When "Sin" Pays: A Look at Big Tobacco

What is a sin stock? Industry Focus will be looking at a whole series of them in coming weeks, from traditional cigarettes to e-cigs, alcohol, and more. This week we begin with the classic sin stock: tobacco.

The big three tobacco companies are preparing to become the big two, as Reynolds American (RAI) and Lorillard (LO.DL) await regulatory approval for their merger. Find out how this deal reshapes the competitive landscape and more on this consumer goods edition of Industry Focus.

A full transcript follows the video.

Sean O'Reilly: I've got a fever, and the only prescription is to talk about consumer goods stocks! This is Industry Focus.

[INTRO]

Howdy everybody I'm Sean O'Reilly with, for the first time, Vincent Shen. How are you?

Vincent Shen: I'm doing very well, thanks.

O'Reilly: Thanks for joining me. I've got to know, are you a Blue Öyster Cult fan? "Don't Fear the Reaper" -- that was the song I was referencing.

Shen: I'm not.

O'Reilly: No?

Shen: No, I'm not.

O'Reilly: Before our time, I think!

Shen: Yes.

O'Reilly: First thing that I wanted to dive into here, this is going to be the first in a long series of consumer goods focused videos that we're going to talk about sin stocks.

Shen: That's right, sin stocks.

O'Reilly: Obviously we'll be talking about tobacco, e-cigarettes, a little alcohol in there; it's pretty much everything you need to have a really good time.

Shen: Absolutely!

O'Reilly: First thing we're going to talk about is tobacco. What is a "sin stock," before we get into that?

Shen: A sin stock is generally any company that's doing business in an industry that has some negative social stigma attached to it, the classics being the ones you mentioned; tobacco, alcohol, gaming.

Some investors will even consider things like private prison corporations and things along those lines to be categorized as sin stocks too.

O'Reilly: The thing that I like, to judge if it's a sin stock or not, are if it takes advantage of some kind of negative aspect of human nature.

Shen: Yes, absolutely.

O'Reilly: Tobacco being, obviously ...

Shen: Defense companies as well.

O'Reilly: Yes. Humans like to fight! Why is the tobacco industry considered a sin industry -- for our listeners that can't guess!

Shen: It's been known for decades now that smoking causes cancer and a lot of other diseases. The CDC estimates that nearly 450,000 people a year still die from smoking-related illnesses.

O'Reilly: In the United States?

Shen: Yes, just in the United States.

O'Reilly: Wow. That's out of a population of 350 million, so that's small but it's a lot.

Shen: It's significant.

Obviously they're addictive, and there are still 45 million smokers in the U.S. A lot of them come from lower-income and less-educated demographics, so it's apparent the kind of ethical and moral gray area that tobacco companies operate in.

O'Reilly: Right. There aren't a lot, but who are the major players before we really dig in here?

Shen: In the U.S., the industry is dominated by three players common referred to as Big Tobacco.

O'Reilly: Soon to be two!

Shen: Yes.

O'Reilly: We'll talk about that in a minute here.

Shen: They include Altria (MO 1.45%), Reynolds American, and Lorillard. Right now, Reynolds and Lorillard are in the process of going through a merger which is going through at the end of this month, among the shareholders.

O'Reilly: The feds are really looking closely at this.

Shen: Yes, they're concerned.

O'Reilly: Because it's already oligopolistic.

Shen: Exactly.

O'Reilly: Now, what you're talking about, it's just going to be more so.

Shen: If the merger goes through, you're talking about two companies dominating over 80% market share for the U.S.

O'Reilly: That's crazy.

Shen: Exactly.

O'Reilly: For our listeners that don't know, Imperial Tobacco you were mentioning is going to be the new number three.

Shen: That's right. Once Reynolds and Lorillard go through their merger, Imperial Tobacco will be purchasing some brands and their market share will jump from about 3% to 10%, making them the number three player in the country.

O'Reilly: That's wild. Man!

Obviously it tapers off to much smaller companies from there. I think the next biggest is Vector Group (VGR -1.05%), and they have a market capitalization of just $2.6 billion, which is microscopic compared to an Altria.

Shen: Exactly.

O'Reilly: It's not even there on the radar.

What kind of brands do they own? What kind of market share are we talking about? If I'm going to a cigarette store, what brands am I going to see on the shelf?

Shen: Just to give everybody some context, the total U.S. market for cigarettes is about $90 billion a year. Altria overall has a 47% market share, but their Marlboro brand makes up the large majority of that, the Marlboro brand being 41% of the entire market. They are bigger than the next 10 brands combined.

