News Analysis date published New: 
Wednesday, June 23, 2010 - 14:55
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Thursday, August 15, 2013 - 04:50
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Wednesday, June 23, 2010 - 14:55

New Taxes May Hurt Big Tobacco, but this Stock is a Winner

Wednesday, June 23, 2010 - 2:55pm

Desperate times call for desperate measures. Facing a gargantuan budget deficit, New York Governor David Paterson has announced plans to add another $1.60 in taxes to every pack of cigarettes sold in his state. That will push the average retail price above the $9 mark. Might other states look to follow suit? If so, the long-awaited death knell for Big Tobacco may finally be at hand.

Up until now, Lorillard (NYSE: LO), Altria (NYSE: MO) and Reynolds American (NYSE: RAI) have managed to stay one step ahead of Father Time: They withstood huge legal bills, thanks to their prodigious cash flows; they stemmed revenue declines in a shrinking market by steadily boosting prices, and they offset increasing restrictions against indoor smoking by boosting their smokeless tobacco brands.

Like the frog in the boiling pot of water, many consumers have stuck by their tobacco consumption, even as a pack-a-day habit now exceeds $150 per month. That’s more than many people spend on gassing up their cars every 30 days. How much is too much? $180 per month? $200 per month? New York’s new tax rate pushes that figure to $270.

Lorillard is the clear loser from New York State’s moves. The company controls 25% of the New York market, well above its 10% national share, thanks to the popularity of its Newport menthol brand. Menthol is an increasingly favored choice, as the percentage of adult smokers that prefer them rose from 34% to 38% from 2004 to 2008. That has led to steady market share gains for Lorillard.

Trouble is, the Food & Drug Administration (FDA) is getting more pressure to ban menthol cigarettes, just as it has before with cigarettes that cater to youth. Menthol is the "ultimate candy flavoring," said the University of California's Tobacco researcher Phillip Gardiner in a recent article on Health.com. A scientific panel has convened and will issue recommendations on how the FDA should regulate menthol-flavored cigarettes. The FDA has not tipped its hand, but should it decide to further restrict the sale of -- or completely ban -- menthol cigarettes, shares of Lorillard would quickly take a big hit.

Lorillard, Altria and Reynolds American have another area of concern beyond the specter of higher excise taxes. Attorneys in Florida are challenging a law that caps appellate bonds for cigarette makers. A state law put in place in 2003 and which was revised last year caps the total amount tobacco companies pay at $200 million. If the courts agree to hear that appeal, other states may also re-visit the landmark legal settlement that has already cost the industry billions of dollars.

Altria is a little better-insulated than Lorillard, with less dependence on menthol and increased emphasis on smokeless tobacco. As more bars enact smoking bans, consumption of smokeless tobacco has been steadily increasing. Altria entered the smokeless tobacco market through its $7 billion purchase of UST. So the company, which had to offer an eye-popping 10% bond yield to raise that money, could ill afford to see cash flow drop too quickly.

In a similar vein, Reynolds American will owe $1.8 billion during the next four years to pay off its 2006 acquisition of smokeless tobacco purveyor Conwood. That accounts for all of the cash flow Reynolds is expected to generate during the next four years, leaving little margin for error.

Action to Take --> Tobacco stocks have always been praised for the high levels of cash flow, impressive dividend yields, and seemingly endless supply of consumers that choose to keep consuming tobacco. But with every passing price increase, an increasing number of consumers will decide that their wallets can no longer take such a deep monthly hit. At some point, unit volume declines will be even greater than the serial price increases these firms can pass through. That’s when sales and profits will start to materially shrink, dragging share prices down with them.

Investors willing to invest in small, speculative companies may want to look at Star Scientific (Nasdaq: CIGX), which has developed a process that removes many harmful chemicals that are often introduced in the curing process. The company has also developed a smoking-cessation product that is aimed at slowly weaning tobacco consumers from any nicotine addiction. To date, the company has not yet generated a meaningful base of revenues.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.