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| Like a dancing spark in the wake of a car's passing, cigarettes have
been jettisoned from many a portfolio in recent weeks. However, investors
are lighting up again just as quickly, prompting a rally in tobacco issues
despite the omnipresent specter of litigation. The virulent campaign waged
against tobacco has cast a cloud over the segment, but as every investor
knows tobacco shares have always traded at a "litigation discount." Beleaguered
bellwether PHILIP MORRIS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %>, synonymous with the slice of
Americana known as "Marlboro," traded in the range of 10-17 times earnings
in the years 1990-1993. This 70% fluctuation in valuation occurred
despite earnings that grew at a compound annual rate of 18% during the period.
Volatility thy name is litigation.
WARNING: NON-FINANCIAL INFORMATION TO FOLLOW
The following is a brief point and counter-point
concerning the possible moral implications of investing in the tobacco industry:
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Definitions
Consolidated Cigar Holdings, Inc.
Philip Morris Companies,
Inc. Schweitzer-Mauduit International |
Over 400,000 people die every year as a result of smoking-related illness and tobacco companies actively market their products to minors in order to balance a domestic demand equation that has remained relatively flat for years. At the same time, we are no longer living in the 40's and 50's, and it is now widely known that smoking kills -- autonomous individuals in a free society are allowed to make their own choices with regard to engaging in legal activities. As to the perennially debated question of addiction; fast food cheeseburgers are addictive, cheap and cause heart disease but no one's suing McDonalds... yet. Different actors have different obligations. As a public policy maker, the common interest is protected by banning smoking in the public space, so that the potential harm engendered by the activity is limited to those that choose to engage in it. Similarly, the obligation of this columnist, fortunately, is not to moralize about the evils of smoking, gambling or drinking but to report the facts surrounding the amazing amounts of cash that these activities generate. This forum is extroverted in its agnosticism, because this columnist's opinions on "moral issues" are of no value to you. They are just another person's opinion. You, dear Fool, are sufficiently endowed to make these judgments yourself, therefore the focus of this column concerns questions of valuation. So if the tobacco industry offends you, invest in a socially responsible mutual fund and find out more about what you can do to ban smoking. Just please, please, don't write the Fool any letters about the evils of smoking. Back to our regularly scheduled programming. Clearing The Air The litigation bombshell recently dropped by industry troublemaker Bennet Lebow may turn out to be a dud. Lebow, the majority shareholder of BROOKE GROUP LTD. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BGL)") else Response.Write("(NYSE: BGL)") end if %>, which in turn owns Liggett Group, agreed to break ranks with its partners in crime and turn over thousands of documents detailing industrywide closed-door discussions on nicotine to states' attorneys. Attempts by industry giants to block release of these documents based upon violation of joint attorney-client privilege have not met with much success (full rulings will come after March 31). The terms of Lebow's agreement negotiated with the 22 states filing suits against the industry makes Liggett a more attractive acquisition target, as the lesser of two settlement evils (the four remaining tobacco companies are fighting two major class action suits). The agreement was actually tailored to stir passions in the upcoming proxy battle at RJR NABISCO <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RN)") else Response.Write("(NYSE: RN)") end if %>, where only the revenues of the tobacco arm would be threatened, not Nabisco. The terms of the agreement were structured in this manner to provide incentives for RJR shareholders to opt for a split-up of the company (Lebow and financier Carl Icahn own 5.8% of RJR and hope to break the company in two). Ultimately, even if an industrywide settlement did occur, the companies involved generate sufficient cash flow to easily cover settlement fees in the range expected (12% of pre-tax profits over 25 years). This may in turn serve as suitable closure for a segment weighed down by litigation tribulations and restore depressed multiples to their full valuation levels. The average enterprise-to-EBITDA multiples of the group are 5-7 times forward earnings (97'). Most other companies that sell consumer staples trade at an average ratio of 10-15 times forward estimates. Mulling over possible future scenarios, if Philip Morris were to be afforded the same multiple as comparable consumer staples, the capital gains (tax) that would have to be paid on that amount by shareholders would pay the entire federal deficit for more than a year. Crazy. Big Smoke As a group, tobacco related concerns appreciated 20% in 1996, with some notable outperformers like Universal which was up 30% and Philip Morris up 25%. Tobacco companies thrive in a "no news" environment and setting arbitrary time periods for evaluation is hampered by extreme short-term sensitivity to litigation related news. Tobacco will always be dominated by the large players, primarily due to distribution related entry barriers to upstarts hoping to undercut the big boys. Monthly cash payments to retailers, and marketing agreements that cover shelf space allotments are de rigeur in the business, insuring that the big names will always receive VIP treatment (Philip Morris's "Marlboro" brand captured 47.8% of the American market last year). Tobacco companies manage growth by careful balancing and marketing their portfolio of brands in existing markets. Tobacco is an international business, however, with the U.S. accounting for a paltry 8% of the number of cigarettes smoked worldwide. Out of the 5.5 billion packs of cigarettes consumed each year, only 480 million are smoked by Americans. However, the demographics from country to country are remarkably stable and not subject to huge swings in demand. In the U.S., roughly 26% of the population smokes, and this figure has remained stable for a number of years. This has prompted a replenishment effect, where the tobacco companies in order to insure stability in their revenue streams must target young smokers. Overseas revenues for the major American cigarette suppliers increased an average of 11% last year. The only way for tobacco companies can grow their revenues is by expanding into new markets and effectively marketing their brands. For instance, Philip Morris and B.A.T. Industries have much of their overseas plant capacity in Brazil where they enjoy significant economies of scale in their operations. The more markets they can push their products in, the lower their overall costs. Tobacco companies are constantly involved in a complex balancing act that involves pricing, costs and product mix. The companies have pricing flexibility overseas on the order of 3-4% depending on the markets (somewhat less in the U.S.). It is this flexibility that determines each company's tiered product offerings, from the low end to premium brands, for each market. |
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