Cigarette Makers: Burning Hot or Up in Smoke?

Philip Morris International Inc. (PM), Reynolds American, Inc. (RAI), Lorillard Inc. (LO), and other cigarette makers may be seeing lower demand and increased government regulation, but their stocks have been among the most profitable and stable during the economic crisis.

The cigarette industry has been remarkably robust throughout the global economic downturn – it turns out that smokers will cut just about everything but their smokes from their budgets. The industry’s return on equity – a measure of a company’s profitability – is the highest in the market at an average of 54%, while many cigarette producers also pay a healthy dividend. These kinds of fundamentals are enviable in a recession, and have led to strong stock performance.

However, it is no secret that the cigarette industry faces many headwinds. Price increases, higher taxes, and nationwide advertising campaigns – ironically funded by the industry itself – has reduced demand for cigarettes both domestically and internationally. Meanwhile, the recent approval of the Family Smoking Prevention and Tobacco Control Act will allow the FDA to have a hand in tobacco product standards and advertising guidelines.

A Solid Stock Performance…

Look at the stock price of any cigarette company and you wouldn’t know that the industry was facing any troubles. Philip Morris International is trading 47.8% off its lows, while domestic players like Reynolds American are trading more than 50% off of their lows for the year. So, what’s the reason for the strong gains in the stocks, despite a questionable outlook?

The first catalyst is the fact that cigarette companies have relatively non-elastic demand and a stable dividend, which makes them extremely safe stocks during an economic downturn. In fact, dividend yields for many cigarette makers surpass that of other consumer staples companies, while free cash flows are strong enough to ensure they’ll be paid on time, every time.

Dividends are used by consumer staples companies as a way to attract investors, since they typically experience lackluster growth rates. Dividend yields for some of the industry’s top players include Philip Morris International Inc. at 4.8%, Lorillard Inc. at 5.4% and Reynolds American Inc at 7.5%, which are higher and safer than their consumer staples counterparts.

The second catalyst is the fact that bottom-line results haven’t been hit as much as many analysts expected. It’s true that volumes declined substantially for many cigarette makers – in a trend that is likely to continue – but strong pricing power has enabled them to make up for the lost sales by improving their profit margins on existing sales despite an economic downturn!

In October, Philip Morris and Reynolds American both reported third quarter profits that beat analyst estimates as higher prices offset declines in volume. Both companies even went so far as to increase their 2009 earnings forecasts, despite unprecedented increases in excise taxes, an extremely weak economy and intense competitive activity.

Industry Headwinds Pick Up…

Despite the bullish picture painted by the cigarette industry, the headwinds facing them are only set to pick up. State governments looking for ways to raise tax revenues amid a drop in the real estate market are turning to so-called “sin taxes”, which has led to unprecedented increases in excise taxes on cigarettes. Meanwhile, lower volumes promise to be a continuing trend as anti-smoking campaigns continue to pick up steam particularly in the U.S.

The House and Senate approval of the Family Smoking Prevention and Tobacco Control Act also promises to create some problems for the industry. The most obvious impact is the $85 million upfront and $700 million annualized payments over the next ten years that the industry will have to pay in order to fund the legislation. However, it will also give the FDA a say in tobacco product standards and advertising guidelines.

The new regulations may help some established cigarette makers who already lead the industry, such as Philip Morris, as it helps keep competition at bay. However, the higher excise taxes on cigarettes, which have already led to $5-a-pack smokes in some states, may prove to be a problem for all industry players, as double-digit job losses and an uncertain future have weakened consumer spending.

Key Points

* Cigarette industry stocks have been trading higher as they represent a safe haven investment and have been reporting higher profits due to strong pricing power.
* Cigarette volumes have been on the decline amid higher prices and anti-smoking advertising campaigns, which has led to a sharp drop in demand.
* New regulations could inhibit new products from quickly entering the market, but help already-established companies maintain their dominance.
* Eventually, lower volumes will take their toll on bottom-line results as price increases cannot be relied on indefinitely to support net income.

By Simon Monger, 2 November 2009