The Future of the Giant Cigarette Makers

March 13th, 2015 00:00

Altria and Reynolds American, which will shortly purchase Lorillard, are considered the two largest cigarette manufacturers in the United States.

The complications that both companies are dealing with are well known, the number of American smokers has dropped from about 42% in 1965 to 18% in 2012, based on the Surgeon General's Report on Smoking and Health. Due to this downsizing market, both enterprises reduced jobs, increased prices, and extended into non-cigarette product categories in order to guard their bottom lines. Yet will that fragile balancing act be maintainable during the coming 10 years? Let us look at a number of possible downfalls and factors that could shape the future of both tobacco leaders.

Altria and Reynolds American often increase their prices in order to compensate the decreasing cigarette shipment volumes. Pessimistic arguments against both companies generally mean that increasing prices were boosted by larger excise taxes, and will eventually strike a ceiling and result in income decline.

That argument originally is wise when we examine the price of cigarettes in the U.S. to other countries. 40% of adults smokers in Russia, where a package of cigarettes is available at about $1.74 with taxes included. In contrast, 18% of adults smokers in the U.S., where a regular cigarette package costs $6.36. When we evaluate the price of cigarettes as a percentage of regular monthly revenue, the common Russian spends about 0.17% on one cigarette package, in comparison with the 0.14% for the average American. At the same time, smokers in the U.K. pay $10.99 for a cigarette package; still the country has a bigger smoking rate of around 19%. In Australia, where a package costs $12.14, 17.5% of adults still light up. These evaluations suggest that Altria and Reynolds American can most likely easily afford to practically double their U.S. prices within the next 10 years without any apparent effect on smoking rates.

Local cigarette manufacturers could preserve pricing power for years to come, however changes in cultural perceptions and excise taxes outpacing price boosts could result in shipments to drop faster than predicted. For the moment, investors need to pay attention to Altria and Reynolds' expansions into non-smoking field. If constant progress in these businesses compensates a collapse in cigarette shipments, both stocks will be worth keeping. However once price increases fail to compensate earnings declines, it could be time to look somewhere else for large returns.

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