The tobacco industry in the U.S. has flourished despite excise tax hikes, marketing restrictions and growing health consciousness. Even as the consumption of cigarettes in the U.S. has declined steadily, Big Tobacco has leveraged its pricing ability that comes from relatively inelastic demand and strong brand loyalty to boost profits. However, the economics of the industry are changing rapidly due to the growing popularity of other nicotine alternatives, such as smokeless tobacco and e-cigarettes. The sensitivity of the demand for traditional cigarettes to price changes has increased over the past few years, which increases the potential downside of these companies from further excise tax hikes and other FDA regulations, such as a ban on menthol cigarettes. Here we estimate Altria’s (NYSE:MO) potential downside from the implementation of a proposed federal tax hike on cigarettes.
Altria is one of the largest tobacco companies in the U.S. with over 50% market share in cigarettes and smokeless tobacco products. The brand portfolio of Altria’s tobacco operating companies include well known names such as Marlboro, Copenhagen, Skoal and Black & Mild, and markets premium wines sold under various labels including Chateau Ste. Michelle and Columbia Crest. According to our estimates, cigarettes and smokeless tobacco products drive more than 85% of Altria’s stock price.
Federal Tax Hike
Despite all the challenges faced by the tobacco industry in the U.S., its dollar value has actually grown steadily over the years. This is because the Big Tobacco companies have been able to more than offset the decline in cigarette consumption through pricing measures. The sticky nature of the demand for cigarettes due to its inherent addictive nature and consumer brand loyalties has greatly helped the tobacco companies. Altria, the biggest player in the market, has been able to grow its adjusted operating income, primarily from the sale of cigarettes at more than 8% CAGR since 2009.
Historically, the price elasticity of demand for cigarettes, which is a measure of the sensitivity of their demand to price changes, has been in the -0.3 to -0.4 range.  However, a steady increase in this metric has been observed over the last few years. Over the 3-year period starting 2009, Altria’s average revenue per cigarette increased over 14% on price hikes primarily driven by excise taxes while its shipment volume declined by more than 9%, implying a price elasticity of -0.65. If this trend continues, the market for traditional cigarettes will deteriorate at a much faster rate than seen in the past.
In the U.S. government budget plan for fiscal 2014, there is a provision for a steep federal tax hike of $0.94 per pack of cigarettes.  If implemented, the impact of this measure on the tobacco industry will be huge. Just to give some perspective, the proposed hike in federal tax on cigarettes will imply an ~30% hike in revenue per cigarette, which could translate into a sharp 20% decline in volumes at an assumed price elasticity of -0.7. We currently project the consumption of cigarettes in the U.S. to decline at 3-4% CAGR in the long run due to indirect tax hikes at the state level and growing popularity of alternatives such as e-cigarettes. We also expect the proposed federal tax hike to face strong opposition from the industry. However, if implemented, it will imply more than 10% downside to our current $38 price estimate for the company.
Disclosure: No positions.