How Big Tobacco will benefit from US anti-smoking laws

This is a landmark year for US tobacco. After years of being coddled by the Bush administration, Congress will soon pass an aggressive bill that will bring cigarettes under the control of US health authorities. Strict rules on advertising will be introduced and the path will be paved for Congress to raise federal cigarette taxes by 61 cents, to $1 a pack. "I think that 2009 has the potential to be the most historic year in making progress on tobacco since the first surgeon general's report in 1964," Matthew Myers of the Campaign for Tobacco-Free Kids told The New York Times.

Why then has US tobacco giant Altria, maker of Marlboros, given its full support to the bill? Well, because the firm has read the small print. "This legislation might as well be dubbed the Altria Earnings Protection Act," says Fortune magazine. For starters, the bill prevents the US Food and Drug Administration (FDA) from ever banning cigarettes. But just as importantly, the wording makes it extremely unlikely that the FDA will ever approve a new cigarette product because the entrant would have to be deemed "appropriate for the protection of the public health". So the bill basically featherbeds the dominant tobacco groups' share of the market. It even mandates a crackdown on sales of counterfeit cigarettes, which have been a major thorn in the industry's side in recent years.

Why are the Democrats going so easy on Big Tobacco? Because they know what every tax-hungry government knows you can tax the hell out of cigarettes and people won't stop smoking. The Irish government, for example, worked out that lifting the price of a pack by 30% only led to a 1% fall in smoking. They've exploited that fact to take in 53% more revenue from tobacco tax over the last decade, according to Eithne Donnellan in The Irish Times.

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That's why Obama supports the bill. He has worked out that the $1-a-pack tax will raise $35bn to fund his health reforms. And why not tax them? The tobacco groups look healthy financially, says Duff Wilson in The New York Times. Total wholesale revenue in America is estimated at well over $40bn this year. And while the volume of cigarettes sold might drop off by 5%-10%, according to Citigroup analyst Adam Spielman, the big tobacco groups won't lose out, because they can just lift their prices.

Those privileges make the big US tobacco groups a solid defensive bet this year. The number of cigarettes smoked in America might have declined by a third since 1990, according to the American Lung Association, but the big tobacco groups have maintained a profit margin of 30%. Litigation is no longer the earth-shattering threat it once was. Just last week, the Supreme Court ruled that tobacco groups could be sued by consumers for marketing Light' versions of their cigarettes as less life-threatening than their regular brands. The ruling opens the doors for 17 pending Lights' cases nationwide. Yet the stocks haven't budged. "The market is now disregarding litigation," says Adam Spielman.

Vice stocks those related to tobacco and gambling, among others have beaten the S&P by an average of 12% over the past six recessions, say Merrill Lynch analysts. The high dividends that American tobacco groups pay look very solid this time too. With Congress likely to pass the tobacco bill in the coming months, investors will have a solid line of earnings to tap into. The more ethically-minded can take comfort from the fact that Obama will have funds to address the problem of more than 400,000 people dying of smoking-related diseases in America each year. We look at one tobacco giant set to benefit below.

Altria leaves the competition standing

Altria (US:MO) is by some way the largest tobacco group in America. About 73% of its earnings come from its Philip Morris USA unit, which has a 51% share of the American cigarettes industry. Smokeless tobacco accounts for 13% of its business, with volumes growing at 7%-8% a year. Last March the company spun off its Philip Morris International business (see chart).

If the tobacco bill becomes law, says Fortune, it will be in a stronger position still." Altria has control over its earnings to an unusual degree," says Adam Speilman its dominance means "it controls industry profitability".

That's why investors can be fairly confident Altria will deliver earnings growth within its guided range of 8%-10%. There are risks the more the US government taxes tobacco, the harder it will be to grow profits. Stringent regulation could almost rule out new products or marketing, making it harder for firms to innovate, says Spielman. But a change in tastes away from Marlboro seems unlikely. Altria is also likely to win many of the Lights' cases it has a good record of winning such litigation. And given regulation will make it harder for new and existing rivals to compete, Altria's 8.3% dividend yield looks safe. Its shares trade on a forward p/e of 8.8.