Shares of tobacco companies have been having an excellent year this year. The primary impetus behind this move was the proposed merger between Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO). This would reduce the number of primary competitors in the United States from 3 to 2 [with the other being Altria Group (NYSE:MO)]. It would also create synergies between the two merging companies, who could reduce their total number of production facilities. Analysts estimate that the savings could reach $400 million, and at 20-times earnings that amounts to $8 billion in market cap.
However, one tobacco producer has largely been left behind—the largest company in the industry Philip Morris (NYSE:PM). Philip Morris is an American-headquartered and listed company, but it sells exclusively overseas. The company was formed when Altria Group spun the company off in 2008 so that investors could have a choice between investing in the domestic Altria Group or the international Philip Morris.
The latter company has underperformed as of late and this has caused the stock to underperform as well. But now the shares trade at a significant discount to its American peers—about 20 percent on a price to earnings basis—and while tobacco companies aren’t fast growers they are stable cash-flow generators, and with Philip Morris trading inexpensively relative to its peers it makes sense to at least consider taking a position for the intermediate term in the hopes that over the next year or so the company can recover and the valuation gap will be bridged. Such a bet can be worth 25 percent plus 4.5 percent in dividends with all things being equal.
I am not so bullish on the tobacco industry given the decline in tobacco use in the United States, but Philip Morris may be an exception. The company has a couple of advantages that its American counterparts lack. The first is exposure to foreign currencies. Despite loose monetary policies all over the world global currencies have begun to strengthen against the dollar. This is especially true for emerging market currencies, which had been underperformers in the past couple of years. In fact, weak emerging market currencies can account for some of Philip Morris’ underperformance over the past few months, as this weakness has impacted the company’s year over year comparisons. But with these currencies strengthening again and with the long-term secular decline in the dollar, it makes sense that Philip Morris will recover. It also makes sense from a portfolio strategy perspective to own a stable cash-flowing asset that will benefit from relative strength in foreign currencies.