Introduction: The global tobacco industry has been often vilified and in some regards, rightfully so. The tactics used by the US manufacturers during the later part of the twentieth century were both deceitful and the spread of misinformation led to an inordinate amount of preventable deaths. However, this article is not to focus on the moral aspects of smoking, but to examine the industry's current state and how it relates to the relevant investible securities.
My drive to write quality Seeking Alpha articles on the tobacco industry is two-fold. First, I often feel the articles posted on the website, while informative, do not cut to the meat and potatoes of how the industry works and why the stocks offer attractive, long-term investment returns at the right price. Attributes such as dividends and repurchases are the symptoms of a good business. One must find the cause of a good business as the symptoms could easily mask the true underlying economics of an industry. Second, while I have only been abreast of the tobacco industry for roughly five years, the amount of misconceptions about the business by both the media and investors is confounding to me. Compound that with the fact that much of the information presented below was obtained publicly over the Internet for free and the resulting misconceptions remain puzzling.
The US Tobacco Industry: In this article, I will present a brief overview on the US tobacco industry. While the US market has some various nuances that make it slightly unique, the underlying industry dynamics are relatively the same as compared to other geographies. To avoid reinventing the wheel, please feel free to read through my article on Philip Morris International (found here) that includes a brief synopsis of the tobacco industry in general and addresses current threats to the tobacco profit model.
After the US Surgeon General's 1964 report on smoking (found here) the causal link between smoking and cancer was first established and decades of research that followed backed up that finding. Americans 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 the 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 2500 cigarettes per year in 1964 to roughly 1000 cigarettes per year in 2012.
Increased awareness over the health dangers of smoking has reduced per capita consumption and the trend for the foreseeable future remains downward. Cigarette consumption per capita has fallen by roughly 3.8% per year over the last 30 years in the US and overall consumption has fallen by 2.6% per year, as per capita decreases have been offset by ~1.0% population growth.
The key sticking point to why many investors and the media misunderstand the tobacco business is the extent to which nicotine and cigarettes have limited substitutes. The addictive nature of nicotine and the lack of substitutes has created a product with tremendous price inelasticity. For every price increase of 1% for cigarettes, quantity demanded falls by less than 1%. Many studies (for example) have been done to measure the price elasticity of demand for cigarettes with estimates ranging from -0.25 to -0.50. Which means for every 10% increase in the price of cigarettes, quantity demanded would fall between 2.5% to 5%. However, from a revenue standpoint, total revenue would increase as the higher prices would more than offset the lower volumes. While increased public awareness over the dangers of smoking have reduced price elasticity towards the higher end of that range, in the US price elasticity remains firmly above -1 and a detailed search of internal company documents (found here) confirms these data points and trends.
This relationship has held up remarkably well and data from the US shows that the tobacco industry has indeed posted robust revenue growth in the face of declines in cigarette stick consumption. The Federation of Tax Administrators releases an annual report on the overall tax burden on cigarettes. The data found in these reports is presented below along with data obtained from the Bureau of Economic Analysis.
US Total Tobacco Expenditures, as reported by the BEA, have largely increased every year since the 1930s. Since 1962, two years before the Surgeon General's report came out exposing the negative health effects of smoking, total Tobacco Expenditures grew at a 5.6% CAGR until 2012.
However, the BEA includes taxes when tabulating their annual results. To negate some of these taxes, one can subtract reported federal, state and local excise taxes as reported by the FTA's Tax Burden annual report.
The graph below presents these results. As expected, by the 1970s and 1980s, excise taxes on tobacco products began to grow quite rapidly, with two very large tax increases taking place in just the last few years. The rapid increase in state excise taxes in the early 2000s, is likely the result of the Tobacco MSA, the 1998 settlement between state AGs and the large tobacco firms.
