Tobacco: more hated stocks
Not financial advice. Full disclaimer available here.
Summary:
Tobacco is pretty much an oligopoly.
The main tobacco companies have pricing power, thick margins and require little CapEx to sustain their activity which allows them to pay fat dividends.
Philip Morris is the leading firm globally but the stock is fully priced in my view.
The closest competitors are inferior and trade close to fair value.
I don’t see a clear gap between price and value so I’d rather pass on big tobacco.
After recommending uranium and oil, Twenties Research is now considering Tobacco stocks. Some of you might start to think I am at war with ESG investing. Kind off... But I am more interested in looking at what is cheap. These companies have a lot to like starting with...
Big dividends
Tobacco stocks offer some of highest dividend yields on the market. While dividend payments have increased in absolute terms, this is mostly the results of poor share price performance over the past 5 years. Here is the stock chart of the 5 companies leading the tobacco industry (2008 is the starting point because that’s when Philip Morris was listed).
The performance is not as bad it looks because the payout ratio for the industry has always been high, meaning the majority of corporate profits are distributed to shareholders as dividends. Therefore, dividends account for a major portion of total investment returns. For example, despite a 45% price correction, Altria shareholders (ticker symbol MO) are actually up from 5 years ago if you factor in the reinvestment of dividends quarterly.
Here are the current yields and corresponding share prices:
These yields are unusually attractive in a world of negative interest rates. In fact, this has to be one of cheapest group of stocks in the market today. Having said that, price does not equal value so let’s dive in and look at the businesses we are getting for the deals above.
Great margins
The first thing that strikes me as appealing about tobacco stocks is that the industry has terrific margins. Gross margins and operating margins for the top 3 companies are 60%+ and 30%+, respectively. These are on par with the margins of today’s stock market darlings: Microsoft 65%/40%, Google 56%/35%, Facebook 82%/51%, Apple 38%/28%. Tobacco companies are huge cash cows!
The main reasons for those high margins are 1) brand loyalty & 2) barriers to entry. First, cigarettes are notoriously addictive because of their nicotine content. Once a smoker is hooked, he just keeps buying, usually from the same brand. From an investor standpoint, it’s a dream business because repeat purchases are pretty much guaranteed. Therefore, tobacco stocks are rather defensive in nature.
Second, while the tobacco business is super profitable, there isn't a lot of competition. Ever since the negative consequences of smoking have been known, the industry has been subject to massive sales tax and advertising restrictions. These rulings effectively prevent new firms from entering the market, thereby protecting the incumbents.
What’s more? Tobacco companies spend very little on capital expenditures because they don’t need to reinvest much in the business to maintain their operations. They have a product formula that works so they can afford to return most of their profits to shareholders. For instance, Altria has been raising its dividend for the past 51 years!
Pricing power
The tobacco market is huge: 19% of adults smoke! However, the volume of cigarettes consumed each year is in secular decline, estimates are about 5% a year. Still, sales are flat because tobacco companies have been making it up on price. This is a testament to the pricing power of these corporations. Consumers are not discouraged by rising costs to the point that revenues are decreasing.
Growth in new product categories such as vapour and heated tobacco are also contributing to sales. Big tobacco is pushing those lower risk products to provide alternatives to smokers who are conscious of the health consequences but unable to quit. At the same time, they hope to attract new customers (even though they can’t publicly admit it).
So far, the results have been mixed. Philip Morris has had great success with their IQOS brand and believes to have converted 19mn users to reduced risk products (RRP). British American Tobacco is projecting £5bn in net revenues from RRP by 2025, over 3x its current level. Japan Tobacco began rolling out RRP internationally after moderate success in their home market. Meanwhile, Altria and Imperial Brands have failed to capture this opportunity.
Market leadership
The biggest tobacco company in the world is actually a Chinese firm owned by the state. It is therefore not investable. That's unfortunate since China is the world's largest consumer of cigarettes with 40% of total consumption. Luckily, it is not a competitive threat to the other players because it only exports a tiny fraction of its production outside of China.
