Philip Morris (NYSE:PM) may have gotten into the e-cigarette market at precisely the wrong time. The market for e-cigarettes has been growing quickly, but as it grew the calls for legislation became louder. The FDA's original stance on e-cigarettes was considered too soft by 29 attorneys general. They penned a letter to the FDA, available here. This may come as bad news for Philip Morris, which in June purchased Nicocigs Ltd. It should be noted that Philip Morris, brilliantly, does not have direct exposure to the U.S. market. The company's revenues primarily come from the EU, Middle East, Africa, Asia, Latin America, and Canada. If there is an increase in legislation in the U.S. it may increase competitive pressures abroad as companies would need to redirect their products to other markets. Nicocigs Ltd. commanded about a 27% market share in the U.K. and Philip Morris felt their product would be a great complement to the products they licensed and distributed from Altria Group, Inc. (NYSE:MO).
Fortunately, or perhaps wisely, Philip Morris became legally separated from Altria group in March of 2008. As a separate company, that still has transactions with Altria, they have acquired companies across the globe. However, any legislation against e-cigarettes could hurt potential business down for the road for Philip Morris. Philip Morris has exposure to the U.S. market in two ways. One is through an agreement with Altria. Under that agreement Altria is able to use some Philip Morris products in the U.S. in exchange for Philip Morris using the Altria group products outside of the U.S. The second form of exposure comes from the international market's competitive position. If there is a sudden increase in legislation that limits U.S. sellers, they may need to unload their inventories onto the international markets. In late June Philip Morris provided guidance towards earnings of $4.87 to $4.97 per share. As reported in The Independent, CEO André Calantzopoulos said the introduction of "reduced-risk" products put the industry in the early stages of a transformation process.
The call for legislation, documented by the WSJ, included several key points. Specifically, the attorneys general asked the FDA to:
1. Prohibit characterizing flavors other than tobacco and menthol in e-cigarettes and other tobacco products
2. Restrict the advertising, marketing and promotion of cigarettes and smokeless tobacco, as well as strengthening and updating those restrictions
3. Strengthen the health warnings for the deemed tobacco products
4. Restrict the advertising, promotion, and sale of all tobacco products over the internet
5. Define e-cigarette components and parts and apply the proposed restrictions on age verification, vending machine sales, and health warnings regardless of whether such components and parts contain nicotine
6. Include "premium" cigars in the deeming rule
7. Regulate pipe tobacco to prevent avoidance of regulations applicable to tobacco actually used as roll-your-own tobacco
If the FDA actually follows the advice of attorneys general it could be devastating to the industry in the U.S. and damaging abroad from increased competition. Since those requests feel quite abstract, let's go through them individually.
E-cigarettes managed to avoid some problems by avoiding being classified as cigarettes. Back on September 22, 2009, a ban on flavored cigarettes went into effect. The flavor "menthol" was still allowed, but more appealing flavors were criminalized. To cite the law, as written by the FDA under the authority of the Family Smoking Prevent and Tobacco Control Act:
"…a cigarette or any of its component parts (including the tobacco, filter, or paper) shall not contain, as a constituent (including a smoke constituent) or additive, an artificial or natural flavor (other than tobacco or menthol) or an herb or spice, including strawberry, grape, orange, clove, cinnamon, pineapple, vanilla, coconut, licorice, cocoa, chocolate, cherry, or coffee, that Is a characterizing flavor of the tobacco product or tobacco smoke"
E-cigarettes do not create smoke. They create vapor. Therefore, according to the prevailing logic, they are perfectly fine to use flavors. As you can see, they had no problem incorporating flavors.
Restricting the advertising
This could really cut into the growth for the market. If you think the fruity colors are just innocent appeal to customers, check out one of the ads for e-cigarettes:
I have no affiliation with the provider of that video.
For anyone that doesn't wish to view the video, it's a man in his twenties (my estimate) talking about the benefits of the e-cigarette. One of the benefits is that he can enjoy them at work or in restaurants. I think they sent the wrong message, because the visible and public consumption may encourage more voters to ask for legislation against the product.
The CDC has been vocal in their opposition to the wide spread use of e-cigarettes by minors. The director refers to it as "deeply troubling". From 2011 to 2012 the percentage of teen's that had tried e-cigarettes rose from 4.7% to 10.0%. Further, the study also showed "76.3% of middle and high school students who used e-cigarettes within the past 30 days also smoked conventional cigarettes in the same period.
From a business perspective, recruiting children to an addictive drug makes perfect sense. From a humanistic perspective, it's morally disturbing. Returning to the letter sent to the FDA, on page 15 it states: "The adolescent brain is particularly vulnerable to nicotine addiction. Adolescents are also less susceptible to withdrawal symptoms, creating an all-reward, no-regret system for psychostimulant use."
Strengthen the health warnings
I really don't see this being an issue. I have a hard time imagining that people trying a cigarette for the first time are reading the box.
Restrict the advertising, promotion, and sale of all tobacco products over the internet
This could be another serious hit to the industry. In January 2012, another letter was sent to the FDA urging a ban on sale of tobacco products over the internet because it was a "significant source of sales to minors".
Define e-cigarette components regardless of whether they contain nicotine
Again, this would really cut into the e-cigarette segment. The attorneys general are attempting to close down a loophole that would otherwise have rendered a great deal of the legislation useless. I would consider this a significant blow because it would make it more difficult to acquire components. If I wanted to start smoking e-cigarettes, this loophole being closed, combined with a ban on purchasing it over the internet, would force me to actually drive to a store and possibly be carded. Not a problem for me, but definitely a concern for teens.
Include "premium" cigars
This is another loophole that was being used to classify products as various types of premium cigars and thus avoid the legislation that was intended to impact them. These loopholes are valuable to the industry. They may seem abstract, but the money to make those dividend payments flows through the loopholes.
Regulate pipe tobacco
This solves another loophole where tobacco would be categorized as being for the intent of the less regulated use. Again, the legislation is meaningless if the loopholes are not closed.
If the FDA acts seriously on these requests it could deal a very damaging blow to the industry by dramatically reducing their prospects for long run growth and higher margin business. However, I do not expect the FDA to act on all of the requests. I am not a lawyer, but I am a cynic. Given that the cigarette industry has dramatically more invested in the long term effects of these decisions, I would expect lobbying dollars to find the right homes and the resulting legislation to at least retain some of the loopholes. The media would be able to portray it as a victory, the industry would portray it as a loss, but then earnings would continue as usual if the loopholes are not closed. That's just my prediction though. Using Yahoo's price history for the last year, it looks like the market either hasn't taken the attorneys general seriously, or does not believe the existing supply of U.S. based inventory would have a significant impact on pricing abroad.
The "huge" drop in late June was when Philip Morris lowered the earnings guidance.
Overall, I'm concerned about the risks facing the company, but I think they will be capable of protecting their distribution chains. I think it is more likely than not that lobbying dollars find the right ears and get the right loopholes to keep going. So long as that happens, there shouldn't be a huge increase in exports that would have a large impact on Philip Morris. . I would be very concerned about holding a large undiversified position in the stock, but in the context of the portfolio I think PM has a place. Compared to the companies conducting their sales in the U.S., Philip Morris has a stronger position. The addictive nature of their products combined with a heavily diversified market gives the company a resilient flavor.
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