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Investing in Tobacco

Written By Briton Ryle

Posted February 26, 2015

The tobacco industry has been under attack for decades, from anti-smoking campaigns, to advertising restrictions, to class-action lawsuits, to smoking prohibitions in restaurants and public buildings. Even retailers are lining up for the attack, removing tobacco products from their shelves as pharmacy chain CVS Health Corporation (NYSE: CVS) did in September of 2014:

“All CVS/pharmacy locations are tobacco free as of September 3, 2014, beating our original target date by nearly a month,” CVS announced late last year. “When we first shared our decision to remove cigarettes and tobacco from the shelves of our 7,700 CVS/pharmacy locations, some called it a bold decision. We called it the right decision then, and we call it the right decision now.

“We all know the dangers associated with tobacco products,” the announcement continued. “In fact, smoking is the leading cause of premature disease and death in the United States with more than 480,000 deaths each year. While the prevalence of cigarette smoking has decreased from approximately 42 percent of adults in 1965 to 18 percent today, the rate of reduction in smoking prevalence has stalled in the past decade. More interventions, such as reducing the availability of cigarettes, are needed.”

CVS has raised an interesting point. Although the percentage of Americans who smoke had been steadily declining for some 50 years since 1965, that decline has flatlined, having reached a point of sustainability in that those who remain are die-hard smokers who will continue smoking to their dying day.

This very trend shows up in the stock performances of the nation’s cigarette companies. Where for years the companies have been gradually losing more and more in sales volume, they have reached a point of sustainability. In fact, a look at their stock performances in recent years shows a reversal of fortunes, as four of the nation’s top five tobacco companies have beaten the S&P 500 index from 1.66 to 7.13 times.

What is their secret? How have tobacco companies been able to not only survive this onslaught but even prosper in the face of it? It all comes down to some very simple and basic company management.

Let’s begin with the lay of the land to see just how well the tobacco companies have been fairing.

Prospering While Under Fire

Despite losing some 57% of their customer base as the percentage of smoking adults shrank from 42% of the American population to 18%, the five largest U.S.-based tobacco companies have been fairing remarkably well, as graphed below.

Over the past 10 years, where the broader market S&P 500 index [black] has gained 75%, the top five U.S. tobacco companies have risen in order from most to least:

• Lorillard, Inc. (NYSE: LO) [orange], market cap $24.77 billion, up 535%,

• Reynolds American Inc. (NYSE: RAI) [purple], market cap $40.20 billion, up 271%,

• Altria Group Inc. (NYSE: MO) [blue], market cap $109.44 billion, up 269%,

• Vector Group Ltd. (NYSE: VGR) [yellow], market cap $2.50 billion, up 125%,

• Philip Morris International, Inc. (NYSE: PM) [beige], market cap $129.12 billion, up 68%.

Tobacco Investments Feb 2015


With four beating the S&P and the one coming very close to matching it, tobacco companies must be doing something right to prosper so well while being under constant assault. Just how have they been doing it? In two ways in particular:

A) Diversification

Their management teams are well aware of the declining tobacco market in the U.S., having seen the writing on the wall for decades. They have thus had little choice but to enter into other ventures that provide some diversification to their portfolio of businesses.

For instance, the largest company Phillip Morris split its company in two – one focused on the U.S., which is now the second largest company in the industry, Altria Group, and the other focussed on the overseas tobacco market, which was renamed Phillip Morris International.

Although the American cigarette market may be dwindling, international markets are still quite robust, especially in such nations as Indonesia, the Philippines, Italy, Russia, Pakistan, Colombia, Serbia, Germany, Mexico, Greece, the Czech Republic and Slovakia where PM International has a strong presence. In total, the company sell tobacco products in approximately 180 countries in Europe, the Middle East, Africa, Asia, and Latin America.

As for the U.S. spin-off Altria, it too has diversified with its new line of e-cigarettes, or smokeless products.

What is more, both PM International and Altria have entered completely unrelated markets, such as producing their own wines. Although, in some regard the two activities are often enjoyed together at social activities and dinner parties, as smoking and wine drinking tend to go hand-in-hand.

As for the smaller three companies in the top five, Reynolds has diversified into smokeless e-cigarettes and nicotine products, Lorillard has diversified into e-cigarettes as well, while Vector has diversified into real estate.

B) Improved Efficiency

Another way in which the companies are combating their diminishing U.S. customer base is by cost cutting and improved production methods. They have taken great strides in widening their operating and profit margins to levels that are absolutely unheard of in the rest of the broader market.

In order of best to worst profit margins, the top five companies rank as follows:

• Altria Group, profit margin +28.25%, operating margin +42.69%,

• Philip Morris International, profit margin +25.17%, operating margin +41.11%,

• Lorillard, profit margin +23.50%, operating margin +44.93%,

• Reynolds American, profit margin +17.35%, operating margin +32.00%,

• Vector Group, profit margin +8.86%, operating margin +23.72%.

What is more, only one of the five suffered revenue shrinkage over the past 12 months, it being Phillip Morris International which lost 7.60%, while the other four all enjoyed revenue growth ranging from 2.50% for Lorillard, to 4.70% for both Altria Group and Reynolds, to as high 95.00% as in the case of Vector Group.

There are some pretty astute managers running these companies, to say the least. Despite shrinking popularity and customers in the U.S., they are managing not only to stay alive but to grow, providing their investors with ample stock appreciation going forward.

Those prospects are also reflecting in futures earnings growth estimates over the next five years, in which three of the five companies are expected to beat the S&P’s 7.90% growth rate, one is expected to nearly market-perform, while only one is seen under-growing: with Vector growing 11.00%, Lorillard growing 9.00%, Reynolds growing 9.05%, Altria growing 7.77%, and PM International growing 3.95%.

These are signs of longevity, where management is continually scouring the landscape for new opportunities to adapt to changing conditions. There are generally two types of companies out there: those that stay with what has worked in the past, and those that progress toward what will work in the future.

The former will continue to flourish as long as conditions remain the same. But as soon as their market starts to change, like the tobacco industry has been experiencing, then only the latter will be around when their old way of doing business is rendered obsolete. I suppose that is what separated the mammals from the dinosaurs. And we all know what happened to the dinosaurs.

Joseph Cafariello