10 reasons tobacco is hot

The stocks have soared over the past year, and they stand to benefit from low interest rates and more conservative investors.

By Kim Peterson May 31, 2011 3:42PM
The tobacco industry is smokin' hot right now. Just look at the recent performances of some of the biggest stocks. In the last year, Altria (MO) has soared 40%, Reynolds American (RAI) 53% and Lorillard (LO) 60%.

There is no stopping this sector. The top stock in the group? Analysts from UBS say menthol leader Lorillard is the top pick, and they're raising their price target on the stock to $124. Lorillard is trading at about $115 today.

Lorillard has a strong growth trajectory, and is expanding its Newport line to include non-menthol cigarettes such as its recently introduced Newport Red. In the first quarter of this year, Lorillard's sales rose nearly 13%, profit rose 7% and the company raised its dividend 16%.

Post continues after this video about how the government hates smoking but loves the tax money that comes from cigarettes:
The UBS analysts are bullish on tobacco overall. Here are the 10 reasons why two of the analysts, Nik Modi and Benjamin Schmid, say tobacco is on fire:

1. Low interest rates. Strong dividends in the sector are attractive to investors frustrated by low interest rates. Lorillard shares are trading at a 4.5% dividend yield, and Altria shares are at a 5.5% yield.

2. A more risk-averse market. Investors are pulling back from embracing risk, and now they want stocks with strong fundamentals and a growing cash distribution. Tobacco stocks fit that bill.

3. Tobacco stocks similar to staples. Investors love consumer staple stocks because of their dividend potential, growth and ability to withstand economic downturns, the analysts write. Tobacco stocks are even more visible and defensible than many staples.

4.No currency or commodity mishaps. There is no potential for currency troubles with Altria, Reynolds American and Lorillard because 100% of their profits come from the United States, the analysts write. Other consumer companies do a large chunk of business overseas, and their profits could drop as the dollar strengthens.

The tobacco industry isn't that affected by the rapid rise in commodity costs, the analysts write. The biggest expense is tobacco costs, which aren't that sensitive to rising prices for oil or other materials.

5. Low capital allocation risk. There are no big merger or acquisition deals in the making, and the big tobacco companies are favoring share buybacks and dividends. "We believe investors can have a sense of comfort with how shareholder money is being used," the analysts write.

6. Pricing power. There's plenty of room for prices to grow in the U.S., the analysts write. Cigarette prices in the United Kingdom are 83% higher than in the U.S., and smoking rates seem to have bottomed out there.

7. Lower lawsuit risk. The industry is long past the "peak litigation era" of 2000 through 2005, the analysts write. Several Supreme Court rulings have made most class-action industry lawsuits irrelevant.

8.Barriers to entry. It will be tough for a competitor to get a new tobacco brand to market now, since the government is tightly restricting advertising. And the approval process for a new product launch is very rigorous, the analysts add. Finally, it's expensive to do business under the watchful eyes of the U.S. Food and Drug Administration. New costs are forcing smaller cigarette makers to raise prices or leave the business.

9. Less focus on taxes. Oh sure, some states are trying to raise taxes on cigarettes in a grab for more revenue. But New Jersey and Rhode Island are actually considering lowering cigarette taxes. Maybe some states are figuring out that raising taxes isn't all that effective, given that people can find other ways to get cheaper smokes.

10. Leverage at retail. Cigarette makers dangle plenty of incentive payments in front of retailers, and that gives the makers a good deal of leverage. In fact, a new program from Marlboro asks retailers to take a hit on their Marlboro margins, or risk losing special reward payments from the manufacturer. Pretty brilliant.

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