In our investment universe, British American Tobacco (BAT) is the largest company by revenues followed by Philip Morris, Altria, Japan Tobacco and Imperial Brands. Altria is the outlier because it only services the US market where its Marlboro brand dominates (it has for over 45 years). Reynolds American is the second largest-tobacco company operating in the US and is owned by BAT. I am highlighting the US because it’s one of the top 3 countries by combustible volume (Indonesia ranks second on the leaderboard after China).
Internationally (ex. US), Philip Morris is the clear market leader. Philip Morris International Inc. (PMI) was spun out of Altria in 2008 and also has Marlboro under its belt, the premier cigarette brand by far. PMI owns 5 of the top 15 cigarette brands in the world. BAT and Japan tobacco (JT) share the second spot, with JT gaining market share in recent years. Imperial Brands is the underdog with only a fraction of the others’ top line.
Regulatory headwinds
The tobacco industry is subject to very high taxes. On top of the usual VAT rate, companies have to pay excise tax which takes a huge chunk out of revenues. Take BAT for instance, in 2020, the company reported net revenues of £25.8bn; but between duty, excise and other taxes: £39.2bn went to the state, and that does not even include corporate income tax! Ultimately, these costs are passed on to consumers but imagine how profitable these companies could be without the tax burden.
In a way, governments are the largest shareholders of tobacco companies. They are thus quite involved in the industry. The emergence of reduced risk product is a good example. Regulatory bodies such as the FDA are to confirm whether this new category is indeed less harmful to consumers. The private sector provide their own research to support their claims but in the end they still require approval from a public entity before going to market.
Big tobacco makes for a good political target. Altria, which already got crushed on their investment in Juul Labs, is now under scrutiny simply for investing in the vaping firm. Who’s going to argue against governmental excesses when citizens’ health is at stake? This is a risk for investors looking to put capital to work in this space. The good news is that regulators won’t kill the golden goose because otherwise there would no longer be eggs to collect.
Beyond tobacco
Imperial owns the majority stake in a European distribution company called Logista. The segment accounts for about 55% of Imperial’s sales. Unlike tobacco, distribution is a terrible business to be in: it is capital intensive and it has tiny margins. Logista does not add anything to the bottom line of the group: it’s a liability. It was disappointing to see that the turnaround plan of the new CEO did not even mention the possibility of divesting the distribution business.
Japan Tobacco derives its revenues from 5 business segments: Japan tobacco (26% of sales), international tobacco (62%), pharmaceuticals (4%), processed foods (7%) and others. This is a much better split than Imperial. However, food processing – similar to distribution – is a very tough business. Again, the lower margins and revenue per headcount tell the story quite well.
Altria is an interesting case. The company has a small wine business which it is in the process of selling. They also have a 10% equity stake in Anheuser-Busch Inbev (ABI) – the beer giant. The alcohol business is fantastic but here is the problem: Altria inherited from ABI shares at the worst possible time, in October of 2016. Since then, the shares have lost 50% of their value and Altria has not been able to sell because of a 5-year lock-up period.
I have not look at ABI in detail but the company seems loaded with debt. I don’t necessarily expect ABI to go bankrupt but I think it’s best to stay away from Altria. Now that we are approaching the 5 year mark, it will be interesting to see what management does with this newfound liquidity. If they decide to unwind their position, there is no guarantee that the proceeds will be used towards productive endeavours.
Recently, Altria has made a couple of bad acquisitions which cost the former CEO Howard Willard his seat. This excerpt from a Reuters article says it all:
Altria has proved itself adept at poorly timed dealmaking. The company acquired a 45% stake in cannabis firm Cronos (CRON.TO) in March 2019. Cronos shares have since declined almost two-thirds. Worse, Altria has taken more than $11 billion in write-downs on its investment in vaping firm Juul Labs, roughly 90% of what it paid in 2018, after the firm got tangled up in lawsuits.
These two acquisitions are the reason why I stated earlier that Altria had failed in the new product category department. Both businesses made sense for the company; but they paid stupid prices and lost billions of dollars in shareholder value. Since the new CEO - William Gilford - served as CFO during the two prior acquisitions, it does not give me much confidence about the future. Moreover, you only get US exposure with Altria which is a minus.