The net result of excluding the excise taxes is that total US tobacco revenues have indeed increased over the last several decades. Cigarette consumption in the United States peaked in 1981 at 633.3B sticks and per capita consumption peaked in 1979 at 2821. Over the next twenty years, tobacco revenue after taxes grew at a CAGR of roughly 8.0% per year, while total cigarette volumes fell by 3.9% per year. This suggests that the price/mix of cigarettes sold has risen by over 12% per year since 1981. This is evidence of tobacco's inelastic demand curve at work.
So while the data shows that pricing for tobacco cigarettes in the US has risen markedly over the last few decades, the question of "why" remains. As mentioned in my PM article, nicotine has limited substitutes and user demand is relatively inelastic, allowing companies to increase prices, while seeing a correspondingly lower relative decrease in volumes purchased. In addition, government regulations that increase barriers to entry and litigation risks that prevent larger CPG companies from entering the market, have created oligopolistic competition in markets like the US where a small number of competitors share the majority of profits. Limited competition assures that price increases are followed by industry constituents without the risk of companies instigating price wars.
To better assess the dynamics of US cigarette pricing over the last few decades, the chart below plots pricing data on log base 10, to show the first derivative of price increases and how its rate has accelerated since the 1960s.
To back up the finding above that examined the entire US cigarette market, similar metrics for Altria's US cigarette business are presented below. Not surprisingly, the data confirms much of what the overall market data has suggested.
Altria has experienced volume declines for the better part of two decades. From the mid 90s, Altria has seen a decline in overall organic cigarette volumes at a rate of 2.5% per year from 1991 until 2013. However, organic pricing has increased markedly since 1991, a CAGR of 6.1% up until 2013. The net of these two factors is an organic revenue growth rate of 3.8% for Altria's US cigarette business since 1991.
Looking forward, revenues for cigarettes and other tobacco based products should remain growing in the LSD range, between 0-3% per year. This is based upon a ~4% drop in per capita cigarette consumption combined with a 1% increase in the US population every year resulting in a 3% annual decline in overall volumes. Pricing should remain robust, even in the face of growing substitutes such as e-cigarettes, to the tune of 3-6% per year. Should e-cigarettes come under greater FDA scrutiny and regulations (which is highly likely, in my view) and should the Reynolds (NYSE:RAI)/Lorillard (NYSE:LO)/Imperial Tobacco (OTCQX:ITYBY) deal go through, pricing would likely be shifted towards the higher end of that range of 3-6%.
The cigarette industry's volume declines have been slow enough such that operators in the US have been diligent about continually reducing their manufacturing footprints to maintain operating profitability. This coupled with strong price increases has driven favorable operating margins for domestic operators such as Altria.
This should continue going forward, as the competitive dynamics in place should remain and competition between operators will remain nascent. Input costs remain benign as the FTA estimated that $473MM was the total farm value of domestic leaf tobacco used in US cigarettes as compared to the $75,000MM in net tobacco revenue generated in 2012.
Many investors, unduly so, remain focused on the end-game of domestic tobacco volumes. Will volumes end up at zero? Data on illicit drug use in the US suggests that while declines will continue for the short to medium term, the overall steady state of tobacco consumption (or more specifically, nicotine consumption) will not be zero. However, the following paragraph is presented to theorize the resulting end-game for tobacco usage in the US. For all intensive purposes, the investment time horizon for most investors in tobacco companies is too short to include potential outcomes of end-game volumes.
An annual survey done by the University of Michigan, called "Monitoring the Future" (link) shows long-term trends on lifetime prevalence rates of illicit substances used by US 12th graders. Use of tobacco has fallen since the late 90s, while the use of marijuana has increased. The more pertinent data is the use of cocaine and heroin, at penetration levels similar to their early 90s prevalence rates. This article was not written to opine about how or why some people decide to consume illicit substances. Instead, the point here is that despite being highly illegal to possess and very dangerous to use, a percentage of people still continue to choose to consume drugs like cocaine and heroin. Similarly, despite future users being aware of the negative health effects, a certain percentage of the population will likely continue to consume nicotine products such as tobacco cigarettes.
