Tobacco consumption is declining in the industrialized world as a result of the combined effect of smoking bans and health warning labels on cigarette packages. Nevertheless, tobacco companies do have two things going for them — smoking is still climbing in emerging markets and the litigation threat has decreased with the dismissal of large punitive damages in a couple of key lawsuits.

In addition, the consolidation that has been going on in the sector in recent years as big companies swallowed up small ones, the cash flow that the companies generate, their good dividends and general lack of debt are the reasons Stéphane Champagne, portfolio manager at Signature Advisors, a unit of CI Investments Inc. in Toronto, is enthusiastic about tobacco.

Altadis Group of Paris, with 2.9 billion euros ($3.5 billion) in tobacco sales in the first nine months of fiscal and calendar 2006, is the result of the 2001 merger of France’s Seita SA and Spain’s Tabacalera SA.

There’s speculation that Altadis could be the subject of a takeover bid by Britain-based Imperial To-bacco Group PLC, which had sales of £3.2 billion ($5.5 million) in fiscal 2006, ended Sept. 30. Imperial Tobacco has been on the acquisition trail during the past 10 years since being spun off from Hanson PLC, also of Britain. There have been many, relatively small transactions made by Imperial Tobacco.

There has also been speculation that Altria might go after Imperial Tobacco.

The biggest tobacco producer is New York-based Altria Group Inc. , whose Phillip Morris USA Inc. and Phillip Morris International Inc. subsidiaries had combined net revenue, excluding excise and other taxes, of US$27.1 billion in the first nine months of fiscal and calendar 2006. (All dollar figures are in U.S. dollars unless otherwise noted, and all sales or revenue figures are after excise and other taxes.)

London-based British American Tobacco PLC (a.k.a. BAT) had revenue of £7.3 billion ($12.7 billion) in the first nine months of fiscal and calendar 2006.

Japan Tobacco Inc. of Tokyo, which is 50% government-owned, with tobacco sales of ¥971 billion ($8.1 billion) from April through December 2006 — the first nine months of its fiscal 2007 — is planning to add significantly to that amount with a takeover of Britain-based Gallaher Group PLC, which had sales of £1.3 billion ($2.4 billion) from April through September 2006, the first six months of its fiscal 2007. Gallaher is considering the terms of the offer.

Mergers and acquisitions are obvious strategies in a sector characterized by declining demand in the industrialized world and the need for market access in emerging markets. However, Patricia Fee, money manager at IG International Management Ltd. in Dublin, warns that there’s a risk of paying too much.

The decreasing litigation risk is also very important to this sector. Although there are still lots of cases against tobacco companies, the courts have been rejecting big punitive damages. A key case was the Engle class-action lawsuit in Florida, in which the Florida Supreme Court in July 2006 refused to reinstate the $145 billion in punitive damages previously awarded.

Another important case was the U.S. Federal Justice Department’s charge of racketeering, with claims of $280 billion. In August 2006, a U.S. District Court ruled that the tobacco companies were “guilty of decades-long racketeering enterprise that conspired to hide the dangers of smoking.” Yet the court upheld a February 2005 Appeals Court ruling that disallowed penalties for past conduct. The defendants included Altria and BAT. Altria is appealing the racketeering ruling.

There is still one major case outstanding: the Schwab class action is looking for damages of up to $200 million. Analysts generally assume it will go the way of the other suits.

Global money managers recommend Altria, Altadis and BAT, while they consider Japan Tobacco’s stock price to be too expensive right now.

Here’s a look at the four companies in more detail:

> altadis group. UBS Ltd. has a “neutral” rating on the stock, but increased its 12-month target price on Jan. 15 to 41.20 euros from 37.60 euros based on what it sees as the increased likelihood of an Imperial Tobacco bid for Altadis. The shares were trading at 40 euros in mid-February.

Although relatively small, Altadis has two distinguishing and positive characteristics. First of all, it is the world’s No. 1 cigar maker, which is a profitable niche market. Cigars accounted for 660 million euros, or 22%, of sales in the first nine months of 2006, and 212 million euros, or 25%, of the 865 million euros of earnings before interest, taxes, depreciation and amortization.

@page_break@Second, the company’s logistics business, which involves the delivery of product for many competitors as well as for non-tobacco firms, accounted for 30% of Altadis’ revenue. Other firms have some distribution, but it is far less important to them than it is to Altadis; the business earned 231 million euros, 27% of EBITDA.

Another plus, says Fee, is that the company still has “substantial synergies to exploit in France and Spain through restructuring, factory closings and so on.” Altadis has targeted 215 million euros in related cost savings before the end of 2008.

The biggest negative for Altadis is its heavy exposure to low population growth and declining consumption markets such as Europe, which accounts for 70% of cigarette sales revenue. Its three flagship brands are Gauloise, Gitane and Fortuna. The company plans to globalize Gauloise in the sub-premium segment.

Altadis earned 339 million euros in the first nine months of 2006, down 20% from 423 million euros the year prior. Sales were 2.9 billion euros, down 3% from three billion euros. Net debt as of Sept. 30 was 2.2 billion euros.

> altria group inc. This is the top pick for Champagne and the only tobacco company that Charles Burbeck, head of global equities at HSBC Halbis Partners in London, recommends. Credit Suisse Securities (U.S.A.) LLC in New York has an “outperform” on the stock, with a 12-month target price of $95, up 10% from the $86 the shares were trading at in mid-February.

