoker in New York- and invested the money saved in a 401k, a Roth IRA, or any other type of tax-deferred pension plan that yielded a 7% return rate (an average yield by all standards), by the time he'd retire 40 years later he will dispose of an extra $54,657 that would have been lost forever had he decided to smoke for just one more year between the age of 25 and 26. 

What's my point? Some people smoke their money (literally), while others make money by owning shares in cigarettes companies. Some let the smoke work for them and end up in their bank accounts instead of working against them by making its way into their lungs. That leads me to conclude that if people are willing to spend their hard earned dollars on a product like cigarettes, you might as well own them (the cigarettes I mean...). That way you can take the compounding they would have received and keep it to yourself.

The US cigarette market

In the US, Altria Group (NYSE: MO) and Reynolds American (NYSE: RAI) hold roughly 50% and 28%, respectively, of the market share of the domestic cigarette industry. Then comes Lorillard (NYSE: LO) and its 12.6% market share, and Imperial Tobacco with its 4.2% stake. An investor who owned stock in those 4 businesses would be in the position of knowing that his tobacco investments controlled a combined 94.8% market share.

However, not all companies are created equal. By digging further we realize that Lorillard and Reynolds American are actually subsidiaries of British American Tobacco (NYSEMKT: BTI). As for Altria Group, it is the parent company of Philip Morris USA, which constitutes its tobacco division in the United States. Therefore, you really have two corporations -Altria and British American Tobacco- who own over 90% of all the domestic cigarette market share. Talk about an economic moat.

Is the cigarette business sustainable?

19% of Americans (43.8 million) were daily smokers in 2012, down from 42% in 1965. Smoking rates in the US have been declining every year for the past 40 years. This is partially offset by population growth, but it is still ultimately a doomed business due to higher health care costs and huge government pressure on the tobacco industry in the form of higher taxes and tougher regulations.

However, the situation in the rest of the world is different. Sure, smoking has gone down in every first world country (Western Europe, Japan, Australia, Canada and the US) for the past decade -with the exception of France- but worldwide smoking as a whole has been going up because in developing countries people are smoking more and more. 1.3 billion people (20% of the world's population) are now daily smokers. China, India, Indonesia, and Russia constitute the greatest markets for tobacco consumption, along with the US. Between the five of them they make up for half of the world's entire population of smokers. With its staggering 350 million smokers, China is of course the greatest tobacco market on earth, as it accounts for 27% of the world's total consumption of cigarettes. There is no doubt that the global cigarette industry is a healthy business and a much more promising one than the domestic American cigarette market.

All roads lead to Philip Morris

Why Philip Morris International (NYSE: PM)? Because it is the largest tobacco company in the world, and because it focuses exclusively on the international market, leaving the domestic market to its sister company Altria Group through Philip Morris USA (PM was born from the 2008 spin-off with Philip Morris USA). In 2012, PM held 16% of the international cigarette market outside the US, and 28.1% excluding China and the US. It owns Marlboro, the world's number one cigarette since 1972, and one of the most powerful trademarks among all consumer products. In 2012, Marlboro's volume was bigger than the next two largest cigarette brands combined, and exceeded that of the top four global brands owned by British American Tobacco. PM operates 56 production facilities in 33 different countries, produces 860 billion cigarettes each year, and has been acquiring major cigarette brands of countries around the world at a very high rate. If the Chinese market ever opens up – it is still under the complete domination of the state monopoly held by the China National Tobacco Corporation - PM would be in the driver's seat to take advantage of it.

But Philip Morris International not only dominates every market in which it competes, it also generates a lot of cash flow and returns almost all of it to its owners in the form of dividends and share buy backs. It trades at a fairly attractive valuation of 17.4x earnings and generates an impressive operating profit of 43.9% for every dollar of revenue. It therefore has more money to spend through its R&D department than its competitors to come up with a cigarette that would remove the toxic elements that ultimately cause cancer and heart disease. It is estimated that 100 elements out of the 5000 elements found in every cigarette are dangerous for your health, but nicotine is not one of them. Therefore, if there is a company that could ever come up with a "clean cigarette," Philip Morris would be the first in line. If they manage to pull it off, it would be like winning the lottery for huge companies like PM and British American Tobacco. Most government regulations and taxes would go down (along with all the law suits), and PM would be making so much extra cash that it could build the Marlboro cowboy a gold statue!

The best thing about the tobacco industry is that it is mature, and therefore almost all of the earnings can't be reinvested in the business for future growth. It has to go to share repurchases, cash dividends, and acquisitions. The other advantage of a major global player like Philip Morris International is that its sales and earnings are generated in foreign currencies. As the Dollar gets weaker due to higher deficits and money printing carried out by the US Treasury and the Fed, the company could take its Euros, Yens, Rubles or Renminbis, convert them into Dollars and buy back shares, gaining a huge cost advantage. In other words, as long as the Dollar continues to lose value, companies like Philip Morris International that rely on foreign sales will grow more attractive. This gives management more room to benefit the shareholders, which is what every owner should look for in a management team.  

PierreDV 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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