Monday, July 10, 2017

Just say no to tobacco stocks

Last year, Credit Suisse published research claiming that the tobacco industry was the best-performing sector of the American stock market from 1900 to 2010. Similarly, Jeremy Siegel wrote in his 2005 book The Future for Investors that Altria, formerly Philip Morris, had been America's best-performing stock during its existence as a public company. And Altria has continued its winning ways since 2005, beating the S&P 500 by a wide margin.

Tobacco companies have achieved their strong performance despite facing many challenges: sales and excise taxes on cigarettes have steadily risen over time, the number of cigarettes consumed in the United States has fallen more than 50% over the past 35 years, and a wave of product-liability lawsuits threatened to bankrupt the tobacco industry during the 1990s.

Its ability to withstand these challenges, combined with its strong historical profitability and the addictive nature of cigarettes, makes tobacco stocks look invincible. Despite that, I believe that the industry's strong performance is coming to an end and that tobacco stocks are secular shorts.

This article will focus on Altria because it's the largest American cigarette manufacturer, but I expect the whole industry to suffer in the coming years.

Why tobacco has outperformed

Determining why tobacco companies have prospered for more than a century is beyond the scope of this post, but I think there are three reasons why Altria's stock done well over the past 15-20 years:

Price hikes. Although cigarette sales volumes have fallen steadily, manufacturers have more than offset this by increasing their profit per cigarette. According to Horseman Capital, cigarette prices have tripled since 1998 and "British American Tobacco has seen its net profit margin rise from 5% in 1998 to 25% [in 2013]." The 1998 Master Settlement Agreement between the US states and large tobacco companies enabled these price increases by turning the cigarette market into an unofficial cartel.

Rising valuations. Altria traded below 6x earnings in 2000, and it trades at 22x earnings today. Initially, its valuation rose as the threat of ruinous personal-injury lawsuits receded. Later, falling interest rates increased the multiple investors applied to Altria's stable cash flows and made its dividend more attractive to yield-seekers.

Rising leverage. In March 2008, after spinning off Philip Morris International, Altria's tangible book value was $1.6 billion. Today it's -$5.2 billion. The main reason why Altria's net worth declined is its cash acquisition of UST in early 2009, which it financed by issuing $9.7 billion of debt. Offsetting that is Anheuser Busch's cash-and-stock acquisition of SABMiller, in which Altria held a major investment, which resulted in billions of cash proceeds to Altria and an upward revaluation of its remaining brewery investment.

Excluding acquisitions and sales, since 2011 Altria has paid out slightly more than 100% of its earnings in dividends and stock buybacks. The company's ability to operate with historically high leverage and a 100% payout ratio is, in my opinion, key to its popularity with investors.

Why it can't go on

For several reasons, I expect cigarette volumes to continue declining, but without the compensating price hikes that cigarette manufacturers have effected in the past:

• Nicotine may be addictive, but contrary to popular belief, addicts are capable of making trade-offs and delaying gratification. In one experiment, crack addicts who were offered a choice between drugs and delayed cash payments often chose cash.

• In the United States, cigarette smokers are disproportionately poor and uneducated. Their ability to pay more for cigarettes is limited, so further price hikes may prompt them to quit smoking or roll their own cigarettes.

• The Centers for Disease Control conducts surveys to measure teenage smoking. Historically, the percent of high school students who had used tobacco in the previous 30 days exceeded the percent of adult who smoked. The teen smoking rate fell below the adult rate ten years ago, however, and it has remained lower since then. I believe this presages an accelerating decline in the adult smoking rate.

• E-cigarettes allow for the ingestion of nicotine without any of the toxic byproducts that burning tobacco produces. This has made them increasingly popular among smokers:

Paradoxically, e-cigarettes' superiority gives public-health agencies a reason to demonize them. If public-health advocates and bureaucrats define themselves as crusaders against the evils of tobacco, then replacing cigarettes with e-cigarettes eliminates their reason for being.

Accordingly, the Food and Drug Administration took steps last year to impose onerous new regulations on e-cigarette manufacturers. The Trump administration has dramatically reduced the growth of federal regulations, however, including delaying implementation of the FDA's rules for e-cigarettes. I believe the administration's hostility to regulation makes the continued growth of e-cigarette usage likely.

