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Summary

  • The tobacco industry faces material current and future headwinds.
  • The materialization of these headwinds would be near-fatal to the industry.
  • Two major problems exist for tobacco companies, without desirable solutions.

Philip Morris International (NYSE:PM) has been selling tobacco products since the end of the 19th century, and will continue to sell them long after this article is published. However, there are a few things that can bring an untimely end to the business model of the tobacco industry. Is it the debt load? No, (and here's why). Is it too high excise taxes? No, the EBB and flow of excise taxes (vs. black market trade) imposed by world governments over the years is normal and expected. Is it product banning? No, banning is out of the question because people will continue to buy from the black market, circumventing the taxes the governments need so desperately. Is it because tobacco consumption is in a long-term secular decline? Again no, tobacco consumption is actually rising, contrary to popular belief.

The real downfalls of Philip Morris can be broken into two categories. Right now one is hypothetical, and the other is currently happening. Since December 2012, in Australia, all cigarettes must be in plain packaging with the brand name in a standardized font, virtually eliminating the value of the trademarked brand. Packages may also have grotesque pictures, attempting to thwart smoking. This law is currently being challenged by several countries throughout the world, who have taken their claims to the World Trade Organization court. If the law is upheld by the WTO, many countries around the world have indicated they will likely follow suit and enact similar plain packaging laws. However a report released in October 2013 says tobacco decline in Australia is 0%, despite eliminating nearly all branding and advertising. The report also stated that illicit tobacco trade is running overdrive and is increasingly profitable without paying taxes (much to the chagrin of the Aussie government). I was skeptical at first, however the report is by KPMG, giving it credibility. Not many companies live and die on their reputation quite like KPMG (remember Arthur Andersen)?

The last paragraph was purely objective, now for some subjectivity. I am very alarmed that countries are attempting to ban trademarks of certain companies, because it is a very slippery slope. Where does it end? Perhaps next Australia will enact laws to be a dry country, or all alcohol needs to be a special container with graphic pictures of cirrhosis and such. Next comes laws restricting gambling, guns, fast food, sodas, etc. To me, this is a pointless crusade and censorship at its finest.

Without advertising or branding, there is little differentiation for the consumer; little diversification for Philip Morris; and worse yet, without a brand, there can be no brand loyalty! Why buy a $7 pack that looks the same as a $3 pack? This is the biggest problem facing Philip Morris, and the tobacco industry today. But what is the biggest potential problem in the future?

Nicotine is a highly addictive substance, which separates the tobacco industry from most consumer-discretionary industries. Nicotine, and its addictive properties, is the key behind the pricing power of tobacco, and puts tobacco into the consumer staples category. Without addiction, the tobacco industry goes from an inelastic to elastic market overnight. Tobacco consumption would be another pleasure that people could leave as they pleased. Pricing power becomes an oxymoron for the industry, instead of the foundation it was built on. In a recession people will still need to buy Colgate-Palmolive (NYSE:CL) toothpaste, Procter & Gamble (NYSE:PG) toilet paper, and Altria (NYSE:MO) tobacco. The problem is that scientists the world over are working on a cure for addictions, including tobacco. The article linked is not the panacea, but it is a start, and the vaccine will improve over time. This isn't Nicorette patches or a reduced-risk product, its a shot that reduces the pleasure from nicotine. This is a near fatal blow to the tobacco industry, which now has the same pricing power as a bread company. The gross and net margin contraction from a nicotine vaccine would be material, to say the least.

I don't think they will have a vaccine ready for some time (years), but when it does, it will likely bring the industry to its knees. It will be similar the fate of the personal camera after the popularity of smart phones with a built-in camera. Only those who really want a camera for camera's sake are going to buy them, and the same will go for cigarettes. In a post-vaccine era recession, toothpaste and toilet paper will be bought, but they can skip the tobacco. Tobacco becomes discretionary, and is no longer a consumer staple.

Philip Morris is my largest holding, and I've added in the $90s, $80's and $70's and will continue to add at these lower levels. However, while most investors worry about the short-term, I am only concerned with what will happen in the long-term, and I feel this gives me a distinct advantage over the average investor, as my retirement is roughly 40 years away.

The reason I wrote this article is because Philip Morris is my largest holding and I've given plenty of thought to this topic. I look forward to your comments. More about my portfolio here.

Source: The Downfalls Of Philip Morris And Tobacco: It's Not What You Think