Little to no growth in the sales of leading tobacco companies may have steered away many investors from the tobacco industry. However, leading tobacco companies are finding ways to augment their revenues. Let's take a closer look at three companies that could become smoking hot in the near future.
Before I turn to the potential growth in sales of companies such as Reynolds American (RAI) and Lorillard (LO.DL), let's tackle one preconception that many investors hold – the sharp deterioration in the number of smokers. Is the tobacco industry contracting at a rapid pace? Not as fast as you might think.
Based on a recent report by the CDC, the number of smokers reached 43.8 million in 2011. Back in 2005, this number was 45.1 million. This represents a 2.8% decline in the number of smokers over a six year period, i.e. less than a half percent drop each year. Moreover, the number of every day smokers has decreased by 6.5% between 2005 and 2011, i.e. a little over an annual one percent decline. These numbers suggest that the drop in the demand for cigarettes has been very gradual in recent years. Further, the sharp rise in prices of cigarettes in recent years and the very low estimated average price elasticity of -0.4 (for a 1% increase in the price of cigarettes, the demand declines by 0.4%) could explain the stable profit margins and moderate drop in sales for tobacco companies.
The chart below shows the profit margins of Altria Group (MO 0.12%), Reynolds and Lorillard in the past several quarters.
Source: Google Finance
The chart clearly shows that the profit margins of these tobacco companies have slightly increased in the second quarter of 2013 compared to 2012.
Finally, a recent study suggests that the warnings about potential side effects that are advertised for cigarettes could actually increase the demand for cigarettes. The reason behind this finding, according to the researchers, is that "participants came to see the warning as an indication of the firm's honesty and trustworthiness." In any case, this finding has yet to reflect in the number of smokers as it continues to slowly fall. In the past year, tobacco companies have found new ways to expand their reach; one of these ways is by selling e-cigarettes.
E-cigarette market continues to rise
The ban that prevents tobacco companies from advertising their products may have slowed down the growth in demand for cigarettes; the big advantage provided by e-cigarettes is that tobacco companies were allowed to use commercials to promote e-cigarette products. This change is likely to help augment revenues from e-cigarettes in the coming years. Also, e-cigarettes have fewer use restrictions compared to regular cigarettes, e.g. e-cigarettes are allowed to be smoked on commercial flights. This product could be the growth generator tobacco companies have been waiting for.
This positive sentiment could shift if e-cigarette regulations were to change. Last month, 40 state attorneys tried to persuade the Food and Drug Administration to regulate electronic cigarettes in the same way that it regulates cigarettes. The agency's decision is expected to be made by the end of the month. If the FDA decides to label e-cigarettes like any other tobacco product, this decision could adversely affect the advertisements for e-cigarettes. This uncertainty could hold back the rally of leading tobacco companies' stocks and down the line it could impede sales growth.
For now, Lorillard is leading the way in this market with its subsidiary, Blu eCigs. Lorillard's revenues rose by 4.22% in the second quarter. Most of the growth in sales (more than two thirds of it) was due to the rise in sales of eCigs. Lorillard's electronic cigarettes brand accounts for 40% of this market.
Other tobacco companies are still behind Lorillard and they are slowly expanding their reach to this market. Reynolds has been branching out to the electronic cigarettes market via Reynolds Vapor, a subsidiary of Reynolds. The company plans to expand its business by distributing Vuse. The recent news is that Reynolds Vapor will reach retail outlets in Colorado. Altria has also entered this market by rolling out its MarkTen e-cigs brand back in August. Some analysts already estimate this new line of product could augment the market value of Altria by 7%. In the meantime, these companies' stable profitability, as indicated above, kept their dividend yields high.
High dividend yields
One of the main strong points of tobacco companies is their high dividend yields. Reynolds offers a yearly dividend of $2.52 per share, which is an annual yield of 4.98%. Lorillard's current annual dividend stands at $2.20 per share, which comes to an annual yield of 4.69%. Finally, Altria offers an annual dividend payment of $1.92 per share per year, which comes to an annual yield of 5.41%. These high dividend yields are likely to remain these companies' main attraction. Moreover, stable and high profit margins suggest that these companies will maintain their high profitability.
Bottom line
The above-mentioned companies still face uncertainties regarding the e-cigarette. If the FDA continues to allow tobacco companies to advertise e-cigarettes, these products could be the new engine behind these highly profitable companies. This trend along with their high dividend yields could mean that these companies are becoming more viable investments.