Summing it up

Over the past couple decades, a virtuous cycle has lifted Altria's stock: swiftly rising cigarette prices have boosted its earnings, which has allowed it to operate with more debt and distribute more of its earnings to shareholders. Key to this dynamic is the cartelization of the tobacco industry, which e-cigarettes and falling youth smoking rates now threaten.

If cigarette consumption continues to decline and tobacco companies are unable to effect offsetting price hikes, the virtuous cycle will go into reverse: Altria's earnings will fall, and then it will have to prioritize repaying liabilities over returning money to shareholders, and the stock will probably get a lower multiple on lower earnings.

More generally, while cigarette manufacturers have enjoyed remarkable pricing power, no company, no matter how desirable its product, can increase real prices forever. Pricing power is better thought of as a reservoir--vulnerable to being drained through continual exploitation--than a perpetual motion machine.


  1. Great post. One anecdote: I started smoking when I was probably 13-14, and it took me 10 years to quit. My key takeaway is that it's *hard* to start smoking. You have to want to do it. For me, it was because my friends all smoked. It's something you've gotta work at. Furthermore, it takes a while to get properly addicted to nicotine.

    Give kids another option, like e-cigarettes, and I imagine they'll take it. We would have.


    1. Thank you.

      I've read that many vapers--at least here in the U.S.--use vape shops as a place to hang out and socialize. That seems to confirm what you're saying, i.e. to the extent that smoking is a result of peer pressure or serves a social function, e-cigs offer the same thing while (as you say) requiring less of a commitment.

  2. Good article and I agree that MO is overvalued. Having said that, the valuation of 6X in 2000 was an extreme. I remember back then that it was basically a panic that tobacco companies would be going bankrupt shortly.

    1. Thanks, that's a good point--it was only 6x for a few months in early 2000 when old-economy stocks were out of fashion and the litigation risk was really dire.

      On the other hand, Philip Morris had a large food business at the time, which the market was probably willing to give a higher multiple. So one could argue that if PM/Altria traded at, say, 12x earnings in the early 2000s, and the food biz was worth 15x, then the look-through valuation for tobacco was lower. For comparison, RJ Reynolds separated from Nabisco in 1999 and became a pure-play tobacco co, and it traded between 6x and 11x earnings in 1999-2000.

      According to this writeup, MO and RJR got really cheap again in early '03 even though the legal situation had started to ameliorate:

    2. I recall at the time many "talking heads" were arguing that the food portion of the company was completely negated by the potential liability of the tobacco side. Hard to know how the market was actually valuing the food portion back then.

  3. Risks to your short thesis: PM buys MO, iQOS gets approved in US and blows e-cigs out of the water/gains a ton of share.

  4. You don't even mention iQOS...the momentum seen in Japan is impressive for PM and it will eventually be an option in the US too. Since its still tobacco, governments can still tax a win-win for regulators and tobacco companies, if the consumers like it

    1. I know IQOS has been wildly successful in Japan, but I wouldn't extrapolate that to the United States. E-cigarettes are de facto banned in Japan (they can't be sold with nicotine liquids, defeating the purpose), so IQOS doesn't have an electronic alternative there they way it will when it launches in the U.S.

      I also expect innovator's dilemma to hamper IQOS's competitiveness: in Japan, heatsticks costs the same as cigarettes, and my guess is that pricing will be similar in the U.S. to protect margins. By contrast, e-cigs can be much cheaper. There are some hobbyists who buy expensive kit and spend more than they would on cigarettes, but the things I've read online suggest that the average user saves a lot of money vaping vs smoking (and, presumably, using IQOS).

      Actualy, we've already seen the tobacco incumbents succumb to innovator's dilemma with their e-cigarette offerings (Blu, Vuse, Vype, etc)--they're proprietary systems that force users to by high-priced refills in a limited number of flavors, so from the perspective of a serious vaper, they aren't competitive.

      I agree with you on taxes, though--my biggest fear w.r.t. e-cigarettes is that as they become more popular, the government will equalize taxes between cigarettes and e-cigs, eliminating a big incentive to switch.