What's Behind the Rally in Tobacco Stocks?

Despite the tobacco products carrying a stigma of health issues, the shares of tobacco titans portray a different picture with most reaching highs never seen before.

In the past three months, Zacks categorized Tobacco industry gained 16%, outperforming the S&P 500 Composite Market’s increase of 5% in the same time frame.

While Reynolds American Inc. RAI showcased a gain of 9.6% in the past three months, other tobacco stocks including Altria Group Inc. MO and Philip Morris International Inc. PM witnessed an increase of 11.3% and 23.3%, respectively during the same period. All these stocks carry the Zacks Rank #3 (Hold).

You can see the complete list of today’s Zacks #1 (Strong Buy) Rank stocks here.

Let’s delve deeper into the factors that are behind this rally:

Favorable Macroeconomic Factors

Lower gas prices, an improving job scenario and increasing consumer confidence came as economic boons, and did the trick for these stocks. Plus, these companies will always benefit from the addictive nature of tobacco.

Focus on Tobacco Alternatives

Further, to maintain share in the developed countries, the tobacco giants have resorted to innovation in the form of e-cigarettes and Reduced Risk Products (RRP) to mitigate losses from an increasing number of quitters. This is particularly encouraging as according to Euromonitor International, the global e-cigarette market is expected to grow to $51 billion, or hold 4% share of the worldwide tobacco market, by 2030.

Altria is steadily expanding presence in the e-cigarette market with its MarkTen and Green Smoke brands. Moreover, in an attempt to boost unconventional tobacco products, Altria acquired privately-held Sherman Group Holdings, LLC and its subsidiaries (Nat Sherman) in an attempt to expand its premium smokeable category. The takeover benefits Altria’s smokeable segment and the brand complements Altria’s Marlboro brand which also falls under the premium category.

Similarly, to cater to the new consumer preference, Philip Morris launched a set of Next Generation Products (NGPs) in 2015, to attract adult consumers while reducing the risks related to tobacco products. The company has also increased investment in research and development for the category in 2016.

Further, it has launched another reduced-risk product — iQOS (Heatsticks that heat tobacco instead of burning it) in two pilot markets in 2016. Its volume and market share reached maximum capacity during 2016. These share gains have been achieved despite the limits imposed by the U.S. Food and Drug Administration on non-combustible products.

Reynolds is also is increasing focus on the e-cigarette category which is becoming highly popular, especially among youngsters. Vuse has received favorable response since its launch in 500 stores in Colorado in Jul 2013, and has gained a major market share. After its phenomenal success in Wisconsin and Indiana, the brand is now available in about 100,000 outlets, mainly in convenience and gas stores.

Decent Fourth Quarter Results

Most of the tobacco biggies posted decent fourth quarter 2016 results backed by high pricing and improved volumes.

Reynolds American delivered higher-than-expected fourth-quarter 2016  results in wherein adjusted earnings of 62 cents per share surpassed the Zacks Consensus Estimate of 60 cents by 3.3%. Further, the bottom line improved 29.2% from the year-ago quarter driven by higher cigarette and moist snuff pricing. Although sales missed the consensus mark marginally, it improved 4.3% year over year backed by higher sales across all segments.

The other tobacco behemoth, Altria Group reported fourth-quarter earnings of 68 cents on Feb 1, 2017. The figure inched past the Zacks Consensus Estimate by a penny and also exceeded the prior-year quarter figure by 1.5%, driven by higher operating income and lower shares.

Although revenues missed the Zacks Consensus Estimate marginally, it inched up 0.1% year over year backed by strong performance of core brands. Altria remains optimistic for 2017 and anticipates maintaining profit on the back of strong pricing power and branding building initiatives. It expects adjusted earnings to be in the range of $3.26–$3.32, up 7.5–9.5% compared with adjusted earnings of $3.03 in 2016.

Philip Morris reported modest results during fourth-quarter 2016 wherein earnings gained 36% compared with the prior-year quarter figure driven by higher sales. However, the figure missed the consensus mark. Excluding an unfavorable currency impact of 13 cents, earnings surged 52% year over year. The company posted decent top-line results wherein net sales gained 9.1% (up 10.5% excluding currency) to $7.0 billion, outpacing the Zacks Consensus Estimate of $6.39 billion.

The sales gain can be attributed to higher sales in Asia and European Union region. Further, Philip Morris anticipates lower currency headwind for the year. The Marlboro maker stated that it expects full-year reported earnings per share to be in the range of $4.80–$4.95, up 9–12% compared with adjusted diluted earnings per share of $4.48 in 2016.

Tobacco makers are confident of their pricing power and continue to maintain decent performance in the upcoming year as well.

Big Tobacco Mergers Ahead

Reynolds American entered into a merger agreement with British American Tobacco (BTI) in Jan 2017, under which the latter will take over the remaining 57.8% of Reynolds for $49 billion. The deal comprises of $29.44 cash and a number of British American Tobacco American Depositary Shares representing 0.5260 of British American Tobacco’s ordinary share.

The highly anticipated tobacco merger between Reynolds American and British American Tobacco cleared the antitrust hurdles from the U.S. authorities in Mar 2017. The only other prerequisite left for the deal is shareholders approval following which the deal is expected to close in third-quarter 2017.

Investors are buoyed by the probable merger as the combined entity will further strengthen the tobacco industry. It will own a global portfolio including next generation products and strong cigar brands including Newport, Kent from British American Tobacco and Camel and Pall Mall from Reynolds.

Moreover, the combined company will benefit from Reynolds’ strong position in the alternative tobacco and next-generation product development, and R&D capabilities. The two companies will also complement each other as Reynolds has most of its operations in the U.S., while British American Tobacco apart from its stake in Reynolds mostly operates outside the country. Additionally, the new merged entity can develop an innovative pipeline of vapor and tobacco-heating products.

Are More Mergers in the Cards?

Further, the merger between Reynolds and British American Tobacco has raised speculation among analysts regarding a probable merger between Altria and Philip Morris in the near future. Altria Group Inc.’s had spun off Philip Morris International in 2008 into a separate legal entity which was until then part of Altria Group.

Bottom Line

As per projections, the growth of tobacco stock’s won’t be impaired in the near future. Per World Health Organization, smoking rates in general have been on the decline in developed countries, but are growing in developing countries, which now represents close to 80% of the one billion smokers in the world. This figure is expected to grow, leading to steady sales and attractive yields for investors.

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