Should Tobacco Investors Shun This Company and Look Elsewhere?

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

Philip Morris' (NYSE: PM) first quarter earnings, although strong, highlight the company's main weakness and Achilles heel.

The strong U.S. dollar managed to wipe out $0.07, or 5% of the company's EPS in the first quarter. The company also sold 6.5% fewer cigarettes as both the economic situation in Europe and higher taxes in the Philippines sent customers away from its brands.

Philip Morris is not dead though, excluding the effect of currency, earnings grew 8%. Meanwhile, excluding the fall in cigarettes shipped to the Philippines, the company's volume of cigarettes shipped only contracted 2%.

The problem is that Philip Morris used to be the best in the tobacco business. Indeed, since its spin off in 2008, any investor looking for a long-term investment in tobacco would turn to the company for global exposure and seemingly unstoppable growth.

However, now with changing tobacco opinions worldwide and a rising dollar, the company is starting to feel the pressure and it is possible that Philip Morris could be losing it crown as the best tobacco company on the market.

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Currency movements are having a significant effect on Philip Morris' earnings.

Indeed, Altria (NYSE: MO) and Philip Morris USA could offer investors something that Philip Morris International does not -- predictability. Philip Morris International's most recent earnings report highlights the fact that erratic policies by foreign governments and adverse forex movements can suddenly affect the company's outlook.

While Altira is not totally immune from sudden changes in government regulation, the company isn't exposed to any exchange rate risks. Furthermore, declining tobacco consumption rates within the U.S. are somewhat predictable, meaning that Altria is able to offset declining consumption with marginal increases in the price of its products -- allowing the company to constantly maintain margins and profitability without sudden swings like Philip Morris.

That said, Altria's main problem is its growth. Since the divorce in 2008, Altria's earnings have grown 47% or around 10% per year. Meanwhile, Philip Morris' earnings have grown 55%, nearly 15% per year. On the other hand, Altria does offer a strong dividend yield and has returned to investors an average of 6.5% over the last five years. Philip Morris, on the other hand, has offered an average return of about 4%.

Additionally, Altria would have given investors a total return of 90.5% over the past five years; while Philip Morris would have given investors a return of 105% (right now Philip Morris is trading at a higher valuation than Altria, if the valuations were the same, Altria's total return would be about the same as that of Philip Morris').

Not just Altria

Investors are not just limited to Altria. Lorillard (NYSE: LO) offers investors a play on the U.S. tobacco market and exposure to the rapidly growing E-cig market.

Unfortunately, Reynolds American is not included within this analysis as the company has not been able to achieve the same kind of steady earnings growth as Lorillard and Altria. 

<table> <thead></thead> <thead> <tr><th> <p><strong>Company</strong></p> </th><th> <p><strong>5-Yr Compounded Diluted EPS growth</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>Lorillard</p> </td> <td> <p>75%</p> </td> </tr> <tr> <td> <p>Reynolds American</p> </td> <td> <p>-13%</p> </td> </tr> </tbody> </table>

Lorillard has no international exposure, having sold its international rights to Japan Tobacco years ago, giving the company a predictable nature as it is not exposed to currency fluctuations. Additionally, while its competitors are grappling with falling sales volumes, Lorillard continues to take market share from its competitors here within the U.S. and its volume of tobacco sold continues to grow - last year was the company's tenth constitutive year of sales growth.

So far, since 2008, Lorillard has been able to achieve faster earnings growth than Philip Morris International, even though the company sells its products solely in the U.S. market where tobacco consumption is declining.

However, the company is facing potential regulation from the FDA and any clamp down on menthol cigarettes would effectively bankrupt the company - this blanket ban is unlikely, however. 

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During the past five years Lorillard's earnings per share have grown faster than those of Philip Morris International.

Excise Taxes are growing

There is another reason that Philip Morris could be losing its crown and that is operating income, more specifically, the company's operating margin. Due to rising excise taxes, currency movements, and rising manufacturing costs, Philip Morris has a rapidly contracting operating margin, currently around 17% of revenue. Altria, on the other hand, has an operating margin of around 25% and Lorillard has an operating margin of 28.4% -- up 1.6% from 2011.


With its crown starting to wobble, it could be time to consider turning away from Philip Morris as a long-term tobacco investment. Perhaps it would be better to invest in Altria or Lorillard, both of which appear to be companies with a stable outlook, good growth, and a steady income

Fool contributor Rupert Hargreaves owns shares of Altria Group and Lorillard. 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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