Overview: A large portion of the investment community and a significant portion of the media incorrectly describe the economics of the tobacco industry. While some attributes of the industry, such as secular volumes declines, are indisputable, the effect of these attributes on the economics of the business are often erroneously estimated.
In addition, the tobacco industry is heavily regulated with various geographies instituting different tax regimes and laws. These differences, while nuanced, do not significantly alter the economics of the business. Given Philip Morris International (NYSE:PM) operates outside the United States, the majority of this article will be concerned with dynamics in countries outside the US, however, data from the US market will be used to better illustrate main points.
Finally, PM will be discussed, its competitive dynamics assessed and its ability to drive significant long-term shareholder value will be examined.
The Tobacco Industry: The tobacco industry, similar to the spirits, beer or coffee industries, is in the business of selling a drug. Not surprisingly, nicotine, alcohol and caffeine are the most widely consumed drugs in the world and have been used by humans for centuries. Nicotine, similar to alcohol and caffeine, is a relatively benign drug when consumed on its own in mild to moderate doses. Unlike alcohol and caffeine, the most common way to induce nicotine is via a method that has been found to be extremely detrimental to one's health: the inhalation of combusted tobacco leaves.
After the US Surgeon General's 1964 report [pdf] on smoking, the causal link between smoking and cancer was first established; the decades of research that followed backed up that finding. American attitudes towards smoking began to shift and the US federal and state governments began to institute excise taxes, sales taxes and other regulations to limit other negative effects of smoking including its externalities such as secondhand smoke. These policies caused cigarette consumption per capita in the US to fall from roughly 4000 cigarettes per year in 1964 to roughly 1000 cigarettes per year in 2012.
Given a preview of this report, an individual in 1964 may have come to the conclusion that the cigarette business was doomed. However, historical returns of the largest cigarette company in the US, Philip Morris Companies, were far and away the strongest of any surviving companies in the S&P 500 from March 1957 to December 2003. This data is presented in a table from Jeremy Schwartz and Jeremy Siegel's 2006 FAJ paper titled, "Long-Term Returns on the Original S&P 500 Companies."
These seemingly disparate concepts of declining cigarette volumes and excellent shareholder returns seem at odds. Historical examples of photographic film and newspapers suggest that declining volumes result in an industry's economic profits being eroded away. So what makes the tobacco industry different?
The Tobacco Business Model: As compared to the industries mentioned above, I believe that the economic and financial attributes of the tobacco industry are different enough that with the right execution, the tobacco industry will remain one of the best businesses that investors can own. This is inclusive of the assumption that volumes will continue to decline for quite some time.
Let's begin with pricing. Nicotine is an addictive drug with limited substitutes and because of these attributes, demand for cigarettes is inelastic. For every price increase of 1% for cigarettes, quantity demanded falls by less than 1%. Many studies have been done to measure the price elasticity of demand for cigarettes with estimates ranging from -0.30 to -0.50. Which means for every 10% increase in the price of cigarettes, quantity demanded would fall between 3 to 5%. However, from a revenue standpoint, total revenue would increase as the higher prices would more than offset the lower volumes.
PM has taken advantage of nicotine's inelastic demand characteristics and has aggressively taken prices up on their products. Given that the price elasticity of cigarettes is >-1, organic revenue growth for PMI has increased at a CAGR of 5.1% from 1995 until 2013, an extremely attractive growth rate.
Looking forward, in order for organic revenue growth to remain positive going forward, price elasticity for cigarettes needs to remain in its historical range. While nicotine itself has relatively limited substitutes, cigarettes have begun to see competition, especially in OECD countries. These two substitutes are smokeless tobacco and electronic cigarettes (e-cigarettes). While these two products pose a risk in disrupting the current cigarette model, I believe that they will not pose a long-term threat to the shareholder returns of companies like PMI.
Overall pricing dynamics remain favorable. In addition to continued price increases in developed markets, PMI should be able to take significant pricing in Non-OECD geographies. These geographies are typically emerging market economies with large labor pools and significant increases in real wages. As wages in Non-OECD countries grow at rates above that of OECD countries, PMI will be able to raise prices in Non-OECD at a faster rate as compared to OECD countries. This makes PMI's cigarette business much more attractive as compared to more OECD focused tobacco companies such as Reynolds-American (NYSE:RAI), Altria (NYSE:MO) and Imperial Tobacco (OTCQX:ITYBY).
With an established path for organic revenue growth of between 4-5% for the foreseeable future, the next step in modeling PMI's business is to estimate the Company's operating profitability. Given favorable competitive dynamics, which are outlined in additional paragraphs below, the cigarette business has extremely attractive margins. Suppliers have limited power over PMI so input costs are just a fraction of the selling price per pack and portend to attractive Gross Margins. Overall EBIT margins are also attractive at PMI given limited SG&A spending compounded by a very small corporate overhead footprint.
