TOBACCO STOCKS - AN UPDATE
The book Going Down Tobacco Road ended in 2017, about the time British American Tobacco bought the 60% of Reynolds American that it did not own. Mid-2017 saw the peak prices for tobacco stocks. Investors began to doubt tobacco’s long-term prospects, even though the cigarette companies were profitable, and the stocks had outsized dividends. Growth stocks were the market darlings – companies in high tech areas with profit growth projected for years ahead. Tobacco stocks’ performance lagged woefully.
THE FIRST SHALL BE LAST AND THE LAST SHALL BE FIRST
From 2017 until late 2021, the tobacco stocks declined. Investors questioned their future and whether they could sustain their rich dividends. Tobacco stocks bottomed in October 2021. For the previous 4.5 years, they had an average return of -10%. The market value of the industry declined -15%; partly because the companies shrank as they bought back their own shares. In contrast, the S&P 500 index returned 92%. But the contrast was greatest between tobacco and technology/growth stocks. As a proxy for growth, the ARK funds (a family of six funds filled with super-charged companies expected to transform the world over the next ten years), grew 295%.
Analyst/investment manager Lawrence Hamtil issued a report in May 2021 about the rich dividends from tobacco as a hedge against inflation, and he has been right. Tobacco stocks bottomed in October. Since then, they have returned 17%. The S&P 500 has declined -6%. The ARK funds have dropped -50%.
PERSPECTIVE ON THE LAST 5 YEARS
The industry has limited growth prospects and a steadily shrinking customer base. But the tobacco managements appear to have learned lessons from the diversification mistakes that troubled RJR for 25 years.
Tobacco still needs only limited capital investment and throws off exceptional amounts of cash. Rather than redeploying that cash in non-tobacco ventures, the companies paid out much of their free cash in dividends and stock buybacks. Over the last five years, dividends per share have risen 21 %. Buybacks have retired 6% of the outstanding stock.
Companies recognized that cigarettes are under siege and that they needed to offer new “nicotine delivery systems.”
THOUGHTS ON TOBACCO’S FUTURE
No doubt, tobacco faces head winds. The number of people using tobacco is declining. Someday, the tobacco industry will disappear. But that time is not yet in sight. The basic economic factors that have shaped the industry still apply.
A market for nicotine will exist for years. If tobacco were outlawed, a black market would fill the void. Governments and other stakeholders (not just shareholders) love the money they receive from tobacco. Federal and state excise taxes on cigarettes are $31 billion annually in the U.S. This does not include income tax paid by tobacco companies. Other governments across the world are also “addicted” to cigarette tax revenue. For almost five hundred years, governments have enjoyed revenues from tobacco, while paying lip service to eradicating the industry.
There will be fewer users, but tobacco’s addictive nature still allows for price increases to replace the profit from declining volume. Since the cash needs of the business are not large, modest increases in operating cash flow can translate into more dividends for shareholders.
Just as three of the four major U.S cigarette companies merged to get economies of scale in the last two decades, other tobacco companies may do the same. Recently, Philip Morris International announced that it will buy Swedish Match.
STOCK VALUATION SUMMARY
This table shows the financials of the world’s six major tobacco companies. The industry sells at a comparatively modest twelve times earnings with a generous dividend yield of 6.0%. The industry market value is over $400 billion.
WHAT THE “EXPERTS” THINK
My comments are based on tobacco history, and not very recent history at that. However, several fine analysts follow tobacco stocks and have their finger on the pulse of the industry. They have not given up on tobacco. For in depth analyses, their work is worth a look. Their links are:
Vivian Azer - Cowen - New York City.
Jonathan Fell - Ash Park Capital - London.
Interview with Meb Faber 1/28/2021
Lawrence Hamtil - Fortune Financial - Overland Park, Kansas.
Tobacco as a Defense Against Inflation May 26, 2021
Rae Maile - Panmure Gordon - London.