It Ain't Easy to Quit
(Guest Commentary by Rick Konrad – July 9, 2010)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary. Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will discuss briefly his views on the European sovereign debt crisis, and then offers his detailed thoughts on the tobacco industry and selected tobacco stocks. This is a must-read for those subscribers with an interest in consumer staples stocks or those with high dividend yields. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see "Chasing Yield and Bank Reform does not mean Reformed Bankers” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
After a welcome three day Independence Day break from what felt like a very long string of losses on Wall Street, calmer heads seem to be prevailing. In Europe, the economic fears eased a bit. Spain sold 6 billion Euros of 10-year government bonds with a bid to cover just over 2.1. About two thirds of the issue was sold to non-domestic buyers. There were also comments by the French Economy Minister, Christine Lagarde, saying that European banks would pass the “stress test”, although many analysts are upset over the fact that the details of how some of these measures are weighed will not be released.
Is there valid reason for the stress re European bank stress? European banks seem to have been somewhat meek about writing down assets. The IMF projects that by the end of this year, US banks would have written down about 7% of their assets, while euro zone banks would have written down about 3%. Furthermore, for a population that is similar to that of the US, Euro-zone bank assets are about three times those of the US banks, implying that their leverage to equity is that much greater. Credit default swaps also are priced at more ominous levels for European banks than their US counterparts.
In a recent Goldman Sachs report (June 23, 2010) views the capital that has already been raised as adequate, and the opportunity to be subject to the stress test as an opportunity for transparency and reassurance.
The remarkable thing about this is that so much of the private housing market excesses that led to the banking problems was centered in the US and the UK. Yet, the US and UK banks are now generally viewed as stronger than most of their European counterparts because the former have been subjected to serious stress tests (with the results published for the individual American banks), because they have marked to market impaired and illiquid risky assets, and because they have (hopefully) completed their recaps. The perception that somehow European banks and their regulators have held back or been frozen into inaction has certainly hurt the valuations. The greatest irony in all of this is how these private sector problems become sovereign problems. Hence, the long standing proposition that when things go well, the financial sector is private, but that when things go badly, it becomes public.
As I have indicated previously, our only bank holdings at present are US Bancorp (USB) and Bank of New York Mellon (BK). The rationale is that these are the least bank-like of the banks. Bank of New York rallied this week following the surprisingly encouraging news about earnings guidance from State Street (STT). Despite the rebound of the trust banks on the heels of the STT pre-announcement, the trust bank universe has underperformed the S&P since the first quarter reports as fears of revenue shortfalls have dominated thinking, given declines in asset values and the widespread acceptance that a prolonged low rate environment will continue to mute earnings. Lacking any specific catalysts to warm up the macro picture, we believe the trust bank universe has been left cold. I still like the notion of buying them when they are cold.
One of my clients asked me to have a look at the tobacco sector in the light of the recent increase in cigarette taxes in New York. When the incremental New York tax on cigarettes rose $1.60 per pack, the cost of some cigarettes jumped to more than $10. Just to put things into perspective, New York's new total tax of $4.35 per pack would be in line with other states which also have high taxes, including Rhode Island ($3.46), Connecticut ($3.00), New Jersey ($2.70), Hawaii ($2.60), Wisconsin ($2.52), Massachusetts ($2.51), Vermont ($2.24), Washington ($2.025), Alaska ($2.00), Arizona ($2.00), Connecticut ($2.00), District of Columbia ($2.00) Maine ($2.00), Maryland ($2.00), Michigan ($2.00), Alaska ($2.00), Arizona ($2.00), District of Columbia ($2.00), Maine ($2.00), Maryland ($2.00), and Michigan ($2.00). Compare that with tobacco-friendly states like Missouri, where smokers can light up in style and fork over merely 17 cents a pack in taxes. Other smoking havens include Virginia, which taxes packs 30 cents, Louisiana, at 36 cents, and Georgia, which slaps only 37 cents tax per pack. What is the impact on demand of having to cough up (pun intended) such a high tax?
Though some governments seem to view higher cig taxes as a mission to improve health, it ain't necessarily so. High tobacco taxes intended to cut the smoking rate in Canada help create a black market where organized crime profits from the increased demand for contraband cigarettes, according to a new report from a Canadian public policy think-tank, the Fraser Institute.
The study, Contraband Tobacco in Canada, documents various federal and provincial tobacco tax policies and anti-smoking initiatives that have been implemented in Canada since the 1980s, and describes how governments have attempted to counteract the black market.
The research showed that the illicit trade of cigarettes increased whenever tobacco taxes were raised, so increasing taxes to discourage smoking is quite ineffective.
For many years, Philip Morris was a fixture within most value investors' portfolios. The break-up of the old MO into Altria and Kraft has created domestic and international components of the business as well as the separation of the food component. It has been almost two years since the spin-off of Philip Morris International. These years have been ones of substantial change at Altria as the company has positioned itself to take advantage of evolving adult tobacco consumer preferences in the United States. Altria successfully integrated John Middleton and UST and Altria's tobacco operating companies have leading positions in all of the major tobacco categories with four exceptionally strong brands -- Marlboro, Copenhagen, Skoal and Black & Mild.
Federal and state government issues also continue to be important to the tobacco business. On April 1, 2009, significant federal tobacco excise taxes went into effect. The federal excise tax on a package of cigarette increased by 158% to $1.01 per pack, and there were corresponding increases in smokeless tobacco products and machine-made large cigars of 158% and 155%, respectively. The year-end weighted average state excise tax on cigarettes increased by 12.5% in 2009 to $1.26 per pack as many states faced large budget deficits and a corresponding need to raise revenue. Clearly, revenue shortfalls at both the federal and state levels will continue to impact taxation and hence, consumption of cigarettes in this country.
