Oddball Stocks Newsletter Excerpt - Big Tobacco (Issue 37)

This is an excerpt from our Feature article in Oddball Stocks Newsletter Issue 37 (November 2021), "Value in 'Dying' Industries":

Back in Issue 20, we mentioned a McKinsey & Co research piece “Could Roger Federer be as successful playing badminton?” that tracked the economic profit of the world's couple thousand largest companies over a ten year period and found that about half of firms' performance is attributable to industry. There were twelve tobacco companies in their sample, and nine of them were in the top 20% of performance. And there were twenty paper companies, but none of those were in the top quintile of performance. Overall, their conclusion was that it is better to be an average company in a great industry than a great company in an average industry.

Investments in tobacco companies generated immense shareholder returns for more than a century, after cigarette rolling machines were introduced by James Duke in the late 19th century. The question now is whether this will continue, and do the tobacco company valuations compensate for the risk? There is a perception that the cigarette business is dying – but this has been the perception for as long as some of our subscribers have been alive, for about six decades since the U.S. Surgeon General's report on harmful effects of smoking was published. Linear extrapolation predicted that tobacco companies were doomed again because cigarette smoking dropped from 21% of American adults in 2005 to 14% in 2019.

However, humans have been using tobacco for thousands of years, since it was first introduced into human culture by the native inhabitants of South America. The Columbian exchange quickly brought it worldwide in the 16th century. Nothing about human biology has changed that would make people not want to use nicotine. The desire is there but it has been suppressed – rationally, no doubt – because of the connection between cigarettes and lung cancer. There are now far safer ways of consuming nicotine than cigarettes, such as vaping and oral nicotine products. The big tobacco players (Altria, Philip Morris, and British American Tobacco; essentially a duopoly of Marlboro versus Camels) are priced at a low multiple of their current cigarette earnings, and each one is an option on potentially very valuable reduced-risk nicotine businesses.

The most expensive big tobacco company, valuation-wise, is Philip Morris. It is also the largest by enterprise value and the most profitable. For the first nine months of 2021, revenues net of excise taxes are up 9.6% and operating profit was up 14%. Year-to-date, the company has generated $7.9 billion of cash from operations, and it spent $1.9 billion on future oriented acquisitions (Vectura and Fertin Pharma), $459 million on capital expenditures, $2 billion on debt repayment, and $5.6 billion on dividend payments. Philip Morris is the most expensive stock because it has the #1 cigarette (Marlboro) but is geographically diversified (as opposed to Altria which sells Marlboro in the U.S. only), has a popular reduced-risk heated tobacco product (the IQOS), and has not committed acquisition bungles the way that Altria did with Juul and Cronos. Philip Morris also has the least financial leverage.

Altria, the American counterpart to Philip Morris, has more moving parts. The enterprise value is currently $100 billion, but the company owns 10% of Anheuser Busch Inbev, which is worth $10 billion or so at market price. Revenues net of excise taxes are up about 1.5% year-to-date and operating income is up 6.4%. Year-to-date, the company has generated $5.7 billion of cash from operations, and it has spent $100 million on capital expenditures, repaid $1 billion of debt, bought back $972 million of stock, and paid $4.8 billion of dividends.

Finally, British American Tobacco is the most leveraged of the big three companies (debt/EV of 42% as opposed to 15% and 24% for Philip Morris and Altria) and has the second-best cigarette brand. The enterprise value of is currently $135 billion. For the first half of 2021, cigarette volumes were up 2% but revenues were down 3%. Note that for the tobacco companies (PM and BTI) with multinational operations, it can be difficult to untangle the effects of currency movements. At constant exchange rates, the revenue for cigarettes was actually up 6%. Non-combustibles revenue was up 20%, with "traditional" oral tobacco volume down 3% but vapor (Vuse) up 70%, heating products (Glo) up 99%, and "modern oral" (Velo pouches) up 124%. At constant exchange rates, non-combustible revenue was up 29%. Operating income was down 4% (although in constant currency it was up 5.4%).