Smoke ’em if you got ’em

The tobacco space, from an investment perspective, is fraught with peril.  That said, Tobacco Bonds are some of the most liquid and highest yielding segments of the US municipal bond market.

Smoking rates in the Developed World have plummeted (less than 20% of Americans currently smoke versus peak levels of 30% when 53% of men smoked, in the “Mad Men” era). Smoking rates in the US have declined, on average 3.3% per annum from 2000. US cigarette shipment are set to print their first positive growth print since 2006 in 2015, which has resulted in a rally (9% return ytd) in high yield tobacco bonds, after a stonking 19% rally in 2014. Most see this uptick as an outlier, with the downward consumption trend firmly in place.

Perhaps the largest Structured Settlement case study ever is the “Tobacco Bond” segment of the municipal market where US States (17 of those States eligible to do so) securitised a portion of the approx. $206bln Master Settlement Agreement (MSA) made with the major tobacco companies in 1998. Over $90bln of Tobacco Bonds have been issued. There are $32bln in senior lien (par amount) outstanding with $19bln rated below investment grade. Phillip Morris, Lorillard and Reynolds American agreed to make annual payments to US States to resolve liabilities for health care costs related to smoking. The bonds were largely issued on a non-recourse basis, hence the bond investors have their repayment prospects tied to on-going cigarette shipment volumes. Many of the bond structures underestimated the pace of smoking cessation and the rating agencies estimate upward of 80% of the o/s bonds will result in a partial loss of principal (extension of maturity dates in most cases). Plenty of clever muni houses troll in this space which is likely the best way to gain exposure given the inherent complexities in selecting specific bonds. Most funds limit their exposure to the space to 15-20% of fund AUM. One of my favourite bonds in the space when still on US soil, in the top Federal tax bracket, was Illinois $1.5bln “Railsplitter” deal of 2010 which was structurally superior to all before it in that with a 17.5 year maturity (many deals had 30+ year final maturities) and it was able cover debt service even with smoking rates declining by 10% per annum (levels still never seen).

Asia tobacco sidebar: Recent cigarette stats out of China are beyond comprehension, where it was recently reported that  68% of males > 15 year old currently  smoke cigarettes. The “normal ratio” of male to female smokers is 5:1 but in China is approaches 20:1 with a scant of women 3.2% partaking. A full 1/3 of all cigarettes sold globally are sold in China (versus their 17% population weighting). Nobody to sue here, as China Tobacco runs the show. Tobacco related revenues account for upwards of 7% of China government revenues presently. A full 30% of Chinese males are projected to eventually perish from smoking related illness at current consumption levels. Next to be sorted will be the price elasticity equation, as these heady revenue numbers are achievable with a pack of Yellow Crane Tower smokes selling for US$0.40 equivalent! With the near nationwide ban on smoking in US prisons (the US has 5% of the world’s population but incarcerates 20% of the world’s prisoners) there are reported cases of single prison cigarettes selling for US$30.00. Odd that the US would push for such a government sponsored longevity study when the cost per inmate is so high, but that is a topic for another day. In India, over 75% of cigarette consumption is in single cigarette (aka loose) format, a practice Modi would like to ban but enforcement will be all but impossible. ITC controls 80% of the tobacco trade in India and they are sold through 7mm+ establishments (sole proprietor corner stores primarily).

Phillip Morris (PM) equity trades at a PE of 19x with a dividend yield of 4.67%. Reynolds-Lorillard (RAI) merged in mid 2015 and sports a PE of 17% and a dividend of 3.11% (Reynolds bought the 4th signatory to the MSA is 2004). For those willing to put in the work there could be compelling “hedged high yield” trades worth considering where you buy the tax exempt tobacco bond (most effective for those in the highest 38.6% Federal tax bracket)  and hedge via shorting PM and RAI stock to your deemed recovery value. Higher order analysis is required as the Tobacco Bond coupon is tax exempt (muni interest is not subject to 3.8% Obamacare investment tax either) and you would be cross hedged in a taxable instrument with a high dividend which you would be on the hook for. If you think big tobacco equity is fully valued + and that there is too much pessimism built into the high yield Tobacco Bonds, this strategy certainly reduces the funding cost of the position. JCG