Profits: The Healthiest Thing About Cigarettes

These days, tobacco is taboo. But behind the political firestorm that's engulfing the cigarette makers, you'll find a group of stocks that nevertheless promises healthy returns. Investors who don't mind tobacco stains in their portfolio could clean up.

Wall Street had all but written off tobacco shares. By early April, even diversified heavyweights Philip Morris and RJR Nabisco were trading at multiples that valued their cigarette operations at little or nothing. Then, on Apr. 26, British conglomerate BAT Industries announced that it was buying the American Tobacco subsidiary of American Brands. The $1 billion deal, at nine times earnings, put a fresh spin on tobacco stock valuations. "That buy should have alerted investors that domestic tobacco isn't worthless," says analyst Ronald Morrow of Smith Barney Shearson. Although tobacco stocks edged up in the latter part of April, many analysts still believe there remains plenty of room for further appreciation.

Distant thunder. Still, the barrage of bad news that has beaten down the stocks isn't over. Antismoking activists predict the courts will pierce the tobacco companies' Teflon defense against product-liability cases. The upshot? Some see damage awards rivaling asbestos payouts.

In the meantime, the industry's fundamentals are surprisingly strong. Rebounding from last year's bloody price war, 1994 earnings for Philip Morris, Reynolds, and American Brands, which represent more than 80% of the domestic market, should leap 11%, Morrow estimates. Nettlesome discounts to wholesalers are disappearing, and the higher-margin premium cigarettes have regained market share.

As a result, the industry will throw off more than $3 billion in free cash flow for the year, up 75% from 1993. That's plenty of money to continue aggressive investment in the expanding global market for cigarettes. It's also enough to help support tobacco as a stand-alone business, in case Philip Morris or RJR should follow through on talk that they might spin off their food companies. Meanwhile, current investors should be happy with dividends of around 5%.

Analysts are particularly high on Philip Morris. Sanford C. Bernstein & Co.'s Gary Black is projecting 12% annual growth in earnings and dividends between now and 1998, even with an expected 75 cents-a-pack hike in federal cigarette taxes. The company's strong support of Marlboro is the driving factor. A year ago, Philip Morris turned the stock market upside down with its 40 cents price cut aimed at shoring up the brand. As hoped, Marlboro managed to reverse its slide, posting a 1.1% uptick in market share for the 1993 fourth quarter. To pump up its entire stable of brands, the company has introduced a "frequent buyer" incentive program, which will provide rewards to wholesalers who are willing to stock a higher percentage of Philip Morris products at the expense of competing brands.

Marlboro's price dive was a direct hit on the earnings and volume of No.2 Reynolds. By yearend, however, Reynolds was the only tobacco company to increase share, jumping 1.8% for the year. Analysts say that parent RJR's stock is a bargain at $6.50. In addition to the upside in tobacco, the Nabisco food business--No. 1 in cookies and crackers--is strong, turning in 10% volume growth for the last two quarters, thanks to a slew of new products and line extensions.

And if that's not enough to entice investors, RJR is selling Preferred Equity Redemption Cumulative Stock (PERCS) at $6.50. With a 9.25% dividend, PERCS offer an attractive yield: RJR doesn't pay dividends on its common stock. The PERCS convert into common stock after three years, or before then if the shares hit a call price of $9.43. Unlike a failed RJR offering a year ago, the PERCS deal rewards investors for positive returns from food and tobacco operations. Investors snubbed the previous plan to issue a separate Nabisco-only stock when RJR, squeezed by the cigarette price war, retracted a promise to pay a dividend on the remaining tobacco shares.

Right snuff. The outlook for smaller players is mixed. BAT's Louisville-based Brown & Williamson Tobacco subsidiary, a distant third in the U.S. market, needed to beef up or get out. Picking up American Tobacco's 6.7% helps. As declining domestic consumption squeezes the little guys, expect more consolidation ahead. Loews Corp. may eventually shed its Lorillard unit, whose successful Newport cigarette brand might make an attractive U.S. target for a foreign tobacco company. Investors should steer clear of highly leveraged Liggett Group. Slumping share and reliance on slimmer-margin generic cigarettes make Liggett the most vulnerable player.

But small doesn't always mean weak. UST Inc., maker of moist snuff, is a tiny powerhouse, with an 85% share of its market. Smith Barney's Morrow predicts that future earnings will grow by 15% to 18%. As smokers look for alternatives to lighting up, U.S. Tobacco is expected to benefit.

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