Smoke Up Steady Returns With These Tobacco Stocks

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While the tobacco industry has faced greater regulatory pressure from plain packaging proposals to more graphic healthcare warnings and tax pressure, there is still strong upside to be found. Particularly, I find that the company with the sharpest growth curve is unreasonably the cheapest. Moreover, the domestic leader continues to gain share despite what you think would have been market saturation. Below, I review 3 of these companies.

Altria (NYSE: MO): Market Leader & Growing

Altria is the leading marketer of tobacco products in the United States. Its brand, Marlboro, is a solid investment to back if you are bullish on the long-term prospects of the economy and want a meaningful way to accrue passive streams of income. Specifically, Altria offers a 5.4% dividend yield. However, this stability comes at a higher price: Altria trades at a respective 17x and 13.7x past and forward earnings versus corresponding figures of 16x and 13.5x for Reynolds and 14.2x and 13x for Lorillard.

As disappointing as this premium is, the company is still forecasted for 6.7% annual EPS growth over the next 5 years. So, even if multiples contract to 16x, the stock will still provide an average annual return above 9%. This is reinforced by incredible retail gains across all of the company's brands in the third quarter. Though PM USA's category volume fell 3% for the first nine months of 2012, retail share expanded by 120 bps to 49.9%. Interestingly, premium brands have outperformed discount brands on this metric. Marlboro grew 100 bps whereas L&M grew by only 60 bps to 3.9%. This is particularly impressive, since you would expect the leading US tobacco marketer to have reached its saturation point. Simply put, increased promotional spending has successfully converted adult competitive smokers.

Ironically, the company's exclusive exposure to just the United States is proving to be more of a positive catalyst than expected as international regulations become more stringent. In early December, Australia passed a bill requiring plain packaging--tarnishing a rich centuries-long history of active advertising. Speculation is now rising that the European Union will step up anti-tobacco regulations that go beyond these blunter health warnings--some are considering a ban on menthol-favor cigarettes altogether!

Reynolds American (NYSE: RAI) Vs. Lorillard (NYSE: LO)

Whereas Reynolds provides upside on the non-core tobacco market, Lorillard provides upside through its growth. Reynolds is shifting more towards smokeless categories, such as chewing tobacco and even electronic cigarettes. The "e-cigarette" industry has grown at substantial rates, and the release of "Vuse" from RJ Ryenolds Vapor successfully targets this trend. Vuse has been rolled out to a limited count of stores and could be a big catalyst on an uncertain regulatory environment that has forced tobacco producers to hike prices. In mid-2011, Reynolds increased prices by 6% to match the hike on Altria's cigarettes. This, along with productivity hikes, has helped the company increase margins despite active promotion. In addition, the company is marketing its first nicotine replacement therapy "Zonnic" through Niconovum.

At the same time, Reynolds may be doing all of these "tobacco lite" products because of core weakness. RJ Reynold's market share fell 100 bps to 26.4% in 3Q12. In my view, the real upside comes from multiples expansion in Lorillard. Over the last 5 years, Lorillard has had better free cash flow trends than competitors. Its FCF is down "only" 20% versus -46.8% for Reynolds and -79% for Altria. Revenue trends have been even better with the top-line growing 64.6% versus 31.3% for Altria and -7.9% for Reynolds. Why then is the company trading at such a discount to Reynolds and Altria?

Lorillard is forecasted for 8.7% annual EPS growth over the next 5 years. It offers a 5.2% dividend yield. This makes for 13.9% annual returns barring a multiple expansion. Assuming EPS grows at this rate and a multiple of 16x, the company will be worth $187. When you factor in dividends, this provides for a 17.2% average annual return. I believe investors will come to jump on this opportunity.

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