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Should Tobacco Investors Fear the FDA?

July 24, 2013 | About:
The US Food and Drug Administration announces it is considering banning or strictly regulating menthol cigarettes…and the share prices of the companies that make and sell those menthol cigarettes take a tumble. Haven’t we seen this movie before?

Midday Tuesday, the share prices of Altria (MO), Reynolds American (RAI) and Lorillard (LO) were down by 2.8%, 1.9% and 4.1%, respectively, on the news that the FDA was considering stiffening the regulation on menthol-flavored cigarettes. Apparently, despite decades of anti-smoking educational campaigns and prohibitively expensive taxation in many American cities, the flavored cigarettes encourage non-smokers to pick up the habit. Who knew.

Lorillard took a bigger beating from the market than Altria or Reynolds American because menthol-flavored cigarettes make up a much bigger chunk of sales. Newport—Lorilard’s premium menthol-flavored brand—is the top selling menthol brand and the second-largest-selling cigarette brand overall.

Should investors be concerned about this?

I wouldn’t worry too much about a menthol ban, per se. We went through this same song and dance back in 2011. The FDA made noise about banning or strictly regulating menthol cigarettes, which depressed Lorillard’s stock price—and created the conditions for one of the best trades of my career. The FDA’s case—that menthol-flavored cigarettes taste better and thus encourage more people to smoke—is a weak one. By the same logic a screwdriver should be illegal because the orange juice masks the taste of the vodka. It’s hard to see something like this holding up in court.

But don’t mistake my downplaying of the risk of anti-menthol regulations for bullishness on tobacco stocks. The last “menthol scare” created a fantastic investment opportunity in Lorillard shares because it made them fantastically cheap. They traded for less than 12 times earnings and yielded nearly 7% in dividends. Today, Lorillard changes hands at 15 times earnings and yield a much less impressive 4.7%. Altria and Reynolds American sport earnings ratios that are considerably higher—and higher than the S&P 500 average—while also yielding about the same as Lorillard in dividends.

And while I believe this menthol scare will pass, there are other regulatory challenges that are likely to linger for a while—including the move to plain packaging.

I wrote last week that plain packaging laws attack Big Tobacco’s most valuable asset: its companies’ brands.

Cigarettes in Australia now come in plain boxes with identical plain-type fonts on the front and grotesque pictures of cancerous death on the back; no logos or branding is allowed. Aussie smokers have complained that their cigarettes now “taste different,” and early indications are that the rules are reducing cigarette consumption at the margin. Most of the developed world is considering implementing similar plain-packaging rules.

Does this mean imminent death for Big Tobacco? Of course not. This is an industry that has survived decades of regulatory attacks and lawsuits and yet still goes about its business profitably. But at the margin, plain packaging rules will erode the value of Big Tobacco’s business.

Tobacco stocks have had a great run over the past decade, beating the market on a total return basis by a wide margin. But that outperformance was made possible by their cheap valuations and astronomically high dividend yields, and these conditions are not in place today. If you want to buy Big Tobacco for its still higher-than-average dividend payouts, be my guest. But be realistic and don’t expect the same kind of outperformance going forward.

About the author:

Charles Sizemore
Charles Lewis Sizemore, CFA is the Chief Investment Officer of Sizemore Capital Management. Please contact our offices today for a portfolio consultation.

Mr. Sizemore has been a repeat guest on Fox Business News, has been quoted in Barron’s Magazine and the Wall Street Journal, and has been published in many respected financial websites, including MarketWatch, TheStreet.com, InvestorPlace, MSN Money, Seeking Alpha, Stocks, Futures, and Options Magazine and The Daily Reckoning.

Visit Charles Sizemore's Website


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