Why Altria Is A Profitable Opportunity

Dec.21.13 | About: Altria Group, (MO)

Stringent regulatory environment, added pressures from anti-tobacco groups and the increased awareness of health effects of cigarettes have finally taken their toll on cigarette manufacturers. The recent results of major cigarette manufacturers show a net decline in cigarette volumes across the board as small gains in lesser developed/emerging markets were not enough to offset the downhill trend in the much larger and developed markets.

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Source: Financial Reports of Companies

As can be seen from the table above, cigarette volumes have declined significantly over the first nine months of 2013 compared to the previous year. Although all of the companies were able to completely or partially offset the negative impact of volumetric decline through price hikes, the possibility of continuing this strategy in the future is going to be difficult due to the declining demand for tobacco.

Pushed by the falling demand of tobacco sticks, large tobacco companies have finally entered the market of its natural replacement. Although E-Cigarettes have been around for quite some time, it is only now that the tobacco manufacturers have accepted the potential threat and the commercial viability of the product. Apart from Lorillard (NYSE:LO) which entered the e-cigarette market in 2012 with the acquisition of BluEcigs, one of the largest e-cig companies in the US, almost all major tobacco companies entered the market of e-cigarettes in 2013. With the e-cigarette market poised to grow at a CAGR of 38 percent through to 2017 and expected to surpass traditional cigarette sales by 2047, the opportunity in the market for e-cigarettes is immense and presents itself as the only viable source of growth for tobacco companies amid the declining demand and increasing regulatory squeeze.

Recent News and Potential Impact

As per recent news, a commercial court in France ruled that e-cigarettes qualify as tobacco products and should only be sold by registered tobacconists. This comes in as game-changing news to the emerging industry and if this takes precedent in the rest of Europe or the US the impact will be far reaching and potentially harmful to the nascent industry.

Although the ruling is still under appeal, it implies that e-cigarettes should be treated as tobacco products which means less advertisement and limited supply channels. The emerging industry has been able to gain momentum in the last year or so through compelling ad campaigns and celebrity endorsements. However, the new French court ruling means that there will be restrictions on advertisement and this could adversely impact the growth of the industry.

The court ruling also states that e-cigarettes can now only be sold through registered tobacconists, meaning that the only retail channel open to e-cigarettes would be that which is already saturated by the traditional tobacco companies. Currently a large proportion of the sales of e-cigarettes have been through the internet and this in some part has enabled the manufacturers to operate at higher margins than traditional cigarette manufacturers. The new ruling restricts the sale of e-cigarettes via the internet and also through general merchandise and retail outlets. The lack of availability of the product may also adversely impact the sales growth of e-cigarettes in the future.

Although the ban is still under scrutiny and limited to one country, the possibility of other nations following suit is not a farfetched proposition. Recent developments in the European Union tend to suggest that the idea of stringent regulations on e-cigarettes is more than likely to occur and the decision of the French court, if upheld in the appeal, will be strike one for the e-cigarette industry.

Within the US, the largest market for e-cigarettes, the situation is not that different. The desire of FDA to bring e-cigarettes under its regulatory authority and impose strict control on the product is no secret. Currently, the FDA is still contemplating the issue and is expected to announce regulations with regards to e-cigarettes soon. It is expected that the new FDA regulation will likely push e-cigarettes under the tobacco product umbrella and enforce similar regulations as with traditional tobacco products.

Impact on Manufacturers

If the ban is imposed and transcends across borders, I believe the e-cigarette market dynamics will heavily tilt towards the major tobacco companies. This belief is based on the fact that once regulations go into effect marketing and selling of e-cigarettes will become awfully similar to that of traditional tobacco products. Over the years large tobacco manufacturers have established industry links and expertise in operating their businesses in this manner while the new e-cigarette companies are still heavily dependent on online sales and would need to spend heavily in establishing a new wholesale network. The new regulations will only be business as usual for large tobacco companies and will have no significant adverse impact. With the restriction of sales of e-cigarettes to minors already in place in some states, I believe that the new regulations might not significantly hinder the growth in demand for e-cigarettes in the US due to the existence of the large network of registered tobacco sellers. This will not impact the availability of the product for users; however, it will have a negative impact on the reach of smaller e-cigarette companies to its existing user base.

Based on this, I believe that once these regulations come into play, large manufacturers will be able to benefit precisely due to their large size, available resources and established networks. I believe that going forward in a post-regulation environment, there is a possibility of major consolidation within the e-cigarette market with smaller companies willing to sell off their assets and brands to larger players in an attempt to decrease the time and investment needed to reach the end users. Given this, I have identified two companies that provide the most profitable exposure to the e-cigarette industry and are expected to capture a larger market share over the next few years. Lorillard, through its first mover advantage, and Altria (NYSE:MO), due to its strong financial position, are likely to enhance growth in the e-cigarette market. Within this market Lorillard has a superior outlook given the fact that the company's brands are some of the biggest e-cigarette brands in US and UK via the acquisition of BluEcigs and Skycigs. The company already has an established demand and user base. However, due to the expected ban or phasing out of menthol cigarettes in the US, which constitutes approximately 90 percent of the company's total revenues, Lorillard does not present itself as a profitable investment opportunity.

Altria, on the other hand, is only partially dependent on menthol cigarettes with approximately 20 percent of the company's sales coming from this category. Altria is the largest cigarette company in the US holding approximately 47 percent of the market share. From amongst the peers selected, Altria has the largest potential for growth as the successful launch of its e-cigarette brand and the strong financial position the company can greatly benefit from the expected trends in the industry as mentioned above.

Financial Performance and Position

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Source: Company Financial Reports

As can be seen in the figure above, the company has achieved superior performance over its peers during the first nine months of 2013 despite dropping volumes. The company achieved the highest growth in earnings, free cash flows and cash balances and the slowest growth in total debt. Altria was the only company amongst its peers to see a positive change in its book value per share and debt to equity ratio.

This puts the company in a more favorable position than its peers to be able to fund its future growth. On the backing of the successful launch of e-cigarettes in one state, the company has already initiated the expansion of sales in a second state and it will not be long before it starts pushing its new product throughout its existing markets. The ongoing corporate restructuring and cost reduction, debt reduction and low investment needs means that the company sits on ample resources to fund future growth. This is the reason why I believe that Altria provides a profitable opportunity to gain exposure to e-cigarettes during times when the regulatory environment is changing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.