Tobacco Companies Might Interest You

Zain is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Philip Morris International (NYSE: PM), British American Tobacco (ADR) (NYSEMKT: BTI) and Imperial Tobacco (ADR) (NASDAQOTH: ITYBY.PK) are the leading cigarette and tobacco-product manufacturers in the world. In the last quarter, the enforcement of stringent laws restricting cigarette endorsement together with lagging demand due to weak economic conditions pulled down the revenue for major tobacco producers. Amid this difficult business cycle, in the following article we will analyze how British American Tobacco managed to stay ahead of both of its major rivals.

Recent events

Despite strong pricing, the latest quarter had been rough for Philip Morris. Total revenue and net income declined by 2.5% and 7.3%, respectively, due to lower cigarette volumes in key markets. Declines in shipment volume mainly reflected in Europe are due to an unfavorable impact of excise-tax driven price increases, a recessionary European economy and increased illicit trade. To my astonishment, the company managed to take a hit of 5.7 % in its revenue in the growing Asian market, which is easily attributable to the higher costs the company is incurring. With a 60% increase in the tobacco tax in the Philippines, Philip Morris is feeling the hit because of its large market share in the country.

However, Philip Morris has made a few smart moves in order to strengthen its presence in the emerging markets. It recently bought back 20% of its stake held by Grupo Carso in its Mexican business. The company now owns 100% of its Mexican business; this buyback will prop up EPS. Philip Morris has deeply benefited from increased sales in Japan; the company established its brand in the country since Japan's tobacco’s production stopped in the aftermath of a seismic disaster and tsunami. Moreover, it also acquired Fortune Tobacco in the Philippines, building its stronghold in the growing Asian and emerging markets. These moves will offset the lower demand in Europe.

Emerging market exposure

British American Tobacco, due to its sales structure, is less vulnerable to volume declines because of its low sales dependence on Europe. Europe only accounts for one-10th of the total sales. The rest of the sales come from the company's international business, particularly the emerging markets. Amid lower demand cycles, the company still managed to increase its revenue by 5%, which is sustainable in the long run.

British American Tobacco is re-entering Myanmar through a joint venture with IMU enterprise; previously the company had a market-leading position in Myanmar, which it aims to rebuild. British American is aggressively pursuing the Asian markets, Myanmar, bordering China, Laos, Thailand and India, provides the company with an opportunity to boost its sales and enhance its market share in Asia. Moreover, the company is heavily investing in tobacco alternatives, or non- combustible cigarettes since the world will witness a rapid decline in tobacco use.

Headwinds for Imperial

Imperial Tobacco is also experiencing the headwinds due to difficult trading conditions in Europe, particularly due to stern government regulations and excise- tax driven prices. Company profits fell by 6.5%, with a 2 % decrease in revenue. Realizing that the market backdrop would remain tough for some time, Imperial Tobacco is resorting to cost savings and a slightpull back in its investments to boost margins.

Imperial Tobacco has been more focused on the European market, which is why the company has taken a huge hit in terms of volume declines, with a 5.9 % shipment decline. However, lately the company is exploring opportunities in the emerging markets, relying on price increases and growth in these regions to offset declining consumption and government levies, particularly in Western Europe and North America.

Competition

Indicators

Philip Morris

British American Tobacco

Imperial Tobacco

Price/Earnings TTM

17.0

17.9

45.5

Price/Book

-33.8

8.7

3.4

Revenue Growth

(3 Yr. average)

7.6

2.3

24.7

Income Growth

(3 Yr. average)

11.5

12.3

0.8

Return on Equity

-

47.3

7.0

Dividend Yield

3.8%

4.0%

5.0%

Current Price

$88.23

$107.06

$67.78

*Data from Morningstar on July 22

Dividends and revenue

British American Tobacco provides a decent and modest dividend as compared to its rivals. The dividends have been increasing at a prudent ratio due to continuous profitable operations in emerging markets. Philip Morris has provided a constant dividend yield over a period of time; to the contrary Imperial Tobacco has been constantly cutting its dividends to retain cash to fuel its downward trending operations.

However, the company has shown a hefty increase in its revenue due to growth in fine-cut tobacco and Snus; plus it has also achieved revenue growth in certain key regions. British American Tobacco scores the highest in the net income metric, due to its diversified operations all across growing emerging and Asian markets. British American Tobacco, with a 65% payout ratio supported with a healthy free cash flow, is in a much better position to offer the stated amount of dividend yield.

Final thoughts

A price increase in the US and a recession-hit European economy provides an unfavorable environment for the tobacco companies to operate in. Imperial Tobacco is more exposed to the developed markets, where tobacco use is stigmatized and is on a decline. Apart from that, it leaves the company more vulnerable to business headwinds from lower demand in these markets. However, British American Tobacco and Philip Morris are well positioned in the growing emerging markets to contain the demand declines.

On another note, tobacco use altogether is gradually declining, with demand gradually shifting towards tobacco alternatives. British American Tobacco has been is in the tobacco-alternative industry for quite some time now, producing and marketing e-cigarettes. Hefty investments have been made in next generation tobacco products by British American Tobacco in an attempt to add sustainability to its operations.

Furthermore, Philip Morris and Imperial Tobacco have also been exploring opportunities in the tobacco-alternative industry; however British American Tobacco, being the first mover, has a larger market share as well as added advantage over its competitors. So in my opinion, British American Tobacco is better poised for long-term growth; hence, it is my pick of the day.

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Zain Raza has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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