Across PMI's operating divisions, EBIT margins vary, a function of relative pricing between markets and different levels of fixed cost leverage as geographies have varying levels of volumes and a different set of operating assets such as cigarette production factories. The different levels of capacity utilization drive each division's EBIT margins.
The overall trend for operating margins at PMI is favorable and has an upward bias. Improving EBIT margins should be driven by rationalizing capacity in certain geographies as volume declines continue and by PMI taking larger price increases in non-OECD countries in relation to PMI's cost increases.
In addition, increased prices have often fallen to the bottom-line for cigarette manufacturers resulting in higher margins in OECD vs. Non-OECD countries (given that prices in OECD are greater than prices on non-OECD). As price convergence takes place, margins in Non-OECD geographies should move upwards. Imperial Tobacco, the global #4 cigarette manufacturer, has leading shares in the U.K. market, where the average price per pack including tax is over USD $13. While it is extremely unlikely that any of PMI's geographies will experience this level of retailing pricing per pack, it does suggest that the current 44-45% EBIT margin at PMI could continue upward, especially if pricing in OECD countries to outpace that of non-OECD countries.
Competitive Dynamics: The tobacco industry also benefits from very favorable competitive dynamics such that the generous economic profits generated by the industry accrue to the cigarette manufacturers. Furthermore, industry characteristics prevent new entrants from entering the industry which reduces competition and reinforces the competitive positioning of the incumbents. Finally, market shares in various geographies are consolidated and competition remains oligopolistic resulting in rational price increases.
A Porter's Five Forces analysis is useful in assessing the current competitive positioning for PMI.
Bargaining Power of Customers: The bargaining power of customers is very low. Individual customers have essentially zero input on what price PMI charges for a pack of cigarettes. PMI sets the price of its product and often, because of taxes and governmentally regulated minimum prices, consumers have little ability to either haggle on price or switch producers based on price.
Bargaining Power of Suppliers: The bargaining power of suppliers is also very low. PMI sources raw materials such as paper, tobacco leaves, filters and other products from a diversified base of suppliers. PMI's concentrated purchasing power allows it to drive down prices and margins on their suppliers.
Threat of new entrants: The threat of new entrants is also relatively low. Start-up tobacco companies are nonexistent, and other consumer products companies such as Nestle or Unilever are not familiar with the regulatory and litigious aspects of cigarette production. In addition, the majority of cigarettes are sold behind a counter in a very controlled distribution environment. This creates a significant barrier to entry as PMI highly incentivizes retailers to stock their products over others. With limited ability to add distribution space for new competitors, PMI and incumbents face limited threats from new entrants into the category.
Threat of substitutes: While the threat of substitutes for nicotine is limited and there are no true substitutes for nicotine, cigarettes, as a nicotine delivery device, face new threats from other products that deliver nicotine. This is arguably the biggest potential threat to PMI's business model.
Industry Rivalry: Industry rivalry is relatively benign. Given the long-term secular volume declines in traditional cigarettes, coupled with the concentrated market shares of the industry participants, competitive rivalry in the form of price wars is very uncommon in the tobacco industry. Many markets are characterized by a market leader who often initiates a price increase with the other industry participants following with similar increases soon after. While periods of price competition have come up from time to time (Marlboro Monday, for example) they are few and far between.
Reduced Risk Products and E-cigarettes: The most critical issue for the tobacco industry currently is the risk of new nicotine substitutes coming onto the market. The largest of these substitutes is the e-cigarette. An e-cigarette is a device in which a heating element called an atomizer uses battery power to vaporize a liquid solution that contains nicotine. This vapor is then inhaled into the user's lungs and nicotine is absorbed into the bloodstream similar to a combustible tobacco cigarette.
The liquid vaporized is typically a solution comprised mostly of propylene glycol (C3H8O2), a colorless and odorless gas. The US FDA labels propylene glycol as "generally recognized as safe" and as such it is used by food companies as a preservative. Additional components in e-cigarette liquid including flavorings and the active ingredient, nicotine, which is often derived from tobacco leaves or eggplants.
While this article will not delve into debating how harmful e-cigarettes are, I argue that, compared to combustible tobacco cigarettes, e-cigarettes are safer. First, e-cigarettes do not combust organic material as compared to traditional tobacco cigarettes. This prevents users from inhaling tar produced as a by-product of organic material combustion. Second, e-cigarettes are relatively void of tobacco-specific nitrosamines (TSNAs), the key group of carcinogens found in tobacco products. A study published in Nicotine & Tobacco Research found that TSNAs in e-cigarette liquid were roughly equivalent to that of nicotine gum and patches. This is not surprising since the creation of TSNAs involves tobacco leaves and the fermentation process implemented during tobacco leaf curing. Note that this study calculated the levels of TSNAs present in each product and different absorption levels could affect the levels of TSNAs absorbed into the body during consumption.
