The Best Tobacco Stocks of 2017

The field has narrowed considerably this year.

Rich Duprey
Rich Duprey
Dec 21, 2017 at 8:09AM
Consumer Goods

A year makes a big difference in the tobacco industry, as the cigarette companies that are focused on international markets outperformed domestic players in 2017. Last year, it was the reverse. But there are some caveats, because the tobacco industry isn't the same as it was 12 months ago, and the waters are increasingly muddied about what is domestic and what is international.

That's primarily due to the continued consolidation under way in the market, with British American Tobacco (NYSE:BTI) acquiring Reynolds American, and the closer ties between Altria (NYSE:MO) and Philip Morris International (NYSE:PM), which still fuels speculation that they will become one company once again.

MO Chart

MO data by YCharts

Why Altria lagged

U.S.-based Altria was this year's tobacco laggard by a wide margin, and the cause was twofold: a poorly received earnings report and the potential for expanded regulation.

Earlier this year, California raised the cigarette tax by $2 per pack, which more than tripled the tax from its then-current level of $0.87. It also raised taxes on ancillary tobacco products, including electronic cigarettes that contain nicotine.

Although Altria and other domestic producers raised their prices in response to the initiative, which ensures that their profits aren't hurt as much as they otherwise would be, the tobacco giant still took a big hit because California is the second largest cigarette market and Altria's Marlboro is highly exposed to the state, with better than 50% share of the market there.

It was estimated total cigarette volumes tumbled 4.5% in the second quarter alone because of the tax increase, and Altria's domestic shipment volumes fell 5% as a result.

The other problem was that the FDA said it wants to reduce nicotine levels in cigarettes to "non-addictive" levels, which could very well require reducing them to nearly impossible-to-obtain negligible amounts. It may effectively create a ban on cigarettes.

Altria has bounced back from the initial shock and a better third-quarter earnings report, but not nearly enough to overcome the deficit of its earlier highs or the gains of its rivals.

Stack of cigarettes.

Image source: Getty Images.

Why British American Tobacco did well

Right around the time the FDA was announcing its new regulatory proposal, British American Tobacco was completing its acquisition of Reynolds American. The London-based cigarette company acquired the remaining 58% of Reynolds it didn't already own in a $49 billion cash and stock transaction, which obviously gave it greater exposure to the new regulatory environment.

However, it also gives the company greater strength to reach numerous developing countries where impediments to smoking aren't as strict.

It also combined Reynolds' leading Vuse electronic cigarette with the significant investments British American was making in next-generation e-cig devices like its iFuse glo, which offers the increasingly popular heat-not-burn technology and is the market-share leader in the technology.

British American Tobacco's stock also fell on the regulatory news in July, but not nearly as far as Altria.

A woman holds an iQOS electronic cigarette

Image source: Philip Morris International.

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Why Philip Morris International led the way

Without any real exposure to the U.S. market, Philip Morris International's stock barely budged on the FDA's announcement, but like all the tobacco companies, its shares have trended lower over the ensuing months, though they've gained more strength in recent weeks.

Philip Morris has a competing heat-not-burn e-cig on the market, and it has been gaining ground wherever it's been introduced. Perhaps the biggest trial will come when the FDA renders its decision on the device sometime next month, determining not only whether it can be sold in the U.S., but perhaps also whether it can earn a reduced risk designation. By gaining that label, Philip Morris' iQOS device, which is marketed primarily under Altria's Marlboro brand as HeatSticks, would have a tremendous competitive advantage. It will be able to say its device is better for you than cigarettes, something its rivals couldn't do.

It's the close relationship between Philip Morris and Altria that has many suspecting the former may move to acquire the latter. They have reciprocal marketing agreements in place on the next-gen e-cig devices, and merging their businesses would make for a single, cohesive entity.

Although the tables turned on the cigarette companies in 2017, they may all be moving toward being more closely aligned, with few differences between them.