On this blog, in my articles, and even in my books, I have often used the example of how capital allocation determines the wealth one ultimately has. Many times, I used the illustration of a married couple, both of whom smoked a pack a day for 20 years, and calculated how much wealth they had seen, quite literally, go up in smoke.
There are two sides to every equation and, I realized, if someone is going to spend their precious capital on a product like cigarettes, I may as well own the company that sells them. That way, I can basically take the compounding they would have received and keep it for myself. This led me to begin researching the global tobacco companies, which I hadn’t looked at since I was a teenager.
A Side Note on The Morality of Selling Cigarettes
Some in my family have wondered how I could support buying shares of a cigarette company given that one of my grandfathers died from decades of smoking, which basically made it impossible for him to breathe. (Interesting thing about my family: We always die from vices. Those who don’t often live a very long time. Smoking, drinking, overeating, or refusal to go to the doctor have always been the causes.)
How is it, then, that I have no moral qualms about the businesses? Because I believe people make choices and it is our responsibility to own those choices. It isn’t The Cheesecake Factory’s fault that their 1,000 calorie banana cream cheesecake tempts me from two blocks away. When the tobacco lawsuits were starting in the mid-1990’s and I was in junior high and high school, I remember thinking how ridiculous it was that someone smoked two packs of cigarettes a day and then wanted to sue because they died young! It shouldn’t take a brain surgeon to figure out that puffing smoke isn’t good for you. The report on cigarettes being detrimental to your health came out in the 1960’s! If someone hadn’t quit in the three decades since, it is their own damn fault.
Besides, if we are going to start drawing moral lines in the sand, heart disease and diabetes kill far more people each year than almost any other cause. By that metric, I should be boycotting Coca-Cola, Pepsi, Kraft and Nestle. That is ridiculous. It wasn’t Philip Morris’ fault that my grandfather died of smoking. It was his fault, just like it is my fault if I miss a day at the gym. When did the United States stop becoming the land of opportunity and start becoming a nation of blame-everyone-else victims?
The Domestic Cigarette Industry Looks Like a Cartel – Four Companies Control Almost 95% of Market Share
In the United States, Altria and Reynolds American hold roughly 50% and 28% market share of the domestic cigarette industry, respectively. Add in Lorillard and its 12.6% market share and Imperial Tobacco, with its 4.2% stake. An investor who owned stock in those four businesses would be in the interesting position of knowing that his tobacco investments controlled a combined 94.8% market share. That means that for every 100 people you see smoking a cigarette in the United States, you’d have likely made a profit on 95 of them.
R.J. Reynolds, which trades as its own stock but is effectively a partial subsidiary of British American Tobacco, disputes these figures. The firm states in its stockholder reports that it believes 16% of the total U.S. industry shipments from from deep-discount cigarette brands made by small manufacturers that aren’t subject to the huge tobacco settlement in the late 1990’s, giving them an enormous cost advantage. Even if that is the case, the combined market share of those four cigarette companies in staggering. (Side note: The biggest customer for many of these cigarette manufacturers is McClane Company, a subsidiary of Berkshire Hathaway that provides wholesale goods to convenience stores, restaurants, and other outlets.)
These companies definitely have their work cut out for them. Smoking rates in the United States are declining every year, and have been since the early 1980’s. This is partially offset by population growth; that is, even if a smaller percentage of people are smoking, more people in the world means more absolute smokers help offset that trend. Still, it is ultimately a doomed business. If a pharmaceutical company could develop a treatment to cure nicotine addiction, it could devastate the major tobacco manufacturers overnight.
Furthermore, in 2009, President Obama signed into law an act that gives the FDA the authority to regulate the cigarette and tobacco industries, which could drastically curtail their ability to sell products. If, as part of the health care reform, Congress makes the cigarette companies go to plain packaging, refuses to allow the post office to ship cigarettes, refuses to allow online retailers to sell cigarettes, and continues to raise excise taxes, it is possible these companies could be put out of business and the stockholders experience significant losses.
Cash Flow Is King
Why would I even be looking at the stocks given these entrenched challenges? Cash flow. The companies generate so much cash it is obscene. We’re talking about 30% to 40% of every dollar of revenue falling to profits before taxes in some product groups. The old-line tobacco companies were smart enough to buy up other, stable cash generating firms such as Nabisco, General Foods, and Kraft. It wasn’t that long ago that every time you bought an Oreo or Kraft cheese, you were sending profit to the cigarette makers. That is no longer the case due to spin-offs but there is still a stream of earnings coming into the coffers with which management should be able to do something intelligent. Particularly because the tobacco industry is mature and almost all of the earnings money can’t be reinvested in the business for future growth. It has to go to share repurchases, cash dividends and / or acquisitions.
Still, the recent authority granted to the FDA to regulate the cigarette industry could mean huge volume losses in the future. Success in this industry is anything but certain. These are not “no brainer” stocks, like buying Coca-Cola at 8x earnings would be.
The Global Cigarette Industry Is More Promising than the Domestic Market
My favorite out of all the tobacco companies isn’t selling cigarettes in America at all. It is cigarette maker Philip Morris International. It is huge. It dominates almost any market in which it competes. It trades at a fairly attractive valuation. It generates tons of cash. It returns almost all of that cash to owners in the form of dividends and share buy backs.
The company was born out of the transformation at the old Philip Morris, which broke itself into three pieces over the past few years – Altria, Philip Morris International and Kraft Foods. Altria is the domestic company that controls the USA cigarette market. Philip Morris International got the rest of the world. Kraft became a stand-alone food company. All three are publicly traded and now completely separate from the others with their own board of directors, management, offices, production facilities, stockholders, bank accounts and strategies.
Why do I like the company so much? Virtually all of its sales and earnings are generated in foreign currencies but it reports its figures in United States dollars. If profits are up, but the dollar is up more, it could look like earnings fell even though the economic purchasing power of the company expanded in, say, Great Britain or Germany. That gives management tons of opportunities to use currencies from around the world to its advantage. If the dollar crashes, the company could take its Euros, convert them into dollars and buy back shares gaining a huge cost advantage.
It’s almost a play on the trashing of the U.S. dollar as the Federal Reserve continues to print money, we continue to run massive budgetary deficits, and our trade policies result in an imbalance. The weaker the dollar, the more profitable Philip Morris International.
Even with all of that said, I wouldn’t want a huge part of my net worth in any of these stocks. I like them as nice, smaller dividend holdings a la the Tweedy Browne & Company school of widespread diversification in a retirement account. That is why they aren’t part of the actively managed money, but rather the passive long-term holdings.
(Just for fun, here are the three new companies that were created after the old Philip Morris broke itself into pieces these past few years.)
The first was Altria Group [ticker symbol MO], which retained the old Philip Morris North American tobacco business as well as the smokeless tobacco companies. It has a market capitalization of $51.85 billion, a p/e ratio of 14.97, and a cash dividend yield of 6.10%.
The second was Philip Morris International [ticker symbol PM], which took the global tobacco business of the original company. It has a market capitalization of $107.3 billion, a p/e ratio of 15.87, and a cash dividend yield of 4.50%.
The third was Kraft Foods [ticker symbol KFT], which included the consumer food business selling everything from Oreos, Maxwell House coffee, Oscar Mayer, Cadbury chocolates, Trident gum, and Kraft cheese. It has a market capitalization of $55.19 billion, a p/e ratio of 11.53, and a cash dividend yield of 3.60%.