Philip Morris’ Potential Downside From The EU’s Illegal Cigarette Trade

The European Union (EU) contributes ~28% to Philip Morris International’s (NYSE:PM) consolidated net revenues and is the most profitable division of the company with adjusted EBIDTA margins of over 50%. The division contributes over 25% to the company’s total value by our estimates.

However, Philip Morris’ EU operations have been under pressure over the past few years due to the growing presence of illegally traded cigarettes in the region amid weak macroeconomic conditions and a difficult regulatory environment for tobacco products. Here we take a look at the potential downside to the company’s valuation from sustained weakness in the EU cigarettes market.

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Illegal Trade

Illegal cigarette trading is a huge concern for the local governments as well as cigarette manufacturers in the EU. Its growing prevalence has been exaggerating the decline in tax-paid cigarette consumption in the region. The tax-paid cigarette market has declined by ~20% in volume over the past five years while overall cigarette consumption in the EU has declined by ~17%. This is primarily because illegally traded cigarettes volumes grew by ~8% to 65 billion units over the same period. We estimate the number of illegal traded cigarettes by using our estimates for the market share and shipment volume data and then apply the amount of illicit trade as estimated by the European Commission. ^[1]

More importantly, the trend has worsened over the recent years due to excise tax hikes and high unemployment rates that are driving consumers towards cheaper cigarettes. As a result, cigarette manufacturers have been reporting sharp declines in shipment volumes. Philip Morris’ shipment volume in the EU dipped by ~8% y-o-y for the first six months of this year despite being able to maintain its market share leadership in the region.

The EU recently announced a strategy to step up its fight against illegal trading of cigarettes on widening revenue losses. According to the European Anti-Fraud Office (OLAF), unpaid custom duties and taxes amount to annual losses of over EUR 10 billion to the EU and its member states. The union plans to curb the growing illegal trade by reducing disparities in excise taxes across member states, strengthening its regulatory authorities and increasing the security of its supply chain along with imposing heavier sanctions on smuggling activities. We will be closely watching the impact of these measures on tax-paid cigarette volumes in the EU over the coming years. ^[2]

Other Issues

Apart from the growing illegal trade of cigarettes in the EU, rising excise taxes, high unemployment rates and shifting consumer preferences towards other tobacco products have also been dragging down the total consumption of cigarettes. The regulatory environment may even get worse for cigarette manufacturers as the EU plans to ban menthol and other flavored cigarettes and force manufacturers to increase the proportion of graphic warnings on cigarette packs to discourage smokers. A potential ban on “slim” cigarettes that are popular among women smokers is also under consideration.

The implementation of these regulations can have a huge impact on the overall market as the menthol and slim categories make up ~11% of the total cigarette consumption in the EU. ^[3] Moreover, according to a research conducted by the Department of Health and Aging of the Australian government, graphic warnings on cigarette packs are not only effective in communicating the adverse health effects of smoking and improving consumer knowledge as a result, but are also helpful in discouraging the uptake of smoking and preventing relapse as well. ^[4]

Potential Impact

We currently expect total tax-paid cigarette volumes in the EU to decline to ~400 billion units by the end of our forecast period from ~520 billion in 2012, which implies a CAGR of just over -3%. In the chart below, we show a moderate rate of decline in the long run as the latest measures announced by the EU commission to curb illegal trading are expected to increase the proportion of tax-paid cigarettes consumed in the region. However, if illegal cigarettes trading continues to flourish and the planned regulatory measures aimed at reducing overall cigarette consumption are implemented across member states, we could see downside to our estimates. In a scenario where the average rate of decline reaches 6% annually in the long run similar to the decline in the last three years, the market of tax-paid cigarettes in the EU could fall to ~300 billion units in our forecast period and imply ~10% downside to our current $87 price estimate for Philip Morris.

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1. Stepping up the fight against cigarette smuggling and other forms of illicit trade in tobacco products – A comprehensive EU Strategy, European Commission, June 6, 2013 [↩]
2. Stepping up the fight against cigarette smuggling and other forms of illicit trade in tobacco products – A comprehensive EU Strategy, European Commission, June 6, 2013 [↩]
3. Cigarette Bans to Hit Europe, wsj.com [↩]
4. Evaluation of the Effectiveness of the Graphic Health Warnings on Tobacco Product Packaging 2008, health.gov.au [↩]