I recently considered the investment prospects of Altria Group Inc. (MO, Financial) and Philip Morris International Inc. (PM, Financial), the tobacco giants that own the rights to the Marlboro cigarette brand in the U.S. and internationally.
As I noted, these companies have some attractive qualities. Ethical considerations aside, these businesses tend to have high returns on invested capital and large profit margins.
These qualities are not unique to tobacco companies, but thanks to the economics of the cigarette industry, they are pretty universal across the sector. Tobacco companies can manufacture each cigarette for a fraction of the price they can sell it for.
It is also fascinating to see how stringent regulations have helped the industry grow over the past couple decades.
Tobacco sector headwinds
When tobacco companies were banned from marketing their products to consumers, it came as a shock to investors.
However, over the past couple of decades, it has become clear this ban only benefited the sector leaders. They no longer needed to spend large amounts of money marketing their products to consumers and could rely on their brand value.
Meanwhile, challengers stood no chance. They couldn't market to consumers, so they couldn't compete with the big boys.
At the same time, the industry has prospered thanks to the strict tobacco tax regime most countries have adopted.
Every time a country increases the tax rate on a tobacco product, companies can push up prices, disguising the price increase with the tax hike.
This strategy has helped cigarette manufacturers grow their profit margins and offset declining tobacco sales volumes at the same time.
These qualities are the reasons why I have always been interested in the tobacco industry. It's fascinating to see how the industry has adapted and changed over the past couple of decades while fending off hundreds of billions of dollars in lawsuits from consumers.
British American Tobacco PLC (BTI, Financial) is Philip Morris' main competitor in the international market. Unlike Philip Morris, which relies heavily on its most valuable brand, Marlboro, British American's portfolio is far more diverse.
It is also investing heavily in so-called reduced-risk products. It has a plan to increase its exposure to these markets substantially by 2025. It has set this as the date for the reduced-risk division to start earning a profit.
Growth potential
One of the reasons investors tend to avoid tobacco companies is that it is difficult to project how they will grow over the next 10 years.
The best way to value a company is to look at the cash flows it will generate from now "until Judgement Day," to quote Warren Buffett (Trades, Portfolio). It is challenging to project cash flows for tobacco companies because the industry continuously faces so much pressure from so many different angles.
However, British American's exposure to reduce the risk of non-combustible products does provide a path to growth for the business.
In the second half of the company's financial year, non-combustible products users were up by 3.6 million to 17.1 million for 2021 as a whole.
With the number of users in these product categories expanded, the company is expecting revenue growth for the entire year to be above 5%.
This kind of growth suggests that the company does not deserve its current discounted valuation. The stock is currently trading at a forward price-earnings multiple of around 8. It also yields around 8%.
This valuation seems to suggest the stock does offer a margin of safety at current levels. Whether or not this margin of safety compensates for the risks surrounding the tobacco industry is up for debate. Still, it is clear the company is moving away from traditional tobacco products.
