Altria In The Post-Merger World

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The U.S. tobacco industry has undergone changes off late, the most significant being the much talked about merger between Reynolds American and Lorillard. This merger, which was completed in June 2015, is an important development for the American tobacco industry predominantly because of the degree of consolidation it brings. In particular, the industry was already highly consolidated, with the top 3 players accounting for over 85% of the market. With this merger, which involves players that represented the no.2 and no.3 spots, the degree of consolidation in the industry has intensified further, with the top three players now accounting for over 90% of the market. Before the merger was given regulatory clearance, we analyzed what impact this merger could have on industry leader, Altria (NYSE:MO). (See: What Does The Reynolds-Lorillard Deal Mean For Altria) A few months into the merger getting regulatory clearance, let’s look at how things have panned out so far.

Our first hypothesis was that Altria would face tougher competition, particularly in the menthol category. This is because the new Reynolds would have America’s top menthol brand, Newport, in their portfolio. Apart from this, Reynolds’ own Camel brand holds the no.3 position in the menthol market. In this case, combining forces could give Reynolds an advantage in terms of production, distribution, branding, and even pricing, which could, in turn, impact future prospects for Altria’s menthol offerings. So let’s look at whether this has actually panned out this way, so far.

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Altria reports data for Marlboro as one brand, and does not report sales for the menthol brand in isolation. Shipment volumes for Marlboro in Q3 underwent a 1.1% increase year-on-year, as opposed to volume declines in the previous two years. This could indicate that the Reynolds-Lorillard merger has exerted little impact on Marlboro sales. However, the increase in this year could have been a consequence of a moderation in industry wide declines in general. This could mean that the shipment increases observed this year may just have been more pronounced had competition not intensified against the merger. Furthermore, Marlboro’s non-menthol offerings find a much wider audience in the U.S.  In this case, even a drop in menthol sales against the recent merger could have been offset by higher non-menthol sales.

Next, we said that the combination could exert pricing power since technically there are fewer players competing in the market. This could, in fact, prove to be an advantage for Altria since they could also enjoy a higher pricing power. However, on the flipside, Altria is technically competing with a larger entity who could be a higher threat to their competitive standing. In this case, they may have to exert caution when it comes to instituting price hikes to avoid losing customers to the new Reynolds. Furthermore, the combination is bound to realize cost savings in terms of production, distribution, branding, and marketing. At some point, they could choose to pass on these cost savings to customers in the form of lower prices, or at least in the form of a slower increase in prices. So, let us look at what has actualized up until now.

Let’s start with the Reynolds-Lorillard combination. In the beginning of the year, Reynolds instituted a $0.07 per pack increase, and further resorted to price hikes to garner sales, according to the company’s third quarter earnings call. Altria has also resorted to price hikes, with the company increasing prices by $0.07 per pack across all brands, as well. Price hikes of this magnitude have been instituted in previous years, too.  Hence, for the time being, it seems like the higher degree of consolidation in the industry has, in fact, given big tobacco players a higher pricing power that they are continuing to use to their advantage. However, economies of scale could be realized in the medium to long term, in which case, Reynolds could resort to a moderation in price increases to garner share. If this happens, it could limit Altria’s ability to push up prices to steer revenues, as well.

Last, but not the least, the Reynolds merger is mostly about menthol. With Lorillard’s Newport, the company’s main focus is on championing the menthol space. In that, the company said that they would introduce new styles of the Newport brand, along with hiring Lorillard’s sales head to steer further share gains. The company, in particular, hopes to drive the brand on the East Coast, where it has little presence currently. Furthermore, it hopes to combine forces when it comes to distribution and marketing, to drive sales for all three key brands – Camel, Pall Mall, and Newport.

Now, Altria’s prime focus is the non-menthol space, which the company currently champions with its star brand, Marlboro. Although not of prime importance, Altria has been increasingly innovating to capture audience in the menthol realm, as well. The company’s latest innovation, Marlboro Midnight, is testament to this. However, the very fact that Altria has a bigger presence in non-menthol gives them an edge.  In general, while cigarettes may never find themselves being banned, the added usage of menthol could. In fact, regulatory authorities have already been probing whether the addition of menthol promotes initiation and addiction. Earlier, a law was passed, which banned all other flavor additives, with the exception of menthol. Now, if this law is actually extended to menthol offerings as well, Altria could be better positioned to deal with this than Reynolds.

In conclusion, looking at initial data from operations after the big merger in the tobacco space, it seems like little has changed for Altria. In particular, volumes seem to have grown, and their pricing strategies have not undergone a change in response. However, both these impacts could be a consequence of better industry conditions, rather than Altria being immune to a change in the competitive landscape. In the medium to long term, things could pan out differently, in the sense that the larger conglomerate at the No.2 position in the industry now, could alter Altria’s strategies going forward.

We have a price estimate of roughly $60 for the Altria Group, which is slightly above the current market price.

See Our Complete Analysis For Altria

Sources:

  1. Altria Form 10-Q, SEC
  2. Reynolds American Form 10-Q, SEC
  3. Reynolds American (RAI) Susan M. Cameron on Q3 2015 Results – Earnings Call Transcript
  4. Altria Group (MO) Martin J. Barrington on Q3 2015 Results – Earnings Call Transcript
  5. Reynolds American: A First Look After the Lorillard Merger

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