The Battle For Value In Tobacco
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
While dividends are always nice, there is more to tobacco than just these payouts. Dividends, moreover, are subject to double-taxation (the corporate and individual levels) and could be perceived as an implicit suggestion that management does not trust its ability to reinvest in growth opportunities. For that reason, I recommend gauging the value of a tobacco company by its market share gains and potential, economic moat, growth potential, and free cash flow potential.
When it comes to risk/reward, tobacco stocks are generally known for providing safe streams of income for investors. However, the degree of risk can still differ substantially between two different brands depending on their market appeal on geographical exposure--whether or not it is subject to plain packaging, particularly high taxes, and so forth. Altria and Lorillard differ in this respect. Altria trades at a respective 17.3x and 13.9x past and forward earnings versus corresponding figures of 14.6x and 13.4x for Lorillard. So, clearly, the market is implying greater risk / operational stresses for the latter; but, is the market accurate?
On the most cursory glance, it is reasonable to assign the premium. Altria markets the world's most popular cigarette brand Marlboro, although it markets exclusively in the United States (sister company Philip Morris International takes care of operations across the seas.) Lorillard is most well-known for its Newport brand, which represents all but one-tenth of the business. On the other hand, Lorillard has been gaining market share and increased its stake 20 bps to 14.4% in the third quarter. According to 2009 sales information, Marlboro had 39.9% of the US market versus 9.9% for Newport, so the latter has been on the rise. Lorillard is also forecasted for 200 bps greater annual EPS growth over the next 5 years at 8.7%.
More importantly, Lorillard is generating strong return on invested capital at 91%--the driver of all value creation. This is well above the industry average of 32.6%.
Lorillard may have missed expectations by 6 cents in the third quarter with EPS of 2.17, but the company has done well relative to its competition. An FTC report finds that tobacco producers are focusing more on pricing than on advertising, so it is particularly powerful to see share gains in such a challenging environment. In light of how high taxes are on cigarettes, consumers are compelled by the slightest price differences. Free cash flow, however, could be stronger. Over the last 2 years, FCF generation has basically held steady on a TTM-basis at around $1.1 billion, a 7% yield. By contrast, Altria has a free cash flow yield of 4.6%. Dividend yields are also roughly the same at around 5.2%.
A Potential Star Scientific (NASDAQ: STSI) Play?
Lorillard also has exposure to alternatives to traditional cigarettes with its blu eCig, which began a national retail roll-out and advertising campaign in the third quarter. But if you are looking for companies with particularly strong tailwinds to broader global regulation against tobacco, I encourage buying shares of Star Scientific. This company producers less toxic dissolvable smokeless tobacco, such as compressed powdered tablets and its STONEWALL Hard Snuff brand. In addition, it licenses technology to reduce the toxicity and harmful effects of traditional tobacco products. Bear in mind, however, Star Scientific has been shifting away from tobacco with the introduction of Anatabloc, a dietary supplement that has reported positive inflammation-mitigating benefits.
Some have argued that the company is facing a cash crisis, but the decision by several long-term shareholders to exercise $20 million in warrants will go a long way in boosting confidence. The CEO also agreed to reduce his salary to $12 per year until Star Scientific breaks even. Free cash flow has started to trend upwards on a TTM-basis from around -$25 million by the end of 2010 to -$18.3 million today. Shares rose 10.2% on this news. This was a more tepid market response, however, than the 18.4% decline experienced when the company reported that it only gained $5 million from settling with RJ Reynolds--much lower than what was expected.
In my view, Star Scientific could be a potential takeover play. It has products that have shown potential but are just in need of larger promotional spending that comes from a large capital base. If a larger tobacco producer or consumer goods business acquires the company, it could generate meaningful revenue acceleration for the target and thereby grow value.
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