Tobacco stocks on fire despite proposed cigarette tax hikes

Cigarette stocks
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Investors are lighting up for tobacco stocks despite ongoing anti-smoking campaigns and proposed cigarette tax hikes on the ballot in four states.

California's Proposition 56 would triple the tax on a pack of cigarettes and is garnering strong voter support in the latest polling. Colorado, Missouri and North Dakota also have proposed ballot measures in November to boost cigarette taxes.

"Generally speaking, these are fairly manageable increases," said Cowen analyst Vivien Azer. She said there's a "very sticky nature" of demand for cigarettes, meaning smokers don't give up their habit that easily even when faced with price increases.

Volume declines are slowing

Cigarette use domestically has been declining over the past several decades due to unfavorable public sentiment and anti-smoking campaigns. Estimates from the federal government show roughly one out of every five adult Americans is a smoker and rates are highest among people living in the Midwest and South.

Yet, cigarette volume declines have started to slow and tobacco stocks — known for their generous dividends — have ignited investor interest.

Shares of U.S. tobacco companies Altria Group and Reynolds American are each up more than 13 percent in the past year and outshining the S&P 500 Index. And stock of the international tobacco business spun off by Altria years back, Philip Morris International, is up well over 20 percent in the last year.

"We are now in the surprising position where U.S. cigarette sales are growing faster than sales of food." -Adam Spielman, Analyst, Citi Research

"The tobacco market last year did pretty well," said Adam Fleck, an analyst at Morningstar. "They have strong competitive advantages from their pricing power and market dominance."

According to Euromonitor, U.S. tobacco volumes posted a 0.4 percent decrease last year but that was the lowest volume decline domestically in more than two decades.

"We are now in the surprising position where U.S. cigarette sales are growing faster than sales of food," said Citi Research analyst Adam Spielman in a note earlier this month.

Indeed, data from Euromonitor shows total U.S. tobacco sales last year posted a 3.6 percent increase over the prior year and reversed years of declines. By comparison, the domestic packaged food category showed anemic growth of 0.2 percent in 2015.

The improving economy appears to be playing a key role in helping to boost tobacco demand.

Specifically, analysts point to the improving employment situation among lower-income consumers — a core tobacco customer. Also helping are hikes in the minimum wage as well as lower gas prices.

Morningstar's Fleck said there's still trouble ahead for tobacco since he believes long-term growth in the U.S. will "be negative in the kind of low- to mid-single digits.That's really driven by continued health concerns and cigarette consumption specifically."

In particular, the analyst said low teen smoking rates are "highly predictive of future smoking levels among adults." Government figures show smoking rates from 2011 to 2015 declined among middle and high school students.

On Wednesday, Jefferies initiated coverage of all leading global tobacco companies and issued a buy rating on Reynolds American and kept a hold rating on Altria Group.

"We believe this is the start of a new era with industry value drivers fundamentally more favorable than in the past," Jefferies analyst Owen Bennett said in the initiation note. "On this basis, we believe valuations can be justified and look attractive (even cheap) on an underlying number."

Risk of new federal taxes

However, the Jefferies analyst said "the biggest two risks to us are another large federal excise tax increase and a menthol ban. On both fronts, we see little chance of any development within the next three years."

Back in 2009, President Barack Obama signed a nearly 160 percent increase in the federal excise tax on cigarettes, from 39 cents per pack to $1.01 per pack.

But taxes could be set to rise in the nation's most populous state. Big Tobacco is spending millions to defeat California's Proposition 56. If passed, taxes for cigarettes would rise $2 a pack, from 87 cents to $2.87. Taxes also would be extended to other tobacco products such as e-cigarettes with nicotine. The last time California raised statewide tobacco taxes was in 1999.

"Studies have shown that for every 10 percent increase in the price of a pack of cigarettes, youth usage goes down like 7 percent and adult use like 3 to 4 percent" -John Schachter, Spokesman, Campaign for Tobacco-Free Kids

"We know that they will do whatever they need to to fight to preserve their bottom line instead of the lives and health of kids and others," said John Schachter, director of state communications for the Campaign for Tobacco-Free Kids, one of the groups in a coalition supporting California's Proposition 56.

He added, "Studies have shown that for every 10 percent increase in the price of a pack of cigarettes, youth usage goes down like 7 percent and adult use like 3 to 4 percent."

Earlier this year, California became the second state after Hawaii to raise the legal age of smoking to 21.

"Prop. 56 is a deceptive $1.4 billion tax increase that proponents claim will help people quit smoking, but only 13 percent of the revenue raised is dedicated to helping people quit or stopping kids from starting," said the No on Prop 56 campaign in a statement provided to CNBC.

Support for Proposition 56 is currently at 63 percent, with another 32 percent against the measure and 6 percent without an opinion, according to the USC Dornsife/Los Angeles Times poll published last week. The poll consisted of just under 2,000 likely voters.

"We've seen historically that these companies are typically able to eventually pass on those tax increases in the form of price increases to the customer," said Morningstar's Fleck.

In Colorado, a proposed tobacco tax measure known as Initiative 143 would triple the taxes on a pack of cigarettes by adding $1.75 per pack to the existing 84 cents tax already on the books. Moreover, it would increase the levies on other tobacco products such as cigars and e-cigs by more than 20 percent.

North Dakota's so-called Measure 4 would lift the state's current 44 cents per pack tax on cigarettes by $1.76 per pack, or a jump of 400 percent, meaning it would go to $2.20 per pack. What's more, it would increase taxes on other tobacco products and also add taxes for e-cigs with nicotine. Altria and Reynolds American have put nearly $900,000 into the campaign to defeat the North Dakota tax.

Missouri's proposed tobacco taxes are part of two different measures. Analysts say some big tobacco companies supported the new regulation in Missouri under the so-called Amendment 3 because it essentially closes a loophole where lower-priced cigarettes (from wholesalers) were given a better deal under the original regulation. Amendment 3 would increase taxes by more than 350 percent on a pack of cigarettes, from 17 cents to 77 cents, and adds new fees for tobacco wholesalers. The state's competing measure, known as Proposition A, proposes lower tax increases without the levies on the wholesale side.

In August, Pennsylvania raised the state's sales tax rate on cigarettes from $1.60 a pack to $2.60 a pack. In Philadelphia, the tax rate will be $4.60 a pack, reflecting a $2 per-pack tax the city added in 2014.

At present, Chicago holds the distinction of having the highest combined cigarette tax rates in the U.S. ($6.16 per pack, when including state and local fees) followed by New York City ($5.85 per pack), according to the Campaign for Tobacco-Free Kids.