Tobacco on Top

Analysts report "10 Reasons to Stay Bullish on Tobacco"

NEW YORK -- UBS analysts continue to be bullish on tobacco, according to a new report.

Their reasons included:

Pricing power. Analyst Nik Modi and associate analyst Benjamin Schmid write that they believe the "Big 3" can sustain 4% to 5% net pricing through 2020, partially due to price elasticity relationships over the past 30 years continuing to hold. "Additionally, an analysis of the cigarette market in the U.K. (as a sanity check) leads us to believer there is plenty of room to grow prices in the U.S." The report adds that U.K. prices are 83% [image-nocss] higher than prices in the United States and smoking rates seem to have bottomed out in the country.

Unique leverage at retail. Unlike most consumer staples sectors, the tobacco companies have the "lion's share of the power when it comes to shelf space allocation" of brands. According to the report, this is mainly due to legally binding retail trade contracts and the fact that c-stores (which reportedly account for 70% of the sales) is very fragmented and "generate roughly 30% of in-store revenue from the tobacco industry (making them very reliant on incentive payments from manufacturers)."

Tobacco stocks behaving like staples. Consumer staples historically have traded at premiums, as investors reward companies for a combination of cash distribution, growth, visibility and insensitivity to economic factors, according to the report. But over the past few years, volatility of foreign exchange rates, input cost fluctuations and broad-based concerns over global macroeconomic conditions have create more "cyclicality" for staples companies. "Within this context, we believe the U.S. tobacco sector offers investors a much higher level of visibility and defensibility than its staple peers."

Diminishing excise tax risk. As states continue to examine increasing cigarette excise taxes, New Jersey and Rhode Island continue to consider lowering their taxes. "While we are unsure if the tax reduction bills will pass, we believe that the proposals suggest that at least some states may not be realizing the amount of revenue increase that they may have previously anticipated from prior tax increases due to cross-border trade and other factors."

Other reasons included low interest rates, structurally lower litigation risks, low capitol allocation risk (compared to staples), governmental regulation raising barriers to entry, the market becoming more risk averse and no exposure to currency volatility (since Altria, Reynolds American and Lorillard profit comes from the United States).

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