Four smoking hot tobacco stocks

But tobacco is still tapping into human weakness to generate repeat business. They’re also rapidly innovating and diversifying, placing their bets on the next generation of products including vaping and e-cigarettes, regarded as less harmful, yet reliably addictive alternatives to conventional cigarettes.

Leading tobacco companies have been generating a steady stream of cash flow and high profit margins, ensuring hefty dividend payouts. As a result of the ongoing weakness, the following tobacco stocks are trading at prices substantially below their fair values and represent attractive buying opportunities, according to Morningstar equity research.

A leading global tobacco company, Philip Morris International (PM) makes and sells cigarettes and other nicotine-containing products outside the United States. Although the firm’s portfolio includes leading premium brands such as Marlboro and Parliament, it has been aggressively pushing into the smoke-free product space.

“Philip Morris International possesses a formidable franchise in the tobacco industry, formed by the aggregation of intangible assets and a cost advantage,” says Morningstar equity report, noting that “brand loyalty tends to be higher in premium price segments, which benefits Philip Morris disproportionately.”

The addictive nature of the product, the report adds, forms a powerful competitive advantage in conjunction with tight regulation, which dampens market share volatility and competition on price.

Philip Morris is currently in merger talk with another tobacco titan, Altria. The deal, if approved, would be the industry’s biggest ever. “This combination would occur, primarily to align the interests of both parties in the distribution of iQOS [a rechargeable heated tobacco product] in the U.S., but also because of the potential for cost synergies,” says Morningstar sector director, Philip Gorham.

The combined entity will bring “the world’s largest cigarette, heated tobacco and vaping brands under one roof,” adds Gorham, who pegs the stock’s fair value at US$102, implying a free cash flow yield and a dividend yield of 5% each.

Following the acquisition of Reynolds American, British American Tobacco (BTI) is competing with Philip Morris to be the largest listed global tobacco company. British American’s global brands include Dunhill, Kent, Pall Mall, Lucky Strike, Rothmans, and Camel. The firm also sells vapor e-cigarettes (Vype), heated tobacco (Glo), as well as smokeless tobacco products, and owns 31% of Indian cigarette maker ITC Limited.

While conventional tobacco will remain the driving force of the industry profit pool for at least the next decade, British American, like its peers, is betting big on the new categories expected to win share of smokers. “In heated tobacco, BAT’s Glo has taken tobacco market share of around 5% in Japan in 2018,” says a Morningstar equity report, pointing out that heated tobacco is most likely to successfully attract smokers.

Although BAT lags its largest rival PMI’s iQOS, the latter may lose its first-mover advantage as BAT has the potential to regain share through next generation products over time, the repot adds.

At the same time, wide-moat BAT has doubled down on the combustible business with acquisition of Reynolds, “an incredibly strong asset in a market with plenty of remaining potential for raising prices,” says Gorham, who appraises the stocks fair value to be US$59 per ADR, implying a more than 6% free cash flow yield and a 4% dividend yield.

Imperial Brands (IMBBY) is the world’s fourth-largest international tobacco maker. The UK-based firm holds a leading global position in the fine-cut tobacco and hand-rolling paper categories, and is a leading seller of cigars in several countries. Recent acquisitions have expanded the company’s footprint stateside and in Western Europe.

Imperial company has been aggressively lightening its portfolio and paring costs. “In portfolio optimisation, the company has made great strides, reducing its total brand count by 32% by the end of fiscal 2017, and it targets a total reduction of 50% by 2020,” says a Morningstar report, adding that “the streamlined portfolio should allow for more focused brand investments and sustainable cost reductions.”

The impressive execution on the brand migration program has led to a consumer retention rate of around 95%, the report adds.

Although heightened regulatory risk in the U.S. poses a risk to cash flows, Imperial's wide economic moat, derived from brand equity and distribution capabilities, should allow it to deliver healthy margin and cash flow in the medium term. “Imperial achieves best-in-class tobacco margins in the mid-40% range, as well as 90%-plus free cash flow conversion, and it has a medium-term target of 10% annual dividend growth,” says Gorham, who puts the stock’s fair value at US$48 per ADR, implying a 5% dividend yield

U.S. tobacco giant, Altria (MO) comprises Philip Morris USA, U.S. Smokeless Tobacco, John Middleton, Ste. Michelle Wine Estates, Nu Mark, and Philip Morris Capital. The firm also owns a 10.2% stake in brewing behemoth, AB InBev. Through its subsidiaries, Altria holds the leading position in cigarettes, machine-made cigars, smokeless tobacco, and vaping in the U.S. market.

Although the company’s Marlboro brand holds 40% share of the domestic market, it is no longer a pure play on U.S. cigarettes. “Over 15% of our valuation is derived from its 10.2% share of Anheuser-Busch InBev, and of the consolidated business, 15% of EBIT comes from smokeless tobacco and wine, while recent acquisitions in vaping and cannabis are likely to be contributors to EBIT in the near future,” says a Morningstar equity report.

Still, U.S. cigarettes remains the lynchpin of Altria’s earnings power, a market that remains relatively attractive despite undergoing secular contraction, says Gorham, stressing that the company can continue to increase its revenue, profit and dividends by consistently pricing above the rate of U.S. cigarette volume declines.

Given that the “U.S. is the fourth most affordable market for cigarettes among the OECD countries, there is ample room for manufacturers for raising prices over time,” adds Gorham, whose US$58 fair value estimate for the stock implies a dividend yield of near 5%.

Addictive products and insurmountable regulatory barriers form Altria’s wide economic moat, he adds.