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The writing must have been on the wall last month when the final 650 Imperial Tobacco workers in Ontario and Quebec were told their plants were closing by 2007. Imperial's parent, British American Tobacco, blamed a 38 per cent decline in sales over the past decade of BAT cigarette brands like du Maurier, Player's and Matinee.
To make matters worse, British American Tobacco admitted its Canadian business could face bankruptcy following a recent change in Canadian law that gives provinces the right to sue cigarette makers for past and future health care costs. The change mirrors similar legislation and litigation in the United States and Europe. While it seems the tobacco industry has taken its last puff, tobacco stocks are on fire.
The fact is tobacco stocks have been climbing over the past two years thanks to generous dividends, some creative corporate manoeuvring, and lingering demand from customers who are literally addicted to the product. For fund managers tobacco stocks have become a rock of certainty in an uncertain equity market.
British American Tobacco (BTI AMEX 3-year graph) pays out a yield of 3.6 per cent and its stock has surged 83 per cent over the past two years. That pales in comparison with rival, Rothman's 5.2 per cent yield. In late October Rothman's reported a second quarter profit increase of over $30-million compared with the previous year, despite a flurry of litigation hitting its bottom line.
Rothmans attributed the increase to its low-cost cigarettes. With Imperial Tobacco about to exit the picture at least one money manager says things can only get better for Rothmans in the longer term. "The Imperial Tobacco closing will lower overall costs and allow them (Rothmans) to be more cost competitive," says Norman Levine, managing director of Portfolio Management Corp. Mr. Levine doesn't currently own any tobacco stocks but he admits the history of consistent dividend payouts from the industry makes it appealing despite the mountains of litigation faced by cigarette makers. "Tobacco is the most profitable legitimate business in the world, but you have to weight it against declining sales and litigation" he says.
Rothmans (ROC TSX 3-year graph), the only major tobacco company to list on the TSX, is up 21 per cent since the beginning of this year.
But dividends aren't the only thing lighting the tobacco industry's fire. Over the past few decades tobacco companies have managed to play a corporate shell-game to draw less attention to the fact that their product kills people, and Altria is a perfect example. Through Phillip Morris, Altria produces Marlboro cigarettes - but Altria also has an 86 per cent stake in Kraft Foods (KFT NYSE). The Kraft brand has helped divert Altria's image from the Marlboro man to kinder-gentler Kraft Dinner (which also makes Oreo cookies and Oscar Mayer lunch meats). When socially conscious investors think of Altria they may be more likely to think of Kraft Dinner.
Now the world's largest and most profitable cigarette maker may not need the wholesome Kraft image. According to a recent report in Barron's, Altria is considering splitting the company into three if a pair of outstanding court rulings in the U.S. go in its favour. The split is expected to boost Altira shares considerably because it would allow its profitable Phillip Morris division to concentrate more on growing international markets in Indonesia, Columbia, Eastern Europe, Turkey and the Middle East where the health dangers of tobacco are not as widely known.
Other major tobacco companies have also thrown up smokescreens. If you invest in Rothman's or British American Tobacco, you really invest in holding companies with a majority ownership stake in tobacco companies. That makes it easier for dividend-loving money managers to load up their portfolios with tobacco companies without making a splash on the ethical radar screen.
So who owns tobacco stocks? The largest ownership stakes in the tobacco companies themselves are big institutional investors who can reap the benefit of strong, reliable dividends without attracting too much attention from unit holders who may not be comfortable holding tobacco stocks. The largest outside shareholder in British American Tobacco is Fidelity Management, which holds the stock in some of its Fidelity funds. The New York State Teachers Retirement fund also holds a large stake in BAT.
Large shareholders in Montreal-based Rothmans include CI Investments Inc., McLean Budden Limited, Dynamic Mutual Funds Limited and big Canadian banks including TD and CIBC. Not surprisingly, Rothmans is most often a major holding in dividend funds.
Retail investors who don't want to own tobacco stocks, and would like to know they are in their funds, should speak with their financial advisors.
Several analyst reports highlight the pros and cons of investing in tobacco stocks at any given time, but very few highlight the biggest and most brazen advantage that tobacco makers hold over any other industry - science has proven their product is physically addictive. To put that fact into perspective imagine how valuable Nortel shares would become if telecom equipment was physically addictive.
Another ace-in-the-hole for tobacco companies comes from the same governments that are bombarding them with litigation and legislation. A large chunk of the retail price of Cigarettes in Europe and North America is made up of tax - and tax revenue is nearly as addictive to governments as cigarettes are to smokers.
Ethics aside, the value of tobacco stocks boil down to costs - and tobacco industry costs boil down to litigation costs. Kevin Doyle, a senior portfolio manager with KBC Asset Management recently told the Sunday Times he believes litigation costs have been absorbed into the share price. "The real question is, 'Who ultimately will own the cash that these companies generate - the shareholders or the litigants?'"
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.