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What do you call an industry that just got hit with billions of dollars in liabilities in court and still finds itself hunted coast-to-coast by dozens of American Bar Assn. members? Try generous and still attractive.
At first glance, it sure looks as if things couldn't get worse for the tobacco business. Especially after a major setback in mid-July, when jurors in Florida's celebrated Engle case slapped a $145 billion penalty on Philip Morris (MO), R.J. Reynolds Tobacco Holdings (RJR), and others. Ironically, despite a recent string of bad news, tobacco companies have found a number of ways to please shareholders since the beginning of the year. The large-cap members of the sector grouped together in a Standard & Poor's stock index were up 7.4% as of July 21, quite a bit more than the 0.7% the S&P 500-stock index had been able to scrape together over the same period.
Management hasn't left the stock market to do all the talking, either. Tobacco's top brass have been busy rewarding shareholders with plenty of the industry's abundant cash flow in the form of dividends. That money has come in part from steady price increases like the 3% hike Philip Morris announced at the end of July. The sector's dividends are among the best around: Morningstar Inc. calculates that the tobacco group's average payout is a huge 7.2%, almost one-fourth more interest than the 5.8% offered up by the 30-year Treasury and certainly far beyond the spindly 0.5% the S&P 500 currently forks over to investors. Philip Morris' 7.2% yield has helped propel the stock's total return above 16% for the year. R.J. Reynolds' 11% dividend payout is as high as the historical returns the S&P 500 has provided investors since the Depression, and its 70% total return year-to-date is the stuff value-portfolio managers dream of.
NO QUICK PROFIT. The perks don't stop there. Philip Morris has put extra cash to use by snatching up $3 billion in share buybacks, spending $900 million on that in the second quarter alone. No. 2 in the business, RJR has repurchased some $500 million of its own stock since being spun off from RJR Nabisco in 1999. "These companies are huge free-cash-flow generators," says Derek Taner, a portfolio manager with Franklin Templeton. "And that has allowed them to create shareholder value in these tough times via buybacks and dividend hikes."
Tobacco is still no place for a quick trading profit, however. There's no getting around the fact that a troupe of grim barristers continue to hound the industry. As of Mar. 31, for instance, RJR was dogged by some 536 cases pending. And no matter how sweet a deal the cigarette makers now offer shareholders, the legal headaches aren't likely to go away soon.
Besides the headline case in Florida, cigarette makers are beset by another high-profile court battle with the Justice Dept. In addition, dozens of other suits linger in dockets throughout the nation. And way you look at it, the tobacco industry will be tied up in the legal system for a while. "Timing these stocks and trying to figure out when they'll trade on fundamentals instead of worries is a hard call to make," says David Adelman, tobacco analyst for Morgan Stanley Dean Witter. "For the Engle case, for instance, greater clarity could come in three months, or it could be off another two years in the appellate court."
COURT TRIUMPH? If you're patient, though, there may be reason to take heart. For one, Philip Morris et al. are likely to appeal with all the force their deep lobbying pockets and well-staffed corporate counsels can muster. Even as an appeal is being planned in Florida, legislators have taken steps to limit the sum the tobacco companies will have to pay plaintiffs. If you follow legal precedent, the Engle case might soon unravel, too. To date, 28 attempts to grant class-action status to suits against the tobacco industry have failed. That's reason enough why many experts now handicap the case in tobacco's favor.
It doesn't hurt, either, that tobacco shares are extremely cheap, even after their strong showing so far in 2000. The reason: The industry was hammered in 1999 by the same litigation worries. The S&P index for the group fell 54.2% in 1999. As a result, Morningstar statistics show the industry price-to-earnings multiple mired at a lowly 6.8, far below what the S&P 500 index now commands. "There's no question that this industry is significantly undervalued," says Morgan Stanley's Adelman. "The sector has traditionally traded at about seven to eight times cash flow. Currently, it's getting no more than five times."
One company that's somewhat more protected than its peers is Philip Morris. The largest cigarette maker, thanks to brands like Marlboro and Virginia Slims, Philip Morris looks a lot like the lone growth story in the sector, yet its stock trades at a level low enough to fetch a good deal of interest from value investors. At an Aug. 4 close of $26.62, Philip Morris shares were priced at only seven times forward earnings and still remained nearly 40% off its 52-week high. Some analysts project the company's tobacco profits to grow 7% in 2000 and 8% in 2001.
PADDING EXPOSURE. In addition, Philip Morris can lean on its Kraft division, which contributes a 34% slice of the corporation's revenue, as well as its Miller Brewing arm, which pitches in 5.5% of sales. All told, the company is in line to increase earnings 11% this year, according to S&P analyst Richard Joy. Not only that, but Philip Morris' $14.9 billion acquisition of Nabisco should bolster the company's lineup of consumer brand names with mainstays like Oreo and Chips Ahoy! and could help the company slash as much as $600 million a year in redundant costs by 2003. On the Street, where consensus estimates currently project 12% average annual growth for Philip Morris the next five years, 6 of 10 analysts who follow the stock rate it a strong buy or buy, according to Zacks Investment Research.
For R.J. Reynolds, the consensus estimate is for an average 7.7% annual growth over the next five years. Four of seven analysts who follow the maker of Winston, Camel, and Doral rate it a strong buy or buy, according to Zacks. There's no question about the company's merits as a value play: At its close of $31 on Aug. 4, Reynolds was trading at 7.3 times estimated earnings for the next 12 months, according to Morningstar, and still remained close to 15% off its 52-week high.
If you're looking for a stake in tobacco with a portfolio to pad the exposure, the Warburg Pincus Focus Fund might fit your criteria. As of May 31, 3.9% of the fund's portfolio was parked in Philip Morris shares. A fund that gravitates toward large-cap and consumer-goods names, Warburg Pincus Focus (BSEVX), a relatively new offering, was up 12.7% year-to-date as of July 28 and 22.2% in 1999.
Anderson teaches journalism at the City University of New York. His Sector Scope column appears every other week on BW Online Edited by Beth Belton
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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