Altria Group Inc (MO), Philip Morris International Inc. (PM): One Potential Buy in a Declining Industry

The cigarette industry is controversial in terms of the impact it has on the health of the general public. Everybody is aware of the harmful effects of cigarettes, but do we know why? Activism by public health groups has gained exponential growth in the recent years and now we have doctors, television personalities, and other opinion makers educating about the harmful effects of cigarettes.

What does this mean for well-known companies like Altria Group Inc (NYSE:MO) and Philip Morris International Inc. (NYSE:PM)? I believe that investors who have taken long positions in these stocks will suffer as the long-term outlook of the cigarette industry is negative.

Industry outlook

It has been reported by CDC Vital Signs that among U.S. adults, smoking has declined from 20.9% in 2005 to 19.3% in 2010. Now, you might say that this change is really insignificant, but the real deal here is that the percentage of daily smokers who were smoking 30 or more cigarettes per day has decreased from 13% in 2005 to 8% in 2008. Therefore, the small decline in the number of smokers has been compounded due to people smoking lesser cigarettes than before. These statistics will only get worse with the increase in no-smoking areas and anti-smoking campaigns.

Another important fact here is that the market for cigarettes in the United States has also been declining steadily. The U.S. Federal Trade Commission reported that 274 billion cigarettes were sold in 2011 compared to the 402 billion cigarettes sold in the year 2001.

Situation of cigarette companies

The companies in discussion have basically grown in the same nest. Altria Group Inc (NYSE:MO) spun off its international tobacco operations in 2008 to form Philip Morris International Inc. (NYSE:PM). Altria has exclusive rights to sell its products in the United States alone. Altria Group Inc (NYSE:MO)’s 2Q13 results show that its revenue increased by almost 14% on a QoQ basis but decreased 1.2% on a YoY basis. The company extracts 68% of its revenue from cigarettes and cigars, whereas another 21.7% of its revenue comes from the sale of smokeless tobacco products.

In total, that makes up to 90% of the company’s revenue. Its other businesses, including wine, financial services, and SABMiller, only account for 10% of revenue. This is enough evidence to debunk the argument that Altria Group Inc (NYSE:MO) can grow despite a negative outlook of the cigarette industry as almost two-thirds of the company’s revenue is tied to it. The only upside to the company is its solid 5.41% annual dividend yield. Therefore, value investors can still benefit by acquiring this stock

Philip Morris International Inc. (NYSE:PM) is also in trouble. The company, for some years, was able to achieve what its spin-off was intended for. However, the recent performance of the company has been anything but disappointing. The company’s 1Q13 results showed that revenue fell 6.15% on a QoQ basis, whereas it increased 2.8% on a YoY basis. The company’s operations in several different countries have come to haunt it because now the company has to deal with the legalities of each country separately.

Around the world, the company’s flagship Marlboro brand is seen as a luxury item, inciting government to put duties and taxes on its sales. Rising excise rates and a strong dollar have also been hurting the company’s profitability. The recent opening of the Chinese market is a potential upside for the company though.

Possible solution to the problem

The tobacco industry, at large, has become quite unattractive for investment. However, I believe that one company still has potential in this industry. Universal Corp (NYSE:UVV), a leaf tobacco merchant and processor, is the answer to the problems facing the cigarette giants. Universal’s customers are all those companies which use tobacco as an input, and that also includes the cigarette giants I have discussed above.

From 2010 to 2012, the U.S. market for smokeless tobacco increased at CAGR of 7%. Also, the United States has become the largest market for moist snuff and this market has increased manifold in the last 10 years. Therefore, Universal Corp (NYSE:UVV) is set to benefit from an increase in the consumption of smokeless tobacco and cigars/pipe tobacco in the United States and worldwide.

The company trades at a trailing P/E of 13.4 compared to the P/E of 17.1 and 16.3 for Philip Morris International Inc. (NYSE:PM) and Altria Group Inc (NYSE:MO), respectively. With debt/equity of 0.2 (industry average is 3.2) and interest coverage of 10.4, I believe the company is sweetly positioned to utilize its strong balance for growth in the coming years.

Foolish takeaway

The negative long-term outlook of the cigarette industry will eventually catch up with Altria and Philip Morris International Inc. (NYSE:PM) one day. It’s better to play safe with your money and invest in a business which has a low-risk profile with opportunities for growth. If you would ask me, I would put my money into Universal.

Usman Ghani has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International.

The article 1 Potential Buy in a Declining Industry originally appeared on Fool.com and is written by Usman Ghani.

Usman is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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