Tobacco companies are the companies that everybody loves to hate.
On one hand, these companies produce cigarettes, which have been linked in no uncertain terms to cancer and many other deadly diseases.
On the other hand, tobacco companies are fantastically run businesses. Even though their products have been under attack from regulators and policymakers around the world and the consumption of cigarettes is in terminal decline, these companies have produced some of the best returns for investors on the market.
Several tailwinds
There are several reasons why these companies have generated such fantastic returns, despite their deteriorating fundamentals, while others have struggled .
First of all, tobacco companies know what they are. They manufacture and sell cigarettes, so there is no desire for them to spend money buying into other businesses or sectors. This means big tobacco has avoided any value-destroying acquisitions for the past several decades.
Second, manufacturing and selling tobacco, a highly addictive substance, is hugely profitable. As Warren Buffett (Trades, Portfolio) once described: "I'll tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. It's addictive. And there's a fantastic brand loyalty."
Third, even though the sales of cigarettes are falling around the world, tobacco companies have been able to offset this decline by raising prices. Inflation data shows that between 2000 and 2018, cigarettes experienced an average inflation of 5.7% per year compared to the overall inflation rate of 2.12% over the same period. Companies have been able to increase prices for two reasons. First, tobacco is highly addictive and, second, as governments have raised taxes on tobacco, the companies have been able to sneak in price increases. If the tobacco tax is going up by 5%, who is going to notice an extra 0.5% per annum?
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Consumers don't blame tobacco companies for this growth; they blame policymakers for pushing taxes higher. As margins on cigarettes are already so attractive, the incremental price increase has a significant impact on the bottom line.
A speed bump to growth
Tobacco companies have been reliable investments for years; that is, until 2018. Two of the sector's most significant players, British American Tobacco (BTI, Financial) and Altria (MO, Financial), have seen billions of dollars wiped off their market cap in the past several weeks due to a proposal from the Food and Drug Administration to ban the sale of menthol cigarettes in the United States. The big question is, is this an opportunity to buy or does it mark the beginning of the end for big tobacco?
The answer to this question isn't so easy. Menthol sales account for around a quarter of British American's profits. Menthol's contribution to the bottom line is smaller for Altria's, but still significant.
The next step in the process will be a lengthy legal battle. The FDA will need to prove that menthol is worse and more addictive than traditional cigarettes, a claim the tobacco industry wholly disputes and says it has the science to prove it. Soon after the announcement was made, British American put out a press release saying, "The science today does not support treating them differently from other cigarettes."
Estimates vary, but it could take as long as 10 years for this court case to move through the machine in the United States. In the meantime, big tobacco can continue selling menthol.
What if a ban does come into force? Well, as tobacco is addictive, it is unlikely smokers will suddenly stop smoking, so rather than acting as a cliff edge, the ban will probably only accelerate smoking's decline. For the past several decades, big tobacco has proven to investors it knows how to navigate an industry in terminal decline. I don't think this is going to change anytime soon.
The bottom line
Overall, in my opinion, these companies could be attractive investments at current levels.
Considering how they have navigated the industry up to this point, and will remain relevant even if a mental ban comes into place, companies like British American and Altria should continue to produce returns for shareholders for many years to come, although prior performance is no guarantee to future returns.
Disclosure: The author owns shares of British American Tobacco.
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