The tobacco sector is well known for its defensive nature and solid dividend payouts. Indeed, companies like Philip Morris (NYSE: PM ) , Altria (NYSE: MO ) , Reynolds American (NYSE: RAI ) and Lorillard (NYSE: LO.DL ) , in one form or another, have been paying out dividends to their owners for decades, making some people very rich.
Unfortunately, as investors hunt for yield in an increasingly yield-starved market, the tobacco sector is becoming expensive.
However, a quick screen of the sector reveals one thing: domestic tobacco companies are now more expensive than their international peers.
In particular, according to market data company Morningstar, at present Lorillard, Altria, and Reynolds are trading at historic P/Es of 20.1, 19.1, and 21, respectively. On the other hand, Philip Morris is trading at a historic P/E of 17.1 and a forward P/E of 15.1 .
Based on these valuations, you could be forgiven for thinking that domestic tobacco companies have a better outlook than Philip Morris. However, based on current data, the opposite is true.
From 2000 to 2011, an 11-year period, the US Centers for Disease Control reported that the overall consumption of tobacco fell by 27.5%, from 450.7 billion cigarette equivalents to 326.6 billion. Cigarette consumption declined even faster as these figures include a 482% increase in the consumption of pipe tobacco and a 233% increase in the consumption of large cigars.
It's reasonable to assume that between 2001 and 2021, the volume of cigarettes sold will decline by another 25% (according to Reynolds the industry's volume declined around 5% in the last year alone ).
However, internationally, the opposite is true. Indeed, over the period 1990 to 2009, the volume of cigarettes consumed around the world increased from around 5,300 billion cigarettes to just under 6,000 billion, an increase of approximately 13% -- with the decline in consumption within developed markets like the US excluded, this figure would have been much higher .
Nevertheless, as mentioned above, investors have shunned Philip Morris recently and favored the company's domestic peers, despite the gloomy growth outlook.
There are several reasons for this favoritism. Firstly, Philip Morris' earnings have recently been hit hard by a strong dollar as unfavorable currency effects took $0.34 per share off of Philip Morris' 2013 earnings, or around 6.4% of reported earnings .
Secondly, unfavorable currency impacts have led to management downgrading its 2014 forecast. When Philip Morris announced its 2013 results the company guided for 2014 EPS of $5.02-$5.12 at prevailing exchange rates, versus $5.26 in 2013. Excluding unfavorable currency effects, Philip Morris expects to report EPS growth of 6%-8%.
Philip Morris' domestic peers will not face the same currency headwinds.
Domestic tobacco has also been boosted by the prospect of merger activity. Indeed, it is widely accepted now that Reynolds is in late-stage discussions to acquire smaller peer Lorillard. Analysts believe that Reynolds could bid more than $70 per share for Lorillard, which explains Lorillard's current lofty valuation. If you want to read more about the proposed Reynolds-Lorillard deal, check out your one-stop-guide here.
Still, it remains to be seen if this merger will go ahead, there are rumors that the parties involved are worried about the price. So, forgetting the deal activity, are Lorillard, Reynolds and Altria really worth their premiums?
Well for Reynolds at least, it appears not. RJR Tobacco, Reynolds' tobacco arm estimates that its volume of cigarettes sold was down about 6.2% for the year, while industry volumes were down about 4.2%. It would appear that Reynolds' sales are deteriorating faster than the rest of the industry.
Meanwhile, Lorillard is at risk from the possible regulation of menthol cigarettes. The FDA have been debating this issue for some time now and are expected to rule on the issue later this year.
And lastly Altria. As the largest cigarette company with the US, Altria does deserve a premium over its domestic peers. That being said, the company is still confined to the US and has no international exposure. On this basis the company should trade at a discount to its international peer, Philip Morris.
Philip Morris is an international company and all of the data shows that the international cigarette market is still expanding. On the other hand, the domestic market is shrinking and for this reason, Philip Morris deserves a premium over its domestic peers.
However, at present Philip Morris is trading at a discount to its domestic peers, which gives investors the chance to snap up Phillip Morris' shares for exposure to the international tobacco market on the cheap.
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