National governments in Europe and overseas are clamping down on smoking, both as a public health policy and to raise tax revenues. Bans on smoking in public places, restrictions on tobacco marketing, and rising excise taxes are causing headaches for tobacco manufacturers around the globe. The extent to which restrictions will be implemented is not yet known, and in this report we examine some of the proposals on the table. We conclude that several of these measures may not lead to the material consumption declines that their proponents expect, and that for those manufacturers with the strongest brand equity and the broadest portfolios, increasing regulation could create opportunities to stabilise market share.
Marketing Restrictions Tightening
Tobacco manufacturers are severely restricted in their ability to market products, particularly in developed economies, where advertising in most forms is prohibited, and several countries have plans to further restrict tobacco marketing. One proposal includes a ban on cigarette displays in stores, a measure already in place in Finland. If implemented, the prohibition of in-store displays would remove one of the last remaining opportunities that manufacturers have of communicating with smokers, but we do not expect it to lead to significant volume declines. In fact, it may lead smokers to smoke their favourite brands more consistently, particularly if in-store pricing displays are also banned. This would, in our view, set current market shares in stone, which would be a positive for market leaders Altria, British American Tobacco and Philip Morris International.
A ban on in- and near-store pricing displays is likely to favour manufacturers of premium brand cigarettes, in our opinion. "Pulse" promotions (temporary price discounts implemented to gain market share), a strategy recently employed by Reynolds American on its Pall Mall discount brand, would be far less effective. As a result, we think this would lead to more rational industry pricing. Trading down would become less of a threat during an economic downturn, and it will become easier to steadily increase prices without causing sticker shock to consumers.
A restriction being considered in the UK is the enforcement of plain packaging. Under the proposal, brand logos would be banned and packs would be a generic colour. We doubt that such a measure would achieve its goal of reducing consumption, but we do think it may encourage trading down. Packaging is an important--and one of the only--methods that manufacturers have at their disposal to communicate with smokers, and they invest heavily in pack design (for example, Reynolds employed clothing and tattoo designers to create Camel packs). If manufacturers were no longer able to use the appearance of their product packs to appeal to their target market, we think smokers may switch to cheaper brands, but we doubt it will persuade them to quit. The primary beneficiaries could be Imperial Tobacco in the UK market and Reynolds American internationally. Imperial has a solid portfolio of discount brands and dominates the roll-your-own loose tobacco category. The losers would be firms with a product portfolio skewed to premium brands--Altria and Philip Morris International.
Taxes on the Rise
In 2009, the federal excise tax on cigarettes was increased by 158% to $1.01 per pack in the US, with similar increases on smokeless products and cigars. In 2010, 13 states have proposals to raise the state excise tax as they attempt to close gaps in their budgets. In international markets, the outlook is no less challenging, with tax hikes likely to occur this year in several markets. Although Greece, Romania, Turkey, and the United Arab Emirates are all likely to impose disruptive price increases in 2010, we expect most countries to raise taxes in a way that is not too disruptive and on an ad valorem basis, which is likely to limit consumption declines. Price shocks from tax increases can cause unintended harm, including an increase in counterfeit trade, particularly in markets that share a border with another market that has lower taxes. In Canada, where excise taxes have been higher than those in the US, one third of all cigarettes smoked are counterfeit or contraband. In Germany, where tobacco taxes are the fourth-highest in Europe, the number of untaxed cigarettes has grown from 16% in 2005 to 20% in 2008 and is still rising. According to DZV, the German cigarette association, this costs the government EUR 4 billion (£3.4 billion) in annual tax revenue.
As taxes rise, downtrading is a risk, and we think that those companies with portfolios that include a strong presence in discount categories will cope best with the challenges. British American's volume is spread roughly equally over premium, midpriced, and discount brands, and we think this allows the firm to take advantage of the long-term migration toward more expensive products in emerging markets in Eastern Europe and to hedge against downtrading in more mature markets.
Menthol Under the Spotlight
In the US, tobacco regulation now falls under the remit of the Food and Drug Administration. One of the first tasks the FDA has undertaken is a review of the menthol category, which represents approximately 30% of the domestic industry. Antismoking campaigners have argued that menthol can be used to target a younger audience, and that menthol tobacco is more damaging to health than nonmenthol products. The panel's findings will be released in the second half of 2010. If evidence of either is produced by the panel (which contains a majority of antismoking representatives) further restrictions on menthol may be implemented. We doubt the panel will implement an outright ban because the $20 billion category is a money-spinner for federal and state governments. In addition, this is a racially charged issue. Menthol brands are smoked by 75% of African-American smokers in the US, and we doubt that the FDA would be willing to anger a key voting group, particularly with midterm elections looming later this year.
Lorillard has the most to lose from a clampdown on menthol, and we recommend that investors take a wait-and-see approach to the outcome of the FDA review before taking the plunge. With that said, Lorillard's flagship brand, Newport, possesses very strong brand equity, and the firm has outperformed its peers for several consecutive quarters, despite Newport's premium pricing. An overreaction by the market to menthol regulation may provide an attractive entry point later this year.
Tobacco Industry Fairly Valued
Given the challenges ahead, we think the tobacco manufacturers on our coverage list are fairly valued. With Altria's and British American Tobacco's dividends yielding almost 7%, and Philip Morris International's yielding 5%, investors looking for investments in high-yield companies with competitive advantages should take a look at the tobacco space. However, investing in tobacco stocks is not for the faint-hearted, and having the stomach for "fat-tail" risk--the risk that a significant but low-probability event could materially damage profitability--is a requirement.
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