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Tobacco Industry Stock Outlook: Will RRPs Help Heal Burns?

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The tobacco industry has been in rough waters of late, thanks to regulations imposed by the FDA and growing drive among consumers to quit smoking. These factors have been denting cigarette consumption rates, eclipsing the performance of players in the industry. Nonetheless, companies are finding a breather in reduced-risk alternatives.

According to research by Nielsen, cigarette volumes declined as much as 2.9% within just 12 weeks ended Jun 16, 2018.  As for 2018, Nielsen expects cigarette volumes to go down around 3.4%. Looking into historical data, the Centre for Disease Control and Prevention (CDC) stated that cigarette sales in the United States dropped 3.5% in 2017 from 2016.

A major reason for the declines is increased regulatory hurdles in the form of marketing limitations, anti-smoking campaigns and higher excise duties. To add to the woes, the FDA is drastically reducing nicotine in cigarettes to minimally addictive levels.

In spite of the odds, the U.S. tobacco industry has been gaining support by rising demand for reduced-risk tobacco products (RRPs), also known as smokeless, e-cigarettes and vapor products. Well, the radical move toward smoke-free alternatives clearly shows that players in the tobacco space are turning over a new leaf. In this regard, RRPs like iQOS and MarkTen are a rave among consumers looking to quit cigarettes. Markedly, industry biggies such as Philip Morris International Inc. (PM - Free Report) and Altria Group, Inc. (MO - Free Report) have been pioneering this change and investing massively in research to develop innovative products under this category.

Apart from RRPs emerging as a game changer, higher cigarette prices are expected to keep helping tobacco companies stay afloat amid tough conditions.

Industry Lags on Shareholder Returns

Concerns surrounding declining cigarette volumes have kept investors on the sidelines. In fact, the Zacks Tobacco Industry, within the broader Zacks Consumer Staples Sector, has underperformed both the S&P 500 and its own sector over the past year.

Stocks in this industry have tumbled 24.6% over the past year. Meanwhile, the Zacks S&P 500 Composite has rallied 13.8%, whereas the Zacks Consumer Staples Sector has lost 7.3%.

However, there was a marked variance in the performance of individual stocks within the group. While most tobacco companies are reeling under declining cigarette volumes, few have been able to offset the downsides with higher revenues from smokeless and other low nicotine products.

One-Year Price Performance


 

Though the industry’s performance is far from impressive, tobacco firms’ bold ambitions with respect to RRPs might revolutionize the industry, bringing back the lost glory.

Tobacco Stocks Trade Cheap

One might get a good sense of the industry’s relative valuation by looking at its price-to-earnings ratio (P/E), which is the most appropriate multiple for valuing Consumer Staples stocks like tobacco because earnings are effective in gauging performance.

This ratio essentially measures a stock’s current market value relative to its earnings performance. Investors believe that the lower the P/E, the higher the value of the stock will be.

Despite the multiple headwinds, the tobacco industry’s valuation picture appears attractive. The industry currently has a trailing 12-month P/E ratio of 15.6X, which is below the one-year median level of 20.3X and the one-year high of 22.1X over the past year.

The space also looks attractive when compared with the market at large, as the trailing 12-month P/E ratio for the S&P 500 is 20.7X and the median over the past year is 20.4X.

Price-to-Earnings Ratio (TTM)

The valuation argument in favor of these stocks becomes all the more compelling when we take into account the tobacco stocks' income component, with most of these companies paying out lucrative dividends. The average dividend yield for the Zacks Tobacco industry is currently at 5.1%, more than double the S&P 500 average. 

