These Tobacco Stocks are Hard to Quit

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

According to a Nielsen Data analysis, the cigarette sales in the U.S. for the four weeks ending on January 19, 2013 rose by 1% year-over-year for the 15th consecutive month. Although the overall sales volumes were down, the higher pricing policies of the companies helped to overcome this weakness. Reynolds American (NYSE: RAI) saw the steepest decline in volume by 7.2% year-over-year, but the price and mix grew by 3.9%, which was ahead of the industry average for the 17th time. Altria Group (NYSE: MO) sales were up by 1.8%, helped by expansions of Marlboro NXT and Marlboro Southern Cut. The volumes of Lorillard (NYSE: LO) increased by 12.6% and overall sales were better than the industry average. Various health-related concerns have affected the tobacco industry, resulting in declining sales. However, these companies are continuously trying to adopt different strategies to offset the declines. Let's have a look at these three companies and what they have to offer to investors.

Reynolds American

Reynolds reported its 2012 fourth quarter results with an EPS of $0.76, beating the consensus estimate of $0.73. The company saw some weakness in its cigarette segment, as the volumes were down by about 2.7%. The volumes of Reynolds brands Pall Mall and Camel were decent, but volumes for the rest of the portfolio were weak. A lower tax rate, increased cigarette pricing, and strong performance of the American Snuff Company & Santa Fe helped Reynolds to beat the estimated EPS. The decrease in volume of the cigarette segment raised some concerns, as it was below the average industry decline of 0.8%. For 2012, Reynolds’ cigarette shipment volumes decreased about 5.6%, as compared to the industry average of 2.3%.

However, despite the disappointing performance, the situation is not bad for the company. Its cost reduction plan seems to be on track and the benefit of credit with the settlement of Master Settlement Agreement (MSA) payment cannot be ignored. The MSA agreement was a deal reached in 1998 with 46 states, when Reynolds, along with Altria, Lorillard, and others, agreed to restrict their advertising initiatives, create a fund for public education, and pay a part of the medical costs incurred by states to treat illnesses related to smoking. In December 2012, a dispute was settled with 17 states that introduced new methods to define future adjustments from 2013 onward. As a result, all tobacco companies will benefit from credits generated via this resolution.

Reynolds will be receiving credit of around $1 billion in MSA payments in the next five years. Of this amount, credit in 2013 could be approximately $200 million. The company indicated its intention to use the amount for expansion of its new products like Zonnic Nicotine Gum and Vuse, the e-cigarette. The credit will also be used to build the equity of four of its major brands: Camel, Pall Mall, Grizzly, and Natural American Spirit.

In March 2012 the company also initiated a cost reduction program with a goal of $25 million in 2012 and $70 million by 2014. Reynolds achieved the goal for 2012; even surpassed it a bit, and the plan seems to be on track for 2014. I see cost saving as a major source for its gross margin expansion in the future. The higher than the industry average decline in volumes of the cigarette segment shows the company's weak situation as compared to the industry in general. However, cost savings and credit in the MSA payment should help the company's performance in the short-run. In the long-run, some urgent actions are required for the recovery of volumes of the cigarette segment. My view for the stock is neutral.

Altria Group

In the fourth-quarter of 2012, Altria's revenue increased by around 3.6%, driven by higher pricing for its products. The company declared an EPS of $0.55 which was in line with the consensus estimate. For 2012, the company's total cigarette shipment volumes declined only 0.2%, as compared to the industry average of 2.3%. Altria's signature product Marlboro has gained in market share in the last quarter and reached 42.6%. The growth seen in the brand was due to its new products such as Marlboro Black NXT, Marlboro Southern Cut, etc. I see upside in the stock from its robust cost saving plan, expected MSA payment credit, and lower tax rate.

The targeted cost saving for 2013 is around $400 million. The cost saving plan includes cutting down the number of employees, improvement in its processes, amalgamating some facilities to achieve synergy, etc. The goal is achievable considering that Altria has already taken initiatives in 2012 to meet the required cost reduction.

Altria will get an MSA credit in April 2013 worth $450 million. Although there has been no clear guidance by the company, the amount saved could be returned to investors in the form of dividend or share buybacks.

The company has a high forward dividend yield of 5.1% with an 80% payout ratio. Altria's commitment to pay its investors is backed by a strong portfolio, cost reduction plan, and credit in MSA payments. I recommend the stock as a buy.

Lorillard

Lorillard reported a fourth-quarter growth in revenue of 5.3%, propped up by strong pricing and improved volumes in the cigarette segment. In the quarter, the incremental sale of e-cigarettes drove most of the operational growth. The segment's operational margin came out at 18%. Lorillard currently holds 30% of the e-cigarette market.

The company's e-cigarette category is turning out to be a profitable investment. In April 2012, when Lorillard bought blu eCigs, the annual sale of blu e-cigarettes was around $45 million. In the quarter alone the sales for the product reached around $39 million, reflecting good demand and the increased reach of e-cigarettes. E-cigarettes are now available in more than 50,000 stores and soon enough will be available in another 25,000 stores. E-cigarettes maintain a high gross margin ratio of 41%, less than the 51% of the regular cigarettes. In addition to this, e-cigarettes don't have the marketing constraints that regular cigarettes have. The company is facing some supply shortages because the current e-cigarettes are made manually in China. The segment grew nearly 300% quarter-over-quarter. Looking at growth and return, I feel the product has a lot of potential for the future.

Additionally, of the three stocks discussed, Lorillard is the one with maximum exposure to the FDA. It has some substantial equivalence applications and peer review of the menthol report approval, which may get an extension, and a few products in the pipeline like menthol and non-menthol gold products. The leadership of Lorillard in the menthol cigarette market is its greatest asset. Such products generate most of the company's revenue. This accompanied with the growth possibility of e-cigarettes makes my faith in the stock stronger. I recommend a buy.

The investing opportunities

I am bullish on Lorillard and Altria Group. The progress in the sale of e-cigarettes and leadership in the menthol cigarette market strengthens my faith in Lorillard. The stock should see some upside in future.  Altria and Reynolds will benefited from their respective cost cutting plans and MSA payment credits. On the other hand, the continuous decline in Reynolds’s volumes and its crossing the average industry decline raises some concerns for this stock. Hence I recommend a buy for Altria, but a neutral rating for Reynolds.


ShwetaDubey 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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