Tobacco stocks have been extremely successful investments for long-term shareholders, and as the calendar changes, investors are looking closely at what will affect tobacco stocks in 2017. Stalwarts like Altria Group (MO 0.70%) and Reynolds American (RAI) have helped lead the way in the U.S. market, while the 2008 spinoff of Philip Morris International (PM 3.83%) from Altria gave U.S. investors another opportunity to jump into the international tobacco area as the company went up against British American Tobacco (BTI 0.51%) and other international competitors. All of these tobacco giants will have to watch closely at the impact of consolidation, reduced-risk products, and currency fluctuations on their respective markets.
Image source: Reynolds American.
Will there be fewer tobacco giants in 2017?
Many things on Wall Street are cyclical, and the tobacco industry is seeing the pendulum shift back toward consolidation. Part of what spurred the spinoff of Philip Morris from Altria was the belief that less concentrated businesses would be better for investors, and in particular that Philip Morris would benefit from more benign regulatory frameworks abroad than Altria was having to endure in the U.S. market. However, that trend has clearly reversed itself, with Philip Morris and British American Tobacco both seeing greater regulatory efforts in markets across the globe.
As a result, the thesis for having separated U.S. and international tobacco operations has disappeared, and that has spurred interest in mergers and acquisitions. In particular, British American Tobacco made a buyout bid for Reynolds American back in October, which made considerable sense given that the international tobacco company already owns more than two-fifths of Reynolds. The two companies have failed so far to come up with an agreement, and some wonder whether fears about possible deterioration in the strong performance that has sent U.S. tobacco producers higher could put a halt to further discussions. However, others believe that a deal makes sense and could happen in 2017.
If Reynolds and BAT combine to create one global tobacco giant, it would only make sense for Altria and Philip Morris to consider the same move. Altria investors might prefer the current partnership arrangement that the two companies have, because it has left them insulated from currency risks and has let them concentrate on the relative strength in the U.S. market. In the long run, though, the trend toward consolidation could easily spur a reunification effort, especially if British American Tobacco makes the first move among the biggest companies in the space.
Dealing with the dollar
Another issue that has been of concern to investors lately has been the strength of the U.S. dollar. Dollar gains played a big role in holding back Philip Morris in late 2014 and 2015. 2016 brought a slight reprieve to the downward impact that Philip Morris has suffered from currency declines, but toward the end of the year, the dollar has once again pushed higher as interest rates in the U.S. have begun to climb.
Currency issues have made Altria and Reynolds look more attractive to U.S. investors, because their domestic focus takes currency issues effectively out of the equation. Indeed, currency-related hits to earnings have pushed Philip Morris' dividend payout ratio to the point at which it has had to limit severely the amount of capital it returns to shareholders. The international tobacco giant has stopped doing buybacks and given shareholders just 2% dividend increases in the past two years, and further dollar gains could do even more damage to the company going forward. Looking forward, as U.K.-based BAT deals with the Brexit impact and both global companies look at potential M&A deals, the impact of currency will remain important.
Focusing on reduced-risk products
Finally, investors will want to watch closely how things go for the efforts across the industry toward promoting reduced-risk products. Arguably the biggest news item of 2016 for Philip Morris came in December, when it submitted its application for its iQOS heat-not-burn technology to the U.S. Food and Drug Administration for consideration. If iQOS gains approval, then Altria will have the right to commercialize it within the U.S., giving it a huge first-mover advantage over Reynolds American in the reduced-risk space. Moreover, Philip Morris will be able to use FDA approval as a marketing tool across the globe, further adding to the success of the platform.
Reynolds and BAT are looking at reduced-risk products of their own, so investors shouldn't assume that they'll inevitably be losers from advances in reduced-risk technology. Nevertheless, early success from Philip Morris in Japan has given iQOS the inside track to growth, and all eyes will be on the FDA as it considers the product over the course of the year.
Tobacco stocks have generally done well over the years, but 2017 will be a critical time for them. Investors will want to track developments in these areas to see if tobacco stocks can make the most of the opportunities they have before them.
