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The Tobacco Industry is comprised of a small set of corporations that grow, sell and distribute tobacco and related products throughout the world. A variety of products, at several price points, cover most customer tastes.

Health concerns, which have fostered legal and regulatory pressures, limit the growth prospects of this mature industry. Barriers to entry are relatively high, though, due to government restrictions on marketing and advertising. Consequently, a small number of companies serve this market. In fact, the industry's consolidation over the past decade has created an oligopoly. Pricing power helps to offset declining volume. Sales and earnings are fairly stable throughout the economic cycle.

Operating Considerations

Industry realignment is a means to offset the effects of a tough operating environment. Companies have used mergers and acquisitions as a tool to improve market position. Overseas expansion offers attractive growth due to rising income levels and less regulation. Added scale allows these corporations to better withstand competition from small discounters at the retail level. Expansion may be funded by equity, debt, or internally generated funds, depending on availability.

Market position is important. Given the limited opportunities for growth in this highly competitive industry, brand equity support is crucial in developing customer loyalty. A leading market position gives a company greater pricing power, which is important, especially under difficult economic conditions. The leader of a particular product category often determines price points.

Cash flow management is crucial to success. A focus on operating efficiency is paramount. These companies generally have favorable profit margins, thanks to good cost control. The players in this industry have historically posted wide margins. Ample cash flow is needed to fund ongoing operations and, in most cases, a generous dividend.

Risk Factors

Concerns regarding the health effects of tobacco usage have led to a steady decline in demand in the developed world. The industry has to deal with ever-tightening regulation. Governments have placed limitations on how companies market established and new products. Also, smoking bans in public places are spreading around the globe, curbing consumption.

This market is not completely immune to the business cycle. A serious economic slowdown will lead to a drop in consumption, since in many countries tobacco products are heavily taxed, pushing up prices, and consumers have limited discretionary income. In tough times, customers readily trade down to cheaper alternatives or abstain altogether. Discounters (legal and illegal) can exacerbate the situation and have a negative impact on pricing and profits.

Sales

Rising health concerns, prices, excise taxes and regulation have weighed on demand. Declining sales volume and increased tobacco production costs have pressured profitability. At times, foreign currency exchange can have a notable effect on year-to-year sales comparisons. Managements have endeavored to improve sales by selectively raising prices, acquiring competitors, pursuing markets with limited regulation, and developing smokeless products. Sales volume from continuing operations is the best measure of a company's ability to compete and win share.

Profitability

Tobacco companies also seek to maximize profitability through continuous cost management. Sizable litigation costs, however, are often a drag on bottom-line performance. Too, these companies are not reluctant to carry substantial debt on the balance sheet, and interest expense can be an influential line item on the income  statement. The industry is not capital intensive, but a wide production and distribution network needs to be maintained to optimize operating results. Well-established distribution presents a high hurdle to new market entrants. Notwithstanding some momentary dips, over its long history, the tobacco industry has a solid earnings track record.

Concluding Thoughts

Tobacco stocks are generally considered defensive. Their betas are usually below the market average and they are typically accorded high Price Stability ratings. Still, their Safety ranks are often Average (3). Indeed, tobacco companies usually have considerable, though manageable, debt obligations (affecting Financial Strength). Moreover, lawsuits are a recurring theme in this industry, and a large award can cause short-term share-price volatility. Nonetheless, good earnings and cash flow streams add to the appeal of this sector. Investors should keep in mind, however, that recessions and periodic government efforts to impose regulation may hurt operating performance and stock valuations.

These equities offer investors decent growth when new markets are tapped or successful, nontraditional products are developed. On a more consistent basis, the stocks provide attractive income. Dividends advance regularly. Reductions only occur under unique circumstances, when a large division is spun off, for example. Payout ratios above 50% are not uncommon. Yields are often in the mid-single digits.

Tobacco issues rarely have price-to-earnings ratios above the market averages. Legal and regulatory risks play a role in keeping valuations at reasonable levels. On balance, the industry is suitable for investors seeking long-term growth and income and willing to assume a moderate degree of risk. Stocks of companies that have a good record of lifting sales and net profits and dealing with regulators, lawsuits and competitors should be favored.