Butts and Beers

The American people are a unique bunch.  At lunch they often sneak into a quiet restaurant to read the local news, sip a cold one and smoke a butt or two before returning to the job.  After work, they gather in groups, order a round of beers, carry on and smoke their cigarettes in packs. 

On the weekends, they congregate outside (when weather permits), have barbecues, drink beers and smoke their cigarettes.  And when it’s cold, they turn on the television, tune in to an exciting sporting event, gulp beers and – if the wife permits – have a few more butts on the La-Z-Boy.  If she doesn’t allow, they’re usually happy to step out into the cold for a drag or two before the fingers turn blue and it’s time to return to the telly.

It’s no wonder, then, that some of the most lucrative businesses in the good ol’ U.S. of A. revolve around the production, packaging and marketing of these two products: cigarettes and beer.

Fatten you up and destroy your lungs, they will – unless you put your money into the shares instead.

Two Winners in Almost Any Market Environment

There are two standout performers in the cigarette and beer field, and it’s a mug’s game trying to choose between them.  Best to lay out their stories rather than force you to guzzle or inhale one over the other.

The first is Altria Group (MO:NYSE), still widely known as Philip Morris (it’s actually the holding company for Philip Morris, U.S.A.).  Altria makes – you guessed it – cigarettes and other tobacco products and owns just over a quarter of Miller Beer.  They also dabble in cigars.  You probably know them best for their Marlboro, Virginia Slims and Parliament brands, which hold roughly 50% of the American smoking market.

Miller Beer is the world’s second largest brewery.

The skinny on Altria is that although the stock has been hit hard in the recent crisis – though not as hard as the overall market – it has been buffeted by its dividend yield, currently at 8.53%.  But there are a couple of issues that still bother Mr. Market about this stock and neither has to do with that hacking cough or oversize belly you’re sporting.

• First, taxes: under a democratic president, federal excise taxes on tobacco could be raised by as much as $0.61 a pack – not likely enough to make your average Marlboro man quit, but he may draw out his last few butts before his next purchase.

• Second, a large three tranche $6 billion issue of debt to finance the purchase of UST Inc., makers of Skoal and Copenhagen smokeless tobacco products.

Both of these issues have dampened investor enthusiasm for the stock, but the coming spurt in the general averages will certainly light a flame beneath MO.  By the time that corner is turned the stock should be smoking.

The following is a fizzy overview of some of the factors that will drive the stock price going forward:

• Tobacco litigation is nearly complete.

• Price growth and cost cutting will trump any declining consumption trends.  As the chart below shows, regular price increases of 5% or more are standard in the industry:

• Ongoing share repurchases will significantly bolster the share price.

• A higher market multiple (P/E) can be expected as MO is a Dow component.

Note, too, that cigarettes and beer are not the products one gives up in a recession.  Movies, yes.  Travel, yes.  Restaurants, certainly.  But a beer and a cigarette are America’s last line of social engagement.  If you can’t share these, brother, you ain’t got nothing to share.

A Camel and A Chart

Next is Reynolds American (RAI:NYSE), the parent company of R.J. Reynolds Tobacco, a company with a long history in American tobacco products.  Their most popular brands, CAMEL, KOOL, PALL MALL, DORAL and WINSTON are household names the world over.

RAI has had tremendous success growing their lines in the last few years.  As seen on the charts below, sales, income, EPS and shareholders’ dividends have all experienced solid growth in the last three years.  The dividend alone has risen by an impressive 19% in that period.

Reynolds is currently working on a new product called Camel Snus – a dissolvable tobacco strip or pouch that it hopes to sell to a heretofore resistant clientele: women.  Also available before long will be tobacco lozenges, all part of a new push toward new, smokeless products.

But these products are not without their detractors.  Some claim that they’re responsible for the same health problems as traditional cigarettes; indeed, the EU banned Snus earlier in the decade over cancer fears.

But Reynolds is pushing ahead in the hope that they will be more socially acceptable than cigarettes: no second hand smoke, no spitting, no bad smell. 

But most intriguing about Reynolds may be its current technical position.  The chart below shows RAI over the last six months.  A few things are immediately evident.

First, near term support at 40 is strong.  And with the October 10th low bettered by higher lows in late November, we now await higher highs (above 50) to set up a surer technical foundation.

Also supportive is the rising Relative Strength from as early as July.  Clearly the selling momentum has weakened even as the stock continued to fall.

Broadening out to the weekly chart shows more:

For nearly two full years the stock has been gathering into stronger hands, again, even through this latest period of price weakness.  This is tremendously bullish.

Add to this a dividend yield of 8.06% and you have one chug-a-lug of a smokeout!

As to which one is the better buy, we’d have to take a pass.  We like the initial surge that MO will likely experience both as part of the Dow and as a participant in the first wave of large caps to be guzzled by fund managers.  Then again, over the long haul, RAI looks better to deliver by virtue of its cleaner balance sheet.

Take your pick.

The Residual Income Report recommends immediate purchase of Altria Group Inc. (MO: NYSE) at $15.00, and Reynolds American Inc (RAI: NYSE) at $42.17.

And smoke ‘em if you got ‘em.

Matt McAbby
Analyst, Residual Income Report