Are They Undervalued? A Review of 3 Tobacco Stocks

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The regulatory environment for tobacco companies certainly hasn't improved. A judge recently ordered industry producers to admit that they deceived the public as early as 1964. One deception, regulators argue, includes tricking consumers into believing that light and low tar cigarettes were less harmful than regular ones. This "admission" will amount to more than just a public release; in fact, it will require heavy advertising financed by corporate resources. The Department of Justice is also appealing to reverse a recent court decision against forcing tobacco companies to use graphic warnings. And across the globe, regulators appear to be moving towards requiring either plain packaging or more graphic visual warnings. While Uncle Sam and his global peers may not be too fond of tobacco companies, the industry can provide a nice stream of income. But are they also undervalued? Below, I review 3 cigarette marketers with this in mind.

Philip Morris (NYSE: PM) & Reynolds American (NYSE: RAI)

Philip Morris is one of my favorite stocks given its consistency in earnings growth, focus on international penetration, and strong income support. It offers a 3.8% dividend yield and is the premium cigarette marketer with "Marlboro" under its belt. It trades at a respective 17.9x and 15.4x past and forward earnings, and analysts forecast 9.9% annual EPS growth over the next 5 years (around 100 bps below the rate of the past 5 years).

Most importantly, market share has been trending upwards--particularly in emerging markets. Market share in Asia has grown from around 21% in 2009 to 29% today. Share in Eastern Europe, Middle East, and Africa has gone up from 18% to around 18.5% during the same time period. In the European Union and Latin America & Asia, share has fallen by only by around 200 bps at most. Moreover, the company still retains a tremendous position in these regions with a share of 38% and 30%, respectively. In general, the company is either #1 or #2 in the regions that it operates in. These returns will be quickly allocated back to shareholders. Management explained that it finds "significant intrinsic value" in the stock and that it will pursue aggressive share repurchases (currently approved for $18 billion) to communicate that belief to the market.

But the company's high multiples prevent it being a value play at less than 10% annual EPS growth. Reynolds is cheaper at 16.3x and offers an even greater dividend at a 5.5% yield. Unfortunately, its EPS is expected to grow by an annual rate of only 6.7% in the next 5 years. The company is focused on introducing new products into the market to stay competitive. In addressing the decline in smoking rates, management unveiled a new electronic cigarette, although its profitability is anyone's guess. It should be noted, however, that the e-cigarette industry has seen substantial growth. The strategy has shifted away from advertising and towards pricing in what appears to be a secular transition. For years, the company has built itself up through strong marketing departments. If this proves to be a secular transition, it could be a boon for Reynolds as Marlboro loses its "go to" brand appeal for first time smokers.

Lorillard (NYSE: LO)

Lorillard is one of America's oldest public companies--dating back 250 years ago to before the United States was even formed. The Newport and Maverick marketer has projected for the strongest growth amongst its larger peers with expectations for a 3% rise in sales in 2012. Analysts forecast EPS to grow by 8.7% annually over the next 5 years despite a rate of 11% in the past 5 years. At 14.6x past earnings, Lorillard is the cheapest of the company's highlight in this report.

Assuming Lorillard meets expectations, 2016 EPS will come out to $11.70. At a multiple of 16x, this translates to a future stock value of $187.20. Discounting backwards by 10% yields a present value of $116.24--roughly in-line with the current market assessment. So, Lorillard is not undervalued. But, based on my future projection, it will provide an average annual return of 16.1% when you factor in the dividend yield. Multiples are unlikely to compress, so the earnings growth and dividend yield will be, at worst, driving the stock. This is a terrific return for a stock that is 60% less volatile than the broader market. For this reason, I strongly recommend making an investment in the company.

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