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Why tobacco stocks are richly rewarding investors

There's been an established narrative about tobacco stocks for several years. The big threat of litigation has mostly passed, but smoking in the developed world is declining, putting pressure on the top line. Cigarette companies can only eke out profit growth through a combination of price increases and cost-cutting. Cash flow is steady, and unexciting, but gets passed along to shareholders via dividends and buybacks.

The tale has shifted recently, however. First, it was the idea that the legacy tobacco companies could take advantage of the growing "e-cigarette" and "vapour" trends. That thesis drove the stocks to 2014 highs.

And now? Well, what if we told you people are smoking more good, old-fashioned lethal cigarettes again? The U.S. government says cigarette production is up in the United States so far in 2015, which Bloomberg News reports would be the first annual increase since 2006. (The conventional wisdom is that this is where many consumers are spending their windfall from lower gas prices.)

The top beneficiaries, Bloomberg noted, have been government bonds backed by tobacco revenue. (For years, state and local U.S. governments "securitized" the annual payments they were to receive from a huge legal settlement from the tobacco companies. An increase in smoking, and the attendant payments to governments, now benefits the private bondholders who have first claim on the settlement money).

The tobacco stocks, however, are also clear winners, hitting 52-week highs in recent days. Investors are now pricing them like growth stocks, pushing them to price-to-earnings multiples approaching or exceeding 20, higher than any time in recent memory.

For example, Altria Group Inc., the second-largest tobacco company behind Philip Morris International Inc., has averaged a forward P/E of 18.6 and trailing P/E of nearly 21.1 this year. These are the stock's highest-ever annual multiples in the S&P Capital IQ database, which goes back to the 1990s.

Is the tobacco industry truly born again? Or will these gains go up in smoke?

If the latter question sounds familiar, it's because I suggested the answer was "yes" in May of 2014.

At that time, the excitement around the tobacco stocks was largely due to electronic cigarettes and other new products that simulate the sensation of smoking, absent the burning tobacco at the core of the legacy companies' product offerings. But the question, at that time, was whether these products would produce nearly as much profit per customer as traditional products – even if the traditional tobacco companies manage to become the leaders in the new technologies.

What the story failed to anticipate, surely, was the turnaround in the U.S. tobacco business. Fittingly, Philip Morris International, which sells its cigarettes nearly everywhere but the United States, is up just 7 per cent since that story. But Reynolds American and Altria (the U.S.-focused business formerly known as Philip Morris) are up 70 per cent and 52 per cent, respectively. London Stock Exchange-traded Imperial Tobacco Group PLC and British American Tobacco PLC, which both have U.S. operations, are up 39 per cent and 15 per cent, respectively.

The big question, of course, is whether this change in fortune is temporary. Bloomberg quoted Timothy Milway, an analyst at New York-based BlackRock Inc., as saying the 2015 increase in cigarette shipments is likely an anomaly.

While Mr. Milway was addressing the question in the context of the government bonds, his question is apropos for the tobacco stocks as well. "In the very short term, the number looks pretty good," he said, according to Bloomberg. "Looking out longer-term, we're still negative and we think the declines are going to be above trend."

However, a number of analysts, including ones at more conservative shops, are making the case for tobacco stocks, even after the recent increases. Their cases are often built around classic tobacco-stock theory: Price increases, cost-cutting, and dividend growth. It suggests that investors can profit even at these elevated prices, even if cigarettes return to their historical pattern of decline.

Morningstar gives Philip Morris International four out of five stars in its rating system, with Philip Gorham estimating the company's fair value at $92 (U.S.), versus Friday's close of $87.78.

"Philip Morris International is one of the strongest businesses in our consumer defensive coverage," Mr. Gorham says. "The company generates industry-leading normalized operating margins in the low- to mid-40-per-cent range and boasts a wide economic moat with strong brand loyalty and cost advantages at its core. Nevertheless, we see room for execution improvement and we think margins could go even higher." (Morningstar, which makes a company's "moat" against competition a core of its analysis, awards "wide moat" ratings to all the tobacco companies, but suggests others are trading closer to fair value than Philip Morris International.)

Joseph Agnese of S&P Capital IQ has four-star, "buy" ratings on Altria ($59 target price, versus Friday's close of $58.72) and Philip Morris ($92 target price).

He has a five-star "strong buy" rating on Reynolds American, with a $51 target price (versus Friday's close of $47.36), as he sees benefits to the company from its June, 2015, purchase of Lorillard.

His industry outlook for tobacco reflects favourable pricing, healthy free cash flow growth, and a "relatively benign" litigation environment. "Despite our expectation for a low- to mid-single-digit percentage decline in domestic consumption, we believe industry operating profits will rise modestly in 2015, as cost saving efforts and merger synergies should offset greater investment in focus brands."

Altria's shares have jumped in recent weeks for reasons other than tobacco fundamentals: It owns 27 per cent of brewer SABMiller, which is subject to a well-priced takeover bid from Anheuser-Busch InBev SA. Altria's SABMiller stake "has historically been a helpful contributor to total earnings per-share growth for Altria," says analyst Vivien Azer of Cowen & Co., noting "outsized equity income growth from SABMiller reduces the company's reliance on cigarette pricing."

Industry shift

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