The competitive dynamics of the domestic tobacco industry remain very favorable. These dynamics have been in place for the better part of three decades and have been reinforced by government regulations and taxes. These regulations have entrenched domestic operators and have allowed the majority of economic profits generated by the industry to be realized by the major manufacturers, Altria, Reynolds American, Lorillard and Imperial Tobacco.
Similar to my article on PM, below is a brief Porter's Five Forces analysis on assessing the domestic tobacco industry.
Bargaining Power of Customers: The bargaining power of customers is very low. MO or RAI set the price for a pack of cigarettes and consumers either accept the price or not. Customers have no ability to haggle with MO on price.
Bargaining Power of Suppliers: The bargaining power of suppliers is also very low. Domestic producers source tobacco both from US farmers and internationally. Their supplier base is very fragmented and often stretched by declining demand for tobacco leaves. Tobacco leaves are relatively commoditized and farmers cannot bargain MO or RAI for higher prices.
Threat of new entrants: The threat of new entrants is also relatively low. Very few companies threaten the future market share dominance of Altria and the combined RAI/LO in the US. Stipulations under the Tobacco MSA make it very difficult financially for upstarts to gain share in the US, further entrenching the incumbent operators.
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. MO and RAI further diversified their offerings by acquiring large smokeless tobacco assets in the US, reducing the risk of substitutes. Looking forward, MO and RAI have invested heavily in e-cigarettes to offset a potential future threat of increased substitution away from tobacco cigarettes.
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. The US is characterized by a market leader, Altria, 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.
A Final Act of Consolidation: The RAI/LO merger
Following the RAI/LO/IMT-LON deal, the US tobacco companies could begin to step on pricing harder than they have historically. Lorillard had long been slow on increasing prices in the US, as menthol gained market share and, as such, pricing dynamics hadn't been as robust as one would expect for a market where the top three competitors had north of 75% market share. Following the merger of RAI and LO, with various RAI brands being divested to Imperial Tobacco, evidence suggests the rate of price taken by the larger operators would increase.
During its pitch to investors over the implications of the deal, Imperial Tobacco highlighted the relative affordability of US cigarettes relative to 2013 wage rates and the cost per pack. The cost of US cigarettes, as measured by labor productivity, is very affordable when compared to other economies. This data suggests that Imperial Tobacco believes pricing in the US could go higher.
Following the acquisition of Lorillard by Reynolds-American, pro-forma volumes for the US will be extremely consolidated. Based on a presentation by RAI following the announcement of the deal, 2013 US volume market shares would have been estimated at 50.3% for Altria, 34.1% for Reynolds American and 9.8% for Imperial Tobacco. This further consolidation will provide cost savings opportunities for both Reynolds and Imperial Tobacco, and would likely move pricing higher given the more consolidated market shares. As previously alluded to, Lorillard had not been as willing to increase prices versus Altria and Reynolds, largely due to the market share gains Lorillard had experienced with its Newport brand. Now with the need for Newport to continue to gain scale gone under RAI ownership, the US will now be a duopoly market with Altria and Reynolds American holding almost 85% of US market share.
That 85% proforma market share may concern some investors given the Justice Department may argue against the merger and take RAI to court to fight it. However, the merger should go through as the cigarette industry occupies a very unique position as compared to other industries. Unlike cable TV bills, cell phone service, or electricity bills, constituents do not lobby their congressman or congresswoman for lower cigarette prices. Conversely, the government is not opposed to higher prices for cigarettes, so lower prices following the merger is not an end goal for either the Justice Department or Congress. There is the potential that RAI may be forced to divest another small brand or two to Imperial, but the deal should get done.
The E-Cigarette Threat
The most critical issue for the tobacco industry currently is the risk of new nicotine substitutes coming into 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. For a brief write-up on the e-cigarette business, please read the Reduced Risk Products section from my article on PM (link).
Currently, the FDA is developing new regulations for the e-cigarette industry. This is very important, in my view, as the industry is rife with competition and low margins, a boon for the consumer, but the bane for businesses and investors. Numerous retail operations called "vape-shops" and open-system e-cigarettes are the result of what capitalism is supposed to do when a new market opens up: given consumers choice and lower prices.
