EU Cigarette Crackdown, Good and Bad for Tobacco Stocks

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The European Parliament recently approved new rules for menthol and flavored cigarettes, electronic cigarettes, and slim cigarettes. Although the rules aren't law yet, they are indicative of the trend in Europe. British American Tobacco (NYSEMKT: BTI) and Philip Morris International (NYSE: PM) will feel a pinch, but Imperial Tobacco Group (NASDAQOTH: ITYBY.PK) could feel a real squeeze if the trend continues.

Diversified Giant

British American has a material presence around the world, with over 200 brands sold in around 180 markets. That includes an about 40% stake in U.S. based Reynolds American Tobacco. It earns about half of its revenues from emerging markets, which is where growth in demand is expected to be robust.

The global exposure has helped both the top- and bottom-lines grow over the last four years. The dividend, however, has been on an upward climb for a decade. That said, British American got about 22% of its top-line from mature Western European markets in 2012. That means that more stringent rules out of the region could pinch sales.

However, that's a relatively modest exposure, so despite having the word British in its name, new rules out of the “old world” probably won't be too big an issue. Of course the company's stake in Reynolds exposes the company to similar changes being looked at in the United States that could complicate things, too.

Still Asia Pacific, Western Europe, the Middle East, and Africa, where rules are less stringent, made up about half of revenues in 2012. So there's plenty of opportunity to offset sales declines in mature markets with growth in other areas. In fact, increasingly stringent rules could actually help solidify market share for industry leaders like British American, which would support its market position in slowly declining markets.

The shares are off of their recent highs and yield around 4%. Growth and income investors should consider taking a look and shouldn't get too caught up in the potential changes to EU rules.

Only in Foreign Markets

Philip Morris International was spun off of Altria and controls all of that company's tobacco brands in international markets. Altria still controls its brands in the United States. One of Philip Morris' biggest strengths is this world-renowned brand portfolio, which includes iconic Marlboro.

Like British American, Philip Morris operates in mature markets and emerging markets. The European Union makes a little over a third of the company's top-line. So the proposed rule changes are likely to have a bigger impact on Philip Morris. However, unlike British American, Philip Morris has no exposure to the U.S. market.

That said, faster growth markets make up about 50% of sales, so it has notable upside, too. And that doesn't include the company's exposure to Latin America, which it lumps together with its Canadian operations, a country that has a similar profile to the European Union. So growth potential here is at least equal to British American, and there's no U.S. risk.

The company's top-line has grown fairly steadily since its separation from Altria. Earnings have traversed a roughly higher course, too. With a yield of around 3.8% and a stronger growth profile, it is probably a better option for more growth oriented investors.

Too Much Exposure

Imperial Tobacco is another of the largest tobacco companies in the world. Unfortunately, its stronghold is the mature European market. That region accounts for about half of sales. Of the trio, Imperial is going to feel the biggest sting from any rule changes out of Europe.

Still, emerging markets make up around half of the business, and it has notable positions in cigars, fine cut tobacco, and rolling paper. This doesn't make up for the heavy exposure to Europe, but it helps to diversify the business somewhat.

The company's sales have been stuck in neutral for about three years, which isn't a compelling trend since half of the business is facing potentially more restrictive rules. And earnings fell more than 50% year over year in 2012. On the positive side, the dividend has been increased regularly since being cut during the 2007 to 2009 recession.

The yield of around 5%, however, isn't compelling enough when compared to better positioned British American. Investors should probably avoid it for now.

Not the End of the World

Increasingly stringent rules have yet to stop people from smoking. Although mature markets are in slow decline tobacco companies are increasingly focusing on emerging markets for growth. That should keep performance strong enough for this trio to keep returning value to shareholders via increasing dividends and stock buybacks. And new rules often further entrench industry leaders' market positions.

British American is probably the best option for investors seeking broad diversification. Philip Morris' emerging markets exposure and lack of a U.S. business, meanwhile, looks promising for more growth minded investors. Imperial has the most European exposure and should probably be avoided for now.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. 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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