Remarkably, based on a recent survey, only about 8% of the population currently smokes and has never tried to quit, as compared to the 19% of the population that still smokes regularly despite having tried to quit. One wonders about the impact on consumption if effective and relatively painless smoking aids were developed. Could the industry exist based on 8% of the population?
Despite an ever diminishing population, the headwinds of regulatory change (now FDA regulatory control) the economy's impact on reducing consumption or trading down in quality, and the ever –present threat of tort litigation, MO continues to enjoy superb profitability.
Based on first quarter results, it is evident that MO continues to have some incredibly strong brands with very high pricing ability. Marlboro, with just over 50% of the cigarette market has a price gap, versus the lowest effective priced cigarette of 33% in the first quarter. The price gap used to be almost 70% some 7 or 8 years ago, perhaps one of few signs that the command position of this brand is starting to fade. Copenhagen's retail price was $4.15, and its net price gap versus the leading discount brand, was approximately 45% in the first quarter.
The Ste. Michelle wine business, which was nursed along by the UST management for years is starting to perform a little better, probably due to a somewhat lower price point to other wines on average. Its volumes grew about 10% year over year in an industry that is growing about 2%.
Operating margins in the wine business look anemic compared to all other MO businesses. It represents 10% operating margins on $400 million in sales as compared to 24% operating margins on cigarettes' $21 billion in sales. Even smokeless looks tiny at $1.4 billion with 30% margins.
The company maintains a very high payout ratio of dividends which it targets at 80% of earnings. The impact of a significant increase in taxation of dividends would likely diminish one of the major appeals of the stock.
Though the inherent profitability has been terrific for MO, it is clearly not what it was, primarily due to integration costs of the US Tobacco acquisition (the Skoal and Copenhagen brands.)
MO has extremely high return on equity but to us, the more important measure is return on total invested capital (ROIC). For MO, this is about 11.5%, just above that of the S&P 500 which averages around 10.7%. Lorillard (Newport brand) has a ROIC of over 80%. The reason is quite straightforward, MO management has lost some respect for efficiency over the years and spent heavily on brand support and capex; Lorillard, run by the Tisch family, always had skin-flint management. Even on free cash flow margins (FCF as a % of sales), MO brings only about 2 cents of every dollar of sales to free cash flow; LO takes down 19 cents. MO following the UST acquisition has debt net of cash of $8.7 billion. LO has more cash than debt, almost $1 billion more. Lorillard is also showing better revenue growth.
Though no one will argue against MO as a well run business, and a 6.7% yield to go with it, the facts are that Lorillard has better economics and a not too shabby 5.5% yield. Looking more broadly at other consumer staples companies, I would far rather own some of the international brand companies with emerging markets exposures.
Which brings us to Philip Morris (PM). According to the World Health organization there were 1.3 billion smokers worldwide, the majority of whom (80%) reside in developing countries. Tobacco, though highly lucrative, represents a fairly minor segment of global food, beverage, and tobacco. Tobacco weighs in at merely 8% of these "staple" categories as compared to food at 67% and beverages at 25%. But the profits...wow!
PM has an exceptionally wide geographic base. The company sells its products in 160 countries and has 58 manufacturing facilities in 32 countries. In addition, the company is well diversified in terms of revenue generation from these geographies. Europe, the company's largest geographical market, accounted for 47.6% of the total revenues in the FY2008. Eastern Europe, Middle East and Africa contributed 23.3% of the total revenues in FY2008, followed by Asia (19.2%) and Latin America (10%). The diversified geographic presence should reduce the business risk for the company and makes it resilient to significant weak performance from any of the region.
Contrary to the global trend of tobacco companies diversifying into other businesses, PM has not diversified into any other business segment. As a result, its revenues are highly vulnerable to tobacco-related litigation across the world.
One issue that concerns us to some degree but also represents a long-term opportunity is the low productivity of PM versus other international tobacco companies. The company's employee efficiency, measured by total revenues per employee, is significantly lower as compared to the other industry players. In FY2008, the revenue per employee of the company stood at $0.8 million. The firm has 75,600 employees! The company has recorded lower revenue per employee compared to some of its competitors namely Imperial Tobacco Group and the former parent, Altria.The revenue per employee of Imperial Tobacco Group stood at $1 million in FY2008. For the same financial year, the revenue per employee of Altria was $1.9 million, much higher than the revenue per employee of PM.
However, despite its "inefficiency," this is an outstanding business in terms of its profitability. ROIC last year was 27%, the ROE was over 100%. The payout ratio for dividends represents a little over 65% of earnings, so the dividend growth prospects remain very strong.
Addictive, repetitive, and predictable behavior leads to predictable cash flows as well as dividend streams. Curtailment of advertising has entrenched market shares and saved the industry a bundle. Though the black market for cigarettes may be "smokin" there is precious little evidence that higher taxes have done anything to weaken the profitability of this industry. Free cash flow characteristics are superb as well. Capex is about 1% of sales. For Altria, accounts receivables turnover is 336 times a year, DSOs are just about daily.
Quitting ain't easy. Twice as many smokers have tried unsuccessfully as those who haven't bothered. The industry still has some inefficiencies to deal with, especially internationally so cost cutting is still a prospective positive. Lawyers have once again been held at bay. At the end of June, the U.S. Supreme Court rejected an attempt by the federal government to wrest billions of dollars in damages to fund a smoking cessation program and other remedies.
The decision settled a case filed in 1999 by the Clinton administration, which sought to force the industry to fund a smoking cessation program and other remedies. The U.S. Justice Department under the Bush administration dropped demands from $280 billion to $14 billion. The result...nada.
You may not like the habit and God knows, it's not good for your health. But it sure helps your financial health.
Disclaimer: I, my family, or clients currently own positions in all of the securities mentioned in this post.