Tobacco Stocks Fell, But Should Investors Worry?

Tobacco stocks have not had a good start to the year. So far, Altria (MO 1.91%), Reynolds American (RAI), Lorillard (LO.DL) and Philip Morris (PM 2.82%) are all down more than 3% year-to-date, underperforming the S&P 500 by as much as 2.5%. These figures are in reality insignificant, however, as some of these declines extend back into 2013. Looking back over the data, it would appear that during the last month these companies have underperformed the S&P 500 by as much as 5%.

After these lackluster returns, investors could be thinking about turning their backs on big tobacco. However, there are some very simple explanations as to why these companies have underperformed recently.

Growth issues
Philip Morris has been the worst performer of the tobacco sector during the past six months, underperforming the S&P 500 by nearly 20%; not good.

The start of the decline can be traced back to November of last year, when Philip Morris' management revealed that the company's earnings would grow by less than the previously forecast 10% as the company invested for growth and consolidated its position within the industry. After this year of consolidation, management targets a long-term annual growth rate of 10% to 12%.

Unfortunately, these growth concerns were compounded by the revelation that Philip Morris had been spending more than it could afford on buybacks and dividends since its spin-off from Altria. As a result, management concluded that the company was going to scale back its repurchases to try and improve the balance sheet.

Both of these issues are of concern but not long-term problems. Indeed, after a year of consolidation, Philip Morris should return to growth. The company is still one of the most profitable in the world and it has more than enough cash to return to investors so the buybacks are likely to carry on. More about Philip Morris' plans to return to growth here.

The courts once again descend upon tobacco
The growth issues above only relate to Philip Morris. Domestic tobacco producers are not worried about growth but rather the legal system. Specifically, Altria, Reynolds, and Lorillard recently reached an agreement with the Department of Justice over allegations that the companies had lied about the dangers of smoking to their customers and the American public.

Under the agreement, Altria, Reynolds, and Lorillard must publish ads in the Sunday editions of 35 newspapers and on newspaper websites, as well as buy prime-time advertising space on CBS, ABC, or NBC five times per week for a year -- not a cheap undertaking. In addition, all three companies concerned must publish 'corrective' statements on their websites and affix them to a certain number of cigarette packs, three times per year, for two years. Again, none of this is likely to be cheap.

What's worrying shareholders is that these warnings will likely cost big tobacco yet more customers as an increasing number of smokers are convinced to kick the habit. That being said, it remains to be seen if the warnings will have a significant effect. I say this because a study entitled Can anti-smoking television advertising affect smoking behaviour? Controlled trial of the Health Education Authority for England's anti-smoking TV campaign, which was designed to evaluate the effectiveness of the Health Education Authority for England's anti-smoking television advertising campaign, concluded that an 18-month anti-smoking campaign would reduce smoking prevalence by around 1.2%.

This is a nominal rate of attrition when we consider that the volume of cigarettes shipped throughout the United States declined by around 4% for the first nine months of 2013, without this advertising.

That old menthol debate
Of course the other impending issue that the shareholders of domestic tobacco companies are worried about is the impending decision from the FDA about the regulation of menthol cigarettes. The FDA finally completed its public consultation on the matter back at the end of November and a decision is due anytime now. A ban would affect all domestic cigarette companies, although it would hit Lorillard the hardest as it is estimated that 90% of the company's revenue comes from menthol cigarettes. In comparison, 30% of Reynolds' sales and 20% of Altria's sales come from menthol. The menthol debate is extensive but it is unlikely that the FDA will come down hard on the product, there is just too much at stake. You can read more about it here.

Foolish summary
So overall, apart from the issue of menthol regulation the two factors currently putting pressure on big tobacco stock prices do not look to be of long-term concern. Philip Morris is likely to return to growth after a year of consolidation and the court judgement will hurt big tobacco but it is unlikely to be a game changer.