Would You Invest In A Dying Industry?
Last week I shared my April Investing Ideas, and the post primarily focused on fallen angels — once great companies that have “fallen” from grace.
As usual, my “ideas” posts always generate a bunch of comments. Some people agree, and other people disagree, but I always like to read the feedback.
This “fallen angel” theme generated some additional questions about two more fallen angels I didn’t mention in the post — Altria and Philip Morris International.
These stocks were interesting enough I decided to do a separate post for them! Their shares have fallen in recent months, and I think everyone wants to know, “When is the right time to buy?”
But are these really angels on their way back to new highs? Or, are they devils slowly sinking into a grave?
Fallen From Grace
Altria (Symbol: MO) and Philip Morris International (Symbol: PM) are tobacco companies that market and sell branded cigarettes, cigars, chewable tobacco, and smokeless tobacco products to consumers.
Generally MO focuses their business on the United States, and PM focuses on everything outside of the United States.
Yes, these are ‘sin’ stocks, that are frequently disliked by many investors. This year in particular they’ve seen a lot of negativity: MO stock is down 21% YTD, and PM is down 22% YTD.
“Them’s no small potatoes.”
The cigarette business is an industry that’s been in decline for decades now. It’s been a dying industry since the 1960’s, when usage peaked at around 43% of adults in the U.S.
Despite the long slow decline, cigarette stocks have been very good performers for investors (up until recently). In fact, last year I wrote a post that discussed why Altria is one of the best performing U.S. stocks ever.
Yup, those are average annual returns of 20.6% from a industry in decline. That really incredible when you think about it!
So shouldn’t we be super excited when top performers like this are finally cheap?
Not really. Just because Altria and Philip Morris enjoyed outstanding returns in the past does not mean they will outperform in the future.
What we really need to understand why the stock price is falling right now. Not what it did in the past!
After doing some research, I was able to come-up with several possible answers to explain the recent fall:
1. Smokeless Tobacco products might not turn-out to be as positive as was hoped. Shares were overvalued on growth hopes.
2. Interest Rates are rising, and these stocks are often considered bond proxies… so when bonds fall due to rising interest rates, so do these stocks.
3. Debt levels are high, and cash flow management problems could hurt future dividends (more on this later).
A Dead Company?
Would you ever consider investing in a company on its way to a slow death?
The question is rather silly of course — EVERY company is going to die someday. They all have a limited lifespan… But how short is the lifespan on cigarette companies?
As far as smoking goes, the CDC estimates that 15% of all U.S. adults smoke, and that number drops every year. Internationally the trend is similar — most countries are seeing a decline in smoking.
In recent years however, new smokeless products had investors convinced that growth was right around the corner. Hopes were placed on new products like e-cigarettes, vaping, and safer “heated” tobacco products.
These new products put ‘dreams of growth’ in investor’s heads, but the facts seem pretty clear to me — nicotine and tobacco products have far less social acceptance than they used to.
Alcohol and caffeine are also addictive substances, but they enjoy far more social acceptance than nicotine based products. It’s considered socially acceptable to drink coffee and alcohol in public.
Cigarettes (by comparison) are highly regulated and heavily taxed. Even ‘e-cigarettes’ cannot be used in most public buildings, and have designated locations for use. (Regulations for e-cigarettes vary by state of course.)
So should investors think of Altria and Philip Morris as “dead companies” in terminal decline?
Not in the immediate sense. The most recent 10Q’s for both MO and PM indicate the hopes for becoming “growth” stocks are probably unrealistic. Phillip Morris has seen some revenue growth from “smokeless” products, but that hasn’t translated into cash flow improvements.
That said, the new products do give Altria and Philip Morris a longer time horizon. I highly doubt these new “lower risk” products are going to draw a ton of new customers. Cigarette use will probably continue to decline into single digit percentages, and taxation/regulation around the new “lower risk” products will continue to rise.
So how do investors profit from a declining business like this? Well, mainly from dividends and share buybacks. That, and buying at the right price.
Income Goggles
Dividend investors have been attracted to Altria and Philip Morris over the years due to a large and growing dividend payout. That (mostly) hasn’t changed.
Currently Altria sports a dividend yield of 5% and Philip Morris pays a tidy 4.27% dividend.
But what does the future hold? Will there still be decades of growing dividends to come?
Unfortunately this is where I believe the big problem lies. In the past, MO and PM were able to continuously raise dividends because they bought back shares and paid the dividend out of free cash flow.
Meanwhile, shares were cheap. In Altria’s case, shares frequently traded hands at EBIT/EV multiples of 5. That’s cheap! Every dollar invested in share buybacks resulted in very good returns on capital employed.
These days the shares aren’t so cheap. Altria sports a EBIT/EV ratio of 11, and Philip Morris has a ratio of 13.3.