O'Reilly: That's insane!

Shen: Yes.

O'Reilly: That's actually crazy.

Shen: That small other portion for Altria is made up of other brands like Virginia Slims, Chesterfield, Parliament -- but Marlboro is by far the dominant player.

O'Reilly: Right.

Shen: Then for Reynolds American, they have Camel, Pall Mall, American Spirit. Reynolds overall has about 24% share of the market. Last, we have Lorillard who has 14% share of the market. They actually have the number two brand, which is Newport, which is about 12%.

That was one of the big attractive parts for the Reynolds merger, because Newport cigarettes being menthol cigarettes, that segment has seen a much more stable volume decline; it's about 1% per year, compared to overall cigarette volume declines about 4-5% per year.

O'Reilly: Would you say, beyond cost savings, are there any other rationales for this merger that we're talking about with Lorillard buying Reynolds?

Shen: It certainly strengthens their competitive positioning against Altria, which is the big bully in the playground.

O'Reilly: The 800-pound gorilla.

Shen: Exactly. It's also a potential for them to join their efforts as they approach some of the future growth opportunities with e-cigarettes and vapor.

O'Reilly: Right, which we'll obviously talk more about next week.

Shen: Yes.

O'Reilly: Real quick, we're obviously not going to bust out Excel spreadsheets or anything for our listeners, but I really wanted to touch upon the astronomical returns on equity and returns on capital in this industry. Can you paint a very brief picture of that for everybody?

Shen: Yes, sure. The companies ...

O'Reilly: They don't even need any equity on the balance sheet. That's how great their returns are.

Shen: Yes. These big tobacco companies, they have really long histories, their management teams are very strong, and their roster is stacked essentially with people who have been in this industry for their entire career.

O'Reilly: Right.

Shen: So, they enjoy significant revenue. Altria, for example, pulls in about $17 billion a year. Reynolds has $8 billion, Lorillard $5 billion. They have significant market caps. Another thing is they enjoy very high operating margins, about 40% if not more than that. Combining all those things with their cash flows, they ...

O'Reilly: Just pay out dividends and buy back stock. That's all they do.

Shen: Exactly. That's why they are so attractive to income investors.

O'Reilly: Warren Buffett had this quote. I'm sure you read this when you were at Virginia, Barbarians at the Gate.

Shen: Yes.

O'Reilly: It was about the buyout of RJR Nabisco, and that of course owned Reynolds at the time. They wanted Buffett to come in and help lend money and all that stuff. He called in. He said, "Yeah, I'll give my blessing. I'll sell my stakes, be a part owner," all this stuff. He didn't want to directly own a tobacco business, but they also made Oreos so that made it OK!

He had this quote and it was, "You make something for a penny, you sell it for a dollar, and you sell it to addicts."

Despite all the regulations up to today -- it's 2015. It's been 25-30 years since that deal went through -- despite all the regulations, all the additional taxes that have been put on top, that hasn't changed. The returns on investment are still insane at these companies, so I don't think they're going anywhere anytime soon.

Shen: No.

O'Reilly: Before we sign off here, I did just want to run down the top stock in the industry, maybe throw in our thoughts on the dividends here.

Shen: Yes, sure.

O'Reilly: Not horrible (unclear) pick one out of (unclear) here.

Shen: Of course. The tobacco companies overall, over the last four years they have returned $123 billion to their shareholders, two thirds of that in dividends and the remainder as share buybacks.

O'Reilly: That's just ... billion with a "B."

Shen: Astronomical numbers.

Altria in particular in the past year has seen really good returns, and their share price has gone up significantly. Most of these companies, they position themselves -- even though they're seeing declining volumes they build strong brand loyalty, and that allows them to raise their prices. So despite the declining overall volumes they can increase their dividends and increase their share buybacks.

O'Reilly: Yes, you see these reports come out and they regularly, a couple times a year, they'll up prices by 5-10 cents a pack, and they have no problem doing that.

Shen: Exactly, because the smokers are addicted, and because that brand loyalty ... I remember seeing a statistic that said that once a smoker has chosen their first brand of choice ...

O'Reilly: They stay with it forever.

Shen: I think over 90% stay with it, or something along those lines. It's very, very sticky.

O'Reilly: This is why Marlboro has 40-whatever% market share.

Shen: Exactly. So they generate a lot of cash flow and, with low capital expenditures, that just really gives them the ability to crank out their dividend payments.

O'Reilly: Very cool! All right. We'll obviously dive into e-cigarettes next week, but for all of our listeners, thank you for listening and Fool on!