Tobacco profits unlikely to be stubbed out soon
Many of its customers are gone, it has lost the glamorous image and the still loyal users run the risk of developing health problems. Yet it’s still among the most profitable industries.
Big Tobacco proved this week it’s still a big player. Reynolds American Inc.’ s proposed US$27-billion acquisition of Newport cigarette maker Lorillard Inc. is designed to position the company to compete with the Marlboro brand in the growing market for menthol cigarettes.
Despite decades of negative factors that would likely spell the end of any other industry, international tobacco companies are raking in cash and staking their territory in the battle for market share.
In Canada, smoking rates have plateaued at about 16% of the adult population, a huge drop from the late 1960s, when about half of Canadian adults smoked. Only 5% of adult Canadian smokers use menthols, but about one-third of Canadian youth who pick up the habit are choosing the milder, minty cigarettes — a trend the tobacco industry is watching closely.
“We could be seeing the beginning of a real bulge in that trend,” said David Hammond, a co-author of the University of Waterloo’s annual Tobacco Use in Canada report. “It really is a trend and a growth area for the international industry.”
The cigarette business in Canada is dominated by three multinational companies — British American Tobacco PLC, Philip Morris International Inc. and Japan Tobacco International. It’s easy to see why smoking is still big business — Canada’s 4.6 million smokers have about 15 cigarettes per day, statistics show, adding up to trillions of cigarettes sold every year.
British American’s wholly owned subsidiary Imperial Tobacco Canada controls about half the Canadian market, with brands including du Maurier, Player’s and Peter Jackson. British American has a major stake in the proposed Reynolds-Lorillard merger as Reynolds’ largest shareholder, agreeing to pay US$4.7-billion to maintain its 42% stake under the terms of the deal.
Philip Gorham, an analyst with Morningstar who covers Philip Morris and British American Tobacco, said cigarette companies have an advantage allowing them to continue to profit despite a shrinking customer base and strict regulations. Economists call that advantage low price elasticity — or in layman’s terms, the fact that people addicted to smoking will keep buying cigarettes even if companies jack up the price.
“People tend to focus on the decline in consumption, which is fair, but what offsets that in terms of profits is their ability to raise prices,” Mr. Gorham said.
Big international tobacco firms have 40% earnings before interest and tax margins, he said. “Which is huge, quite rare across the consumer space. They still have scale, they still have pricing power and they’re still highly profitable.”
Mr. Gorham said government restrictions on tobacco marketing and packaging have some unintended positive effects for the industry. In countries such as Canada, where tobacco companies are all but completely banned from advertising, they can lock in their customers without worrying about other brands poaching them through advertising.
“It stabilizes market share,” Mr. Gorham said. “And, by the way, saves them a few bucks on advertising as well.”
E-cigarettes and proposed bans on flavoured tobacco remain threats to the industry’s profitability. Alberta has banned all flavoured tobacco, although it’s subject to amendments that could exempt menthol.
Evie Eshpeter, a public policy analyst in Alberta with the Canadian Cancer Society, said her organiza- tion is watching the menthol trend among youth closely. She said CCS pushed for the Alberta bill because she thinks it has the potential to have a serious impact on smoking rates.
“Some of those youth smokers will just transfer to regular tobacco, for sure,” Ms. Eshpeter said. “But I think a significant proportion of youth will not pick up tobacco and a significant portion will quit because they don’t have that option any longer.”
With the acquisition of Lorillard, Reynolds is betting against similar proposed menthol restrictions in the U.S. Mr. Gorham at Morningstar said such a ban is unlikely in the U.S. or elsewhere because it would risk a backlash from key voter demographics who are more likely to smoke menthols — particularly black Americans.
“When it’s concentrated in a certain demographic like that, be it colour or age or gender or whatever it is, you risk alienating a certain electoral block,” Mr. Gorham said. “That makes it more complicated.”