That’s fairly expensive. Furthermore, the dividend situation isn’t what it used to be — dividends now exceed annual free cash flow at both companies.
Furthermore, Altria now borrows money to buy back shares. Philip Morris actually stopped buying back shares in 2016 because they couldn’t afford it.
Debt levels at both companies are growing. While it’s not a huge problem “yet” because of low interest rates, it might mean trouble for future dividend increases.
To grow dividends, both companies must (currently) grow their debt levels. At some point, this is going to be unsustainable.
Would I Invest?
Now we come to the big question — Would I invest in either company?
To give a single word answer: No. I wouldn’t, and it’s not because these are ‘sin’ stocks.
First of all, investors need to realize that earnings quality at either company is pretty rubbish. The earnings per share number that’s published has very little to do with how much cash the company actually generates. EPS is garbage here. Investors are better served by completely ignoring that number.
Second, the “magic formula” that fueled the 20.6% stock returns of the past no longer exists. Shares are expensive on a cash flow basis, and dividend payouts now exceed free cash flow. Furthermore, share buybacks are significantly less effective now that money must be borrowed to buy shares.
In my honest opinion, share prices have room to fall further… at least until they become attractive to investors looking for a corporate bond replacement.
This kind of investment might be interesting to some investors, but I would rather skip the potential 10-20% losses.
What do you think? Am I wrong? Do Altria and Philip Morris have a bright future ahead?
[Image Credit: Flickr]
Great analysis as always Tako. I probably wouldn’t invest in them either, and to be honest part of it would be because I hate the thought of supporting an industry that I don’t believe in. On the other hand, owning index funds I do realize that I own a part stake in some companies that I may not fully like. For instance I loathe Starbucks because I hate to see my country being homogenized with the same exact stores everywhere. It makes the country less interesting, more generic, and you can’t even tell where you are anymore because everything’s the same. But I realize that I own shares of Starbucks simply from owning index funds, and the best I can do is to not support Starbucks with my money when I’m out getting coffee
Thanks Accidental FIRE! As an index investor, you likely already own both PM and MO (in addition to Starbucks). They’re all part of the S&P 500.
A couple of my larger long term holdings, but I understand your point. The dividend party can’t last forever unless they are successful transitioning to new products. Tom
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Ouch, you have large holdings in these guys? That’s got to have been a rough ride down.
Thanks for the analysis. They have been great in the past, but you’re right. Past performance doesn’t count because the world is changing. The cash flow can’t be sustained unless their business improve a lot.
Yup, I just don’t see a good case for outperformance anymore.
I love your point that every company is dying (someday) – these two just might be a little closer than most. That nearing mortality can be very good for us as investors, because it forces you to confront valuation and business model questions more than you might normally.
Both of these companies and their cancer stick brethren have been pronounced near-dead a couple of times in my investing career. They may yet have some years ahead, but I agree the valuation isn’t too attractive right now. But I’ll be watching!
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I know some people attempt to calculate DCFs with terminal valuations WAY out into the future, but the data tells us that the average lifetime for a S&P 500 company is actually shrinking.
I’m starting to think that most investors would be better served assuming shorter investment lifespans.
I love your point that every company is dying (someday) – these two just might be a little closer than most. That nearing mortality can be very good for us as investors, because it forces you to confront valuation and business model questions more than you might normally.
Both of these companies and their cancer stick brethren have been pronounced near-dead a couple of times in my investing career. They may yet have some years ahead, but I agree the valuation isn’t too attractive right now. But I’ll be watching!
See my comment above!
Good article. Agree with you to focus on cash flow vs EPS. It is possible that it will become an attractive investment if the price falls further. The shares are closer to fair value now.
As always past performance is not indicative of future results.
-Mike
So true Mike. It’s a common flaw in most investors, they look backward instead of forward!
wow, I didn’t expect a new post right away, thumbs up !!
I knew about the IQOS (e cigarettes) not doing well as expected overseas, so I was a little bit hesitant. What’s more important, as you pointed out, dividends now exceed annual free cash flow, and the need to grow their debt levels to grow dividends. It’s unlikely for them to increase the cash flow to keep up with the dividend payout. Too bad, I got a bit excited when PM dropped below 100. But when I feel like I’m catching a falling knife, I usually am.
Thanks for doing the research, it brings new perspective to analyze a company. before I can be really comfortable in doing the analysis, I better stick with my current index fund XD
No problem YSL. It’s something I really enjoy doing!
I’ve told myself that we wouldn’t invest in the tobacco industry due to personal reasons, so we won’t be investing in these two stocks anytime soon. And you’re right, seems that there are less and less people smoking here in North America. I think smoking is still pretty popular in Asia and Europe though.
