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Slow Growth but Safe Dividends for Tobacco Firms

We see opportunity in Phillip Morris International and British American Tobacco.

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Phil Gorham: Tobacco valuations have taken a big hit over the last 12 months with large-cap global players Phillip Morris International and British American Tobacco down 30% and 50% respectively. Dividend yields are now at a very attractive range in the high single digits, and although we think dividend growth is likely to slow to the low single digits over the next few years, we do think the the dividends are safe and this represents a buying opportunity for investors. 

Investors have been concerned about two things. First, the more assertive approach by the FDA to regulating the industry with proposed measures including a potential ban of menthol flavorings and even a reduction in nicotine levels. And the other thing investors are concerned about has been the recent weakness in the performance of the heated tobacco category in Japan. Iquos, PMI's popular heated tobacco device, will be making its way to the U.S. soon--perhaps this year--and investors that were hoping that heated tobacco would pick up the slack of falling cigarette consumption have been disappointed by a sudden slowdown and growth of the product in Japan. 

On the regulatory front, the FDA's proposed measures are a risk, but the market has assumed the worst-case scenario, and we think that even in the event of a menthol ban, some smokers would switch to nonmenthol cigarettes as has happened in Canada, since it banned menthol in October 2017. In terms of the heated tobacco category, history tells us that disruptive consumer goods rarely follow a straight line growth path and that adoption happens in stages. Investors are overlooking the fact that products coming in the pipeline, including a disposable version of Iquos, could solve some of the issues with first generation devices that have not, so far, appealed to the late adopters in the market. If this happens, we think revenue, earnings, and of course, dividends, can grow for longer than is currently being priced into the stocks.

Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.