RJR Nabisco Holdings Corp. is the second-largest cigarette maker in the U.S., with about a 25% market share. Its brands include Camel, Winston, Salem and others. Investors value its stock at about $8.1 billion.
It also owns more than 80% of the stock of Nabisco Holdings Corp. Nabisco Holdings makes Ritz Crackers, Oreo Cookies and a variety of other packaged foods. Based on the value of the 19.5% of Nabisco that trades publicly, RJR's holding in Nabisco is worth about $7.5 billion.
The investment math here is Alice-in-Wonderland stuff. By implication, investors have lately been putting only a $500-million value on RJR's tobacco business, which in 1997 generated sales of $17 billion and profit of $381 million. At times this year, the relative values have been even more extreme, so that the implicit value of the tobacco business was negative.
RJR Nabisco's tobacco unit, then, is selling for just more than one times recent annual earnings. You can argue about whether the figures should be debt-adjusted, and if so how, but the obvious point is that a $17-billion business is being priced at a song.
The only way to explain such a radical pricing anomaly is that investors think a total wipeout is likely. They expect the tobacco industry to be either legislated or sued out of existence.
My firm thinks differently. We have a substantial investment in RJR Nabisco, as well as several other tobacco stocks.
Here's how I see the odds. I believe there is a better than 50% chance that Congress will eventually give the tobacco companies some liability protection, in the form of an annual limit on payouts for lawsuit damages. I believe the lid will be set low enough so that the tobacco companies can stay in business and earn a profit.
Why? It is not because they deserve to. There are three other reasons why Congress will save tobacco's neck.
First and foremost, despite recent setbacks, many in Congress still hope to spend the money from a big anticipated sin tax increase, probably $1.10 to $1.50 a pack. If Congress kills the goose, it won't get to play with the golden eggs. Second, the tobacco industry is a major employer in several states. Third, the tobacco industry is a major political contributor.
The political heat in an election year may be too great for Congress to give the industry any form of liability protection this year. Still, I believe such protection will be forthcoming in 1999, if not before.
In addition, I believe there is at least a 50% chance that if the parties are left to slug it out in the courts, tobacco companies will win a fair number of the legal rounds. Clearly, the industry no longer looks invulnerable. It has now been hit for both actual and punitive damages.
But there's a big difference between losing your undefeated status and being forced into early retirement. Chemical companies, oil companies and auto companies all have lost major suits and lived to fight another day. Perhaps tobacco will too.
One person who apparently agrees with this line of thinking is Gary Black, a Sanford C. Bernstein & Co. tobacco analyst. He said last week that, despite some adverse court rulings lately, he doesn't expect plaintiffs to win "fistfuls of dollars" by suing the tobacco industry. He notes that close to 90% of Americans are against allowing ex-smokers to win damage awards.
Black and several other tobacco analysts are recommending RJR stock. The Bloomberg database counts seven "buys" and two "holds." As a contrarian, it makes me a little nervous to have so much company, but as a nervous bull I'm glad they feel that way.
If you put together the possibility of liability protection and the possibility that the industry can hold its own in court, what do you have? As I reckon it, you have at least a 75% probability that the tobacco industry will continue in a form bearing some resemblance to its present one.
And if those odds are indeed correct, then RJR Nabisco's valuation becomes a bargain hunter's enticement. Buy a food company and get a huge tobacco company virtually free.
When you look at the entire package of food and tobacco, RJR stock sells for less than nine times estimated 1998 earnings per share. (At the moment, analysts are guessing that the earnings will be about $2.94 a share.) That is little more than one-third of the multiple on the stocks in the Standard & Poor's 500 index.
RJR stock sells for less than stated book value (corporate assets minus liabilities per share)--a real rarity these days. And it sells for only 0.47 times sales, which is also extremely cheap in today's market.
Some people may say that Nabisco itself is overpriced. With the stock selling at about 28 times estimated 1998 earnings, I wouldn't quarrel with that. But if you want to get fancy, and you have confidence that the U.S. tobacco industry will survive, you could sell short Nabisco shares while buying RJR shares. That way you have a pure play on the cheap asset, which is RJR's tobacco business.
Is the selling of tobacco immoral? Yes, in my opinion. But it is legal, under current law and under likely future law. Americans don't seem to have a big appetite to repeat the experience of Prohibition.
Cigarette smoking remains much more popular in Europe and Asia than it is in the U.S. And RJR gets about 36% of its sales abroad. Other countries will regulate tobacco use sooner or later, but few of them will move as far or as fast as the U.S.
Meanwhile, RJR has some time to continue its transformation into a food company, and possibly to attempt other forms of diversification.
So while smoking is an irrational bet, buying RJR stock, in my opinion, is not.
John Dorfman is a Boston-based money manager with Dreman Value Management and writes regularly for Bloomberg News. His firm or its clients may own or trade investments discussed in this column.
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RJR Nabisco Holdings has seen its share price drift lower with negative sentiment about the tobacco business. The company also owns about 80% af Nabisco Holdings.
Monday close: $24.94