Yes, the percentage of smokers is still higher in Asia and Europe, but still dropping. Generally the data seems to say smoking rates are dropping around the globe.
There are a few exceptions, but I don’t expect the market for cancer sticks to be a good one even overseas.
Uggh. No matter what the analysis tells me…As a conscious physician, I simply cannot directly invest in and support big tobacco companies. Not only is it a “sin” stock, these companies produce products that are proven to cause cancer, heart disease, and other chronic diseases. The health consequences of these products are big costs to health care and society as a whole. I feel the same about alcohol, processed food, and processed meat…
I hear you! It’s hard not to own these stocks when you own index funds however. That must be what you meant by “directly invest”.
Unfortunately there will be many more people sickened by these products, and most of them already know the risks.
#UnfortunateFacts
Yup! You got it! That’s why did say directly invest. 🙂
I’m curious, does that philosophy extend to food companies as well? Seems everybody agrees that cigarettes are bad but lately the more I read the more I’m realizing that unhealthy food likely harms far more people through diabetes and heart disease than cigarettes, guns and alcohol combined!
It doesn’t bother me that they’re sin stocks but like you, the earnings quality is rubbish. They’re just not good companies you think you can hold for 10, 20, 30 years. There are other companies out there with better prospects.
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Yep! Better growth prospects, better valutions, and fewer cash flow problems.
Can you consider doing a similar analysis for m-REIT NLY? They have a dividend of ~10%. Thank you for your blog.
I’ll consider it!
It’s interesting that they’re paying out dividends they can’t really support… why? To keep investors happy? To prop up the house of cards? Interestingly, my fifth grader just received a letter tonight he mailed to himself from health class on why vaping is a terrible habit. I see cigarettes dying out. But what about the marijuana industry? It’s surprising that tobacco companies haven’t embraced that vice in an effort to turn things around. Wonder if they can convert all that tobacco land in NC? Oh wait, still not legal in the South…
I don’t have any particular thoughts on the marijuana industry (I haven’t studied it in detail). Last time I checked, most of the companies involved in the industry were pretty crappy.
Are any of them any good?
Very thorough post. Thanks Mr. Tako. I don’t own these shares currently but I did in the past and did fine with them. If you are looking at consumption, I think it would be helpful to consider global vs domestic smoking. I believe (although not certain) that global consumption is still rising – even considering the decline in the US.
Also, as you already know, growth has been the real story in investing since 2009 so any dividend play would be hard to compete — at least as of now. Do you have any thoughts on value (a think dividend stocks could be broadly considered in that catagory) vs growth and when value might start outperforming? Personally I hold positions in both approaches. Thanks!
Neal
I disagree with your assertion that global consumption is still rising. Check your facts based on a volume basis, not a country by country basis.
There’s a couple countries where it’s actually rising, but global volume is still falling.
As far as value/growth investing “styles” go, I don’t differentiate between the two. They’re the same in my mind.
I will likely ride these dinosaurs all the way down. The dividend factors in this ‘rats off a sinking ship’ attitude. Also smoking overseas is still cool, I think.
Good luck to you!
Cigs no, but I heard someone say GIS is the next MO and I was like, “tell me more!” Turned out pretty pretty pretty good for investors.
BTW are my posts showing up? I can’t see them.
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I can see them fine.
Very nice post, Mr. Tako!
Looking at the same facts than you, I would not invest either. But this has nothing to do with the fact that they are cigarettes company. If a company is performing well and is a good investment for growth or dividend, I would invest regardless of whether they sell cigarettes or not.
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The way I see it — it doesn’t matter if I invest or not from an ethical standpoint. They’ll still sell cigarettes and cigars to people regardless of my investment. Any influence I might have over the company’s business practices would be extremely minimal and limited to proxy voting.
Very good post. I see your points but from an investment standpoint I am not too much concerned. The industry had to deal with declines and regulations for decades. The environment they are operating in had the tendency to raise entry barriers and the very few larger players (BAT, MO, PMI, Imperial Brands, Japan Tobacco …) are so highly profitable also due to that factor. Tobacco investments used to be lucrative because stock prices have been very low for decades. Today, in a low interest environment and high stock market most tobacco stocks are far from being cheap.
In my view tobacco still have many options besides new generation products. They can diversify (BAT for instance bought insurance companies some decades ago, Reynolds bought Nabisco etc.) or implement a focus strategy (sell parts of the business, reduce complexity etc.). Just look at the last decades (or even 100 years), these companies are tremendously flexible.
With your excellent analysis above, I’d say MO is a no go. The only thing that keeps it interesting is the slow movement of legalized marijuana. MO or any big tabocco company would be a immediate player in the game due to manufacturing and distribution expertise.
If that will be a big payoff, then you just have to hope the company stays around till Mary Jane is legal throughout the US. It’s a little speculative.