Tobacco companies enjoy solid revenues, earnings and dividends

By their very nature, tobacco companies are cash machines - they have been paying dividends with amazing regularity and have raised their dividend payments every year for decades. British American Tobacco has doubled its dividend in the last five years.

Tobacco companies have produced great returns for shareholders

Many investors dismiss tobacco companies as "boring". Others dismiss tobacco companies altogether on ethical grounds. However, by their very nature, tobacco companies are huge producers of cash.

Many investors refuse steadfast to invest in tobacco companies purely on ethical grounds. It has been proven that their main products - cigarettes and cigars - harm the health of the vast majority of its users. Smoking regularly can take several years off a person's life expectancy.

Putting ethical concerns aside for a moment, who wouldn't want to be selling a product which is legal and that people are actually addicted to, and for which there is no real substitute?

Multi-billionaire investor Warren Buffett, once said about tobacco companies:

“I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty”

New Buffettology explains in detail how to identify excellent companies possessing superior economics, and it introduces the concept of ’business perspective investing’ in which the price you pay for an investment determines your projected annual compound rate of return.

Tobacco companies' "moat": addiction

For millions of people cigarettes and cigars are a 'need to have' product rather than a 'nice to have' product. They keep coming back for more to feed their addiction. Sometimes they trade down to buy cheaper brands, which are often produced by the same company.

Some customers quit the smoking habit but most just keep on buying, even when their income falls during a recession. Often, people reach for 'fags and booze' when things turn grim economically.

Whatever the economic situation, tobacco companies' earnings remain strong due to the perceived pricing power of their products which stems from the strength of their brands, and the diversity of their product range on offer.

Governments are addicted too!

The biggest risk with tobacco companies is political risk in developed countries. However, governments are also "addicted" to the tax take from cigarettes and cigars!

Tobacco related illnesses kill people and given its perceived cost to society, governments need to be seen as doing something to prevent people from (starting to) smoking, such as:

  • smoking bans in public places

  • limiting advertisements aimed at younger people

  • restricting the freedom of the tobacco industry to introduce new products

  • making tobacco products available in the same generic packaging

  • restrictions on point-of-sale advertising, etc.

However, critics of further anti-smoking legislation are quick to point out that both the US and UK governments are 'addicted' to tobacco tax revenues.

For instance, the UK's tax take via duty and VAT, totaling some 10bn in 2008/2009 alone and is forecasted to be substantial higher this year as a result of further tax hikes.

We should also not forget that, in the UK, smokers pay more in taxes than it costs the National Health Service to treat smoking-related illnesses (the current figures are that roughly £2 of taxes is collected for every £1 spent on treatment).

Smokers also "benefit" society because they don't collect the State Pension for as long as non-smokers. In addition, smokers provide a lot of jobs in healthcare and revenues for pharmaceutical companies.

Developing markets are the future

These days, there are four truly global suppliers, including two in the United Kingdom:

In the longer term, the earnings of Western tobacco companies will be driven by increasing volumes in emerging markets.

In recent years, cigarette consumption in developing countries has increased by 1 - 3 per cent while it has declined 2 - 4 per cent in more mature markets such as Western Europe and the USA. As emerging countries develop, increased discretionary income will ensure that tobacco products become more affordable

The future growth of Western tobacco companies clearly depends on them spreading the smoking habit throughout the globe, particularly in the newly industrialising countries and the third world.

Western companies like BAT and Imperial Tobacco have the advantage that their aspirational Western brands are highly valued in developing countries.

Growth by acquisition

While the days of the mega-mergers in the tobacco industry are likely to be over, in fact Philip Morris International itself was created as a spin off from Altria in 2008, both British American Tobacco as well as Imperial Tobacco have recently increased their exposure to faster growing developing countries by acquisition.

In June 2009, British American Tobacco acquired Bentoel which is the fourth largest tobacco company in Indonesia. Following this acquisition, the Asia Pacific region accounts now for 25 per cent of BAT's sales volume. A year earlier, BAT completed the purchase of Tekel in Turkey, boosting its position in that country fivefold.

BAT nowadays claims that it's "the world's most international tobacco group" as well as the world's second largest listed tobacco company. BAT's five most important markets, include Brazil, Russia, South Africa, Australia and Canada - all commodity-based economies, whilst it's also having significant exposure to Latin America, Asia Pacific, Africa and the Middle East - all significant growth areas.

While Imperial Tobacco's "catching up" acquisition of Altadis of Spain, in early 2008, substantially expanded its presence in African and Eastern European emerging markets, making it the world's fourth largest listed tobacco company. However, over 75 per cent of Imperial's revenues are still derived from Europe, whilst controlling 45 per cent of the UK market.

And what about dividend income?

By their very nature, tobacco companies are cash machines. British American Tobacco has doubled its dividend in the last five years whereas Imperial Tobacco's dividend has increased by 26%.

So, if you don’t have any major ethical objections and you’re looking for an investment that's relatively recession resilient, pays a reasonably high income and has a track record of increasing dividends, you may well want to consider having a look at the tobacco sector.

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