Tobacco Stocks Still on Fire

With smoking bans across the globe, lawsuits, and social pressures, why hasn't the industry flamed out?

Later this month, Thank You For Smoking will present moviegoers with the sleazy machinations of a PR man fighting for Big Tobacco -- and Americans' cherished right to smoke. Based on a novel published in 1994, when smokers could light up in New York City restaurants and even on some commercial airline flights, his battle looks about as relevant today as the fight to promote Esperanto.

Indeed, cigarette makers appear to be losing the hearts, minds, and lungs of the U.S. population. Data released Mar. 8 by the National Assn. of Attorneys General indicates that domestic cigarette sales dropped 4.2% in 2005 from 2004, reaching a 55-year low. And smokers are becoming increasingly ostracized in other countries as well, with extensive bans limiting light-ups in once-hazy hotbeds such as Italy and Ireland. Even in France, smoking is finally on the wane (see BW Online, 2/22/06, "French Tradition Goes Up in Smoke").

All of which raises an intriguing question: With all the bad mojo for tobacco outfits, why are their stocks performing so well? The short answer: Even if Europe and the U.S. are no longer attractive markets, there are still plenty of other places to peddle smokes.


  Altria Group (MO) which makes Marlboro, the world's top-selling brand, and owns most of Kraft Foods (KFT), closed at $72.65 on Mar. 8 -- up more than 15% since late April. Rivals Reynolds American (RAI) and Britain-based British American Tobacco (BTI) have performed even better. Reynolds closed at $106.60 on Mar. 8, up over 37% since October. British American finished at $49.78 -- up 43% from last March. And Franco-Spanish Altadis, maker of Gauloises and Gitanes, is up 20% in the last year, to 36.96 euros ($43.91).

For many investors these outfits are attractive for their dividends. In 2005 Altria upped its common share payout by 9.6% to $3.20 per share. Potential consolidation also keeps some stock prices percolating. Altadis, for instance, has been the subject of continued acquisition speculation.

For companies, the bottom line is to shrewdly manage shrinking markets and make further inroads into booming ones. A recent Standard & Poor's note projects that in 2006, Altria will benefit from narrowing the price gap between its premium and discount cigarette brands while it expands its global reach through acquisitions and increasing sales. One other thing that can't hurt for Altria: S&P also sees increasing sales for Kraft.


  Altria says that in 2005 its international tobacco business shipped a jaw-dropping 804.5 billion cigarettes, up 5.7% from the previous year. The company accomplished this as total cigarette sales in several international markets, notably European countries, shrank.

It's clear that tobacco companies can still make money. But in a world increasingly hostile to their product, will it continue? After all, smoking bans tend not to get reversed. And if nothing else, they limit the times and places people can indulge in their habits. According to Altria, the Italian cigarette market dropped 6.1% in 2005 following strict smoking restrictions implemented in January, 2005, and higher taxes on tobacco.

Recent gains notwithstanding, newly released reports by Prudential Equity Group rated Reynolds and British American (which has the smallest U.S. market share of the three) neutral weight with an overweight for Altria, though the three stocks have traded roughly parallel in recent years.


  Perhaps more importantly, Prudential rated the sector neutral, noting in its report on British American that "in the uncertain world of tobacco, stuff tends to happen." British American claims a presence in 180 markets, but even for so global a company, some "stuff" must make an impression. China has hundreds of millions of smokers, and the government has stepped up efforts to crack down on the practice. There may be more bad news ahead for the global tobacco outfits: Prudential suggests that increased litigation could loom internationally.

In the U.S., S&P projects a relative lull in tobacco litigation as smoking rates continue to fall. Altria scored a big win after the Illinois Supreme Court tossed out an approximately $10 billion class-action verdict in December against the company regarding deceptive marketing of light cigarettes. S&P also remarks that a Justice Dept. case against the industry has been "weakened permanently" due to a reduction in compensation sought, reducing "the cash flow risk to major companies."

Still, this is tobacco, and there are plenty of lawsuits in the hopper. As of February, 2005, S&P says Altria's domestic tobacco company, Philip Morris U.S.A., had 269 cases pending against it. Like Prudential, S&P gives the tobacco group a neutral outlook. While the shares have enjoyed a nice ride in recent months, Big Tobacco still may not be able to breathe any easier.

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