Big Developments And Big Tobacco: A Take On Volumes And Prices

The U.S. tobacco industry, in general, has some broad characteristic features, the most prominent ones being declining volumes, and increasing prices. However, the industry has had significant developments this year, which could have major implications for these characteristic features. In this article, we focus on two major developments in the U.S., with which we assess the future of big tobacco companies, such as Altria (NYSE:MO).

So what are the big developments?

First, are the macroeconomic fundamentals in the U.S.  Since the recession, the U.S. pursued unconventional monetary policy to prop up the economy back to former levels. To a large extent, this has worked. While GDP continued to grow at ~2-3% per year since the recession, unemployment levels continued to trend downwards to hit record lows of ~5%. And to steer the economy further, oil prices continued to plummet, almost halving in price from over $100 per barrel to about $50 per barrel. Now, traditionally, tobacco consumption is considered to be acyclical to business cycle fluctuations — i.e. people do not adjust consumption in line with changes in the business cycle. While this secures tobacco names from downturns, one would not expect it to support their business during upturns as well. However, contrary to this, the recent improvements in the U.S. have actually translated into favorable trends. According to data by the Alcohol and Tobacco Tax and Trade Bureau, the first half of this year has actually seen an increase in cigarette shipments, which many analysts attribute to cash freed up from oil savings. If this trend continues, going into the rest of the year, 2015 would mark the first year when cigarette shipments increased in almost a decade.

Source: Alcohol and Tobacco Tax and Trade Bureau

Next, earlier this year, a merger involving two of America’s biggest tobacco names, Reynolds American (No.2) and Lorillard (No.3) was given regulatory clearance. There are two broad implications for Altria from this deal.  The first is that the post merger entity is expected to form a stronger competitive force against Altria with 34% of the market, which could further increase as the combination realizes economies of scale occurring from the deal. The second is that the combination is expected to have a clear win in the menthol category, with Lorillard’s Newport (America’s No.1 menthol cigarette) and Reynolds’ Camel (America’s No.3 menthol cigarette) in their portfolio.  Furthermore, in the larger scheme of things, this big merger has significantly altered the dynamics in the U.S. tobacco industry. For one, the degree of consolidation in the industry has increased, with the top three firms now accounting for 91% of the market, in contrast to 87.6% pre-merger.

Some Implications On Volumes and Pricing

Now, let’s look at what implications these two developments could have for the age old trends that Altria has been facing. In particular, we analyze the implications of these developments on volumes, and pricing.

Let’s start with volumes. Clearly, with stronger macroeconomic fundamentals, there has been a large degree of moderation in industry decline rates. However, how long will this last? If this development is a consequence of oil savings as analysts speculate, then this trend should last as long as the price of oil remains low. As per the U.S. Energy Information Administration, oil prices are expected to average out at $49.53 and $53.57 for WTI Crude oil, and $53.96 and $58.57 for Brent, in 2015 and 2016, respectively. Given that oil prices are not expected to undergo a significant change in the near term, one might expect tobacco houses to continue reaping benefits.

However, it may not be entirely accurate to underestimate how inelastic the demand for tobacco can be. For one, the higher cigarette shipments observed so far may have just come from a more drastic decline in other tobacco products. Furthermore, even if existing cigarette smokers are smoking more, or if the numbers of new smokers entering the market have undergone an increase, it may not be entirely accurate to presume that this trend would hold over the next year or two. This is simply because, tobacco products fall under the category of normal necessities, where to a certain extent higher income could translate into higher consumption. However, beyond a point, this could just plateau. Furthermore, extraneous factors such as health consequences and regulation could very well catch up to reverse this temporary upswing in cigarette shipments. Hence, we believe that even if cigarette shipments do undergo an increase in this year, there is no concrete reason as of now to believe that volumes will undergo an increase  over the ensuing years.

Next, let’s look at pricing. As mentioned earlier, tobacco prices have consistently undergone increases in almost every quarter over the past few years. This has occurred primarily to maintain profitability, as volumes continued to decline, and anti-tobacco regulations continued to intensify. However, recent developments could very well have implications on pricing, specifically for Altria.

On the one hand, after the Reynolds-Lorillard merger, a stronger firm now takes the No.2 spot in the market. Furthermore, the post merger Reynolds is bound to realize major efficiency gains in production, distribution, and marketing, which could translate into major cost savings for them. Now, if the combination chooses to pass these cost savings to customers in the form of lower prices, or even a slower increase in prices, Altria’s competitive standing could be impacted. This could, in turn, encourage Altria to revise their standing on prices, to reduce the overall increase in industry wide prices otherwise anticipated. However, on the other hand, the merger has increased the degree of consolidation in the industry. As the number of players in the industry has been reduced, consumers have fewer alternatives to choose from. This, in turn, could give a player like Altria a higher degree of pricing power. In this case, the increase in prices could be further exacerbated. So far, data shows little evidence of any price decline. For instance, in 2015, Altria has already instituted a $0.70 per pack price hike across all of its brands. Even over the last year, Altria instituted a price hike of a similar magnitude, first at the beginning of the year and then towards the end. Hence, so far, neither the merger nor the moderation in industry shipment declines has prompted Altria to drag down prices. Moreover, we believe that Altria could continue exploiting the relative inelasticity of demand that customers display to continue charging higher prices.

In conclusion, in spite of the recent developments in the U.S. tobacco industry, we anticipate little change in volumes and pricing to persist in the long term. While volumes could see an upside in the short-term, this trend could plateau beyond a point, even if the contributing factors persist. Pricing, on the other hand, could undergo little or no change in both the short and the long run.

We have a price estimate of roughly $60 for the Altria Group, which is almost in line with the current market price.

See Our Complete Analysis For Altria

Sources:

1. Lower gas prices a form of stimulus for cigarettes, gambling, and alcohol
2. Statistical Report – Tobacco
3. Reynolds American, Lorillard Shareholders OK Merger
4. Reynolds American Bets on Menthol Cigarette Brands
5. Altria Form 10-K, SEC
6. Altria Form 10-Q, SEC

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