The tobacco industry is facing declining sales, but still provides an ample investment climate. Especially for investors who are starving for yield. This was proven by Marlboro-maker Altria Group Inc (NYSE:MO), after it recently increased its dividend by over 9% at the end of August.
Relative Valuation
Altria Group Inc (NYSE:MO) is currently trading at around 16 times earnings and 14 times forward earnings. Its competitor Reynolds American, Inc. (NYSE:RAI) is more expensive, trading at 18 times earnings with a forward P/E ratio of around 14.5.
While Altria Group Inc (NYSE:MO)’s share price is cheaper than Reynolds American, Inc. (NYSE:RAI) in relation to earnings, it isn’t the cheapest in the tobacco industry. One of its major competitors, Lorillard Inc. (NYSE:LO) is even cheaper, trading at only 14 times earnings and a little under 13 times forward earnings.
Altria, however, also offers the highest dividend. Its shares currently yield around 5.5%, which is better than Lorillard Inc. (NYSE:LO)’s 5% dividend. Reynolds American, Inc. (NYSE:RAI) yields about 5.2%. Lorillard’s inferior yield isn’t the only reason its earnings are priced cheaper than its competitors, either.
Goodbye menthol?
The tobacco industry is highly regulated and taxed, but this makes the barriers of entry high and creates formidable moats for the established players. Tobacco companies also generally enjoy strong pricing power that allows them to raise prices to compensate for any financial damages arising from regulatory issues or lawsuits. The case may be different for Lorillard Inc. (NYSE:LO), however.
After successfully banning flavored cigarettes, the Food and Drug Administration is also looking into potentially banning menthol smokes as well. The FDA found that minty menthols were more likely to get people started smoking, while also leading to greater dependence on nicotine.
The results of the menthol battle are crucial to Lorillard Inc. (NYSE:LO), because it gets around 90% of its sales from menthol cigarettes. Lorillard CEO Murray Kessler, in an interview with The Wall Street Journal, indicated that his company will fight an unfavorable ruling in court. He also said that the FDA banning menthol is unlikely. Investors in the company should still be concerned when such a high percentage of sales comes from menthol, however.
Altria Group Inc (NYSE:MO) and Reynolds American, Inc. (NYSE:RAI) have much less exposure to menthol, which accounts for 20% of sales for the former and 30% for the latter.
A changing industry
With traditional smoking on the decline, tobacco companies are looking for new products to sell in the United States. Altria Group Inc (NYSE:MO) invested heavily in smokeless tobacco products and controlled around 55% of the market at the end of 2012, with brands such as Copenhagen and Skoal dominating. Reynolds American, Inc. (NYSE:RAI) holds an estimated 33% of the smokeless tobacco market, and this unit has shown some strength amongst declining Camel and Pall Mall cigarette sales.
Lorillard Inc. (NYSE:LO) opted to invest less in smokeless products and jumped full-throttle into e-cigarettes. It acquired a major e-cig player, Blu, for a cool $135 million and instantly got the first-movers advantage. Blu e-cigs now account for a 40% share of the market. CEO Kessler let it be known, however, that the Blu e-cig is “a small percentage of Lorillard overall, so we’re talking more about opportunity than affecting the existing company.”
The opportunity of the electronic cigarette
Reynolds followed Lorillard into the e-cig category with its Vuse brand. The company claims “a perfect puff, first time, every time” experience. Like Lorillard, it is beginning to advertise its Vuse e-cig on television hoping to grab some market share with its newer product.
