In a world where cigarette sales are down, some of the best tobacco stocks today are selling at dirt-cheap valuations. Here are 3 that I like.
Investor interest in companies that meet high environmental, social and governance standards (ESG) has grown rapidly in recent years. By some measures, as much as a third of all U.S. professionally-managed investments currently emphasize ESG criteria. Yet, long before formal ESG-oriented strategies emerged, some investors already avoided “sin” stocks – those of companies involved in tobacco, alcohol, weapons and gambling. It’s really a matter of personal choice whether to invest in sin stocks, but sometimes they can represent good value opportunities. For example, right now some of the best tobacco stocks look like bargains.
In the past two decades, the tobacco industry has become a mature, highly concentrated and heavily regulated and taxed industry, particularly in the United States. Cigarette consumption in the U.S. and most developed countries is slowly declining, propelling consolidation such that the top four U.S. makers hold a 92% market share.
The landmark Master Settlement Agreement in 1998 largely shielded domestic tobacco companies from medical liability in exchange for their making large annual payments to states in perpetuity and terminating most marketing activities. The FDA fully regulates tobacco products and as much as 44% of the retail price of cigarettes is comprised of federal, state and excise taxes.
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Tobacco company shares have fallen out of favor, with some share prices down 40% or more from their 2017 highs even as the stock market has surged. First, the growing influence of ESG-minded investors has weighed on the shares. From a fundamental perspective, a major issue has been the acceleration in the decline rate of domestic cigarette volumes. Typical annual volume declines have been in the 3-4% range, but this rate increased to 4.5% in 2018 and 5.5% in 2019. The federally-mandated increase in the minimum age to purchase tobacco from 18 to 21 may be reducing demand. More recently, the possibility of new menthol regulations and higher taxes has pushed away investors.
An emerging concern is the growth in “next generation” non-combustible tobacco products that are showing signs of developing into threats to cigarettes. The previously rapid growth of vaping products like JUUL, for example, may have contributed to the erosion of traditional tobacco volumes. In some ways, this mirrors the emergence of electric cars and trucks – demand for traditional products remains robust but a transition to new products is seen by investors as inevitable. As such, companies that are in the vanguard of this shift are viewed more favorably that those that lag. Another similarity: most of these initiatives have rapid demand growth from tiny bases but so far remain unprofitable.
All of these issues have created an investment opportunity in tobacco stocks. While a transition to non-combustible products may eventually occur, tobacco companies may continue to generate vast free cash flow for years to come, rewarding shareholders, as the transition won’t likely occur overnight. And the industry has many appealing traits that remain in place. Revenues are remarkably stable with slow but steady growth, as annual price increases more than offset declining unit volumes. Wide profit margins (45%+) and low capital spending requirements translate into steady profits and cash flow, much of which is paid out as dividends.
Supporting near-term fundamentals is that the accelerated volume decline appears to have stopped, with U.S. volumes flat in 2020. Whether this is a pandemic-related rebound in demand – driven by higher stress, higher disposable income, and fewer limits on where to smoke when at home – or a more enduring change is yet to be seen, but early indications are favorable. Several companies have new leadership that are driving a transition to non-combustible products. These managements also bring a greater awareness of investor and societal concerns about their products, which may at least partially alleviate some ESG concerns.
For value investors, a major appeal is that valuations are near long-time lows, while dividend yields are exceptionally high relative to the stock market. These stocks can also offer defensive traits in an overpriced market. Listed below are three tobacco stocks with good value.
The 3 Best Tobacco Stocks for Value Investors
Best Tobacco Stock #1: British American Tobacco (BTI)
Following its recent acquisition spree, including its $30 billion deal for Lorillard in 2015 and its $49 billion buy-in of the remaining 48% of Reynolds American (2017), British American is one of the world’s largest tobacco companies. It has a 40% share of the global cigarette market, although the U.S. generates just under half of its total sales. Led by a new CEO since 2018, the company is accelerating its transition to non-combustible products to expand upon its market-leading position in this segment. Its vapor, oral and heated products already comprise 12% of total company revenues. Initiatives to simplify the company, reduce costs and release unproductive cash should boost core earnings. Once its non-combustible products turn profitable in four years or so, overall earnings growth could accelerate. Management guided to 3%-5% revenue growth in 2021, which, combined with possible widening of its 44% operating margin, should produce faster profit growth. Like its peers, British American Tobacco produces hefty free cash flow, pays a generous dividend and carries reasonable debt (which it plans to reduce further).
Best Tobacco Stock #2: Philip Morris International (PM)
This company previously was Altria’s international division before its 2008 spin-off, and has essentially no U.S. revenues. The company’s portfolio of top-selling premium, mid-price and discount-price brands includes Marlboro, the #1 selling international cigarette brand that produces 37% of PMI’s total volume. Unlike its domestic peers, the company carries international product liability risk but this is likely to remain readily manageable. Combustible products are a relatively low 76% of total revenues, as its successful IQOS (heated not burned) products, which it sells globally and licenses to Altria for sale in the United States, boosts its alternatives operations. Volumes in 2020 were weak due in part to lower pandemic-related demand at duty-free shops, although operating income rose 5%. PMI expects mid-single-digit revenue growth this year, with an expanding profit margin. The company’s balance sheet is strong, and its generous cash flow provided management with the confidence to recently raise its dividend by 2.6%.
Best Tobacco Stock #3: Vector Group (VGR)
This tobacco company is the fourth largest cigarette manufacturer in the United States, producing discount-priced brands through its Liggett and Vector subsidiaries. It also owns Douglas Elliman Realty (the fourth largest residential real estate company in the nation) and holds direct ownership stakes in large real estate projects in four major markets. The company has a unique trait: its tiny cigarette market share at the time of the 1998 MSA exempted it from onerous perpetual liability payments for volumes up to a 1.93% market share. This permanent cost advantage has helped Vector expand its market share to 4.1%, although it retains some medical liability exposure. Its management team has long tenure with the firm, providing stability. Management and directors own a combined 8% of Vector’s shares, providing the incentive to maintain its competitiveness. Revenue and profit trends are favorable, although its real estate business is struggling, and its balance sheet remains sturdy.
*Editor’s Note: This post was excerpted from a recent issue of Cabot Turnaround Letter.
Do you still any tobacco stocks? Tell us about them in the comments below.
Bruce has more than 25 years of value investing experience, managing institutional portfolios, mutual funds, and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company. Now he is helping his Cabot Undervalued Stocks Advisor readers find those undervalued stocks that let you buy low and sell high!Learn More >>