2 Tobacco Stocks to Buy Over Titans Altria, Reynolds

By David Gould - September 15, 2012 | Tickers: MO, LO, PM, RAI | 0 Comments

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Many defensive investors naturally eye tobacco stocks during uncertain times like today. Phillip Morris (NYSE: PM), Altria (NYSE: MO), and Reynolds American (NYSE: RAI) usually top the list, but they currently trade at high multiples and thus do not offer much room for upside. There are several trends to observe in these stocks before making a decision between whether the possibility of upside elsewhere outweighs the protection in tobacco.

First, for the beginning of the year, cigarette producers kept prices right around constant as they nominally declined. Altria was the greatest share gainer (the first in more than a year) while Lorillard (NYSE: LO) was the greatest volume gainer - up nearly 1 percentage point earlier. Reynolds American fell the most in units sold for cigarettes but nevertheless continues to thrive in the smokeless category, where volume collectively rose nearly 5%, and market share was gained. However, yet again, Altria also gained share.

Newport and Maverick continue to be do pleasantly well for Lorillard with volume up 8.3% y-o-y in February. Altria has just lagged this competitor in volumes and has the widest economic moat and brand as the maker of Phillip Morris cigarettes. "Phillip Morris", or "Phillip Morris International", was spun off from Altria some time back in order to target markets outside of the United States where hopefully regulations were less onerous.

It is also important to look at where the share trends are going for not only the companies overall, but the various brands. Over the last years, cigarette volume has gone mostly down by an average of -1% each month. In fact, from late January 2011 to early February 2012, there were only two months when volume returns were positive. And though the retail/price mix has been positive in the 1.4% to 2.3% region, they have generally trended down since November 2011. In terms of cigarette share, Lorillard has continued to lead the pack with growth within the 100 bps - 150 bps range over every month. 

Perhaps the most important thing to note about this oligopolistic market is that, while Altria has largely reversed its losses in cigarette share, since the beginning of this year, they company was nevertheless losing between 100 bps and 150 bps in market share each month last year. Thus, while Altria may attract investors for its go-to brand image in the cigarette market, investors should also be cognizant that the rising firms may have plenty of potential and that "nothing gold can stay."

In fact, Altria looks overvalued at current levels. The Marlboro creator has traded at north of 20x for some time - more or less in-line with Reynolds's multiples. However, Philllip Morris is at a discount to Altria despite offering the same products in higher-growth markets. I believe that the market is due to correct this anomaly through either elevating the multiples of Phillip Morris or depressing those of Altria. I speculate the Phillip Morris could realize a 2016 EPS of $7.64 and be worth $129.88 at a 17x multiple. If you discount back by even 8% (which is reasonable for the safety offered), there is virtually no margin of safety - the situation is even worse for Altria and Reynolds.

In conclusion, tobacco stocks look slightly overpriced right now. However, their expensive price tag should not necessarily preclude an investment. With Lorillard gaining share, it represents an attractive growth opportunity. A potential turnaround in Altria probably won't cause its own multiples to rise, but it certainly will have a positive impact on the outlook for Phillip Morris. Accordingly, I recommend defensive investments in both Phillip Morris and Lorillard over Reynolds and Altria.

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