The tobacco industry is facing declining sales but still provides a viable investment climate. This is especially true for investors who are starving for yield. This was proven by Marlboro-maker Altria (MO +0.99%) after it recently increased its dividend by more than 9% at the end of August.
Goodbye menthol?
The tobacco industry is highly regulated and taxed, but this makes the barriers to entry high and creates formidable moats for the established players. Tobacco companies also generally enjoy strong pricing power that allows them to raise prices to compensate for any financial damages arising from regulatory issues or lawsuits. The case may be different for Lorillard, however.
After successfully banning flavored cigarettes, the Food and Drug Administration is also looking into potentially banning menthol smokes as well. The FDA found that minty menthols were more likely to get people started smoking, while also leading to greater dependence on nicotine.
The results of the menthol battle are crucial to Lorillard, because it gets around 90% of its sales from menthol cigarettes. Lorillard CEO Murray Kessler, in an interview with The Wall Street Journal, indicated that his company will fight an unfavorable ruling in court. He also said that the FDA banning menthol is unlikely. Investors in the company should still be concerned when such a high percentage of sales comes from menthol, however.
Altria and Reynolds have much less exposure to menthol, which accounts for 20% of sales for the former and 30% for the latter.
A changing industry
With traditional smoking on the decline, tobacco companies are looking for new products to sell in the United States. Altria invested heavily in smokeless-tobacco products and controlled around 55% of the market at the end of 2012, with brands such as Copenhagen and Skoal dominating.Reynolds holds an estimated 33% of the smokeless-tobacco market, and this unit has shown some strength among declining Camel and Pall Mall cigarette sales.
Lorillard opted to invest less in smokeless products and jumped full-throttle into e-cigarettes. It acquired a major e-cig player, Blu, for a cool $135 million and instantly got the first-movers advantage. Blu e-cigs now account for a 40% share of the market. CEO Kessler let it be known, however, that the Blu e-cig is "a small percentage of Lorillard overall, so we're talking more about opportunity than affecting the existing company."
The opportunity of the electronic cigarette
Reynolds followed Lorillard into the e-cig category with its Vuse brand. The company claims "a perfect puff, first time, every time" experience. Like Lorillard, it is beginning to advertise its Vuse e-cig on television, hoping to grab some market share with its newer product.
Altria was late to the game with its MarkTen e-cig, but came out swinging. The company announced that, "Our product design and engineering folks have made a number of proprietary improvements to the existing electronic-cigarette model, and we think our product is superior."
Altria already dominates the traditional cigarette and smokeless-tobacco markets, so there is no reason why it can't surpass Reynolds and take away share from Lorillard down the road. This is especially true considering the electronic-cigarette segment is in its infancy stages and the market is far from developed.
The bottom line
Altria is the best domestic tobacco play and is cheaper than its closest competitor, Reynolds American. Lorillard may be the cheapest, but it carries lots of menthol-related risk and offers a lower yield.
Altria dominates the traditional and smokeless-tobacco industry, and will likely dominate the e-cig market -- or at least be a major player in it going forward. After the recent dividend increase, the company's 5.5% dividend yield makes it an extremely attractive buy for income investors.