UBS has it at “neutral,” with a $94 target price.

Argus Research Co. in New York rates it a “hold” and doesn’t provide a target price.

Altria is spinning off its 89% equity interest in Illinois-based Kraft Foods Inc. in March. This will leave tobacco as its sole operating business.

Burbeck says the Kraft spinoff means Altria’s Philip Morris subsidiary “will have the firepower to undertake more acquisitions.”

Champagne likes the exposure to Asia through Philip Morris International. He notes that analysts generally expect a spinoff of Philip Morris International in the next 12 to 24 months because they believe it would trade at a higher multiple as a separate company as it wouldn’t have the litigation risk inherent in all U.S. tobacco companies.

Champagne also views Altria’s 29% stake in Britain-based spirits company SABMiller PLC — acquired when it agreed to a merger of its Miller Brewing Co. with South African Breweries PLC in 2002 — as a plus. SABMiller could be sold to provide more cash, which could be used as working capital or to increase dividends or buy back shares.

Altria’s Marlboro brand is hugely successful, with a more than 50% market share in the U.S. The brand is also sold in many parts of the world, including in emerging markets.

Altria earned $9.1 billion in the first nine months of 2006, up from $8.1 billion a year earlier. Top-line revenue was $52.3 billion, vs $51.1 billion. This includes both the tobacco business and Altria’s share of Kraft’s operations.

Philip Morris International had operating income of $6.2 billion on revenue of $15.9 billion during this period, down from an operation income of $6.3 billion on revenue of $15.5 billion the year prior.

Philip Morris USA had operating income of $3.6 billion vs $3.5 billion on revenue of $11.2 billion vs 10.9 billion.

Altria’s long-term debt as of Sept. 30 was $1.1 billion.

> british american tobacco plc. Fee considers BAT to be the best investment prospect, on a valuation basis. And Credit Suisse recently upgraded the stock to “outperform” from “neutral” and raised its 12-month target price to £16.20 from £15.60. The shares were trading at £15.90 in mid-February.

Fee counts the fact that BAT hasn’t been part of all the M&A activity going on in the sector as a positive, reiterating the danger of overpaying. M&As aren’t a priority for BAT because it already has high exposure to emerging markets, which, she says, account for 75% of BAT’s sales volume and 60% of operating profits.

The company has 180 brands. The four main ones are Dunhill, Kent, Lucky Strike and Pall Mall, which, combined, account for one-eighth of BAT’s sales. The company plans to reduce the number of brands and streamline production. Operating costs are high in Europe and the company wants to reduce the 19 current factories to two — a challenge, given the difficulty in closing factories in Europe, says Fee.

The company’s operating margin is in line with others in the sector, but Fee thinks it could be quite a bit higher.

BAT earned £1.6 billion on net revenue of £7.3 billion in the first nine months of 2006, vs £1.5 billion on net revenue of £6.9 billion a year earlier. Long-term debt as of Dec. 31, 2005, was £5.1 billion.

BAT owns 42% of North Carolina-based Reynolds American Inc., which was formed in July 2004 to hold the U.S. assets of R.J. Reynolds American Tobacco Co. and BAT’s U.S. assets. Reynolds had $8.5 million in sales in 2006.

BAT’s major shareholder, with 29%, is R&R Holdings SA — which, in turn, is 67% owned by Switzerland-based Compagnie Financière Richemont SA and 33% by South Africa-based Rem-brandt Group Ltd. R&R acquired its BAT shares in 1999, when BAT merged with Britain-based Rothmans International PLC, which Richemont and Rembrandt co-owned.

> japan tobacco inc. A takeover of Gallaher would get Japan Tobacco into the British market, the most profitable in western Europe, according to Fee. Gallaher has 38% of the British market, vs just 1% for Japan Tobacco. The deal, if successful, would also add to Japan Tobacco’s presence in Russia, where it has an 18% share and Gallaher has 17%.

Fee says most analysts don’t think there will be much in the way of synergies for the Gallaher operations because that company is already one of the lowest-cost producers.

Japan Tobacco also has operations in pharmaceuticals and food, but tobacco dominates, with 79% of sales and 98% of operating profits in the first nine months of fiscal 2007. Pharmaceuticals had 18% of sales, but just 2% of operating profits; food sales were just 3% and had an operating loss.

In Fee’s view, Japan Tobacco is a very strong company with lots of cash. It also has the advantage of only four global brands — Camel, Winston, Mild Seven and Salem — while most other companies have many more. The company has a few other domestic brands and a 65% market share in Japan. However, Fee views the stock as expensive and considers Gallaher even pricer.

Japan Tobacco earned ¥193.4 billion in the first nine months of fiscal 2007, up from ¥164 billion a year earlier. Revenue was ¥1.24 trillion, vs ¥1.22 trillion.

The company also produces forecasts for upcoming fiscal years. As of Feb. 8, the forecast for fiscal 2007 ending Mar. 31 was ¥206 billion in net income, up from net income of ¥201.5 billion last year. Japan Tobacco had interest-bearing debt of ¥221.2 billion as of Dec. 31.

Half of its two million shares outstanding are owned by the Japanese government; the rest are widely held. The shares were trading at ¥530,000 in mid-February. IE