Credit analysis
I am a big fan of strong balance sheets because prudent management works. As clever as humans think they are, leverage is usually a bad idea.
Corporations are no different (they are run by humans after all). As we just saw with Altria, investing is hard. What I did not mention is that Altria used debt to finance those deals. Had they try to purchase Chronos and Juul with the company’s own fund, these acquisitions probably would never have happened.
Since all 5 corporations but JT use a fair amount of leverage, a credit analysis is necessary before we start discussing valuations.
BAT is rather indebted as a company. Net debt is over 4 times operating cash flows which in turn cover interests expenses by about fivefold. The current ratio is just under 0.9 and the debt to equity ratio is 67%. That’s not horrible but that does not look good.
A debt to income ratio of 4 means that it would take 4 years for BAT to pay off all their debt. Here is the way I like to look at it as an equity investor: if my investment horizon is 10 years, I only get 6 years worth of cash flow in an industry where sales are flatlining. So, in theory, I should ask for a price multiple of no more than 6.
In practice, it’s more complicated because BAT is not actually required to clear its entire debt load in the next 4 years, or even 10 years for that matter. Considering the maturity profile of BAT’s outstanding bonds, the company appears to be able to service its debt obligations. The highest capital repayment is £3.9bn (due in 2025) versus £7.2bn of free cash flow on average for the past 3 years.
To stress test how robust dividends are, we can subtract the latest dividend payment from that average. Here is the data from the latest annual report:
Using the 3-year average, BAT has £2.6bn of cash left to service its debt obligations in any one year. That’s a significant shortfall for the bonds maturing between 2024 & 2028 and therefore dividends are at risk. A few things can happen:
free cash flow increases enough to cover the shortfall and the dividend is maintained
BAT cuts the dividend to free up cash and repay the bonds
BAT is able to refinance and the dividend is maintained
The first scenario seems rather unlikely even if revenues from RRP increase 3x by 2025. Management would probably want to avoid the second scenario and therefore go for the 3rd option. BAT’s ability to borrow will depend on several factors at the time of refinancing, namely: how well the company is doing, how friendly capital markets are towards tobacco companies (ESG threat) and overall liquidity in the market.
Right now, BAT’s all-in cost of debt is around 3.4% and is rated BBB by Standard & Poors (S&P) which the rating agency describes as: “adequate capacity to meet financial commitments, but more subject to adverse economic conditions”. In other words, BAT ranks 4 out of 12 on the risk scale of S&P. So it’s neither good nor bad. So long as BAT is not downgraded, the company should be able to refinance.
It makes sense for a consumer staples company to use debt as part of its capital structure given the reliability of its cash flows. This explains why tobacco companies don’t keep a lot of cash at hand. The mean current ratio is just above 1 for the five firms included in the study (JT is the strongest with a ratio of 1.56 and Imperial the weakest with a ratio of 0.76). They have access to large credit facilities if they need liquidity on short notice.
Still, BAT has a debt to equity ratio of 67% which is high. The reason BAT carries so much debt on their balance sheet is because of the acquisition of Reynolds American in 2017. This resulted in a large increase in goodwill and intangibles and a drop in return on invested capital. In layman’s terms, it means BAT paid too high of a price for Reynolds.
That’s a nice transition to our next section where we discuss valuations and the relationship between price and quality. But before we move on from the topic of debt, let me give an overview of the situation for the other tobacco firms. JT has the strongest balance sheet without question. PMI is in a good position too with an interest coverage ratio of 9 and a strong credit rating. Altria is in better shape than BAT but definitely weaker than PMI with an all-in cost of debt 70% higher.
Imperial’s debt repayment schedule looks challenging. Similar to BAT, Imperial can service its debt from current cash flows but less comfortably so. The maturity profile is more aggressive with all bonds outstanding due by 2032 and a large capital outlay coming up in 2022. Also, 29% of the debt is on floating rates as opposed to just 7% for BAT. Since the company is committed to reducing debt, we might see another dividend cut, but then again, management would probably want to avoid that.
