Steady growth in tobacco profits likely in 2011

Standard & Poor’s has a positive fundamental outlook for tobacco for the next 12 months. In 2010, the S&P tobacco index rose 20.7%, smartly outpacing the S&P 500’s 12.8% advance and the consumer staples sector’s 11.2% climb. Esther Kwon, S&P’s senior tobacco industry equity analyst, believes the environment for tobacco stock outperformance has improved from an already bright 2010. With the federal government’s last minute extension of the Bush era tax cuts and the persistent low yield environment, tobacco stocks have significantly higher yields, with S&P’s coverage universe yielding approximately 5.5% on average compared to just under 2% for the S&P 500.

In addition, the tobacco litigation environment remains relatively benign, in Kwon’s view. In July 2010, big tobacco chalked up a significant victory when the U.S. Supreme Court rejected appeals by both cigarette makers and the Obama administration relating to the government’s racketeering charge that tobacco companies conspired to lie to sell products they knew to be dangerous. The court’s action leaves in place the previous ruling but prevents the government from trying to extract $280 billion in cigarette companies’ past profits. Although the court also rejected the tobacco companies’ appeal of the racketeering judgment on free speech grounds, the rejection of a financial judgment removed a significant overhang on the tobacco companies, in S&P’s opinion.

After an unpropitious start to the Engle progeny cases with two wins and seven losses by tobacco by late summer 2009, more recent momentum has turned in favor of the cigarette manufacturers when juries decided in favor of Philip Morris USA, a unit of Altria Group for the fourth time in two weeks by October 2010. The Engle progeny cases originated with a case filed in 1994 on the behalf of all smokers, but the breadth was reduced to the state of Florida in 1996. The jury found in favor of the plaintiffs and the court awarded punitive damages of $145 billion in 2000. However, in 2003, the damages award was overturned, and in 2006, the Florida Supreme Court decertified the class, forcing former class members to file individual lawsuits by January 11, 2008. While the number of these cases is large (according to Philip Morris USA, as of December 2009, its tally was 7,711 cases), S&P believes the decertification was a significant victory and thinks momentum for the plaintiffs could continue to wane as their attorneys likely brought their strongest cases to trial first.

As had been widely expected, in April 2009, the federal excise tax on cigarettes jumped to $1.01 per pack from $0.39. S&P believes tobacco is likely to be a continued target for additional state excise taxes and sees attempts to raise rates as likely in the future. Kwon sees cigarette manufacturers continuing to successfully pass these increases through to customers through higher pricing in contrast to the difficulties food manufacturers appear to be experiencing. According to December data from the Bureau of Labor Statistics, the CPI for tobacco and smoking products jumped 5.0% over the last 12 months on an unadjusted basis, notably ahead of the 1.1% climb for all goods. In early December, Philip Morris USA and Reynolds raised cigarette prices by $0.08 per pack, on top of several increases earlier in 2010.

Also, as had been widely expected, in June 2009, President Obama signed the Family Smoking Prevention and Tobacco Control Act into law. This bill gives the Food and Drug Administration the power to regulate both the manufacture and marketing of tobacco products. S&P views the enactment as a slight negative for the industry, but tobacco companies have been well aware of lawmakers’ desire to enact this regulation and have had ample time to prepare for compliance. With likely restrictions on advertising, marketing and packaging, Kwon thinks the law will serve to further solidify the dominance of the largest players, who have the resources to compete as well as comply with regulatory requirements, and weaken smaller competitors. General Tobacco, which had among the ten largest U.S. tobacco companies, wound down its operations this year after failing to make payments under the Master Settlement Agreement, the landmark pact between 46 states attorneys general and the cigarette makers.

Despite S&P’s expectation for a 4% to 5% decline in domestic consumption for each of the next two to three years, Kwon expects industry operating profits to continue rise on higher pricing, restructuring and cost saving actions.

Kwon has a strong buy (5-STARS) recommendation, as of January 3, 2011, on Altria Group and buy (4-STARS) recommendations on Reynolds American, Lorillard, and Philip Morris International.

S&P employs a proprietary methodology for ranking mutual funds and exchange-traded funds (ETFs); rather than looking only at past performance, S&P also incorporates analysis of the underlying holdings and their likely future prospects, as well as risks and costs. Funds or ETFs that hold stocks viewed as undervalued by S&P equity analysts are more likely to get a high ranking from S&P’s proprietary quantitative ranking tool.

Many mutual funds or ETFs hold one or more of the stocks mentioned in this story as a top-ten holding; the mutual fund table screens for those that have a four- or five-star ranking from S&P.

Similarly, many ETFs hold at least one of these recommended stocks as a top-10 holding; the ETF table list contains those that garner an “overweight” ranking from S&P.

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