Altria: A Windfall Gain From Cheaper Oil?

Tobacco stocks are often called defensive stocks in that, they are slower to respond to business cycle fluctuations. More often than not, this is considered to be an asset since it makes the industry resilient to economic downturns. While this is true, it also makes tobacco companies respond less to upturn situations, as well. However, contrary to popular belief, the recent increase in disposable incomes in light of oil savings seems to have elicited a positive impact on tobacco consumption. In this article we first highlight the consumption patterns of Americans in response to lower oil prices. Then we go on to explore the impact of this phenomenon on the tobacco industry. Finally, we look at the implications for U.S. tobacco conglomerate Altria (NYSE:MO), along with what a reversal in oil prices could mean for the company’s future prospects.

HAVE OIL SAVINGS TRANSLATED INTO HIGHER CONSUMPTION?

In recent times, the price of oil has nearly halved, from costing over $100 per barrel to approximately $50 per barrel. Apart from the low cost of the fuel, the mere increase in disposable incomes of Americans was expected to steer economic growth in the U.S. However, this did not seem to happen. For starters, look at the graph below, which compares the decline in oil prices and that in consumer spending. Consumer spending figures have hovered around $90 each month, and there seems to be no significant change to these figures even as oil prices continued to trend downwards. Only the months of November and December saw a jump in consumer spending, however, this could simply be a consequence of the holiday season rather than declining oil prices.

Figure 1: Data for Brent spot prices have been taken from U.S. Energy Information Administration, data for average daily consumer spending has been taken from Statista.

WHAT DO STUDIES SAY? 

Empirical studies that try to estimate America’s propensity to save and spend their oil savings have presented somewhat mixed results. According to one report by CNN, the typical American household is expected to save close to $750 this year from cheaper oil, however, the report also suggests that little of these savings have actually been spent. While some attribute the downturn in consumer spending in Q1 2015 to a harsh winter, others believe that Americans are using the extra money from oil savings to pay off debts incurred previously. In fact, Americans could very well be behaving in tandem with Milton Friedman’s Permanent Income Hypothesis, which essentially says that individuals will spend money at a level that is in sync with their expected long-term average income. Hence, Americans may just not expect oil prices in the long term to remain at ~$50 per barrel. In this case, they view the current increase in disposable incomes to merely be a temporary phenomenon. A government publication in April 29 of this year, found that the personal savings rate increased by 0.9 percentage point in Q1, which is described as “an unusually large increase that is at the 90th percentile of historic increases.”

However, a few months later, another report was released which revealed another side to the story. According to research by JPMorgan Chase Institute, which analyzed spending by 25 million people, households spent as much as 80% of their windfall from oil savings. The report suggested that spending on a number of categories such as dining out, entertainment, electronics, and appliances, all underwent an increase. However, recent data by the Alcohol and Tobacco Tax and Trade Bureau seems to show one other category that gained from oil savings — cigarettes.

ARE CIGARETTE VOLUMES ACTUALLY INCREASING?

Tobacco products are classified as normal necessities in economic terminology, since the income elasticity for the product is positive and less than one. According to research by the World Health Organization, income elasticity for tobacco demand ranged between 0.23 to 0.59 for most countries. In particular, an income elasticity of 0.20 indicates that a 10% increase in income would increase demand by 2%. Given this, one would expect the gains from oil savings to exert little impact on consumption, particularly in a developed nation such as the U.S. However, a first look at the data seems to defy this prediction.

As per the Alcohol and Tobacco Tax and Trade Bureau (TTB), shipment volumes for tobacco products have undergone an increase in the first half of the year — with cigarette shipments increasing 2.2%. Typically, cigarette volumes have been following a declining trend, with volumes falling at about 2-5% annually. In this case, this data goes beyond what anyone would have expected, in the sense that it does not show a slower pace of decline but actually shows an increase. Now, if this trend continues going into the rest of the year, 2015 will be the first year with volume growth in about a decade.

However, a closer look at data also presents one more explanation. For one, the increase in shipments was observed only in cigarettes and snuffs, while other tobacco categories such as cigars, chewing tobacco, pipe tobacco, and roll-your-own tobacco all showed declines. Furthermore, if one compares the year-on-year change between data released in July 2015 and that in July 2014, the decline in other tobacco categories are more pronounced this year (See Figure). In this case, individuals could be trading up to cigarettes from the other alternatives, in light of the oil savings.

Source: Alcohol and Tobacco Tax and Trade Bureau

FUTURE PROSPECTS FOR ALTRIA

Now what implications does this have for Altria? In short, this can only be a positive development for tobacco players. However, future prospects could be altered depending on what the underlying contributing factors are. For instance, if the current increase in cigarette shipments is a consequence of the average American smoking more, or the number of new entrants increasing, the positive impact from higher volumes could stick for a longer time. This is because, given the addictive nature of the product, it may become harder for existing smokers or new smokers to cut back almost instantly, even if oil prices go back to prior levels to exert a strain on finances. At best, a proportion of smokers might down-trade to roll-your-own options. However, on the other hand, if the increase in cigarette shipments, is a consequence of existing tobacco users in other categories moving in to cigarettes, they might almost instantly down-trade back to roll-your-own or chewing tobacco options, once they feel the strain of tighter finances. Having said this, however, there is hardly any prospects for a loss here. This is predominantly because Altria has been historically accustomed to functioning in a declining market. Hence, in this situation, their biggest tools have been pricing and innovations. Thus, even if this sudden increase in shipments is almost entirely reversed, Altria could simply go back to pursuing the strategies that they have already been using, to continue steering revenues. In this case, the increase in cigarette shipments from any oil savings, could be nothing more than a windfall gain for Altria.

We have a $56 price estimate for the Altria Group, which is below the current market price.

See Our Complete Analysis For Altria

Sources:

1. Americans spend majority of money saved at petrol pump
2. Advance Estimates of GDP for the First Quarter of 2015
3. Cheap gas is saving Americans $750. So far, they aren’t spending it
4. Saving Big on Energy Bills, People Take It to the Bank
   
5. Estimating Price and Income Elasticity of Demand
6. Lower gas prices a form of stimulus for cigarettes, gambling, and alcohol
7. Statistical Report – Tobacco

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