Watch Out For Overheated Tobacco Stocks

Source: Thinkstock

Source: Thinkstock

Shares of cigarette and tobacco companies have been performing incredibly well recently. This is because there is a strong possibility that the second and third largest tobacco producers (of those who exclusively sell in the United States) — Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) — are going to merge in the very near future. This benefits not just the two companies involved, but their primary competitor — Altria Group (NYSE:MO) — because companies that operate in an industry that has fewer competitors wind up with more pricing power.

In particular it benefits the two companies involved even more, and there are a couple reasons for this. First, the new, larger company will have better credit, and the tobacco industry is one in which executives aggressively borrow money in order to buy back stock. So long as interest rates remain low they will continue to do so and the merger leverages the new company’s ability to do this.

Second, there are are synergies between the two companies because they can produce cigarettes at one facility after the merger whereas now they produce at two facilities. Analysts have estimated that the savings can be $400 million per year. With tobacco stocks trading at about 20 times earnings, this can add $8 billion in net market capitalization to the combined company.

As a result, tobacco stocks have been rising significantly. All three of the companies that I mention here hit all-time highs on Wednesday. Reynolds American and Lorillard in particular had very strong days on reports that a merger is imminent — the two stocks rose 4.4 percent and 10.4 percent, respectively. If we look at the year to date performances these stocks are outperforming the broader stock market by a wide margin. Altria Group is up nearly 6 percent for the year. Reynolds American is up nearly 20 percent, and the winner — Lorillard — is up nearly 24 percent on this potential merger.

Nevertheless, I think investors need to watch out for the tobacco stocks. While everything I mentioned benefits the industry, these facts add value on a one-time basis, and they do not fix the problems of the industry. These problems stem from one underlying fact: In the United States, tobacco use is slowly trending downward. The industry has done virtually everything in its power to fight this trend, from the introduction of e-cigarettes and other forms of smokeless tobacco to taking advantage of the low interest rate environment to borrow money to buy back stock. These companies have also taken advantage of the incredible brand loyalty that exists in the industry in order to increase prices.

So far these tactics have worked, but unless the tobacco industry addresses the underlying problem of a declining customer base these “fixes” are temporary.

If you have been lucky enough to have been in these names consider taking profits in the near future. These stocks have reached valuations that imply future earnings growth that simply isn’t there, or if it is there it is because this earnings growth is being manufactured through price increases and stock repurchases — both of which are temporary measures. If you must have a position in a tobacco stock, then consider buying Philip Morris International (NYSE:PM).

This company faces many of the same headwinds that the rest of the industry faces, and it has employed many of the same tactics from raising prices to repurchasing stock, but it also has potential growth from emerging markets where consumers see smoking as a Western luxury and where populations are growing. Given recent weakness in earnings the stock has underperformed, but with long term growth potential in emerging markets and wit strength in emerging market currencies, I think the stock can generate reasonable returns over the next few years.

Disclosure: Ben Kramer-Miller has no position in the stocks mentioned in this article.