Given the improved user health outlook for e-cigarettes, many users have tried or switched entirely to e-cigarettes, especially in geographies where taxes on cigarettes have made e-cigarette consumption cost competitive to the user. Thus e-cigarettes are clearly at risk of disrupting the traditional tobacco business model. However, I assert that because of certain factors outlined below, the risk is actually an opportunity for the major manufacturers and as such could further entrench the business moat of companies like PM.
Not a perfect substitute: While the theory of e-cigarettes delivering nicotine without the harmless side-effects of smoking combustible cigarettes has legs, in practice, the devices are not perfect substitutes. Conversion rates for e-cigarette users remain low (data from PM's 2014 Investor showed that in Italy, while trial of e-cigarettes is almost 40% of adult smokers, only 3% have used in the last week). The large driver of this is the inferior nicotine delivery of e-cigarettes relative to combustible tobacco cigarettes.
In a paper published in Nature entitled, "Nicotine absorption from electronic cigarette use: comparison between first and new-generation devices," the authors examine the nicotine absorption curves of various nicotine delivery devices, including a first-generation "cig-alike" e-cigarette provided by V2Cigs and a second generation "vap-tank" system, eVic, provided by Joyetech. The results were then combined with a traditional tobacco cigarette nicotine absorption curve provided by another study.
The results of the two studies are presented below. Nicotine absorption reaches a peak of almost 20 ng per ml of plasma within five minutes of smoking a traditional tobacco cigarette. First generation devices do not achieve nicotine levels above 10 ng per ml of plasma and the newer generation device reached the 20 ng level after 35 minutes of consumption. This difference in nicotine uptake curves is likely the reason why conversion rates for e-cigarette users continues to be relatively benign. To improve the uptake curves, additional innovation may be required including improved e-cigarette liquid formulation, larger batteries and stronger atomizers.
However, until that time approaches, the tobacco cigarette manufacturers such as PM have begun to invest in e-cigarettes and other next-generation products. While the current outlook could pose a threat to PM's current business model, factors currently in motion suggest that the evolution of the e-cigarette and next-gen businesses will benefit the incumbent players and not current start-ups.
Regulatory framework will favor the incumbents: As previously mentioned, the regulatory framework discussion has been a hot topic amongst the public, regulators and legislators. Mitch Zeller, the head of the US FDA, has discussed at length the process of tobacco regulations and how old and new products will evolve within the US regulatory framework. Along similar veins, nations across the world have instituted numerous regulations over the sale, taxation and regulation of tobacco and nicotine products. Many investors believe that these regulations hinder the growth of tobacco firms. This argument is flawed in my opinion and while stick volumes may decline under these regulations, the competitive positioning and operating profitability of incumbent firms is, in fact, enhanced and improved by them.
Based on preliminary releases from the US FDA, along with new legislation passed in both the US and in Western Europe, the e-cigarette market is developing similar to that of tobacco cigarettes. Consumers must be over 18 years old to purchase e-cigarettes and age verification works best in closely tracked distribution channels like retail stores. This suggests distribution dynamics that favor the incumbents like PM that have significant scale and presence in the current retail format. Regulators will impose ingredient lists and stringent requirements over the manufacturing techniques and standards used to produce e-cigarettes. The fixed costs imposed by these regulations will create a barrier to entry for lower volume competitors. Finally, limits on advertising for e-cigarettes will weaken the ability for smaller competitors to promote their e-cigarette brands making other competitive aspects such as distribution, more critical in generating sales. The result of these factors suggests incumbents like PM will rule both the traditional tobacco market and the growing e-cigarette market for the foreseeable future.
Price advantages will not last: Another driver for increased adoption is the essentially non-existent tax revenue generated from e-cigarettes as compared to traditional tobacco cigarettes. However, over the last few years, this dynamic has started to shift and governments around the world have begun to tax e-cigarettes. This is in-line with historical precedence in other "drug" categories. Ethanol, the active ingredient in beer, wine and spirits, is taxed whether it is consumed in any of the previous mentioned forms. Similarly, nicotine will likely be taxed whether it is in the form of snuff, Swedish snus, combustible tobacco or e-cigarettes.
Distribution advantages will be outlawed: A major advantage that e-cigarette manufacturers have is a distribution channel not available to traditional tobacco users, the Internet. However, over time, similar to distribution rules for alcohol, regulators and governments will likely outlaw the distribution of e-cigarettes over the Internet. In fact, in a letter from the US AGs to the US FDA, the AGs noted that e-cigarette sales over the Internet do not guarantee that the seller verifies the consumer's age, leading to underage usage. A ban on Internet sales for e-cigarettes is extremely likely.
