How to Play the Tobacco Industry

I admire tobacco companies. Despite nasty looking warnings on tobacco products, consumers find a reason to consume these items. And despite their minimal marketing campaigns, these companies find loyal customers to retain their growth momentum. This ensures a stable top line and the rising population presents steady growth potential. But when it comes to hand picking tobacco stocks, which companies should make it to your list?
Why not Philip Morris?
Philip Morris International (NYSE: PM) is a well-diversified company and caters to 180 different markets -- except for the U.S. Its international market share aggregates to around 16%, and the company is rapidly expanding in Asia to bolster its growth. But there seems to be two broad reasons why its geographical diversification will most likely strain its earnings.
Firstly, the U.S dollar is strengthening due to the ongoing economic recovery. But since major economies, including Australia, China and India, have been recording lackluster growth, their currencies have begun depreciating. Since Philip Morris generates all of its revenue from international destinations, a strengthening U.S dollar translates into foreign-exchange losses.
Secondly, Australia has imposed a law wherein cigarette packs will come in plain packages, and must contain bigger graphical warnings. The results are awaited but the idea is to curb cigarette demand in Australia. If the Australian government succeeds in cramping the demand, the British government has announced that it will follow suit. This doesn’t paint an optimistic picture for Philip Morris, which is why Altria (NYSE: MO) and Reynolds American (NYSE: RAI) appear more attractive.
A state of confusion?
Both Altria and Reynolds American operate in the U.S, with 50% and 27% market share, respectively. This makes them geographically saturated and reliant on a single market, but it also eliminates the risks of forex-related losses. And thanks to an impressive set of financials, shares of Altria and Reynolds have appreciated by nearly 16% and 25%, respectively, over the last six months.
Thanks to the growing popularity of electronic cigarettes, or e-cigarettes, the electronic segment is now being considered a game changer for tobacco companies. E-cigarettes currently account for 1% of total cigarettes sales in the U.S, but have become one of the fastest-growing tobacco segments in the states.
To capture this growth, both Altria and Reynolds American have announced the launch of their respective MarkTen and Vuse lines of e-cigarettes. There are over 200 existing brands available in the market, but both Altria and Reynolds claim that their e-cigarettes are an upgrade from the current market offerings. So the question arises:  “Which company stands to benefit the most?”
Altria or Reynolds?
Altria has a larger market share with more brand loyalty on which to capitalize. It has a relatively wider distribution network and larger product portfolio. So technically speaking, the venture into e-cigarettes should benefit Altria more. And Altria also owns a 27% interest in SABMiller.
It is the world’s second-largest brewing company, and has been adding strength to Altria's financials. SABMiller's FY 2013 revenue grew by 10%, which is quite impressive for a large scale enterprise. But over the last four years, its revenue is down by 11.9%.
The alcohol behemoth is already witnessing a slowdown in China, and recently suggested that slowing beer sales in the U.S could shrink its FY 2014 volumes by 1% (in the country). Its operations in Latin America account for 32% of overall EBITDA and generated FY 2013 volumetric growth of just 3% year-over-year, which  is down from 9% growth in FY 2012. And management expects a further slowdown in Latin America.
Certainly SAB Miller adds stability to Altria’s top line and delivers more balanced growth. But on the downside, the growth rate from its e-cigarettes category will most likely be dampened by SAB Miller's slowing growth rate.
On the other hand, Reynolds is nearly one-third the size of Altria (by market cap), and operates with a smaller market share. But it is also a tobacco pure play with a saturated revenue stream. This makes Reynolds American more leveraged, but a well-positioned company to capture the blockbuster growth of the e-cigarette industry. This is why its shares reached a 52-week high last week, just after the launch of the company's Vuse line-up.