What Tobacco Companies Are Doing To Fight Headwinds & More

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It is no secret that tobacco companies face a slew of regulations: from plain packaging to more conspicuous health warnings and greater taxation, the downside story has already been well communicated. However, what hasn't been well communicated is the strategies that tobacco companies are taking to move around--or "deal with"--the increased regulatory scrutiny. Below, I review several stocks in the sector with this matter in mind.

Altria's (NYSE: MO) Diversification, Market Leadership Central To Stability

One of the reasons why you should consider investing in Altria is the fact that it is constantly diversifying its income streams. Much of its income comes from the sale of cigarettes (about 87.9%). Altria has already started to increase investment in other areas, such as financial services, wines, smokeless products, and cigars. For example, in 2009, Atria bought out UST Inc., a manufacture of wines and smokeless products. The company has a 27% voting interest in SABMiller. All these diversifications are aimed at creating a shift from the core cigarette industry, which is considered risky. The strict cigarette regulations have reduced consumption and made management consider alternative ways of generating revenue. While cigarette revenue was observed to drop by 1.1% in 2012, revenue from smokeless products is seen to increase. Altria has a considerable market share. 

Altria wholly owns Phillip Morris USA, which is the number one tobacco company in USA. The Marlboro brand, which has been the top selling brand in the last three decades, offers a strong economic moat. To its credit, the company has done a solid job in helping deter regulatory pressure. Altria, as opposed to Reynolds American, ranks number 4 in terms of social responsibility. Consistency in increasing the dividend over more than 4 decades adds to the safe nature of the stock.

Despite these remarkable achievements, Altria is facing possible problems in Europe after the EU said that it was going to tighten tobacco regulations. The EU made it clear that tobacco companies will be expected to do more than just put warnings on products. In Australia, the marketing efforts have been frustrated by passing a bill that requires plain packaging. There are even fears that menthol flavoring might be banned. In the United States, the Department of Justice is appealing to a Court of Appeals a case that will require tobacco companies to adopt more conspicuous health warning labels.

Reynolds American (NYSE: RAI) Also Responding To Market Pressure...

This is the second leading cigarette company in the United States. Reynolds has witnessed remarkable growth, despite the increasing restriction on tobacco products. It has managed to do this by shifting to smaller sized cigarettes and even introducing an electric cigarette known as ‘Vuse’. This has enabled the company to move around high taxes and strict regulations against cigarettes. 

A corporate decline in cigarette momentum has been offset by an increase in price of both cigarettes and moist-snuff. There has also been a notable increase in promotion spending. Pressure from a nearing end to the non-compete agreement with British American Tobacco, however, may reverse the trend.

At a respective 16.2x and 13.7x past and forward earnings, Reynolds is roughly in-line with Altria's. However, surprisingly, the multiples are at a sizable premium to Lorillard's (NYSE: LO) 14.5x PE multiple and 13.3x forward PE multiple. This is surprising, since Lorillard is forecasted for a 122 bps greater growth rate over the next 5 years at 8.7%. Moreover, Lorillard has already grown at a much faster rate (10.5%) during the past 5 years. For this reason, I recommend balancing an investment with either Reynolds or Altria with an even larger stake in Lorillard.

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