A ban on Internet sales will shift a large portion of the distribution of e-cigarettes into the traditional tobacco channel, retail stores. This will create a massive barrier to entry to smaller competitors within the e-cigarette space. The number of retail outlets around the world is vast, and the number of owners of those outlets is equally as large. Tobacco companies exert large influence over their retail partners, telling them what products to carry, how to carry them and where to place them on the shelf. This influence will give incumbent manufacturers the ability to force retailers to carry their e-cigarette brands as the Internet distribution channel is outlawed by legislators. Smaller start-up e-cigarette manufacturers have neither the bargaining power nor the economic resources to supplant the incumbent operators. Evidence in the US e-cigarette market suggests this is already taking place. The national roll-out of RAI's Vuse and MO's MarkTen suggest that market share within the e-cigarette market by the end of 2014 will already have been consolidated between the three largest cigarette companies in the US: MO, RAI and LO.
The China Option: One of the biggest opportunities for PM is the eventual opening of the Chinese market to foreign competition. Currently, the Chinese market is dominated by the China National Tobacco Corporation or CNTC. The company holds a monopoly over the sale of cigarettes in China outside of limited sales of Marlboro cigarettes, which it manufactures through a license from PM. China is the largest cigarette market in the world with over 300 million smokers consuming roughly 1.7 trillion cigarettes every year or roughly 35% of the world's annual consumption.
The monopoly in China has remained in place likely due to the fact that a significant percentage of the Chinese government's tax revenues are generated by the CNTC. A report by the World Lung Foundation estimated that in 2005, the CNTC generated roughly 7.6% of the central government's revenue.
However, the Chinese state-run tobacco monopoly was not the first and previous monopolies have privatized in the past. Japan Tobacco (OTCPK:JAPAF) was once a Japanese state-run monopoly that reformed under public ownership in 1985. Countries in South-East Asia, North Africa and the Middle East had state-owned tobacco monopolies which were privatized in the 1980s.
Over time, China should also move away from the state-owned tobacco monopoly as the government faces a difficult proposition from the Chinese public: why does the owner of the largest tobacco manufacturer in the country also introduce rules and regulations regarding the dangers of smoking and tell its citizens not to smoke?
Financial Model: With the information provided above, a financial model of PMI is presented below. Drivers of the model include:
- Revenue growth driven by declining volumes offset by increasing prices and improving mix. Non-OECD countries should see faster revenue and operating profit relative to OECD countries.
- Margins should improve over time as higher prices fall to the bottom-line.
- EPS growth should be aided by annual repurchase activity.
PMI's long-term EPS growth excluding currency fluctuations remains firmly in the low double digits thanks to the tenets, outlined above. While PMI has Returns on Invested Capital in excess of 30%, the secular volume challenges in tobacco means PM cannot reinvest a significant portion of its profits back into the business. To drive shareholder returns, PM, similar to other tobacco companies, has a relatively high payout ratio (roughly 65%) and has aggressively repurchased its stock. As such, when purchased at attractive valuations, PMI should continue to deliver attractive long-term shareholder returns.
Current Outlook: Over the past 18 months, PMI has struggled with significant headwinds to reported EPS. From competitors in the Philippines selling untaxed cigarettes after an excise tax increase, to cost cutting programs in Western Europe, to increased spending in 2014 on next generation products, organic growth at PMI has been relatively soft. Organic EBIT growth consisting of price, volume and mix has slowed the last two years.
On a reported basis, results have fared worse, largely due to significant currency headwinds as the USD and the CHF have strengthened against most major currencies. Since 2007, PMI has experienced cumulative negative foreign currency developments that have equaled over $1.4B. The outlook for 2014 suggests that number could climb to $2B or roughly 15% of Operating Profit. However, over time foreign exchange movements should balance out with minimal effects of revenues and profits over the long term.
The current outlook for 2014 includes a $0.24 per share charge due to the closing of cigarette production in the Netherlands and a significant headwind from currencies. In addition, increased costs from next-generation products and reduced share repurchases lower the estimated adjusted growth rate to 6% to 8%, down from the 10% to 12%, long-term range.
Valuation: For valuation purposes I ran my financial estimates through a discounted cash flow model, taking into consideration an operating profit growth rate of 5.7% annualized, PMI's current tax rate, future capital expenditure and net working capital needs, any non-cash expenses PMI currently has and the Company's current capital structure. The terminal growth rate is 3%. The discount rate consists of an 11% return on equity, a 5% pretax cost of debt and a roughly 20/80 split on debt to equity in the capital structure. The result is a WACC of 9.5% which suggests a fair value of roughly $101 per share. With shares current trading in the mid 80s, upside appears modest at roughly 15%. However, this article is not to argue that a valuation discount exists with PMI and that it should close. Instead, it is to show that PMI is a company operating in a favorable industry with attractive long-term prospects and long-term investors would greatly benefit from a serial compounder like PMI.
Disclosure: The author is long PM, BTI.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.