Tobacco stocks: A hard habit to break

Somebody forgot to tell investors that cigarettes are a declining business. The S&P 500 tobacco index has beaten the market, jumping 13 per cent so far this year after surging 36 per cent in 2011. While the U.S. tobacco industry must wrestle with falling cigarette sales, rising taxes and potential litigation headaches, dividend hunters can't kick the industry's lush payouts. “The products tobacco companies make are abhorrent … but they are amazing businesses,” says Darren McKiernan, a portfolio manager with Invesco Canada Ltd.

“The beautiful thing about it is that these companies generate so much cash … They pay out 50 to 75 per cent of their earnings in the form of dividends and they buy back stock.” Philip Morris International Inc. and its former parent Altria Group Inc., (MO-N32.420.210.65%) both of which sell the iconic Marlboro brand, are among the best-positioned bets in a sector where dividends now yield 3 to 6 per cent. Both firms recently reported higher first-quarter profit, while Lorillard Inc. (LO-N133.56-1.73-1.28%) and Reynolds America Inc. (RAI-N40.77-0.06-0.15%) saw earnings fall on weaker cigarette volume. Sales of cigarettes have been falling in markets like the United States and other developed countries because of smoking bans and concerns about tobacco-related cancer.

But the industry has been offsetting revenue declines by cutting costs, boosting prices and diversifying into smokeless tobacco products like snuff, which is inhaled through the nose, and snus, which users insert between their teeth and gums. Lorillard, which last year fought off a proposed U.S. government ban on its top-selling menthol cigarettes, expanded its offerings last week by buying Blu Ecigs, a maker of electronic cigarettes that heat nicotine-laced liquid and convert it into a mist. “At some point, the party ends, but as far as I can tell, it is a long, long way off,” said Mr. McKiernan, who owns Philip Morris, Altria and British American Tobacco in his global dividend fund. While the U.S. tobacco industry continues to battle lawsuits, “the litigation environment is more benign now” because it has won some big cases, and litigation is less prevalent in other countries, he said.

“The dirty little secret is that the biggest beneficiaries of tobacco companies are the local governments because of the taxes.” China, home to a third of the world's smokers, is a closed market where tobacco sales are dominated by state-owned China National Tobacco Corp, but cigarette sales are rising in other Asia markets where consumers with more disposable income seek out prestigious brands such as Marlboro. Unlike its three domestically focused U.S. peers, Philip Morris International is “generating growth and has momentum” in international markets, said Wells Fargo Securities analyst Bonnie Herzog. She rates its stock as her “top pick” with a one-year target of $96 (U.S.) a share.

 “I expect Philip Morris' profit in Asia to double to over $10-billion by the year 2020,” she said. “One of the big drivers is Indonesia where I expect profits to quadruple.” Altria is Ms. Herzog's top U.S. pick because she expects its Philip Morris USA unit will become more aggressive in offering alternative tobacco products this year to keep its No. 1 market position. Cigarette sales have been declining for four decades, but the U.S. tobacco category is “closer to flat” when smokeless products “be it moist snuff, snus, dissolvables or electronic cigarettes” are included, Ms. Herzog said. She compares the sector to the beverage category where carbonated soft drinks are fading, but “you have non-carbonated drinks, whether it is water, juice or tea, and energy brands like Monster or Red Bull.”

 S&P Capital IQ analyst Esther Kwon has a “strong buy” on Philip Morris because of its rising sales in emerging markets, and a “buy” on Lorillard and Altria. Lorillard, through its Newport brand, dominates the market for menthol cigarettes, but has launched a non-menthol version that is gaining market share, she said. “We are less positive on Reynolds American, which we have downgraded to a hold” because its brands are vulnerable to consumers trading down to roll-your-own cigarettes, she said.