Tobacco Stocks: What to Watch in 2018

Markets Motley Fool

Stocks of all major tobacco companies produced gains in 2017, though some, like Philip Morris International (NYSE: PM) and British American Tobacco (NYSE: BTI), did much better than others, growing by double-digit percentages.

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Although having a global outlook helped those two outpace domestic giant Altria (NYSE: MO), which gained only 7%, all the players remained very profitable and their dividend yields remain among the most attractive across many industries.

With cigarette smoking still on the decline and electronic cigarette usage continuing to rise, these are five key things tobacco investors should watch in 2018.

1. How will the FDA regulate next-gen e-cigs?

Investors should get a pretty good idea of what's in store at the regulatory level for next-generation "heat-not-burn" (HNB) e-cig technology when the Food and Drug Administration holds a hearing on Philip Morris International's iQOS device at the end of January.

The purpose of the hearing is to determine whether the device has earned a reduced-risk classification, which could give it a competitive edge over other e-cigs on the market. While it seems intuitive that inhaling a vapor is safer than ingesting smoke, the integrity of the tobacco giant's clinical tests was recently called into question, which tosses a wild card into the process. In addition, it's worth noting is that the agency has only, until recently, sought to control the proliferation of e-cigs.

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Also on the table, if not on the agenda, is whether Philip Morris will be able to market the iQOS without the reduced-risk designation. The decision it receives on that question will probably color whether British American Tobacco moves forward with its competing HNB device, the iFuse glo. BAT previously said it intended to file a marketing application in 2018 for the glo, but its plans may change if the FDA comes down hard on the iQOS.

2. How the FDA regulates nicotine levels in cigarettes

Last July, the agency announced that it was in the early stages of developing a plan to require tobacco companies to cut the level of nicotine in cigarettes to "non-addictive" levels. If the regulator finds the acceptable amounts of nicotine to be virtually negligible, it could well lead to an effective ban on combustible cigarettes.

Still, the FDA has yet to actually begin the public rule-making process, and if it looks like it will move toward stricter regulation of nicotine levels, the tobacco companies -- not to mention politicians from tobacco-growing states -- will weigh in. Moreover, there's some question about whether those new rules would apply to e-cigs, many of which feature liquids containing high levels of nicotine.

3. State and local tax hikes

When California raised its excise tax on cigarettes by $2 per pack last year, it was Altria that took the brunt of the impact because its Marlboro brand has a 50% share of the market in the state. In June, the minimum price for a pack of cigarettes purchased in New York City will surge 25% to $13 -- just one facet of a package of regulations Mayor Bill DeBlasio signed into law with the goal of reducing tobacco consumption.

On Jan. 1, Connecticut and New York will be the states with the highest excise tax on cigarettes at $4.35. The highest combined state and local tax rate is $6.16 per pack in Chicago; New York City will place second at $5.85 per pack, though as noted, that will rise later in the year.

4. The impact of smoking bans

Localities continue to implement bans on where people are allowed to smoke. For example, the seaside town of Wildwood, N.J., will ban smoking on its boardwalk beginning with the New Year, but of greater import may be the federal ban on all smoking in public housing that all public housing agencies must have in place by July 30. It broadly covers multifamily units, single-family units, and even scattered development projects. It bans the use of cigarettes, cigars, pipes, and hookahs, and although electronic cigarettes aren't specifically covered, the rules allow public housing projects to ban them as well.

5. Industry consolidation

Although the number of industry players has been dramatically reduced over the past few years as Reynolds American acquired Lorillard and then British American bought up the remaining 58% of Reynolds it didn't already own, the potential for a smaller player to be acquired still exists, as does the possibility of Philip Morris International and Altria recombining.

While the ability to invest in domestic and international cigarette sales separately remains a strong selling point for their stocks, rising U.S. interest rates could spur Philip Morris International to push for a reunion with Atria, particularly now that the two are collaborating on reduced-risk products.

Will tobacco remain strong in 2018?

While there are many headwinds blowing against tobacco heading into 2018, they're largely the same ones the industry has faced for years. Cigarettes, even as a declining business, will remain profitable, and with the potential for new technology to bring major growth to the electronic cigarette market, the coming year could be an exciting one indeed.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.