Altria (NYSE:MO) is scheduled to announce its third quarter earnings on October 25. The U.S. based tobacco company posted strong results in the previous quarter with 9.6% y-o-y revenue growth and an impressive 5.1% gross margin expansion. Revenues were helped by solid growth in smokeless products shipment volumes, favorable pricing for Marlboro, and 24% volume growth for the L&M discount brand of cigarettes. Margins grew primarily due to pricing increases and the positive impact of cost reduction program initiated in late 2011. Exceptional performance of SABMiller, in which Altria has a stake of around 27%, also contributed to bottom-line growth.
Altria faces a declining market for cigarettes in the U.S. and is increasingly relying on pricing to drive revenue growth. The smokeless products segment on the other hand is performing exceptionally well, and we believe that this division has the potential to drive overall growth in medium-long term. We also consider the impact of the recent federal ban on graphic warning labels in the U.S. Finally, we look at how the cost reduction program can benefit margins going forward.
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Growing market for smokeless products
The market for smokeless products in the United States is a relatively nascent one. A large portion of the consumer base for these products consists of smokers who are switching under the belief that it is a less harmful alternative to cigarette smoking. Smokeless products are also subject to far lower excise duties compared to cigarettes, leading to cheaper prices.
We believe that Altria’s smokeless products segment will continue to grow regardless of market share, purely due to the robust growth of overall market for these products. Last quarter, Altria’s smokeless products sales volumes grew 7.6% in spite of market share remaining relatively flat. The market size for smokeless products in the U.S. was around 133 million pounds in 2011. We forecast it to grow at a healthy rate of 4% annually, reaching almost 180 million pounds by the end of our forecast period.
Impact of Federal Ban on Graphic Warning Labels
Another key consideration for Altria’s top-line growth in coming quarters is the recent ban on graphic warning labels by a federal appeals court. As per the ruling, cigarette companies in the U.S. will no longer be required to place such images on their packs.
The ruling provides much-needed relief for cigarette companies considering the constant pressure they are under by governments and health officials. As a result of numerous restrictions on advertising and promotion, cigarette packs are now one of the few remaining modes of advertising left to cigarette companies.
Considering the value of brands like Marlboro and Virginia Slims, Altria would have lost a significant portion of its intangible assets if the ruling had gone another way. Marlboro is already under considerable pressure from cheaper brands, and the main reason it is able to retain market share is its brand value. The company lost almost 1% of its market share for Marlboro in the third quarter last year. This played a major role in the 7% y-o-y revenue decline for the cigarettes division that quarter.
Altria had a share of 45.4% of the U.S. cigarette market in terms of volumes. Going forward, we expect this to gradually decline to around 44% by the end of our forecast period.
Cost reduction program
One of the reasons behind Altria’s impressive gross margin growth last quarter was the cost reduction program initiated in the fourth quarter of 2011. The program is expected to deliver $400 million in annualized savings by the end of 2013. The company has also reduced its workforce by 700 employees earlier this year. We expect this to have a positive impact on its margins going forward.
We currently have a Trefis price estimate of $34 for Altria, which is in-line with the market price.