Stock Investing

These stocks could generate substantial returns for investors not averse to the sin industry.
By Vikram Barhat | 02/05/18

From a health perspective, consumption of tobacco may be frowned upon, but when it comes to investment returns, the allure of tobacco stocks continues to trump social stigma.

About the Author
Vikram Barhat is a Toronto-based financial writer specializing in investing, personal finance and small business. His experience working in various editorial capacities in digital and print media spans more than a decade across three continents. He has written for CNBC, BBC, The Globe and Mail, the Toronto Star and other publications. He can be reached on Twitter @vikrambarhath.

Tobacco companies have been thriving despite the headwinds of growing health awareness, regulatory pressure and a shift in lifestyle choices among young people. Abiding loyalty and a consistent demand that springs from human weakness keep consumers coming back for more and provide these companies with a consistent stream of cash flow and high profit margins, which in turn facilitate smoking hot dividend payouts.

Although conventional tobacco is expected to continue to be the main driver of profit, Big Tobacco manufacturers are rapidly diversifying, independently or through acquisitions, as they shift to the next generation of products, such as vaping products, to retain and gain market share. Further, as the growth in emerging markets helps offset declines in the number of smokers in developed countries, leading tobacco stocks could generate substantial returns for investors not averse to putting their money in the so-called "sin industry."

The following tobacco behemoths are trading at a sizeable discount to their fair value estimates and represent attractive buying opportunities, according to Morningstar equity research.

 

British American Tobacco PLC ADR
Ticker:BTI
Current yield:3.63%
Forward P/E:13.1
Price:US$55.26
Fair value:US$67
Value:17.5% discount
Data as of April 27, 2018

Having acquired Reynolds American last year,  British American (BTI) is competing with Philip Morris International to be the largest listed global tobacco company. Owner of popular brand such as Dunhill, Kent, Pall Mall, Lucky Strike and Rothmans, the company also sells vapour e-cigarettes, heated tobacco, as well as roll-your-own and smokeless tobacco products. The company holds 31% of Indian cigarette maker ITC Ltd.

With consumers becoming increasingly aware of health issues, BAT has been allocating more capital to the vaping category, where it's been fairly innovative with products such as the Vype Pebble, says a Morningstar report. BAT's reduced risk products like glo, the company's proprietary tobacco heating technology, are being rolled out across 40 geographies this year to rival Philip Morris International's iQOS.

"We believe heated tobacco is the category most likely to successfully attract smokers, but we do not regard [PMI's] first mover advantage as being sustainable in the long term, and it is possible that BAT will regain share over time," says the report.

The company is also pushing aggressively in the traditional tobacco markets. "BAT has doubled-down on the combustible business with its acquisition of Reynolds American, an incredibly strong asset in a market with plenty of remaining potential for raising prices," says Morningstar sector director Philip Gorham, who pegs the stock's fair value at US$67 per American Depositary Receipt, incorporating 2019 multiples of 15 times earnings, a 6% free cash flow yield, and a dividend yield of 4%.

The wide moat firm's sustainable competitive advantage, which occurs primarily in its tobacco business, is built on brand loyalty enjoyed by its premium offerings, and a cost advantage.

 

Imperial Brands PLC ADR
Ticker:IMBBY
Current yield:6.44%
Forward P/E:9.8
Price:US$36.65
Fair value:US$53
Value:30.8% discount
Data as of April 27, 2018

The world's fourth-largest international tobacco company,  Imperial Brands (IMBBY) holds a dominant global position in the fine-cut tobacco and hand-rolling paper categories, and is a leading seller of cigars in several countries.

The firm has been aggressively streamlining its portfolio to allow for more focused brand investments and cost reductions. "In portfolio optimisation, the company has made great strides, reducing its total brand count by 32% by the end of fiscal 2017, and targets a total reduction of 50% by 2020," says a Morningstar report, noting the company has been able to achieve a 95% consumer retention rate through its brand migration program.