However, for an investor this breeds competition and low economic profits. Altria and Reynolds have taken steps to compete in this new market, but will likely face continued competitive pressures until the FDA and the US Congress make significant laws to tax and regulate e-cigarettes similar to tobacco cigarettes. If history is any guide, regulations on the manufacture, the sale, the distribution and the advertisement of e-cigarettes will be onerous for small operators and will favor large incumbents such as Altria and Reynolds. Additional regulations should be viewed favorably by investors, as it would improve industry profitability and potentially allow Altria and Reynolds to achieve attractive returns on the invested capital they choose to deploy in the e-cigarette industry.
Altria is the largest cigarette manufacturer in the US. The company was the legacy parent of Philip Morris, which at one point owned Kraft Foods, Miller Brewing Company and an international cigarette business. Following the lawsuits of the late 90s, the company instituted a break-up with the resulting companies being MO, PM and KRFT (which would later spin off its snack and coffee business into Mondelez (NASDAQ:MDLZ)). Altria then acquired UST in 2009, diversifying into smokeless tobacco. MO also retained the Miller Beer stake which was converted into shares of SABMiller (SAB-LON, OTCPK:OTCPK:SBMRY) following SAB's purchase of Miller Brewing Company.
Recently, SABMiller has reportedly been stalked as an acquisition target by AB InBev, the beer giant run by 3G Capital. Rumors of a deal pegged the takeout at almost GBP46 per share for SABMiller. Altria's stake would be worth over $30B before taxes, a substantial part of the company's current market cap. This component is critical for Altria's valuation and investors should be cognizant of that fact, especially following the deal, if it happens.
Outside of the deal, Altria continues to operate well in the US, despite lower cigarette volumes. The smokeless business, while smaller than the cigarette business (just 13% of 2013 EBIT vs. the 87% from cigarettes) continues to perform well volume-wise, as consumers trade into smokeless to get around second-hand smoke regulations that prevent smoking in public places. On balance, pricing remains relatively benign in smokeless as improving volumes have not forced manufacturers to take substantial price increases in smokeless. However, similar to cigarettes, the smokeless tobacco market is dominated by MO and RAI in the US and increased pricing should continue in smokeless for the medium term.
On balance, a financial model with 3% volume declines and 5% pricing in cigarettes, coupled with modest EBIT margin improvements in both Smokeable Products and Smokeless suggested Altria should grow EBIT close to 3-4% per year for the medium-term. Applying a 9% discount rate to the company's estimated future cash flows, a terminal growth rate of just 1.5%, and SABMiller's current market share price, a DCF model suggests a fair value of $48 per share. A deal for SAB or improved regulations over e-cigarettes could provide upside in the shares.
Post the deal for Lorillard and its Newport brand, Reynolds American will be the second largest US domestic producer of cigarettes. Similar to Altria, Reynolds diversified into smokeless tobacco in 2006 by buying privately-held, Conwood, the #2 producer of smokeless tobacco in the US.
As a result of the proposed merger between RAI and LO, management at Reynolds American believes significant cost synergies exist such that over $800MM in run-rate cost synergies will be present by FY2016. My model currently estimates synergies at 7% of 2016 sales for RAI, boosting EBIT to over $5B during that year. Given the favorable volume growth trends in Newport and improvements in price growth following the deal, RAI should be able to grow revenues slightly north of 3%. While the cost savings will boost margins and profitability, these will be slightly offset due to higher interest expense and a larger share count, the result of British American Tobacco (BATS-LON, BTI) maintaining its 42% stake in RAI and the shares issued to existing LO shareholders. Similar to Altria, a modest 3-4% EBIT growth rate over the medium-term, coupled with a 1.5% terminal growth rate and a 9% discount rate, suggest a DCF fair value of $58 per share for RAI.
Disclosure: The author is long PM, BTI, LO.
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.