Are Tobacco Houses On Their Way To Hitting A Tipping Point Anytime Soon?

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Tobacco stocks are often called “defensive stocks,” in that they tend to pay reasonable dividends irrespective of business cycle fluctuations. Historically, the tobacco business is considered to be one that generates a lot of cash, which is used to fund costs and to reward shareholders with high returns through repurchases, as well as nice dividends. But with declining smoking rates, and increasing pressure from regulatory authorities and health advocates, questions regarding the sustainability of the industry arises. In other words, is this billion dollar industry headed for trouble any time soon? Here’s is an in depth discussion on the sustainability and future prospects of this business, in the context of both developed and developing markets.

Contrary to the situation now, the U.S. tobacco industry was actually a growing one until about 1970, where tobacco makers were winning on volumes rather than prices. However, increasing awareness regarding the ill-effects of smoking, tighter regulation to reduce smoking rates, and the introduction of nicotine replacement products such as patches, gum, and lozenges started a change in this trend. With this, a downward movement in tobacco consumption began in the U.S., from which the industry never recovered. Furthermore, a recovery does not seem to be in the cards in the near future as the regulatory crackdown on tobacco products only seems to intensify.

However, the story is different for other countries across Europe, Asia, Latin America, and Africa. According to a report by the Institute for Health Metrics and Evaluation, efforts at reducing global smoking prevalence has shown three phases — “Modest” increase in reductions between 1980 and 1996, more “rapid progress” over the next ten years, followed by a slower rate of “reduction” from 2006 onwards. [1] This reduction in smoking rates after 2006 was on account of an increase in the number of smokers in countries such as Bangladesh, China, Indonesia, and Russia. While this could bode well for tobacco houses, there is hardly any reason to believe that the stories in these growing markets will not mirror that in the U.S.  In fact, the stage is already being set for market declines in countries like Russia, where tighter legislations in packaging and labeling will come into effect as early as 2016. [2] Does this indicate doom for tobacco houses such as Philip Morris (NYSE:PM) ?  Clearly, having operations across diverse geographical regions could be advantageous since it helps hedge against risks associated with any particular market. But what happens when all geographical regions start displaying the same declining trend?

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Looking at the U.S., tobacco companies have used one major tool to deal with declining volumes, which is price hikes. Let’s look at Altria (NYSE:MO), for instance. While smokable product volumes have undergone an approximate 16% decline between 2009 and 2014, the company has managed to maintain or clock in modest revenue gains, which was predominantly driven by a 23% increase in prices. And this strategy works to a large extent for tobacco companies, given the addictive nature of the product that they make.

Alt

But can this go on forever? Probably not. For one, even if price hikes manage to hold on to existing smokers who are hooked on the product, it might make the activity too expensive to attract new consumers. The U.S. is already showing evidence of this, where the percentage of high school students smoking tobacco has consistently declined since 1997, dropping from 36% in 1997 down to only 16% in 2013,  a 22-year low. [3] Furthermore, price hikes may not go down well in developing nations since they tend to be more sensitive to such changes. According to a study titled “Tobacco Control in Developing Nations,” the price elasticity of tobacco demand in emerging markets is estimated at 8%, i.e. a 10% increase in tobacco prices would result in an 8% decline in demand in developing nations, as opposed to a 4% decline in developed nations. [4] In this case, it may become harder for names like Philip Morris to maintain revenues using price hikes, since this could, in fact, exert a larger impact on volumes in emerging markets.

While these factors go on to show that a tipping point is inevitable for this industry, it may be a very long time before these names actually reach that stage. For one, a number of growing economies that currently present opportunity, will probably take a long time to reach the stage that the U.S. has, in terms of volumes.  According to the WHO, while smoking rates have, in general, been declining in developed countries, it has actually been growing in developing countries, which now represent close to 80% of the 1 billion smokers in the world, and this figure is expected to grow further. [5] Furthermore, for many developing countries where incidence of smoking is increasing, the GDP of the country may even be too low to fight the kind of regulatory battles against conglomerates like Philip Morris, to bring any anti-smoking legislations into effect. In a situation where a country’s annual GDP is lower than Philip Morris’ yearly profits,  it may be a long while before it can actually gear up to pay the heavy price in an attempt to curb smoking. [6]

Second, even in developed nations tobacco houses have resorted to innovations in the form of e-cigarettes and Reduced Risk Products (RRP) to mitigate losses from industry declines. While it may seem to be presumptuous to say that these innovations could completely compensate for the losses coming in from industry declines in cigarettes, they could definitely offset a part of the losses. In this case, these products could be a very useful tool for “damage control” in the industry.

Finally, tobacco houses will continue to possess a strong level of pricing power, based on the addictive nature of the product they sell. While fluctuations in demand, in response to price, may differ in degree across developing and developed markets, there is no contention to the fact that tobacco demand is price inelastic, i.e. for any given change in price, demand undergoes a smaller change. Furthermore, even as the price of cigarettes increase, so has the purchasing power of people.  In this case, tobacco companies could continue to take advantage of the addictive property of cigarettes to continue driving revenues, at least in the medium term.

In conclusion, although industry dynamics do not look very favorable for tobacco houses, they have a number of tools up their sleeve that could ensure steady revenues for these companies, namely pricing and innovation. While the industry could face declines, in the sense that the number of consumers leaving the market might exceed the number of smokers joining the market at some point, it could be a long while before this trend actually picks up on a global scale, to impact overall industry profitability. For the short to medium run, tobacco stocks could continue being the cash cows that they have historically been  known to be,  and to continue returning huge dividends to their shareholders.

We have a price estimate for Philip Morris’ stock price of around $82, which is slightly lower than the current market price.

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Notes:
  1. Despite declines in smoking rates, number of smokers and cigarettes rises []
  2. Russia, Tobacco Control Laws []
  3. Current cigarette smoking among high school students lowest in 22 years []
  4. Price elasticity of demand for tobacco products []
  5. Tobacco – Fact Sheet []
  6. How Big Tobacco Went To War With A Tiny Country []