Can Tobacco Stocks Stay Hot?

In our April issue, we zeroed in on the tobacco industry with analyst Mark Hugh Sam. Before joining Morningstar in the spring of 2003, Hugh Sam was a senior research analyst for SoundVest Management in Ottawa, Canada. Hugh Sam has an MBA from York University in Toronto; he also holds the CFA, chartered accountant, and CFP (Canada) designations.

Morningstar DividendInvestor: It seems as if litigation and regulation should have killed these companies off years ago, but they're still going strong. Why is tobacco such a strong business?

Mark Hugh Sam: We think these firms have very wide economic moats. Tobacco is an addictive product, making cigarettes a very inelastic consumer good--volume isn't that sensitive to price increases. Furthermore, the tobacco industry is essentially like a cartel, with Philip Morris USA ( Altria ) being the clear price leader. The firms therefore enjoy enormous pricing power.

For example, the 1998 master settlement agreement with state attorneys general to cover the medical costs of smokers now costs these firms almost $10 billion annually, but the tobacco companies were able to raise net prices to offset the costs. And by banning certain advertising and implementing market share contingencies, the MSA actually helped the big firms get away with raising prices, cutting marketing costs, and still fending off competition. Even if the industry gets hit with another multibillion-dollar legal challenge, we see evidence that these firms will have ample room to maneuver.

MDI: Is falling cigarette consumption a problem?

Hugh Sam: Another testament to the industry’s moat: Demand has been falling 2%-4% per year for the past decade, but the firms have been able to keep operating profit flat in absolute dollars.

MDI: Give us an update on the legal environment.

Hugh Sam: Courts are ruling that if you smoked after the warning labels appeared in the 1960s, then you have to take some responsibility for your health. To win a lawsuit today, an ill smoker would have to have started and stopped smoking before the warnings appeared, link his sickness to that period, and still be alive. I don't think you'll find many of those around today.

Thus, conditions have recently improved dramatically for all main litigation categories. Case counts are falling across the board. The only type of case that is growing are suits alleging fraud in the marketing of light cigarettes, but once the Price case in Illinois is resolved, even these suits will probably fall off.

The Department of Justice’s racketeering case has had several setbacks; there will be no large payment required even if the DOJ wins the case. A separate Supreme Court ruling has capped punitive damages at 9 times compensatory damages, reducing the risk of “multibillion-dollar” headlines.

MDI: What’s the picture overseas?

Hugh Sam: Internationally, the market is huge and growing 2% annually--though last year there was a first-ever decline as the European market was hit by large tax increases. Litigation risk is much less of a factor, because it’s tougher to sue in most other countries than it is in the United States--as well as the fact that many foreign tobacco companies were state-owned.

Philip Morris dominates the international markets, with 23% of the global market excluding China (which is dominated by state monopolies), though it appears Philip Morris might soon gain access to Chinese smokers. None of the other tobacco stocks we cover have meaningful foreign exposure.

MDI: Is Altria still planning to spin off  Kraft ?

Hugh Sam: Altria stated in its 2004 annual report that if the legal environment improves further, as we expect, management would like to restructure the company into two or three separate pieces. Spinning off Kraft would be the easiest to do first, but I am more excited about the prospect of Philip Morris International becoming an independent company. We believe a breakup of the firm could be announced as early as this summer.

MDI: Is there any reason one should consider owning  Reynolds or  Carolina Group ?

Hugh Sam: While Carolina Group owns the strong and growing Newport brand, the shares are a tracking stock, so there are significant governance drawbacks. Reynolds American is really a subsidiary of British American Tobacco , and most of the merger benefits have been realized. Although these stocks trade at a small discount to Altria, we'd prefer to own Altria, all things being equal, or  UST .

MDI: Why UST? Are cigarette smokers switching to smokeless tobacco?

Hugh Sam: At the right price, UST is a great stock to own for the long term. Its exposure to tobacco litigation is significantly less than cigarette stocks', it's even more dominant in its market than Philip Morris is in cigarettes, and, most important, volume is growing. The firm is increasing direct marketing and one-to-one marketing events to gain new tobacco users and switch smokers to smokeless tobacco. Smokeless tobacco shipments rose 6% last year, compared with a 3% decline in cigarette consumption, but even this growth implies that just 0.6% of the nation’s smokers made the switch to smokeless.

MDI: Can these firms raise their dividends in a shrinking cigarette market?

Hugh Sam: These firms have essentially paid out 100% of their earnings through dividends or buybacks over the years while still raising their dividends faster than inflation. We think Altria can continue raising its dividend at 5%-6% annually. But the second-tier cigarette firms’ dividend growth may be less than inflation. In fact, before its merger in 2004 and the subsequent cost savings, R.J. Reynolds was facing a potential dividend cut.

MDI: What are the biggest risks that are left?

Hugh Sam: While the litigation environment has improved dramatically, the big three tobacco cases (Price, Engel, and DOJ) are still unresolved. In addition, there is always the fear that cigarette consumption will go into a free fall if society suddenly loses its tolerance for smoking. We see no evidence of this yet, though.

MDI: Should we buy any of these stocks right now?

Hugh Sam: Tobacco was one of the best performing groups globally in 2004, and now the stocks are trading near or above our fair value estimates. We estimate potential litigation costs in our fair values by using a much higher required rate of return for tobacco stocks than we'd demand of comparable firms in other consumer sectors, like  Procter & Gamble . If the three major lawsuits remaining are resolved in the industry’s favor, the firms’ risk might diminish and would in turn be worth more.

Nevertheless, we advocate obtaining a decent margin of safety before buying in this sector, and that isn't what we see right now.

MDI: Thanks for your insights, Mark.

This article is from a recent issue of Morningstar DividendInvestor, our monthly newsletter dedicated to helping investors find high-dividend stocks with superior long-term return potential. To review a risk-free trial issue of DividendInvestor and receive three free investing reports, click here.