Up in Smoke

That would be the shares of Altria Group, the leading cigarette maker in the U.S. The stock rose 20 percents in 2011 flat market, and it’s up 50 percents over the past two years, nearly four times the market’s gain. Less than two weeks ago, the company, which is the parent of Philip Morris USA and its iconic Marlboro brand, hit a 52-week high of 30.40 dollars.

The stock has lived up to its reputation as a defensive investment, with stable cash flow and a dividend yield of 5.5 percents. That’s a real head-turner at a time when money-market rates are less than 0.5 percents and the 10-year Treasury is yielding less than 2 percents.
Yet in reaching for yield, investors have largely ignored the risks accompanying Altria and its rivals in the tobacco business. U.S. cigarette sales are in a severe long-term decline. Shipments are down by a third over the past 10 years. In 2011 alone, cigarette volumes fell an estimated 3.8 percents, reflecting the weak economy and an ever-growing public backlash against smoking.

To some extent, the industry has been able to offset the volume decline with increases in wholesale prices. The companies have raised those prices by nearly 35 percent over the past 10 years, even as consumers shouldered huge jumps in federal and state cigarette taxes. Total retail prices, including taxes, surged by two thirds over the 10 years, to a national average of 5.95 dollars. That was more than double the rise in overall consumer prices.
Even the cigarette company’s all-crucial pricing power could soon take a hit. Concerns about a potential price war are swirling about the sector as No. 1-selling Marlboro loses market share to less-expensive smokes and new competitors like Newport Red, a no menthol cigarette introduced a year ago by Lorillard.

The specter of another Marlboro Friday— in April 1993, Philip Morris slashed the price of a pack of Marlboros by 20 percents to reclaim market share—still haunts the industry. Not only did tobacco stocks suffer mightily from price-cutting, but the move also raised doubts about the strength of a host of established brands. Another price-slashing battle was precipitated by Philip Morris in 2003, again in a bid to reclaim share. There are no signs of another price war — quite the opposite — but the introduction of budget brands is cannibalizing cigarettespub.biz/cigarettes-news/best-brands-of-the-premium-cigarettes-brands-manufacturer.
INVESTORS SEEM UNFAZED by any of this. Tobacco stocks are trading at multiples of enterprise value to Ebitda (earnings before interest, taxes, depreciation and amortization) between nine and ten, based on 2012 figures, more than a full point higher than their five-year averages, Adel man notes. The stocks also look rich based on their double-digit price/earnings ratios; earnings are growing only in the single digits, and most of that growth, of late, has come from cost-cutting measures. Stock buybacks, often cited as a driver of earnings per share, look to have merely offset stock awards for compensation. Altria’s shares outstanding have barely budged in eight years.

Altria, by far the biggest U.S. cigarette maker in both market value (61 billion dollars) and revenue (roughly 16 billion dollars a year), is unquestionably vulnerable to industry woes. Some 80 percents, of its profit comes from its Philip Morris USA cigarette unit, which, in addition to Marlboro, includes Virginia Slims, L&M, Merit and Parliament. And the company groans under a huge debt load.

ALTRIA USED TO BE LESS DEPENDENT on the U.S. market. But in 2008 it spun off Philip Morris International, which sells the Philip Morris lineup and other brands in some 180 countries around the world. Along with cash flow from packaged-foods giant Kraft Foods, which Altria spun off in 2007, the international unit helped offset declines in domestic smokes, and gave it the wherewithal to wage price wars comfortably. Now that cushion is gone.
All the same, Altria shares are pricey by almost any measure. The recent 52-week high, adjusting for the spin offs, was also an all-time high. At a recent 30 dollars, they are trading at nearly 14 times the consensus-earnings estimate for next year, 2.19 dollars a share. Adel man of Morgan Stanley, assigning a multiple closer to 11, sees them falling to 25 dollars, or more than 15 percents – the equivalent of nearly three years’ worth of dividends.

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