Imperial's recent acquisitions have catapulted it to third place among the largest manufacturer in the U.S. "We like the 2015 acquisitions of assets in the U.S., because the core combustible market offers multiyear opportunities for price/mix driven growth," says Gorham.

He expresses concern, though, over the company's intense focus on vaping, a category he believes is commodified with fairly low barriers to entry. Gorham insists the company may find greater success in the heated tobacco category where it could be more profitable by attracting quitting smokers.

It may be noted that the company has announced plans to test market heated tobacco products in the near future. Imperial's robust competitive advantage, derived from brand equity and distribution capabilities, should allow it to catch up in the important heated tobacco profit pool, says Gorham, whose US$53 per ADR fair value implies a 2019 multiple of 15 times earnings with a 5% dividend yield.

 

Philip Morris International Inc.
Ticker:PM
Current yield:5.22%
Forward P/E:15.4
Price:US$83.06
Fair value:US$104
Value:20.1% discount
Data as of April 27, 2018

The world's largest tobacco company,  Philip Morris International (PM) sells cigarettes outside the U.S. under the Marlboro, Chesterfield, Parliament and Virginia Slims brands, among others. The firm holds 28% of the global market, excluding the U.S. and China.

"Philip Morris has an impressive brand portfolio that is fairly evenly balanced across price points, albeit with a skew to the premium segment," says a Morningstar equity report, noting that "brand identity through product differentiation and trademarks allows" the company to charge "premium prices" for its products.

Last year was a breakthrough year for PMI when its reduced risk portfolio's iQOS brand, a rechargeable heated tobacco product, gained considerable traction in its trial markets, particularly Japan, making its first sizeable contribution to cash flows. "PMI is backing the right horse because we think heated tobacco is the category most likely to become a long-term mainstream alternative to smoking," says Gorham, who recently upped the stock's fair value from US$98 to US$104, prompted by higher revenue and cash flow assumptions.

The heated tobacco category is likely to enable Philip Morris to migrate smokers to its e-cigarette platform as the former most closely replicates the smoking experience. However, it's the competitive advantages in the combustible business that give PMI a wide economic moat, built on brand loyalty, pricing power, cost advantages and the regulatory barriers to entry.

"Amid the excitement of a potentially lower-risk alternative to smoking, the combustible business still represented 93% of PMI's volumes in the fourth quarter," says Gorham, who forecasts robust returns on invested capital, in the 40% to 50% region, over the next decade.

 

Altria Group Inc.
Ticker:MO
Current yield:4.80%
Forward P/E:13.7
Price:US$56.14
Fair value:US$64
Value:12.3% discount
Data as of April 27, 2018

The number one tobacco company in the U.S.,  Altria (MO) comprises Philip Morris USA, U.S. Smokeless Tobacco, John Middleton, Ste. Michelle Wine Estates, Nu Mark and Philip Morris Capital. It also owns a 10.5% stake in the world's largest brewer, AB InBev. The remainder of Altria's sales (about 15%) is made up of cigars, smokeless tobacco, e-vapor tobacco products and wine.

Altria's wide moat is primarily built on Marlboro, which controls more than 40% of the U.S. cigarette market. "The strength of this brand should support pricing increases that eclipse continued volume declines in the U.S.," says a Morningstar report. "While the firm's other segments should continue to grow, we believe cigarettes will remain the key driver of revenue and profitability."

Although the company mostly operates in the challenging U.S. tobacco industry squeezed by falling cigarette volume and rising regulation around nicotine levels, "tobacco manufacturing is still a lucrative business, and Altria will generate steady medium-term earnings growth as pricing and cost control more than offset volume declines," says Gorham.

The tobacco giant's diversified product portfolio and investments allow access to varied markets and across product categories, a hedge against softness in some markets and product niches. The firm's AB InBev stake provides exposure to the global beer market while it continues to maintain its position as the largest smokeless tobacco producer in the U.S., with a 55% share of moist smokeless tobacco market dominated by its Copenhagen and Skoal brands, says Gorham whose US$64 fair value estimate for the stock implies a 2019 price/earnings ratio of 16 times and a 4.8% dividend yield.

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