Underperformance to Continue on Glum Earnings Outlook

Growing enthusiasm among consumers regarding smokeless products combined with cigarette price hikes should help tobacco companies tackle the ongoing challenges and generate positive shareholder returns in the near future. However, declining volumes for one of the prime revenue churning products in the industry — cigarettes — may continue to be a headwind.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The above ratio analysis shows that there is a solid value-oriented path ahead. However, one should look for good entry points based on solid fundamentals and other near-term factors.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is its earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for the industry and its aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

 Price and Consensus: Zacks Tobacco Industry
 


This becomes clearer when we focus on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Please note that the loss per share estimate of $4.17 for the industry for 2018 is not the actual bottom-up dollar estimate for every company in the Zacks Tobacco industry, but rather an illustrative aggregate created by our proprietary analytics model. The key factor to keep in mind is not loss of $4.17 per share for the industry for 2018, but how this estimate has evolved recently.  

  Current Fiscal Year EPS Estimate Revisions
 

As you can see here, the 2018 loss per share estimate has deteriorated from profit estimate of $4.34 at the end of January and $4.24 at the end of June. Clearly, we note that the sell-side analysts covering the companies in the Zacks Tobacco industry have lowered their estimates over the past three months.

Zacks Industry Rank Shows Dim Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.

The Zacks Cosmetics industry currently carries a Zacks Industry Rank #194, which places it in the bottom 24% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that the industry’s rank has been volatile over the past eight weeks though it has remained among the bottom 50% all through.


 

Tobacco Space: Earnings & Revenue Trends

The past earnings of the tobacco space reveals that the group has been witnessing quite an unsteady trend. It’s worth noting that during the latter half of 2017, the industry’s earnings began rising, though it started declining since the beginning of 2018. The recent fall is mainly attributable to declining cigarette volumes and increased regulations to curb its consumption.

  EPS - Tobacco Market
 

The top-line performance of the Zacks Tobacco industry also exhibits similar trends as earnings. From the figure below, it can be seen that revenues began rising from March 2017. The same started to fall sharply since the beginning of 2018.

  Revenues - Tobacco Market
 

Bottom Line

Considering the headwinds plaguing the tobacco space, RRPs seem to be the most viable option for tobacco players to offset declining volumes. According to a Reuters report, the global e-cigarette market is expected to see a CAGR of 22.1% over the 2018-2023 period. A significant factor fueling this market trend is improving disposable income of consumers in developing nations. Tobacco firms with significant presence in such markets are likely to gain from this trend.

Needless to say, to exploit opportunities in the RRP arena, tobacco firms are required to make huge investments, which is likely to mar profitability in the short run. Further, declining revenues from cigarettes limits the ability of companies to invest in prospective areas. Sadly, tobacco companies are likely to continue facing cigarette sales declines. As smoking-related illnesses continue to climb, the need for stringent regulations to curb tobacco sales is of utmost importance. This will continue to dent tobacco sales, affecting the profitability of firms engaged in the cigarette business.

That said, chances of a near-term respite for tobacco companies are slim. Here are a few stocks from the sector investors should steer clear of.

British American Tobacco plc (BTI - Free Report) : This London-based tobacco company, carrying a Zacks Rank 5 (Strong Sell), has lost almost 25% in the past year. Also, the Zacks Consensus Estimate for the current fiscal EPS has gone down 3.4% in the last 30 days.

  Price and Consensus: British American Tobacco
 


Imperial Tobacco Group PLC (IMBBY - Free Report) : This Bristol-based company has lost 16.3% over the past year. The company currently carries a Zacks Rank #4 (Sell).

  Price and Consensus: Imperial Tobacco
 


While most stocks in the tobacco industry seem to have bleak prospects, there is one that carries a Rank #1 (Strong Buy).

Notably, Turning Point Brands, Inc. (TPB - Free Report) has been defying industry downtrends and depicting a sturdy run. This Kentucky-based company, which specializes in Other Tobacco Products, has gained an astounding 130% in the past year. Further, the Zacks Consensus Estimate for the current fiscal EPS has been revised 3.7% upward in the last 30 days. You can see the complete list of today’s Zacks #1 Rank stocks here.

 Price and Consensus: Turning Point Brands
 


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