Price/Quality
I started this research note by talking about dividends. High dividend yields are seductive but investors need to be cautious not to fall into a value trap. Now that we have a good idea of where the industry stands and what the strengths and weaknesses of individual companies are, let’s look at the value proposition of each one.
Joel Greenblatt, a hedge fund manager who has consistently outperformed the market during his investing career, has a screening method called the magic formula. Of course, this is more math than magic. The idea is to rank the attractiveness of stocks based on a combination of price and quality. Investors can access a shortlist of stocks for free by going to: magicformulainvesting.com. Last time I checked Altria was on the list.
Although my version of the formula is probably a bit simplistic compared to the algorithm used by Greenblatt, the basic premise remains the same. We want a low-priced, high-quality stock so just divide price by quality: the lower the ratio, the better. Again, it’s not magic; it’s a model and it’s not perfect. But a ratio below 1 is generally a good sign (like the more popular PEG ratio for comparing companies with different growth rates).
Here is the score for big tobacco:
As you can see PMI is actually the cheapest based on this metric despite having the highest price multiple. That said, you would never pay a price multiple of 42 for such a mature company. So the magic formula is not really helpful in PMI's case. Imperial Brands looks cheap too. BAT is way above 1 because of the Reynolds American acquisition which we covered earlier. Altria has a solid score even though they have not been good stewards of capital. JT may be slightly overvalued but no red flags there.
Valuation
Putting it all together, here is my position on each stock.
PMI appears to be the best business. It’s well managed, it’s the market leader and it’s growing organically. At 20 times FCF, however, the stock is fully priced in my view. According to the latest investor presentation, PMI has ambitious growth targets for the next 3 to 5 years which if met could justify the valuation. The problem is that it does not leave much room for error, if any.
Similarly, I struggle to see a discrepancy between price and value for the other 4 companies. If PMI is fully priced and it is the best business, then what does that say about the other 4 stocks?
I think Altria should be avoided for the reasons discussed above, in short: poor management and US only exposure.
On JT, I stand somewhere between slightly negative and neutral. I value a strong balance sheet and respect the fact that they have been gaining some market share recently. But they don’t have a presence in the US which is a key tobacco market (PMI does through its licensing deal with Altria) and they are significantly less capital efficient than their peers.
Also, the Japanese government owns a third of the equity and could divest its holding as soon as 2023. It’s a risk but it’s unlikely to materialize in my view. If the government wants to exit, they will probably arrange for the central bank to buy their stake (the BOJ has a history of buying assets to support financial markets).
Imperial is not in the same league as the others and, given the challenges the industry faces, I don’t see that changing. Even though it looks dirt cheap on a FCF per share basis (15% yield), I cannot make a case for a higher stock price so best to stand aside.
With BAT, I would be more confident if the company had less debt. The acquisition of Reynolds American has not been a total failure, even though it shows up pretty badly in the return on invested capital (ROIC) calculation.
To complete the discussion from the previous section, a FCF multiple of 6 probably is not warranted, but I do like to apply a discount for leverage. A comparison with JT - the company with the least amount of debt - seems appropriate.
As you can see JT yields 1.5% more than BAT when compared on a like-for-like capital structure (EV). If we just look at the equity (P), however, BAT yields 1.9% more than JT – a 20% increase in return to shareholders for backing a company with more leverage. It’s an OK bet if one places less importance on balance sheet strength than I do. BAT is the largest player by revenue after all and a dividend yield of nearly 8% is tempting.
Conclusion
At current valuations, tobacco stocks looks more like bond proxies to me; that is, investors get steady income from the high dividend payout but no capital appreciation because growth prospects for the industry are poor.
For subscribers who come to a different conclusion, or already own any one of these companies, I am not worried. Just don’t expect the share price to move much. The returns will come from dividends.
So, there you have it: an analysis of the leading tobacco stocks. As I said at the beginning, I don’t have a recommendation for you but I felt that it was worth covering the industry given the attractive dividend yield it offers.
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