bloomberg.com
Tobacco May Soon Be Smoking
The stocks are cheap, and the political environment favors a rebound.
By Matthew M. Stichnoth, Bloomberg Personal Finance, December, 1999
Now, a kind word about tobacco stocks. Wait, don't turn the page! Sure, share prices are way down, and the legal and political problems facing this industry and its deadly product seem almost insurmountable. But the stocks are extremely cheap, while the sector's long-term outlook is almost surely more bullish than the market seems to believe. Even better, the political environment that has hamstrung the industry is likely to improve shortly. It all adds up to the potential for big-time upward moves in the stocks.
The problem ailing the tobacco sector can be summed up in two words: product liability. In particular, since President Clinton announced in January that the federal government would sue the industry over smoking-related health-care costs, the stocks have fallen faster than you can say "menthol 100s." As of October, British American Tobacco (BTI) had dropped 16.7 percent, as the market rose 12.9 percent.
R.J. Reynolds Tobacco Holdings (RJR), spun off from the old RJR Nabisco in June, had fallen by 14.3 percent in four months. And Philip Morris (MO), the industry Godzilla, was off 40.6 percent from its November 1998 high of $58, sitting at $34.44 per share.
Still, it's hard to see what everyone's so concerned about. The tobacco industry has lived with product-liability risk in one form or another for the better part of 30 years and has mostly thrived. It has yet to pay a dime to an individual plaintiff from the private sector. And though a number of judgments pending against the industry are still being litigated, any potential liability will almost certainly be manageable. And while recent headlines have been negative, it's still far from clear that, once the cases wend their way through the appeals process, the industry will face serious liability.
As for the Medicaid-cost-recovery lawsuits brought by the state attorneys general, last year's $206 billion, 26-year Master Settlement Agreement protects tobacco companies from further state suits and resolves the issue once and for all. The industry put through a 22 percent price increase to fund the liability last year; business barely missed a beat.
That leaves the federal suit, which was officially filed in September. "You have to ask yourself whether, in its heart of hearts, the federal government really wants to permanently cripple the tobacco industry," says Peter Thompson, general partner of Coho Partners, a money-management firm in West Conshohocken, Pennsylvania, and an owner of Philip Morris stock. For Thompson, the answer is an emphatic "no." Add up the income, excise, and state and local taxes that Philip Morris pays every year, he notes, and the company is the single largest taxpayer in the U.S. Plus, it's a huge employer nationwide and an ultimate customer for the nation's (government supported) tobacco farmers. The other tobacco companies provide similar macroeconomic benefits.
It's hard to believe, Thompson says, that the feds will push very hard to stifle a business on which they depend so heavily. Roy Burry, an analyst at Brown Brothers Harriman in New York City, agrees: "The government's civil suit is a joke."
Meanwhile, the industry's underlying business is solid and improving. In the Asian and Latin American markets, economic recoveries have allowed consumers to trade up to American cigarettes from cheaper, locally made products. That's a big plus for a company like Philip Morris, which derives more than half its tobacco earnings from outside the U.S. Stateside, Burry says, tobacco companies have so much pricing power that revenue and profit per unit are rising sharply, which should offset the effect of chronic volume declines.
Despite last year's big price hike to fund the state settlement, Philip Morris's earnings this year will likely rise by 4 percent, to $3.30 per share, according to First Call, and by another 12 percent in 2000, to $3.70. British American's earnings should jump by 14 percent next year, to $1.36 per share, and UST's earnings should rise by 8 percent, to $2.90. That gives the stocks P/Es of 9.3, 12.6, and 10.6, respectively.
What's more, the companies are still able to generate mountains of free cash (net income plus depreciation, less expected capital expenditures). RJR pays an 11 percent dividend yield and is expected to start a $300 million to $500 million share-repurchase plan in the coming months. Philip Morris will generate something like $8.8 billion ($3.65 per share) in discretionary cash next year, to be used for both dividends and share repurchases. Three of the four major tobacco firms pay cash dividends of at least 5.5 percent.
Longer term, maybe the most bullish sign for the industry is political. With George W. Bush running 12 percent in front of any Democratic challenger in the polls as of mid-October, the prospect of a less-antitobacco administration should take the pressure off the industry's stocks.
Which gets us, at last, to the group's valuation. As noted, it's rock-bottom. "The sector is cheaper on a relative-value basis now than at any time in its history," says analyst Burry.
Philip Morris's P/E of 9.3 times 2000 earnings, for instance, compares with an average P/E for the market of 23.5. That puts the stock's relative P/E ratio at just 0.4. As recently as the early '90s, it had a market-average P/E. Similarly, Philip Morris's 5.25 percent annual dividend yield is fully four times the S&P's, also a record gap. All this, by the way, despite an expected earnings-growth rate for the company that's twice the market's. Valuations of the other major tobacco stocks are similarly beaten down.
The numbers add up to a minimal amount of downside, with the likelihood of substantial price appreciation. No, the stocks don't have many fans now. But the way things are going, they soon will. Higher prices, too. |
