What Would A Ban On Menthol Cigarettes Mean For Altria?

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In a recent article, we discussed the U.S. market for menthol cigarettes, broadly covering the source of demand, attractiveness of this area for tobacco companies, health implications from its use, and the possibility of a ban on the product. In this article, we focus on how a ban could change the dynamics in the U.S. tobacco industry, and also alter our valuation for Altria.

Demand for menthol cigarettes arises from two main sources — First, from those who use the product to tone down the harshness of traditional smoke, comprising of occasional, inexperienced, or young smokers. Second, from those who like the strong flavor and the physical sensation of the product, which in the U.S. comprises  predominantly African-American men. At a time when the overall demand for cigarettes has been declining, having a strong menthol brand is particularly beneficial to tobacco companies, since they encourage initiation among the youth, create appeal among a fast growing African-American population, and are, in general, harder to quit. However, these very facts become the premise for health advocates to increasingly push for a ban on the product. After escaping two near-ban experiences in 2009 and 2011, menthol cigarettes continue to stand on flimsy grounds as the Food and Drug Administration (FDA) recently categorized the product to be riskier than regular cigarettes to open a public consultation period, with the view of eventually banning the product. [1] While the FDA continues to investigate whether the product leads to higher nicotine dependence among adolescents and a disproportionate harm to the African-American segment, it maybe only a matter of time until the U.S. follows the likes of the European Union, Brazil, and Canada to implement the ban. In a situation in which menthol cigarettes are, in fact, phased out entirely, here is how the dynamics in the American tobacco industry could pan out, particularly for Altria.

We have a price estimate of roughly $46 for the Altria Group, which is below the current market price.

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See Our Complete Analysis For Altria

Impact Of A Ban On Menthol On The Present Day U.S. Tobacco Industry

The U.S. tobacco industry is highly consolidated, with three main players dominating the industry, viz. Altria (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard (NYSE:LO). Overall, Altria is the leader, with close to 47% of the market, followed by Reynolds and Lorillard with 28% and 12.6% respectively. However, in the menthol category, Lorillard’s Newport takes the largest slice, with close to 37% of the market, followed by Altria and Reynolds, at 18% and 12%, respectively. [2]

According to our estimates, the U.S. sold over 250 billion cigarettes to 42 million smokers in 2014. According to the American Cancer Society, close to 30% of smokers opt for menthol products, which gives us a little over 12.5 million consumers choosing the product. Now, segmenting this in line with the 12%, 18%, and 37% break-up between Reynolds, Altria, and Lorillard respectively, we arrive at around 1.5 million consumers for Reynolds, about 2.3 million consumers for Altria, and close to 4.7 million consumers for Lorillard.

In case of a ban on menthol cigarettes, Altria stands to lose around 2.3 million consumers, who presently consume its menthol brand. A study titled “A Ban on Menthol Cigarettes: Impact on Public Opinion and Smokers’ Intention to Quit,” finds that close to 35% of menthol smokers choose to quit and another 25% “find a way to buy a menthol brand.” If this is true, Altria could lose close to 1.3 million consumers in the event that the ban is implemented. In totality, the number of cigarette smokers in the U.S. could fall by about 7.5 million consumers (60% of the 12.5 million current menthol smokers). Assuming that an average customer smokes close to 16 cigarettes a day (derived by dividing total cigarettes sold and the number of consumers), we arrive at lost sales of around 44 billion cigarettes annually for the entire U.S. market. In fact, a study finds that menthol smokers, especially teenagers, smoke double the amount of cigarettes on an average in comparison to regular smokers. [3] In this case, the overall loss in cigarette sales may actually be even more pronounced.

Now consider the behavior of the remaining 5 million customers, of which Altria has close to a million. Given that Altria holds the U.S. number one non-menthol brand, Marlboro, we can expect a considerable number of those switching to regular cigarettes to adopt the brand. Let’s assume an almost 100% switching rate for Altria’s consumers, i.e. close to a million consumers that were earlier smoking Marlboro Menthol, now switch over to Marlboro. Of the remaining 4 million, let’s assume a 70% switch rate to Altria, i.e. close to 2.8 million consumers who were earlier smoking menthol brands under Reynolds, Lorillard, and others, now opt for Marlboro. Notice that this has actually increased Altria’s customer base by over 1.5 million consumers, i.e. a gain of 2.8 million customers from other tobacco companies, and a loss of 1.3 million customers to those who quit or resort to illicit means of procuring the product. If we continue to assume that each of these smokers smoke close to 16 cigarettes per day, the number of cigarettes sold by Altria could go up by approximately 8.7 billion annually, which translates into a 55% market share in smokable products from 50% presently. However, the overall loss from a shrinking U.S. cigarette market, leads to an approximate 14% downside to our current price estimate.

See our complete analysis for Altria in the scenario of a ban on menthol cigarettes in the U.S.

Some Limitations To The Analysis

Although it is guaranteed that tobacco players in the U.S. stand to lose from a ban on menthol, our analysis does not account for all sources of the loss. For instance, if menthol cigarettes are a vital tool through which tobacco companies build their brands among the youth to drive consumption going forward, the decline in the market size for cigarettes may become even more pronounced. Next, we have assumed a constant market share between Lorillard, Reynolds, and Altria in the menthol category, when, in fact, Lorillard’s Newport has been gaining share, while Altria’s Marlboro Menthol has been losing share. This could, in fact, mitigate some of the losses that Altria might face, although we still anticipate the reduction in the overall market size to outweigh the gains from higher market shares. Finally, though we anticipate the FDA to institute a ban eventually, it is unclear as to when the ban will be brought into effect. While our analysis looks at the impact on the present day American tobacco industry, the industry might undergo significant changes. For instance, after a year long scrutiny, the proposed acquisition of Lorillard by Reynolds was given FTC clearance this week, with the divestiture of four brands to Imperial Tobacco. Along with a 34% post-merger share in the market, Reynolds is poised to capitalize on the opportunity in the menthol realm with America’s favorite, Newport, in its portfolio. While the deal is currently awaiting approval from the federal district court in light of a “government racketeering case” that requires the companies to obtain formal approval before any divestitures, it could close as early as next month. In a situation that the deal is closed, leading Reynolds to gain prominence in the menthol market in a way that it manages to attract a higher proportion of new customers in the future, Altria may just stand to gain from a ban, as consumers of these brands increasingly switch over to Marlboro.

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is highly consolidated, with three main players dominating the industry, viz. Altria (NYSE:MO), Reynolds American(NYSE:RAI), and Lorillard (NYSE:LO).  Of these, Altria takes the leading position, with close to 47% of the market in smokable tobacco and 55% of the market in smokeless tobacco.

Notes:
  1. Why the FDA might ban Menthol Cigarettes []
  2. Reynolds American, Lorillard Shareholders OK Merger []
  3. Menthol cigarettes increases smoking in teens: Study []