Warning: Tobacco Shares Best Suited to Industry Loyalists

Tobacco stocks -- long despised by the public and a disappointment to investors -- have bottomed in recent weeks. Shares of Philip Morris (MO Quote) and Loews (LTR Quote), for example, hit their three-year lows in February and March and since then are up 21% and 6%, respectively. R.J. Reynolds (RJR Quote) is up even more, close to 50%.

But if you're jazzed up about the recent strength, take a closer look. You'll see a business that's less than thoroughly compelling.

The proximate cause of the rally is proposed legislation in Florida to remove the threat of bankruptcy facing the cigarette makers from a class-action lawsuit filed there. A six-member jury has ordered the industry to pay $12.7 million in compensatory damages to three sick smokers in the Engle case -- a class-action suit named for one of the plaintiffs, a Miami Beach pediatrician with emphysema.

But the millions in compensatory damages are nothing compared with the possible punitive damages the judge in the case could hit the companies with. Wall Street analysts have pegged these damages in the stupefying range of $100 billion to $300 billion. (To put that into context, the market capitalization of Philip Morris, the industry giant, is about $55 billion.) If the companies were forced to post a gargantuan bond to appeal the Engle case, the financial burden could force them into bankruptcy.

Politicians in the Sunshine State are not coming to Big Tobacco's aid out of overwhelming sympathy. It's all about money. Bankrupting the tobacco companies is not in the fiscal interest of the state of Florida. The state settled its legal case against the companies in 1997 in exchange for $13 billion payable to Florida over 25 years. A bankrupt tobacco industry would endanger those payments. The money has already been built into hundreds of political promises.

SB1720 -- or the "Engle fix," as the Florida Senate bill is better known -- would do two things: It would state that no punitive damage award is allowed to bankrupt a company, and it would cap the bond companies pay on punitive damages in a class action. The cap would be the lowest of $100 million, 10% of the net worth of the defendants or the actual jury award.

The Engle fix is expected to sail through the Florida House. With the Republican-controlled legislature slated to quit Tallahassee by the end of Friday, the legislation could end up on Gov. Jeb Bush's (R) desk very soon. Bush, who has 15 days to act, has said he will support the measure to protect the state's tobacco settlement revenue.

Still Breathing, but Not Too Lively Philip Morris, Loews and R.J. Reynolds vs. the S&P 500

The industry and its boosters on Wall Street say they are convinced Engle will be reversed on appeal. One top industry executive likens the legislation to a "belt and suspenders" approach. "We expect the case to be reversed on appeal, but the bill gives us the time to make an orderly appeal and post a bond without fear of bankruptcy," the executive said. It is the respite that has moved tobacco higher in recent weeks.

Investors who own tobacco or are considering it must look beyond the Engle case, of course. A more fundamental question remains: Why should you bother to invest in cigarette companies given the whirlwind of litigation swirling about them nationwide? Only if you believe that the underlying businesses remain strong and that the share prices are low enough discount the possibility, however remote, that the companies could still be driven into bankruptcy.

Business looks surprisingly good, by some measures. Profits continue to grow. This year analysts estimate that for Philip Morris and Loews earnings per share should grow 13%. Last year, massive cigarette tax hikes boosted retail prices in the U.S. an average 30%, and corporate revenue fell only 8%, according to Morgan Stanley Dean Witter analyst David J. Adelman.

Revenue growth, however, is not spectacular. Growth requires a company to take market share from competitors. For instance, Philip Morris saw tobacco shipments grow 7.2% in the first quarter compared with a year ago; that came at the expense of competitors, who saw their shipments grow only 4% on average. Or growth comes from overseas sales. Among U.S. companies, only Philip Morris has true global reach. RJR has struggled abroad, and Loews is strictly domestic.

There is no doubt that tobacco shares are cheap. Philip Morris and Loews trade for about 5 times this year's estimated earnings. Philip Morris sports a dividend yield of about 8%.

On the other hand, an 8% dividend suggests that investors are not sure the company will be able to make the payments into the future. Tobacco company shareholders may have the businesses taken from them in litigation. The risk may be low, but it is real.

That's why even those investors who love the profits of selling cigarettes rarely have more than 5% of their money in the sector. Says one: "I think that we will eventually come to our senses and the rule of law will lead to a world less hostile to the companies than current prices are discounting. But I have a small investment in these companies. You can't have the certainty required to make tobacco a big investment."

So even if you can surmount any moral qualms about owning shares in companies whose products tend to kill people even if used normally, you may not want to be a three-pack-a-day investor.

A useful site for tobacco industry information is Tobacco BBS, at http://www.tobacco.org.